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Don Valentine: Venture Capital, Market Changes, and Ethical Questions

Don Valentine founded Sequoia Capital (http://www.sequoiacap.com/) in 1972, one of the leading venture capital firms in Silicon Valley. They were among the original investors in Apple Computer, Atari, LSI Logic, Oracle, and Electronic Arts. Valentine is currently the chairman of Network Appliance, the vice chairman of Cisco, the chairman of diCarta, and a director of EventSource. Previously he was chairman of C-Cube Microsystems.

Don Valentine’s investment interests embrace the components, systems, and software industries. Before starting Sequoia Capital, he was a founder of National Semiconductor and a senior sales and marketing executive with Fairchild Semiconductor.

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Ethix: How did you get into this field 30 years ago after being in business at Fairchild and National Semiconductor?

Don Valentine: Fairchild and National were both venture-financed companies. When I was at National, I began investing in small start-up companies that were prospective customers for National. National had a limited engineering capacity to deploy among its customers. Sometimes we chose to deploy a small portion of it with a new young company. The same analytical selection process used to choose that customer I use to make an investment today.

A major mutual fund company asked if I would be willing to do that full time. They would arrange for me to meet the institutional clients of the world and collaboratively manage funds from a number of different places. Among our first clients were the Ford Foundation in New York City and the American Funds Organization in Los Angeles, both of which were, and remain, very high profile asset management companies. That’s how I went from being on the side of running the company to being on the side of financing them.

MARKET FLUCTUATIONS

As an investor, do you see extreme highs and lows as inevitable market phenomena? What causes them?

We financed Apple in 1977 and within three or four years there were 60 or 70 companies in the PC business. This happens continuously in our business. Whenever there’s a singular answer to the question “what’s the next great thing?,” chaotic growth happens. Whenever there is no answer to the question of “the next great thing,” there is peace and harmony.

So as the barrier to entry gets lower the situation gets worse? Was that the case with the dot-com world?

From 1975 to 2000, the amount of money in the venture community probably increased by a factor close to a thousand. The amount of money in the venture community in the late 90s was in the hundreds of billions of dollars. In terms of available dollars, the cost of starting a personal computer company became relatively insignificant. So if in the 70s you could have excesses of 70 companies, by the 90s you could have excesses of 700 or 1000 companies. Everything scales.

Might the next wave be even higher and steeper?

It’s conceivable. I was talking recently to a group of wealthy professional athletes about investing. They thought it was the end of the world when we had a recession. But we’ve had lots of recessions and for the thirty-year period that I talked to them about, it’s much ado about nothing. It’s just another recession. I don’t know if there is evidence that excesses precede a recession. It might be worth having somebody analyze that.

SUCCESSFUL INVESTMENTS and SUCCESSFUL COMPANIES

As you look back over your thirty years at Sequoia, what are the investments that you feel best about? Are there any that you feel bad about?

We financed Apple in 1977, which was a pretty marvelous company; we financed Cisco in 1987, a magnificent company; and then about 1997, we financed Yahoo, one of the most successful companies of the Internet era.

At one point in time, we invested simultaneously in information technology and in biotechnology and medical kinds of things. We learned some things the hard way. First, because of the governmental agency called the FDA, it cost roughly three years in time and 50 million dollars more to launch a company through their approval cycle. These costs did not exist in the IT space. Even if you start the same number of incredibly great companies in biotech, the returns are nowhere near comparable, simply because it takes more time and money.

We concluded that each of these biotech companies needed about a hundred million dollars to get a drug through the FDA to the market. As long as the public was willing to finance those companies, we could launch them. But at some point, the public began to realize that these drug companies were not going to deliver a product (never mind revenues) for ten years.

For example, lots of companies were financed to deal with prostate cancer. But nobody, the public or the venture community, thought through the amount of time it would take to solve this problem. Lots of phenomenal-looking companies were launched, but they were R&D operations with no prospect of a product for years. Well, now we have farmed out the biologists, back to the universities or wherever they are. Now we are financing different kinds of companies.

It is possible to have great financial results during these periods of excess; it is all about selling. Buying is always easy but if you sold your public biotech company or it merged, the funds made lots of money. Despite all the hysteria, many venture firms, ourselves included, made lots of money for our clients during every one of these eras of excess. Our return to our investors from Yahoo was as great as our return to our investors from Cisco. Cisco is a much bigger, seemingly more successful, company. But Yahoo went public early and got to a hundred billion dollar valuation quickly. We had no lack of confidence in Yahoo but we knew that if we took some money off the table our limited partners would be ecstatic. We also made a lot of money in the disc drive business at one point and that was a horrible business.

So the relationship between a successful investment and a successful company is not necessarily the same?

Exactly. It is possible for venture firms like us to have five successful investments in ten — and to have two successful companies in ten, not necessarily the same companies. It is all a matter of how the public market or corporations view what we are doing. For example, if we had something that looked like a contribution to the prostate cancer problem, a major pharmaceutical company would buy it. Lots of money is made during these periods of excess if you remember to sell. It’s not so complicated. When things have PEs of a hundred, sell, and don’t even wait for it to be a hundred, ninety is fine!

This is a business that is linked to the public market. It is linked to buyers of public securities and their willingness to view new things as desirable investments. Right now is one of the best times to invest. Some of the great companies in Silicon Valley were financed during recessions: Cisco, Sun, and Oracle were all financed during recessions. We are convinced that 2001 and 2002 will go down as fabulous times to start new companies and we have proceeded on that basis.

DOT-COM INVESTMENT LESSONS

When you look back at the dot-com meltdown over the last two or three years, has your approach to investing changed in any way? What are the lessons for funding startups?

We learn the same lesson every time, over and over. We started a disc drive company in the early 80s because the first storage device for Apple was an audio tape cassette — conceivably the most unreliable, slowest form of data storage. Out of necessity we started a disc drive company and it was quite obvious that it was going to succeed. Very quickly the disc drive company became valued publicly at a billion dollars. Those shares were distributed as fast as you can imagine. Simultaneously with that blip maybe a hundred disc drive companies were started later in the cycle. Some of us remember and don’t make that same mistake again but others do not remember.

While the Internet gets all the publicity in this period of excess and recession, the amount of money being lost in the telecom business dwarfs the amount of money lost in the Internet business but you don’t hear that much about it. The stories are all about the Internet and why people would finance Internet pet food companies, etc.. But more money was lost by far in the telecom space. Huge amounts. Worse than that, the impairment of a lot of balance sheets of major telecom companies happened at that time as well.

Whatever else happened during the last five years of the 90s, history will mark it as the time that AT&T went out of business. AT&T: everybody’s favorite stock for your mother. Did you read any articles about it? There was not a lot of press. It is being divided up, this piece here, long distance over here. If the Internet imploded, the telecom world exploded.

THE NEXT GREAT INVESTMENT

You have described the cycles of what happened in the past. What do you see happening next? You said it is a good time to invest, but invest in what?

At Sequoia the answer is “the same old things.” For thirty years we have invested in semiconductor companies, software companies, computer companies, network companies. In 2002 that is what we are investing in. There is calm in the market because there is no next great thing. Valuations are down. The availability of space is very rational and at low prices. We can now get spectacular people out of the big companies because their budgets and head counts have been cut.

The normal recessionary environment yields very favorable things for starting fundamental businesses. Especially if there’s no “next great thing.” The next great thing is like blood in a shark-infested water; the sharks go into a frenzy. There’s some mechanism in them that drives them crazy. There are similar reactions in the venture community — investing frantically in an area that claims to have a singular answer. Our position is that there has never been a singular answer. We just keep investing in those things that we know well in this huge IT space.

Now, let’s just talk about semiconductors. For reasons that are a little unclear, Wall Street has always rewarded the semiconductor industry with fascinatingly high PEs. The analogy I’ve always used with Wall Street is that semiconductors are to IT what petroleum is to the automotive industry. Without cheap gas, there are no cars. Without cheap and ever greater semiconductors, there is no computer industry, no IT world. It is all driven by the fundamentally fabulous things that have happened in semiconductors.

Look at what happened to the price of a transistor between 1960 and 2000. Nothing in the history of the world has ever shown that kind of price decline — maybe a trillion fold decline over 40 years. If you bought a transistor in 1960 for a dollar, now for the same dollar you buy a function that is a billion times greater, which may have 20 million transistors on it. It’s one of the few things in the world where the prices have come down steadily in absolute as well as relative terms. Driven by semiconductors, incredible computers become very possible to buy for $700.

DOES MOORE’S LAW STILL HOLD?

Some scientists are saying that Moore’s Law will run out of steam in another ten years. Do you see this happening?

No! What drives this development are the applications. The cost of memory in the last four years has gone from being significant to almost free. The amount of memory available in a 1980 Apple computer was insignificant in today’s terms — kilobytes of memory. Today we’re shipping those computers with terabytes of memory but the price has changed very little in 40 years. You’re paying almost the same amount for a billion times more memory. Huge changes in capability have happened in the past thirty years. Although you begin to approach the same boundaries in magnetics that you do in semiconductors, what drives the developments are applications for things that we’ve never done before.

Silicon and memory devices make cell phones possible. They’re giving them away now just so you’ll pay for the minutes. We hardly think about all these things, but they are colossal technical achievements. So, there are fundamental things that have happened for a long time and continue to happen which is why we have always kept a very broad palette of interests in technical areas.

In 1995 I went to a party celebrating the 20th anniversary of the Internet. The scientists and nerds and geeks of the world had been using the Internet for 20 years. But when it was deployed commercially beginning in the 90s it was deployed as a technique for retailing. You started to see people selling everything, shirts, pet food, furniture. But retailing has always been a crappy business. Huge assets are at risk in inventory. A horrible thing to do. Whether it is Safeway or some other type of retailer, pre-tax profits have always been terrible.

So why would retail (which doesn’t work anywhere, ever) be a good business on the Internet? The answer is, “it wouldn’t!” What a surprise. Think of it: the guys who make shirts are lucky they make 10-15 percent gross profit, whether they are sold in a store or on the internet. The business is horrible. Worse, the Internet allows for comparative shopping. You can look at the price of cars in New Orleans, or New Jersey, or North Dakota. Suddenly all the mystery of retail buying was stripped away. The retail margin was driven down even lower. So why did the venture community start some new retail companies? We failed to recognize that they were retail companies and got caught up in our own collective rhetoric that the Internet was the next fabulous thing that would revolutionize our lives.

Well it is revolutionizing our lives. Cisco Systems, for example, does roughly $20 billion a year in revenue. Eighty percent of that revenue comes in on the Internet. The customers don’t talk to Cisco; they go right through the Internet into factories around the world that make their product. Those factories ship that product directly to those customers. The best indicator of how well it works is Cisco’s metric of day’s sales outstanding (DSO: good companies thank their lucky stars if they have their day’s sales outstanding — the money customers owe you — in 60 days). Cisco, over the Internet, has DSO of only 23 days. Not only do the people buy things easily and better, they pay for them in phenomenal time.

So the Internet is working. It is a colossal advantage and it is one of the biggest things that happened at the end of the last century and the beginning of this century. All the publicity is about buying shirts and cat food on the Internet. Surprise! Take out all the retail-by-accident Internet companies started and you’re down to a few core companies, some of which are very nice. E-Bay’s a pretty nice company.

They don’t have the inventory model.

No inventory. They’re an agent. Seller and buyer don’t know one another, and E-Bay’s right in the middle taking a little nick as it goes from one person to another. A very nice business model. There are brand new companies on the Internet that work. Yahoo is an Internet company with revenues in the hundreds of millions of dollars and with $1.5 billion in cash. What is an Internet company? Internet companies are lots of things. When all the accounting is analyzed and you look at all the money invested in Internet, and all of the profit made, we’ll view it as a phenomenal era.

Warren Buffett’s position is to never invest in the early days of an industry. In 1905 there were a hundred car manufacturers, all doing the same sort of thing in transportation. You could never have figured out which ones to invest in because there were too many. Around the 1930s, the airline industry started up. Now if you look at the history of the airline industry, it has never made a nickel. With all the airline companies started, all the planes built and sold, with billions of miles traveled, the airline industry has generated zero profit in its history. Buffett joked that the obvious conclusion in 1905 was that somebody should have shot the Wright brothers so we wouldn’t have this mess on our hands. He has extravagant and colorful ways of explaining why things work and why things don’t work.

LAGGING TELECOM DEVELOPMENT

Where is the opportunity in the telecom industry?

The telephone company charges you $2.00 per month for the call waiting feature. You don’t notice it but it is on your telephone bill, as an option you chose. Technically, it is a feature that is added to the basic switch they use, with a 90 percent gross margin profit. They don’t like broadband and DSL because those require a big capital investment and the ROI takes years to happen. So the deployment is slow. But over the last five years the voice telephone companies of the world have constantly added inexpensive little features which have made our telephone much more interesting to use. The telephone companies have thrived on these kinds of products or application. Half the features on the telephone didn’t exist five years ago. So there are a lot of very low key evolutionary kinds of product features. I think they purposely keep the drama down so that you as a subscriber don’t get caught up in wondering how much it costs.

Applications of computers have absorbed their ever increasing power in a way that has kept the market going. And yet some studies say we have enough fiber in the ground to last us for 20 to 30 years because there’s no market for all this bandwidth. The applications haven’t developed.

Analogies are always risky, but ten years ago the telephone companies had very little business in data. Their business was almost entirely in voice. Today the amount of traffic in voice and data is the same. Data takes more transmission capability than voice and the forecast is that in five years voice will be dwarfed by the amount of data and video transmitted on slightly different transmission devices.

But the capacity that you’re talking about is part of the reason the telecom industry has blown up to a far more significant degree. All that fiber in the ground is on the balance sheets of different providers out there. Corning was making miles of this stuff — couldn’t make it fast enough — and suddenly somebody said “enough.” I’m not sure what all the influences were because the venture community was not participating in installing fiber. I’m not sure we looked adequately at the rationale and motivation for the installation of the fixed cost transport system.

Part of the telecom story, is that the venture community could not finance optical kinds of solutions for the telecom industry where the leaders, Nortel and Lucent, invested billions over the years. They were just taking market share from each other. All the sudden it just stopped. IT spending in that category just halted. The telecom companies in the U.S. chose not to aggressively offer ISDN, a fairly standard protocol installed broadly in Europe at least five years before it came here. You had to fight to get that product installed. High prices meant that nobody was interested.

Another example is DSL. In the late 90s a whole bunch of DSL suppliers were created by the venture community and others. DSL installations were skyrocketing. But little by little those new telecom companies and most of the DSL suppliers went out of business. The standard old-line telephone companies chose not to deploy DSL very rapidly because it required a very big investment on which they have to wait three to five years for a return. So the deployment of broadband is slow, not because of the lack of applications demand but because the telephone companies, worldwide monopolies, in my opinion, chose to deploy at their rate. They deployed call waiting for obvious reasons, and not DSL. The applications are there but they are manipulated.

CORPORATE BOARD RESPONSIBILITIES

When Sequoia invests in a company, you not only put in a lot of money, you get involved in their leadership at the executive and board levels. In light of the apparent failures of the Enron Board what are your thoughts about the responsibilities of corporate boards of directors?

Our business is starting companies. By now we have financed 650 or 700 companies. The companies we finance are started with only six or seven employees. It takes three or four years to get to 100 or 150 employees. It is very slow rolling out. Very few of our companies ever get to 1000 employees. As directors we are dealing with very small, incredibly simple companies. The companies are organized functionally so one guy is in charge of engineering, another in charge of sales, another in charge of marketing, nothing complicated. Because we are so small and fragile, we can’t borrow; nobody will lend to us! So even if we were smart enough to conceive some, we are not able to be involved in complex financial transactions. Our companies are very simple compared to Boeing, with 200 thousand employees, or any large American company. Because our businesses are so small and so narrowly focused, we don’t have that kind of chicanery going on.

Yahoo and Cisco would be pretty big.

Yahoo has maybe 800 or 850 employees. Cisco has 30 thousand employees.

Do you get less involved when they reach that size?

We’re involved in launching them and then taking them public or getting somebody to acquire them. Our history is to progressively withdraw so that we never get to be on a board like Enron that has complicated transactions.

OBJECTIVE AND SUBJECTIVE INVESTMENT ANALYSIS

When you analyze investment opportunities, to what extent do you rely on data analysis and modeling on computers — and to what extent does subjective human judgment enter in?

It is 100 percent subjective and zero analytical.

So the business cases that people run out there are not that important?

Remember the business we are in. At noon today we’re going to see three guys who are starting a company. We have to make several judgments. Is there a big market of consequence for the product they want to make, which currently does not exist? There is no clear data, so we skirmish around trying to figure out what kind of data would be helpful.
We also have to make a judgment about whether current technology could produce the product that they want to make. We don’t want to be in research but rather in development, using and applying existing technology.

All the things that we go through in our decision tree do not rely on data because there isn’t any. We are pioneering new companies. Business plans in our world are largely focused on an 18 to 20 month product development cycle where there is no revenue. During that 18 to 20 months we are hiring engineers to write software or to develop hardware. So there is nothing analytical going on, we are doing everything intuitively. We are depending on our experience. We are employing all of our infrastructure of knowledge to make a judgment, none of which is related to computer analysis of any facts.

Part of it is the quality of the people bringing the idea. What are you looking for there? How do you judge their character and capability?

It is very difficult. Maybe fifty percent of the companies we finance are run by people for whom English is not the primary language. Indians are accustomed to the English legal system so their basis for behavior and the way companies are structured is similar to ours. Chinese people we finance, on the other hand, have entirely different ethical and business systems. So, whenever we’re dealing with people from overseas, which is a lot, we are hard pressed to apply our system of judgment. It’s a very touchy feely business. It takes time.

We contact the prior company and find out if this guy has demonstrated the skills he claims. But it is very hard to come up with other than “comfort” in these people. What takes off a little bit of the edge is that we only partially finance them. As an example, if one of our companies is going to need 20 million dollars in capital, we do not give them 20 million dollars. For the first 18 months we may give them 2 million dollars and spend a lot of time getting to know one another, seeing how well they perform against what they said they were going to do, before we decide to fund them for the next step. In the meantime, we are adding new people to the company and refining our opinion about the CEO. Can he or she really run this company? Most of the people we finance are technologists who don’t know anything about running companies at the beginning. Venture financing is an iterative process with lots of continuous measurement between financings.

UNETHICAL INVESTMENT OPPORTUNITIES?

Are there investment opportunities that you would decline for ethical reasons — even if other venture capitalists might jump in and you lose out on some serious money?

We try not to finance anybody who has bad references. We try to get references on everybody and not ignore what we are told. These references may be about capability but they may also be about ethical behavior. We do not finance people with criminal records or a history of drug or alcohol abuse. Starting a company is very difficult. You can’t tolerate people who come encumbered with additional difficulties. If there is any hint of ethical misbehavior we just say no — or we say we’re not going to do it with this guy in the leadership role. He may be in some other role but he can’t run the company.

What about the product itself. What about a company that had a great idea in pornography.

There may be businesses like that. I’m not aware of them. We never see them.

What about high tech weapons systems? Here’s something about technology with a big world market out there.

Some of our companies sell boxes that go into military airplanes, tanks and things like that. Some companies we have financed have been suppliers to military weapons systems but as a category it is a very small part of the venture community.

Do you have an ethics code or statement for people at Sequoia Capital or are your people on their own ethically when dealing with potential clients? How do you maintain the culture at Sequoia?

One particular behavior requirement here is to guard privacy and confidentiality. We are very circumspect about the technology being explained to us. This is the crown jewels of the company and it must not be shared. We do not sign confidentiality agreements but we do our utmost to insure that Group A‘s technology idea is not shown to Group B. We keep things partitioned so that we are not a conduit of secrets. Now, if Company A has this phenomenal whizbang and we know one of our companies would be interested in it, with their prior agreement, we try to arrange the introduction of the two organizations. If Company A says no, that’s the end of it.

This is an ethical area of great sensitivity especially when companies are private. When companies are public things change. There are very precise SEC regulations that govern our behavior in public companies. If I’m a director of a public company, my partners do not know anything about that company that’s not public. Anything that’s in the public domain, they know; anything that’s in the private domain of that public company they do not know.

ALTRUISTIC INVESTING

You are in business to make a profit but do you ever think of investing in, say, a cure for cancer or in a business that might provide jobs for lots of people but is not likely to make the same kinds of profits? As a company do you contribute to society and its needs or do you leave that to individuals as private charity?

We are stewards of other peoples’ money. For example, we have money from about fifty different universities and our assignment from them is to optimize their returns. Their position is that if anybody is going to do something socially responsible, they will do it. Not us. That’s what our clients instruct us to do. So we have a single focus from our clients. One of our clients, a very big foundation, has a mission statement that they require us to salute. They don’t want us to finance tobacco, handguns, or napalm. That is not a problem. There’s no danger of any of that happening. But with a few rare exceptions like that, our clients have a precise objective in choosing us to manage their money: they want a return on their investment. They will make all the other decisions.

So if somebody needs money to start a sustainable agricultural program in some other part of the world, they need to go somewhere else, such as a foundation, to get the money they need?

Our clients’ instructions are crystal clear. They are often very active in those other areas but that is the purview of their business. We are merely one of their financial managers. Their instructions are the same for all such managers: maximize the return on investment, do not worry about what we do with the money.

Do you also have some of your own money in play in some of these investments? Wouldn’t that give you the discretion to invest in some more idealistic project?

All of our limited partners, going back to the beginning, want to make sure that we are on the same page. It is not okay for us to invest their money and not our own (or vice versa). If we think it is good enough for us, then it is good enough for them. They want to be in with us or out with us. That is the way it has always been. It is a form of ethical understanding and fiduciary responsibility. It is very fair and we have always done it exactly that way.

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