Don Valentine, Sequoia Capital: "Target Big Markets"

Please join me today in giving a GSB welcome to Don Valentine.

I didn't realize there were this many people who had no place to go at noon. I want to thank all the women in the room for Zappos. This is the only company that we've ever done where the product was priced inversely proportional to the amount of material that made the shoe. So if you ever hear any lady you're interested in or involved with talk about shoe prices, the number of pairs of shoes they have, it is amazing. And you can wonder after that introduction what we were doing investing in primarily ladies' shoes. Fortunately, I say totally facetiously, fortunately Amazon bought Zappos from us about four months ago. And I say they bought it because we were not selling it. And if you can believe it, we had a big argument at Sequoia whether we wanted to sell it for a billion three.

Once we established which currency we were talking about, the argument was short. You might ask or wonder who these people are. And you might recognize some of them. But there's one interesting distinction on this slide. As far as I can remember, very few of them went to the Stanford Business School. There are two very distinguished guys in this slide. Jerry Yang is at the top of the slide. And the reason I point him out first is that he did a building with the proceeds of his Yahoo success. And the man right below him, Jensen Huang, also did a building, which is opening today. So today is a big day to celebrate the results of some of these characters that you see before you. They were selected randomly, as were the companies.

It's always nice when you can make the slide that shows the success and apply your selective memory to those other companies that didn't make the slide. But let me begin by talking about a question that's often asked. I do a lot of the interviewing and recruiting of people joining Sequoia. And one of the subjects I ask them about is—who's got the water?—I asked them about is, why do you want to join Sequoia? Assuming you think we're successful, why do you think we're successful? What have you learned? And it turns out that many or most of the people in the venture business historically would answer that question by telling you they finance the best and brightest, the greatest managers and all that stuff.

We do not, which maybe is why you don't recognize a lot of the people in the picture. We have always focused on the market. The size of the market, the dynamics of the market, the nature of the competition, because our objective always was to build big companies. If you don't attack a big market, it's highly unlikely you're ever going to build a big company. So we don't spend a lot of time wondering about where people went to school, how smart they are, and all the rest of that. We're interested in their idea about the market they're after, the magnitude of the problem they're solving, and what can happen if in fact the combination of Sequoia and the individuals are correct. So if you just think of the picture where Jerry is profiled at the top,

What were we thinking when we financed Yahoo? Or maybe more accurately, the picture in the upper left-hand side for you, the two founders of Apple. What did they have in mind? They had in mind the idea of you all having your own computer. The opportunity to have your own computer then was a DEC 100 computer, a mini computer that cost $250,000. Now I know the tuition is high here, but I don't think a lot of you come here with DEC 100s, simply because there was no way to visualize a world in which the computer was ever going to be cost reduced from the price that Dec had it at to the computer prices that you face now. And using Apple as an example, one of the sub-questions that I was encouraged to talk about is how do you go about picking, choosing?

We don't choose people. We choose markets. And once we choose a market, there's a primary product. And we rarely ever invest in an area where there's only one product. So if you take Apple, none of you are old enough to remember that the original system governing memory was an audio tape player. Now you have to really have a great sense of humor using an audio tape player as a primary memory. They were highly unreliable and they took forever to download the information. So we knew, if you think of the Apple computer as a system, we knew we had to finance one or more memory companies, disk drive companies. We had to have initially floppy disks, which needed financing, disk drives that made the memory information portable.

And fortunately for us, IBM had always had a facility in San Jose where they located their R&D for memories. So this was a very fluid community. We helped ourselves to some of the people from IBM, financed several companies in the disk drive business, one of which achieved revenues of a billion dollars. Without the memory system, the PC is nothing. So if you keep digging away at the system, what else do you invest in? Well, Xerox was very generous being an East Coast company. And I have a slide that I'll save for a little bit that features my vision of Xerox. Xerox had a place called Xerox PARC. And when the Apple people went to Xerox PARC, they found a few things that they needed. They found a mouse.

So we financed all of these things that we found at Xerox PARC. They had the best GUI on the West Coast. Apple has always been famous for having a superior graphic interface, thanks to the generosity of PARC and their people who were very gracious at sharing. So this is how we chose to invest on a system application level. We looked at the system, the Apple computer, and in the final analysis made over 15 investments in that category. And one of the investments we made was an application investment. The guy with the sweater on, Trip, started Electronic Arts. We started the company in our office. And at a point in time when they had more people in our office than Sequoia people, we asked them to leave.

But that's how Electronic Arts was created. And I'll give you another illustration of the six degrees of separation concept being applicable. But we have always tried to aggregate applications and technical capabilities in a platform. And Apple is the example that is probably the most visually prominent right now. Steve was not always the best marketing guy in the world, until recently. But marketing is one of those things that people underestimate. There was a company called Sony that had 90% market share in mobile music. How many of you had a Walkman? How many of you don't have a Walkman? You have one of Apple's products, which if you think about it, is a Walkman on steroids. Fidelity is better, the number of musical choices are better.

So a lot of products, if you miss a generation, are phenomenal knockoffs of huge market shares held by companies like Sony.

And I can't resist.

Wrong direction.

The dinosaurs are very alert this morning. My view of the board of a big company. Xerox was in Rochester. They opened Xerox PARC and they conducted a technological picnic for a number of years where the companies in Silicon Valley ate lavishly at the picnic given by Xerox. Sony was very gracious at donating a product. And as far as I know, they haven't struck back with any attempt to deal with Apple that took their entire market. Why does that happen? Well, a lot of the boards are developed and built around incremental thinkers. And they don't get any better. Xerox, one of my favorite tragedies, was a spectacular company in Rochester, New York, had all the patents, had market share, huge profits, cash flow, that was a dream.

And they were persuaded by some people on Wall Street to move from Rochester to southern Connecticut and to change the nature of the company and become a service company. So they became an insurance company; they became a Wall Street brokerage kind of company. And they left all of the right people in Rochester, where all the patents were and everything. And when that move was made to Connecticut, I have to believe that somewhere in Tokyo, Ricoh, Samsung, and everybody else who were planning on taking their market share away applauded the fact that Xerox was abandoning their strength and going in a direction that made no sense. You have to select a board like that to do that. So we've established the fact that, in our case, the market is everything.

And to us, we have gone into business with some people who had absolutely no business credentials. And we organized the companies in ways so that the people who were going to run them, who were often younger than you are, could run them based on the limited experience they had. So we taught them outsourcing. We tried to explain to them that making everything in-house might have worked for Sloan and the Ford family, but certainly not recently. We tried to teach them that you only had to do a couple of things well in our companies. You had to be very good at technology and engineering, and that normally took us about six people to start the company. The second functional skill we were always interested in establishing was marketing, so that we could tell what the dynamics of the market were.

With our checkbook at Sequoia, we were not interested in creating markets. It's too expensive. We were interested in exploiting markets early so that when we were with the right set of people—wait a minute, we didn't want that. These are the right people: technologists, people who had a dream of some way to solve a problem. Most of them were not interested in becoming wealthy; that was an accident. They were interested in solving technology problems and creating new products, and many of them have done it brilliantly. And that is the sort of cornerstone history, from our perspective, about how and why we start companies, how we choose less the people and more the market, because people, from our point of view, are readily available, and this has been a hotbed of training grounds. So every time a company succeeds here,

Every time. 1969 came around and Intel started, and a couple of years later they had all of their momentum started, you had a whole bunch of people, management in training. So we have been very generous at circulating people throughout the community. A couple of organizations that have been repositories of technology: SRI is one of the historic ones; I've already mentioned Xerox; there's one that you wouldn't ever have heard of called the Wagon Wheel; and what was the fourth one? IBM. These companies were incredibly critical to the formation of most of the great companies in Silicon Valley because they made a component part of a system, which, in our case, if you were investing in systems and applications that solve big problems.

Why did Cisco come out of the blocks screaming? Stanford's IT department was where the product was developed, interestingly. And the problem was PCs had now populated the remote offices in big companies. And the information packets coming from the East to the West at light speed had a hard time finding the right mainframe. So you had a condition called broadcast storms. There were collisions of these packets all over the place. Cisco's solution was to design a product called a router, which merely identified something coming at light speed and directing it to the right end location. Initially, they did this from a private home in Atherton until the Atherton police found out. And they sold them to all of the other IT departments in all of the other universities with their first approach to customers.

But here is an illustration of a product that was derivative of a number of our other experiences that led us to hear about the packet problem, the broadcast storm problem. So finding people who knew something about that was a matter of search. And we have always had a search function looking for the people that we want to populate our companies with. Unlike other people in the venture business, we don't wait for you to knock on our door. We knock on your door. We know, generally speaking, in a lot of respects, which kinds of companies, which kinds of products, and therefore which kinds of people. So the people to us become very important for their fundamental technical skills when applied to a particular problem

that we're interested in solving. A different approach than many people in the venture business have followed. I don't suggest that it's the only approach. I certainly don't want to leave you with the impression that it always works. We have some companies that are beyond the concept of hideous failures. Hard to believe, I understand, but... So, one of the things I meant to mention earlier is that when we talk about questions, I have a rule about questions. I don't answer any questions that are more than 20 words. I'm not interested in your making a speech, but if you have a question, figure out how to express it in less than 20 words. Now I'll tell you about a real experience, because one of the things that's true in my world—the art of storytelling is incredibly important.

And many, and maybe even most, of the entrepreneurs who come to talk to us can't tell the story. So one day there were three entrepreneurs, and by accident there were three people from Sequoia. And this guy started at the atom and was ranting about how they were gonna change the world with this product. After 20 minutes, I just decided that we're not going anywhere. His other two founders were frustrated. So I asked him for one of his calling cards. He gave it to me and I said, 'We're going to take a timeout. And during this five-minute timeout, you're going to write your business plan on the back of your business card. And then we'll come back and have you start over. And those are the only words you get to explain—the ones that are on the back of your business card.'

It was more humorous than not. This man, turns out, could write in microcode. I thought I had done something clever to help him. So he must have had 500 words on the back of his calling card, and his calling card was the same size as everybody else's. Learning to tell a story is critically important because that's how the money works. The money flows as a function of the stories. And one of the critical things I would encourage you to learn, that's way more important in my world than anything else, is how to ask a question. Because you want to have the person comfortably telling you what he thinks is important so that you get it. Now, for a long time, we don't understand the product or the market while we're listening.

So we have learned to string questions in a way that provides the entrepreneur with a way to explain what he wants to do, how long it's gonna take, who the competition is, how much money he needs, without feeling threatening. For many of the investments we've made, we didn't understand the answers. But we constantly work on developing the questions. And when we have had a company that's failed, we always have postmortems at Sequoia, because we're trying to understand what we missed. What question didn't we ask? What answer did we not understand? Because we're dealing with amateur storytellers, and it's important that they comfortably can tell you what's relevant. And despite our audience, which is made up of almost exclusively technology people and people who have been founders of companies, questions.

Think about questions, which is why I have this 20-word maximum. I normally have 15, but I'm giving you a little latitude here. One of the questions that's often asked us is where do the people who populate Sequoia come from? And the answer is pretty broadly geographically here. We're less interested in their education than we are interested in what they did in their prior companies. So the man who joined us this week, I brought his resume just to highlight for you. His name is Alfred Lin. Alfred is not in the picture. An accident. We financed Alfred's first company, which was eventually acquired by Microsoft in, I believe, 1996. Small company, Internet company. Before we really developed the momentum, IBM came and bought it.

We were not trying to sell it. Alfred was the chief financial officer. Alfred's second company, which we financed in 2004, was Zappos. He was the chairman, he was the chief operating officer, and one of the people who admitted to knowing absolutely nothing about women's shoes. So we started a company which we sold to Amazon. The revenues when we sold the company were about $750 million a year. All the shoes were sold over the net. There were no bricks-and-mortar. There were two enormous inventory locations, one in Las Vegas and one in—the name of the city I've forgotten—where Federal Express has all airplanes. Someplace in Tennessee. Where is it? Why did we put the inventory in those places? Because we committed, basically,

to 24-hour delivery. And that's where the planes were. And Alfred had figured out a few things about how to be in the retail business. It wasn't totally a sexist company. There were about 10 or 15% of the shoes sold were for men. How many of you here have ordered shoes on Yahoo? Excuse me. Did you know Yahoo sold shoes? Just testing. Alfred, as is true with a number of people over time, is one of those people who will work within Sequoia as well as start companies outside Sequoia. We'll use him as we have used people like him in a multitasking way wherever he feels is a company he's especially interested in. And some people really like to do that and they're good at it. And Alfred happens to be one of those.

So right now, Alfred is at Sequoia, but we're all looking forward to what comes next. What company is Alfred going to take us to? Which business will he take us to? Because the first two businesses were entirely different from one another. So he's a clever, versatile person who knows what he doesn't know. Think about that. Because the entrepreneurs that we finance oftentimes are clueless about what they don't know. And what we try to do is supplement through our Rolodex and through the people at Sequoia, we try to supplement what they don't know. So we try to make the job of starting the company and the management of the company as easy as possible. We don't do functions in-house that we can outsource.

So the last person we hire in the management team is the financial officer. Why do we need him? We don't have any money. The founders are spending it as fast as they can. They're developing the product which always is, to be generous, a little late. It always cost more money than the founders said, but we knew that. We financed a lot of companies and the results are always the same. So we try to make the management job extremely easy. Don't manage any function that you can hire someone else. So we have people who act as CFOs for our little companies. And they may do two or three of these companies at a time. And there's only one metric that matters in finance in our world, and it's cash flow.

So we hire people that are wizards at cash flow. We don't have balance sheets. We love recessions. Best time to invest, in our experience, for a lot of reasons, but recessions don't hurt us. Nobody is buying. We're in product development, usually. Banks don't lend. They don't lend to us ever. So it's not unusual. So we look forward to recessions and the environment that are in recessions. Now, I didn't tell you early on, because I don't believe in giving you all of the surprises in the front. I had a special advantage going into the venture business. And I think no one else of my relative contemporaries had that advantage. And I know this is one that might take an aspirin and a slug of water to deal with, but I knew the future.

And if you don't think knowing the future is a great advantage, it is a phenomenal advantage. I spent 10 or 12 years in the semiconductor business. All of the products that are here operate on microprocessors. I came from the world where they invented the microprocessor. The guy I worked for, Bob Noyce's name is on the patent for the microprocessor. And we spent huge amounts of time trying to figure out which applications we should attack in which order. So knowing the future made it easy for us to very early on invest in a company like Atari. We invested in Atari in the early '70s. Microprocessors were in production. Intel started in '69. They went into the game business, coin-operated games as well as home games.

All microprocessor-driven. Apple, almost every significant company we were involved with, we understood what it is they were going to use, where to get it, how much to pay for it. And it was relatively easy to aim the entrepreneurs at things that were silicon-intensive, because that was the technological future. People have asked, 'Why haven't we invested outside of Northern California?' And the answer I always gave was, if we were in a plane flying east, we were leaving more opportunities on the ground in Mountain View than we would ever find in any eastern city. So I would ask you to think about any place in North America where venture capital has worked. Any place in Western Europe with 350 or 400 million people where it's worked.

It basically has worked in Northern California. And my definition of work is, look at the monuments. Some of your biggest biotech companies were started here. And it wasn't called Silicon Valley for nothing. So this was an opinion that we held strongly, that we didn't have to go anywhere else. And I used to sort of tease our limited partners about why we didn't finance companies in—choose a state—and I told them that I thought the reason would stretch their credibility, but that the Catholic Church was wrong: the world is flat, and once you go past Denver, you go off the edge into a technological oblivion. Who would volunteer the name of a city or an area where venture capital works? My definition.

Success has to breed big monuments. It's not Boston. And you'd look at Boston and you'd look at the Bay Area and think, 'God, their schools are at least as good as ours. Why doesn't it work?' We have had visitors from around the world. The latest one was unbelievable. The State Department brought the Prime Minister of Armenia. And out of curiosity, we agreed to see them after scurrying around and finding a map and finding Armenia—and it's unbelievably far east of the Mississippi. And the State Department brought these people in. And we had guards. I mean, the Armenian guys had 10 or 12 of their own guys. The State Department brought in seven or eight others. And I said, 'You know, guys, we don't have a conference room with that many chairs.'

Some of you can come. You have to stay outside. So we talked with interpreters. And they always have a gift. So they gave me this gift, one of those coffee table books, and I looked at it quickly, and the Prime Minister said not to worry. It's in two languages. The second language was Russian. So I have this book in case any of you are doing research on Armenia. I have the book. So I'm going to segue in a slightly different direction and I'm going to test you by asking one of you to ask a question, 20 words or less, or I'll kill you. There's a brave man here in the front. We have a microphone coming your way.

What did you learn from your worst investment? 10 words.

Is there anybody here from Armenia? I mean, I need an interpreter. I didn't get the question.

What did I learn from our worst investment? We have invested in a lot of companies, and this is not a statistical business, so we've had a lot of failures. Failure is somewhat of a definition-dependent issue, but we learned that we have never made a bad investment where the technology didn't work. It didn't work when they said it was going to work. They spent more money doing it. But what didn't work was the dynamics of the market. We have developed some pretty spectacular things for which there were no buyers. Now, were there buyers eventually? Yeah. But the critical thing is getting a product developed where the timing of the product's availability and the market demand are simultaneous. Otherwise, you're spending lots of money

on developing a market which you did not intend to spend money on. And invariably, we tend to shut those investments down. Now, to some of you that may sound harsh. And to some of the founders of those companies, it certainly did sound harsh when we said we're not going to finance you anymore because no one wants the product. And we just don't see any prospects. Which gets me to answer the question: where do we get the money from? We decided in the beginning that we wanted to have all tax-exempt sources. So we could avoid difficulties with liquidity and selling things in order to make a distribution to pay someone's taxes. So our limited partners over roughly 40 years have been tax-exempt. We have as examples most of your universities, wherever you went, because we have probably 50 different universities.

We have a large number of U.S. foundations. We have a reasonable number of international, primarily Western European limited partners. So the money comes to us from sources like that, which we aggregate in partnerships. It takes us—in a $500 million partnership, it takes us roughly three or three and a half years to invest that money. And investing that money includes the amount we reserve for future rounds of financing. We never finance anybody totally on day one. We finance them. There are milestones. Depending on how well they do meeting the milestones, we then refinance them. And it's all done very critically. And if, in fact, the return expectation that we started with is no longer reality, we oftentimes shut the company down.

Now, keep in mind, we're financing companies that have 10 people. Many of these financings are done in our office. So they have a lot of free rent, free lunches, free a lot of things. But if they don't get it, they don't get any more money. And yes, it's necessary to make these kinds of decisions. So I think the announcement was that we financed 500 companies. It wouldn't surprise me if we hadn't shut down 100 of that 500 over the years because the expectations for success were no longer realistic. Are you just airing out your armpit, or you want to ask a question? I think you need a microphone, or at least stand up so everybody can hear you. Actually, I'll pass it back to him. Let me complete my question.

I'll hand it to you. Excuse me. Sorry, man. Sky Kurtz. Entrepreneurism is all about aggression. Don't worry, he's aggressive. The question I had, not part of it: the famous or infamous 'Rest in Peace' presentation you published, if you published it today, what would change and why? I'm not sure many or most of you heard the question. Early on in this particular recession, a lot of our presidents were asking what to do about spending, what to do about hiring. So we decided to have a meeting, a very private meeting, in a local place that we never have meetings in, to talk about this openly and positively. We wrote a paper. And you have to understand, with slides like mine, there's a lot of people at Sequoia with a ghoulish sense of humor.

So the front page had a tombstone that said, 'RIP.' Those of you who are not currently fluent in Latin, this was a secret. Only people invited there were management in our companies. No publicity. Two days later, I saw the paper on CNBC. I'm wondering, if we were trying to get a paper on CNBC, we would never succeed. The answer to the question, what impact? Well, it had a lot of impact on our presidents and management because we were interactively discussing what the alternative ways to operate the different companies were in this kind of a recessionary environment. These are companies that don't have very much in the way of cash and not a lot in the way of borrowing ability. Well, this paper—apparently, people that I know on the East Coast called me.

And they said, 'You scared everybody to death.' And I said, 'I don't know how or why. We were just trying to scare 70 people to death, and you were not on the list.' Amazing. The internet has a lot of great features, not all of which are positive. And there was an example of what we were doing very privately being publicized worldwide, because we had limited partners in Europe contact us and wanted to have a conversation about what we were thinking. It wasn't fun. What's that new law, unintended consequences? One of the most significant unintended consequences. We never have meetings like that with all of 70 presidents where the message is caution, keeping the powder dry, being thoughtful on expansionary kind of spending ideas.

And we got more publicity than we ever imagined. So I wanted to tell another story because there must be people in the audience harboring an opinion or resentment because there's only one woman in the slide, which for us is pretty good. This woman was one of about six founders of Cisco. And these are the people in Atherton shipping homemade routers to their opposite numbers in the IT departments around the country. And this woman was one of the core members of management. She invented a concept called customer advocacy. In her opinion, the customers were not well cared for as a generalization. And she was going to ensure that Cisco was not guilty of paying attention to the customers. Pretty heady stuff in a startup.

Well, this lady also happened to be smart, but tough beyond all comparison. And forgiveness was not in her vocabulary. And when somebody in the management of this embryonic company didn't do it the way she wanted it, she shredded them publicly. And the president who I had hired to run Cisco, who was the chief executive—and it was his right to make the decision—he wanted to terminate her. And I said, 'You know, it's your call, but I would encourage you to find a way to use this talent because it's an unusual talent, and I think it's core to what will differentiate this company.' So he agreed. They had a conversation. She took an oath of behavior. I wasn't there for that. And the next thing I knew, about a month later, there were seven vice presidents of Cisco in my office.

And their position was very simple. Either the seven of us stay and Sandy leaves, or Sandy stays and the seven of us leave. What's your preference? So I listened for a while, being one of the world's greatest listeners. I mean, if you're going to laugh, laugh, but don't murmur. So I called the president and I said, 'John, you know, I have a war ready to be declared in my office here. What do you want to do?' And he said, 'I can't make it work. Sandy's got to go.' So Sandy was separated from the company. The company was monumentally successful. It went public. That is, her partner in a number of respects, both of them left a then-public company with $170 million each, and she hasn't spoken to me in 15 years.

I might be lucky. There's no telling what you would say. So decisions are sometimes made that you don't like to see made when a creative force in a company that's doing a lot more good than... has to go. Because otherwise you have to build a whole new management team, including the president. The footnote on the president, John Morgridge, is that he ran the company from basically nothing to revenues of a billion five. He left because that's all he wanted to do. He did an extra 500 million as a favor, but he wanted to leave the company at a billion dollars in revenue and do something different. So John was the most like-me president I ever hired. Now what does that mean? He was the only president I ever hired who was cheaper than me.

He would go to huge lengths to stage talks for the management of the company about spending. This was a company growing extremely rapidly, had gross margins of 68%, was monumentally cash-flow positive. They currently generate, in free cash on a $40 billion sales base, they generate $6 billion a year in excess cash. So John's lesson, the DNA he created, has done the company a lot of good. Where is this clock you mentioned to me? Ah, we're over time. They said if I didn't provide you enough opportunity to ask questions, I wouldn't get lunch. Owing to the fact that I was late going through the labyrinthine directions I had, can we do any questions? Where is the microphone?

Ah, he has custody.

Which markets excite you today, and which market currently in vogue in the Valley gives you the greatest pause or concern?

Answering the question backward, the question is about the markets that I like and the markets that I don't like. It probably started three or four years ago. There was a huge hue and cry about nano. Everybody wanted to do nano. We were not thrilled about nano. We listened to a lot of people, a lot of presentations. And, turns out, in our opinion—and bear in mind, we have a lot of semiconductor background—and the semiconductor business is a process business. It's chemistry. And nano is a process business. There were no applications that you could easily point your finger to and say, 'We can do a product in all of those areas and sell it to a lot of different people.' One of the companies was going to attack the catalytic converter in your car, which uses a precious metal, and they were going to substitute a less precious metal and sell that to the car companies that were still in business.

And we took a pass on nano. It may have been a mistake. It may be that all the great successes in nano are in front of us. But so far, I don't see any notches in anybody's rifle as a result of investing successfully in nano. Now, the positive side of the question is, what do we like? And we continue to like the exploitation of mobile. Steve has demonstrated a whole bunch of consumer-oriented applications. There are lots of other things to be done in the mobile space, in our opinion. But we don't focus on one category to the exclusion of other categories. We have teams of people that specialize in different areas of developing a knowledge base and market sizing information about where we should be spending time.

And I have established for you that we tend to invest in an application system approach, which may be the reason why it didn't work in nano, but it's the reason, perhaps, why it does work in mobile.

Thank you.