Silicon Valley Wrestles with Impact of “Scouts”: UPDATED

Late last week, the tech blog PandoDaily exposed an apparently three-year-long trend of entrepreneurs being led to believe they’re working with moneyed founders-turned-angels, only to discover that the angels actually represent a venture capital firm.

One firm behind such controversial arrangements: Sequoia Capital, whose marketing partner Mark Dempster brightly characterized the relationships as “one of the many founder services we deliver.”

Sequoia may not be alone. Sources tell peHUB that Andreessen Horowitz has its own brand of deal scouts, though in a twist, the press-friendly firm isn’t responding to related questions. (Asked about the allegations, Andreessen Horowitz’s marketing partner, Margit Wennmachers, responded via email: “There are always multiple sources on everything these days.” For good measure, she included a smiley face.)

The whole affair might remind some of the scene in Casablanca when Captain Renault, feigning horror before the Gestapo, says aloud to Rick: “I’m shocked, shocked to find that gambling is going on in here!”

Ryan Koonce, the founder-CEO of Austin-based Adealio, undoubtedly falls into that camp. He says concerns over scouts show a somewhat “naïve understanding of how the Valley really works.”

Having started a number of Silicon Valley companies — including Sequoia-backed PopularMedia, acquired by StrongMail in 2009 – Koonce notes, for example, that a “lot of entrepreneurs get sidelined” when a big-name firm like Sequoia doesn’t come back for a subsequent round, a very real phenomenon known as signaling.

“At the end of the day,” says Koonce, “firms like Sequoia won’t fund all the seed deals they [back], but the deals they don’t fund can’t get funded [by another firm]. Entrepreneurs able to get Sequoia involved without the liability of getting Sequoia involved” should be out celebrating, not fretting to media outlets, he suggests.

Koonce also observes that entrepreneurs will always develop ties with certain venture firms. Koonce points to LinkedIn founder Reid Hoffman, with whom Koonce cofounded the early social networking site Socialnet.com in 1997. “Long before Reid became a partner at Greylock Partners, there was a good chance that an entrepreneur who he backed was going to talk with Greylock [about subsequent funding]. People have good relationships with certain partners and certain firms, and they’re going to send them deals.”

Mike Maples is another example, says Koonce. Maples may have arrived in Silicon Valley in 2005 as an unknown seed-stage investor, but like Sequoia’s scouts, he came armed with the backing of a venture firm. (In Maples’ case, the money came from Austin Ventures, which had funded Maples’ software company, Motive.)

“I don’t see a whole lot of difference between” the situations, says Koonce.

Still, not everyone is ready to dismiss deal scouts as an innovative flourish on a traditional arrangement, and it’s easy to see why.

For one thing, Sequoia says it doesn’t receive information rights, warrants, or a right of first refusal. But  you can bet that the firm shares details of what the startups are doing internally and possibly with their portfolio companies. (Koonce notes that there’s little confidentiality in the Valley in general, saying, “I’ve had VCs send me decks before from competitors. It’s a relatively common occurrence.” )

In the case of Sequoia, a scout also invests Sequoia’s money but keeps any upside from the deal. The implicit arrangement allows Sequoia to broaden its network while enabling cash-poor scouts to throw around their weight. Yet it’s conceivable that the scouts feel less invested in the companies they are pursuing than might an angel who is investing his or her own money.

But the most troubling wrinkle in this story, according to some industry observers, is the lack of openness involved. Venture capitalist Brad Feld calls Sequoia’s approach “antithetical to the way I live my life, which is to be open about what I do.“ Meanwhile, Josh Felser, a serial entrepreneur who today runs Freestyle Capital, a seed-stage fund based in Mill Valley, Calif. says that while none of Freestyle’s portfolio companies has encountered a scouting situation, “I’d be unhappy if one did. If you’re meeting with an angel, you want to know what his or her agenda is.”

Ironically, signaling risk is just one reason why. Says Felser: “I always tell our portfolio companies that if they’re going to allow one VC [into a financing], they should allow in two” to neutralize the impact if one of those venture firms doesn’t re-up. “When you have a VC enter your round as a surprise, that’s not a good thing.”

Adds Felser,  “What’s odd about all of this isn’t that VCs are paying scouts. It’s that the whole thing isn’t more transparent.” As everyone knows, he notes, hiding things is “just a terrible way to start off your relationship with your VC.”

Update: Just off the phone with Sequoia spokesman Andrew Kovacs. He says of the assertion that details gathered by Sequoia’s scouts are likely shared internally, as well, possibly, with its portfolio companies: There is “no cross-sharing of information between Sequoia and [its] portfolio companies. That isn’t the case.”

Photo: Image courtesy of Shutterstock.

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