How Elite VC Firms Manage Portfolio Companies – The Dropbox Case Study
Dropbox became the financial markets’ darling when it went public in March 2018, completing its initial public offering (or IPO) at a staggering $9.2 billion valuation – which quickly rose to $12 billion on the first day of trading.
While a lot was written at the time about the company’s financial performance, the most exciting details on the pre-IPO capital structure itself have been left out.
Yet, Dropbox is a textbook example of how the best venture capital firms manage their portfolio companies to their advantage.
The S1 document that the company filed with the SEC contains interesting information on who the driving force behind the file-sharing company is. Provided you read between the lines, possess knowledge of venture capital deals, and recoup with other sources.
An Odd Jump In (Private) Valuations
Let’s start our story with a tweet summing up how Dropbox had been funded before the IPO.
Successful startups such as Dropbox typically go through several rounds of financing before they go public. These are called Seed, Series A, Series B, then adding a letter for each subsequent round.
As we can see from Recode journalist Teddy Schleifer’s tweet below, it was indeed difficult to make sizable returns for any investor in post-Series A rounds.
Here’s why it is was very, very hard to make a lot of money on Dropbox if you invested after 2008.
— Teddy Schleifer (@teddyschleifer) March 23, 2018
Look at the valuation jumps.https://t.co/SIQCOeffd7 pic.twitter.com/c73bIZ7108
The Series B valuation jumped enormously from the previous round. It went from $25 million to $4 BILLION. Yes, that’s billions.
Recouping both TechCrunch and Crunchbase data, it seems that Dropbox went from between 2 and 3 million users in 2008 to 45 million when the Series B was underway, with an expectation to triple that over the following twelve months. Such growth may explain part of the valuation surge, but probably not all of it.
It so happens that competitor Box had just raised $80M with powerful corporates such as Salesforce and SAP. The reported valuation from the round was $600 million.
Can this explain Dropbox’s valuation gap? Box reportedly had 7 million users when it completed its round. A simple mathematical calculation gets us close to the $4 billion mark for Dropbox’s 45 million users.
| In millions (except $ per User) | Dropbox | Box |
| Series B Valuation | $4,000 | $600 |
| Number of Users | 45 | 7 |
| Valuation $ per User | $89 | $86 |
Why Wait So Long to Raise Funds Again?
It is quite rare for a privately-owned startup to go from a $6 million round to a $250 million one, which is the amount raised in the Series B round.
Dropbox’s business model may explain why the company didn’t need external funding to grow: one of the great features of subscription models is that customers pay yearly subscriptions in advance, therefore infusing the company with cash before it must pay for bills and salaries.
Coupled with a viral marketing model that is Dropbox’s signature play, this characteristic alone may explain why Dropbox’s co-founders decided not to raise money between 2008 and 2011.
They didn’t have to.
Another explanation that has been put forward is that Sequoia Capital, the venture capital fund behind Dropbox’s debut financing, had convinced co-founders Drew Houston and Arash Ferdowsi that it would finance the company if needed.
The extra cushion that startups usually raise could, therefore, have seemed unnecessary – and it meant less dilution for the founders.
Sequoia is as blue-blood as it gets in Silicon Valley. Founded by the legendary venture capitalist Don Valentine, who was called nothing less than “the grandfather of Silicon Valley”, the VC firm made early bets in Apple, Yahoo!, Google, Oracle, PayPal, YouTube, Instagram, and Whatsapp, to name a few.
When they tell you to stay put, you do.
How Badly Did Dropbox Need $250 Million in 2011?
Did Houston and Ferdowsi need the $250 million round?
The company’s 2011 press release mentions the money was raised to finance growth, but also to “make acquisitions, pursue strategic partnerships, and grow the team.”
One thing is certain: the Box fundraising effort made it necessary for Dropbox to announce a large round, too. Recall that, at the time, the two startups were competing head-on.
Note that the two announcements were made one week apart, on October 11, 2011 (Box) and October 18, 2011 (Dropbox).
Box had even announced the first close of its Series D round at the end of September 2011, without naming all the financial investors. It shows how eager both companies were to be the first to make the announcement.
Given how long these operations usually take, one can safely assume that each company knew about the other’s fundraising efforts.
Dropbox’s shareholders being some of the most experienced venture capitalists in Silicon Valley, they were keen on not letting Box stealing the limelight.
Sequoia Capital’s Role in Early Financing Rounds
Apart from the founders, who would benefit from a limited number of rounds and the giant Series B valuation?
Early backers who had acquired Dropbox shares when the company was still relatively small.
Among them, Sequoia Capital. As we will see later, Sequoia played its card ideally to end up with a substantial pre-IPO stake of Dropbox’s equity.
But first, another story. If you browse the net and land, say, on Accel partner Sameer Gandhi’s presentation page, you will find the following information:
Does this mean that the Sequoia partner who invested initially in Dropbox would be Sameer Gandhi, rather than Bryan Schreier?
A look at Schreier’s page on the Sequoia Capital website seems to indicate the opposite:
Given Gandhi is more than a decade older than Schreier, it seems logical that the former was the partner in charge of the Dropbox investment, and the latter his junior team member.
Does it matter?
After all, Schreier is indisputably the driving VC behind Dropbox’s success. (Gandhi left Sequoia in 2008 for Accel Partners, another prestigious VC firm, shortly after making the Dropbox deal.)
In a 2013 interview with Techcrunch, Schreier admits that he joined Sequoia in early 2008, while the “partnership” between Sequoia and Dropbox dates back to late 2007.
Watch him say so at 0’55 in this video.
But why is Schreier, not Gandhi, credited with the now-famous 2007 seed investment into Dropbox?
Crunchbase, the venture capital deal bible, mentions Schreier as Sequoia’s investor in charge of the seed round. Gandhi appears a few lines above, for Accel’s Series A (alongside Schreier).
What is this all about, then? Some “mine is bigger” contest between powerful egos?
These shenanigans lead to one conclusion, which Recode’s Teddy Schleifer sums up best: “This is a Sequoia company.”
And a Sequoia company it was, as we will now uncover.
A Very Large Percentage of Equity
Investing $1.2 million at the seed stage, and still owning close to one-quarter of the company after over $600 million was injected, is no small feat.
Sequoia naturally followed in subsequent investments, but that is not the whole story.
According to the S1 document, Sequoia’s pre-IPO shareholding in Dropbox was 23.2%, very close to co-founder Drew Houston’s 25.3%.
Given the fact that Dropbox’s founders benefited from generous stock option packages (potentially limiting the effects of dilution), it seems clear that Sequoia navigated the dilution waters expertly.
Waiting to raise for the Series B, and realizing it with a 160x jump in valuation, helped the venture capital firm maintain a significant stake in Dropbox.
That stake was valued at between $2 billion and $3 billion in the wake of the IPO. VCs must abide by lock-up provisions, which typically last for six months. At the end of September 2018, Dropbox’s market capitalisation amounted to $10 billion.
Incidentally, it is the valuation reported for the last pre-IPO round of financing back in 2014.
Sequoia: A Strong Bargaining Position
Another unusual element in the Dropbox story, which seems to work to Sequoia’s advantage, is the way the preferred shares were structured.
In most fundraisings, the last round gets liquidation preference over the previous round shareholders – also called “standard liquidation preference.”
In a sale of a company (or its winding down), Series B shareholders would get proceeds first, generally up to the amount they invested in that round. (Venture capitalists call it a “1x” preference.)
If there are proceeds left, they then go to Series A shareholders.
After that, depending on the type of preferred mechanism negotiated between the parties initially, specific rules apply to share excess amounts between preferred and common stockholders.
However, Dropbox’s liquidation preference was structured differently.
It followed the rarer pari passu model: all preferred shareholders share proceeds on a pro-rata basis (lawyers love Latin terms), which means they are paid according to how much each owns of the total pool of preferred shares.
This structure is usually seen in deals where the company but also the prior round investors have a strong bargaining power position.
Sequoia had invested a tiny portion of its $445 million Sequoia Capital XII vehicle leading up to the Series A, which meant the firm could lead a significant funding round if it wanted to.
Sequoia was, therefore, in an excellent position to negotiate favorable terms with Series B investors Index Ventures (lead), Greylock Partners, and Goldman Sachs, among others.
Again, no small feat given the jump in valuation mentioned earlier. Preferred mechanisms are usually used to counterbalance high valuations.
Sequoia’s expert hand was able to negotiate a deal that was very favorable to the firm both for the Series B and the Series C rounds.
As highlighted in the S1 document, if a sale of Dropbox had returned less than $624.7 million, preferred shareholders would have received their pro-rata share of the exit price.
How About Voting Rights?
Economic rights and voting rights are the two pillars of any venture capital transaction.
Thanks to financial engineering and contractual terms, the equilibrium of power at the Board level can be vastly different from the geography of capital.
One way that so-called insiders (founders and sometimes early investors) maintain control of companies, even after they lose majority shareholding, is by issuing new shares with fewer voting rights.
Multiple stock schemes have long been used in non-VC-backed companies. They have become mainstream in venture capital since the 2004 Google IPO, and were features of many subsequent IPOs, including Yelp, Zynga, LinkedIn, and Facebook. It all culminated with SNAP’s 2017 IPO, which issued non-voting shares.
Before the IPO, Sequoia had 23.2% of the shares, but 24.8% of voting power, as per the shareholder table reproduced above.
The VC firm had more voting power than co-founder Drew Houston alone. The co-founders together didn’t control the Board, as they owned 34.3% of voting rights.
The picture starts to emerge: Sequoia’s influence on the Dropbox Board has been paramount. Influential VC firms often handpick the financial investors joining in future rounds, to make sure voting will go their way.
How did Sequoia’s level of control shift after the IPO?
We analyzed the change in Dropbox securities owned by Sequoia, using the Form 4 filed with the SEC on March 27, 2018. Dropbox has three classes of common stock: Class A (one vote per share), Class B (ten votes per share) and Class C (no voting rights).
The table below shows that preferred shares owned by various Sequoia entities were converted into Class A shares.
More precisely, preferred shares were first converted into Class B shares, which is a common feature of IPOs: liquidation preference doesn’t extend to public offerings.
The Class B shares obtained were then immediately converted into Class A shares, a conversion authorized previously and mentioned in the Form 4 document.
Why convert Class B shares into Class A shares, which bear only one vote, while Class B common stock holds ten votes per share? We believe that all insiders had to relinquish some voting power for new investors to buy shares and make the IPO a success.
Dropbox initially offered $500 million in Class A common stock. In the end, the total amount raised and sold was approximately $1 billion, of which around 20% went to existing stockholders, probably including Sequoia.
It is worth noting that Sequoia didn’t convert its whole Class B shareholding (over 130,000 shares) into Class A shares. Subsequent SEC filings seem to indicate that institutional investment firms such as Fidelity now own Class B shares. It could be the result of direct purchases from long-time Dropbox shareholders, such as Sequoia.
Key Lessons from the Dropbox Story
What a run! From a small room in 2007 to the Nasdaq floor a little over ten years later, Dropbox has been through most of the steps you would expect a unicorn[1] – even a decacorn[2] – to go through. Fundraising, hyper-growth, fundraising again, and IPO.
It is also a formidable case study of how the best VC firms, such as Sequoia Capital, support, protect, and control their portfolio companies, creating enormous value along the way for their shareholders and their partners.
Sequoia expertly exploited Dropbox’s virtuous business model to drive cash infusions at the right time, and at valuation levels that limited its dilution.
The Dropbox deal made billions of dollars for Sequoia, five times the size of the entire fund that was initially invested in Dropbox back in 2007.
Stories such as these make institutional investors and large corporations flock to venture capital. It happens in every cycle. But beneath the surface, a tactical game of the highest order is being played. It requires experience, expertise, influence, and patience. Very few can play this game, let alone win at it.
[1] Startups valued $1 billion and more.
[2] Startups valued $10 billion and more.
