Is Sequoia China in Trouble?

(Note Updates below) BEIJING, CHINA– Starbucks is a franchise in China that worked. The company opened locations at the bottom of all the major tourist hotels and downtown areas where returning Chinese, expats and business people traveling to China would pop in for some familiarity and to hold meetings, much like they do in the U.S. For people hoping to mix with that crowd, Starbucks became something of an aspirational brand in China. Tea was what your parents drank; a latte was something exotic and western.

No one thought Starbucks would work in China, but it did. Sequoia Capital, however, is not Starbucks.

There are a few ways to set up venture activity in China. One is to become a limited partner for a local firm. Another is to relocate an existing partner to build an office. The most common is to hire well-known, connected investors already in China, and Intel Capital, which has been investing in China longer than almost anyone, is one of a few farm systems for that. Typically this is known as  the “franchise model.” The hired China partners operate under the Kleiner Perkins or Sequoia brand name and typically share the same limited partners, but the funds themselves are separate. In exchange for that name and fund raising advantage, the Valley firms take a healthy chunk of the carry.

It seemed like the best of all strategies a few years ago. These firms want experts but don’t necessarily want to slow down or meddle in their deal making. But the cachet of the top Valley brands only goes so far over here. In 2008 Kleiner Perkins’ China partnership exploded, with two of its four partners quitting in a dispute that was far more contentious than a lot of Valley media reported at the time. In a week of touring China’s start-up scene, I’ve barely heard the KPCB brand mentioned at all. Now, it seems it’s Sequoia’s turn in the spotlight.

It’s no secret Mike Mortiz has been traveling back-and-forth to China a great deal, and he’s fond of telling reporters that’s because of all the opportunity. I asked him at Kenshoo’s recent US launch party about the unique challenges of investing in China versus the US, Europe or Israel. He said he wasn’t trying to stonewall on the answer, but that all venture investing was just hard, no one place more than another.

Really? Several sources in China and Silicon Valley have confirmed Moritz has been in China this week addressing Sequoia’s so-called “China Problem.” In February, one of Sequoia China’s founding partners, Zhang Fan, resigned due to “personal reasons.” People are fond of pointing out that Zhang’s biggest hit was Asia Media Company, which later had to de-list from the Tokyo Stock Exchange under a scandal. Whether it’s true or not, the situation certainly didn’t do Sequoia’s brand any favors here.

That left the other founding managing director at the helm, the highly respected Neil Shen, who founded, the so-called “Expedia of China,” and Home Inns & Hotels Management. I’ve talked to several VCs and entrepreneurs in China who say Shen is a prickly guy but his deal judgment is unparalleled in the country. Indeed sequoia has had two other IPOs (Renhe and VanceInfo) and a stake in the hot social networking name Another investment, Peak Performance, has filed for its IPO. Shen is even a bit of a hero to some entrepreneurs. But unfortunately, Shen too is in hot water. U.S. firm Carlyle Group is suing Shen for more than $200 million in damages for allegedly blocking a Carlyle deal in a Chinese medical research firm.

Even the widespread speculation could be a big blow for Sequoia, which at one point seemed to be one of the better-adapted Valley names here. It still employs two other managing directors and several more vice presidents and associates in China, but for many Chinese entrepreneurs Shen represents the brand as much as Moritz does in the U.S. There are few China investors with solid operating experience, particularly in the Internet.

And it can’t be good news for Sequoia’s limited partners who haven’t taken too kindly to Sequoia’s pressure to make them invest in not only China, but in other unproven Sequoia funds aimed at India and later stage U.S. companies, according to very wide-spread reports and my own reporting.

Player hating is part of human nature, so it’s no surprise that other Valley investors have whispered with glee that the once-dominant Sequoia seems distracted by all this. The competition’s biggest fear: Moritz solves the problems and Sequoia starts to focus on what it does well again.

(Sequoia did not respond to a detailed request for comment or clairification of this story and has a long-standing policy of not commenting on the firm’s internal matters.)

Update: I’ve updated this story based on conversations with additional sources.

JMA Update: The earlier version of this post included rumors suggesting ethical issues around former Sequoia Capital partner Fan Zhang. Upon reflection we removed all language referring to those rumors as the charges were serious and could not be verified. In fact, we could find no underlying evidence of any inappropriate or illegal behavior by Fan Zhang. If anything, we determined that Fan Zhang has made significant contributions to the entrepreneurial community in China. Also, we have determined that Sequoia Capital firmly supports Neil Shen’s leadership of the China operation. We regret and apologize for any embarrassment this may have caused Fan Zhang, Neil Shen and Sequoia Capital.