Is Microsoft nuts? They violated every convention of VC deal-making by investing $10B in OpenAI, without getting board control or guaranteeing equity.

But maybe they’re onto something.  Let’s take a look and give takeaways for our own VC investment strategy.

In exchange for their investment, Microsoft gets 49% of the equity and 75% of profits, but they’re capped at a 9x return ($90B).  Once Microsoft hits their return number, Microsoft gives the equity back.

Can this possibly be a good idea for Microsoft?
Actually, yes.  Microsoft missed out on social.  Microsoft missed out on search.  If they flushed this investment, they might have some explaining to do – but financially it’s a non-event.  $10B is a rounding error on Microsoft’s annual net income of $70B.

Granted, if Microsoft makes $90B in profits on its investment, in absolute dollars it will be one of the biggest dollar returns of all time.  ($90B is about 3x what Meta makes in a year. As the kids say, it’s real money.)  But on an MOIC basis, 9x is merely excellent, not superlative – especially for writing a huge check into a business that while it has burst into national prominence, remains early stage.  (Yes, they have the fastest-ever user base growth by some measures; but trailing revenues at the time of the investment were just $28mm, and Google’s Bard offering may yet steamroll OpenAI with Google’s vastly greater scale.

But if OpenAI performs, it will turn Bing from an also-ran, into a player in search.  The market agrees; MSFT is up 29% since the deal was announced in January, adding $700 billion to MSFT’s market cap.

Can this possibly be a good idea for anyone other than Microsoft?
Probably not. VCs and PEs love to dress up our investment securities with fancy preference structures, and Microsoft’s deal has the mother of all preferences, soaking up as much as 75% of profits despite being a minority investor.  Sounds like a Mr. Wonderful deal on Shark Tank.  But financial investors don’t get the kind of strategic lift that Microsoft will get from OpenAI.  And financial investors’ preference structures certainly don’t result in us surrendering equity and losing upside.

Having said that, would I take a 9x pref in return for surrendering equity?  I just might.  I‘d lose the chance for a hundred-bagger.  But offering this structure might get a highly sought-after target to do a deal with me if they truly believe in themselves.  So, maybe.  Kudos to MS if they pull this off.  And we’ll look at it on our own deals.