5.11.2022
Last Week
The Power Law
By Sebastian Mallaby
Venture capital, like many areas of finance, is a polarizing industry. At times overeager in its search for unicorns, it has enabled toxic founders and genuine scam artists to become rich. Paul Graham published an essay on "A Unified Theory of VC Suckage." But as proponents might argue, it has also ushered in the modern digital age as we know it. Mallaby, a storyteller at heart, is a firm believer in the latter. In a book full of interesting anecdotes on startups and founders, he makes a passionate defense for VCs.
In his conviction, Mallaby declares that in their unique mix of "corporate strategizing" and "respect for the market," VCs constitute the "third great institution of modern capitalism," right alongside markets and corporations. To understand this perspective, the book covers two broad areas: the origins of VC, its unique mindset among finance, and the case for the industry's positive social impact—why, despite all the fluff, VC really does "make the world a better place" after all.
Adventure Capital
Silicon Valley, in spite of decades of globalization and remote work, remains the center of modern technology, hosting the largest tech giants as well as the earliest startups. The case of Bay Area exceptionalism has clearly attracted many explanations in hopes of replicating it elsewhere. Cases can be made for abundant DARPA funding, a laid-back counterculture, a concentration of scientific talent, or spectacular weather. But according to Mallaby, these narratives fail to explain why the Valley, and not competitors such as Boston or New York, ended up being so dominant. Hacker culture came about at MIT rather than Stanford, and the Harvard-MIT nexus benefited more than Stanford when it came to military funding. The basic advances that enabled transistors, server search engines, and social networks all emerged outside the Valley.
What really set the Valley apart, according to Mallaby, was its ability and willingness to match promising ideas with capital. This was all made possible by the realization that such early bets follow a power-law distribution: most startups fail, but a rare few grow to become ridiculously profitable. The Valley is a place where "the patina of the counterculture combines with a frank lust for riches."
But the tonic of liberation capital provides another explanation, one that merits more attention than it has received until now. By freeing talent to convert ideas into products, and by marrying unconventional experiments with hard commercial targets, this distinctive form of finance fostered the business culture that made the Valley so fertile. In an earlier era, J. P. Morgan’s brand of finance fashioned American business into muscular oligopolies; in the 1980s, Michael Milken’s junk bonds fueled a burst of corporate takeovers and slash-and-burn cost cuts. In similar fashion, venture capital has stamped its mark on an industrial culture, making Silicon Valley the most durably productive crucible of applied science anywhere, ever.
The genesis of the VC model can be traced to Fairchild Semiconductor, a firm that Mallaby claims was traced to 70% of publicly-traded tech companies in the Valley back in 2014. In 1957, dissatisfied with upper management at Shockley Semiconductor Laboratory, a group of eight researchers decided to simply leave and start their own company. In the age of the modest "organization man," such a mutiny was almost unthinkable. Among these "Traitorous Eight," their leader Eugene Kleiner—of Kleiner Perkins fame—obtained a $1.5 million investment from Arthur Rock after initially asking for "a company which can supply good management."
After Fairchild succeeded beyond his wildest dreams, Rock realized that he needed to start funding more companies like this. With his partner, Thomas J. Davis Jr, he founded one of the first limited partnerships, which are now the standard structure for VCs. Davis & Rock realized the fundamental importance of backing the right founders above all else. It is the reason why today, firms will fund strong teams with millions of dollars even if they have no working product, or in some cases not even an idea.
Having discarded conventional investment metrics, the partners needed something else to go by. They found it in judgments about people, never mind that these could sound like a soft basis on which to commit capital. The central principle of the venture business, Davis once explained boldly, could be summed up in four words: “Back the Right People.” For his part, Rock made a habit of skipping over the financial projections in business plans and flipping to the back, where the founders’ résumés were presented.
Over the course of the next decades, VCs backed basically every major tech company in existence today. At times, this backing required stodgy investors to accommodate the eccentricities of founders. When Sequoia Capital was considering an investment in Atari, founder Don Valentine toured a factory with "enough marijuana smoke to 'knock you to your knees'" and stripped to share a hot tub with founder Nolan Bushnell at the latter's insistence. Later in 2004, when Mark Zuckerberg showed up to pitch Sequoia in pajamas, Valentine coached his colleagues to ignore the provocation. Zuckerberg, like Google a few years ago, had decided to focus on raising money from angel investors instead.
There is no single approach to venture capital, and Mallaby gives a great overview of the diversity of investment philosophies. Accel, which ended up convincing Zuckerberg to accept an investment, pioneered a top-down "prepared mind" approach to recognizing deep technological trends. Founders Fund, founded by Peter Thiel, embraced the founder-first mentality and sought the "misfits" who were often "arrogant, misanthropic, or borderline crazy." Seeking to mentor the next generation of startups, Paul Graham founded Y Combinator as a factory for mass-producing capable companies. On the other end of the timeline, investors like Softbank and Tiger Global would upend the industry with their focus on late-stage injections meant to supercharge growth.
The way Graham saw things, force-feeding by VCs created at least three problems. First, big investments meant big valuations for startups, which narrowed the odds of a profitable exit. Many founders might be happy to sell their company for, say, $15 million, but VCs who had already marked up the valuation to $7 million or $8 million would not be satisfied with a mere 2x multiple. Second, big investments meant that VCs took “agonizingly long to make up their minds,” and their dithering distracted founders from their highest calling, which was to write code and create products. Finally, big investments meant that nervous VCs were quick to eliminate the wondrous and weird features of startups. They installed humorless MBAs to oversee quirky coders, much as the Bolsheviks foisted political commissars on Red Army units.
Along the way, there's plenty of cool anecdotes. When John Doerr of Kleiner Perkins insisted that Google hire a new CEO for "adult supervision," founders Larry Page and Sergey Brin found that only Steve Jobs met their standards. Kathy Xu, instrumental in bringing the VC model to China, had Donda West as an English teacher while at college at Nanjing University. The term "venture capital" arose as an abbreviation for "adventure capital" in John Whitney's early experiments with backing risky entrepreneurs.
Making the World a Better Place
Like any fund, the basic objective of a venture capitalist is to generate a good return. When Masayoshi Son of Softbank sought to fund Yahoo, he strong-armed his way into a deal by threatening to fund the competitors instead.
Before the Yahoo team arrived at a decision, Son made a second move that defied all convention. He asked Moritz and the founders to name Yahoo’s main competitors.
“Excite and Lycos,” they answered.
Son turned to one of his lieutenants. “Write those names down,” he commanded.
Then he turned back to Moritz and the founders. “If I don’t invest in Yahoo, I’ll invest in Excite and I’ll kill you,” he informed them.
Business aside, venture capital has long attracted criticism on multiple fronts. Its members are predominantly white and Asian males from Harvard and Stanford. The companies it bets on are frequently useless, or even harmful to the economy or society. In its most dramatic instances, it has elevated abusive and delusional founders into positions of privilege and power. Mallaby admits that VC has a pretty bad diversity problem, but he believes that it has ultimately created far more positives for society. Through identifying talent, it enables the creation and implementation of technology at an incredible pace. In scenarios as with Uber and Travis Kalanick, which Mallaby provides a thrilling account of, it was VCs like Bill Gurley of Benchmark who stepped in to strategically excise a problematic founder.
Venture capitalists are notorious for relying on groupthink, refusing to invest in companies until a fellow firm has given it the stamp of approval and rushing in towards newer trends out of FOMO. A cynic might accuse the best VCs of relying on their reputations, which afford them with increased deal flow relative to lower-tier firms. But whereas path dependency is certainly important in dictating the success of a firm, Mallaby asserts that skill is required to play in the first place. New firms can break into the industry with more efficient and appealing approaches toward funding. Moreover, in several instances, VCs ended up playing a far more important role in choosing CEOs, brokering mergers, and providing counsel than in simply providing capital. In the big picture, a tiny slice of companies ever receive venture funding, but their contributions to the economy are enormous.
Only a fraction of 1 percent of firms in the United States receive venture backing. But in a study covering the quarter century from 1995 to 2019, Josh Lerner and Ramana Nanda find that VC-backed companies accounted for fully 47 percent of U.S. nonfinancial IPOs; in other words, a VCbacked firm was orders of magnitude more likely to make it to the stock market than a non-VC-backed one. Moreover, the VC-backed companies that went public tended to do better than their non-VC-backed peers and to generate far more innovation. Thus, even though VC-backed firms accounted for 47 percent of IPOs, they accounted for 76 percent of the market value at the end of the study.
In the 1950s, the federal government attempted to incentivize entrepreneurship by subsidizing an investment vehicle called the Small Business Investment Company (SBIC). However, the government bungled the program by limiting SBIC funds to $450,000, preventing stock option-based compensation, and capping investments in each company to $60,000. For these reasons, the SBIC never took off as a means of allocating capital. In general, Mallaby is distrustful of government attempts to encourage innovation. He attributes the rise of China's technology sector not to central policy but to a strong indigenous venture ecosystem, and he believes that much of recent government-directed funding has been lost to scams.
Government efforts to promote VC-backed innovation tend to generate debate that is unhelpfully polarized. On the one hand, technology libertarians are wrong to pretend that state interventions have contributed nothing. As we have seen, the internet began as a Pentagon project, and Marc Andreessen built the first web browser when working at a government-backed university laboratory. Two government policy changes—the lifting of restrictions on pension-fund investments in VC and the reductions in the capital-gains tax—contributed powerfully to the flow of dollars into U.S. venture funds around 1980.
Venture capital is now present in every major economy on the planet. Though Mallaby's coverage of China is excellent, the entire book is told from a US-centric perspective. In focusing on the biggest success stories, Mallaby leaves out many details on the native foundations of foreign markets. Given the wide variety of laws surrounding company ownership and governance by country, it is difficult to believe that the American VC model could be easily transferred—in China, US firms had to create shell companies in the Caribbean to manage their stakes. Likewise, it's easy to see that certain firms were less willing to grant Mallaby information—there is little detail on Founders Fund or Sequoia beyond what is already known. Despite its shortcomings, The Power Law is an excellent history of venture capital. For a historically secretive industry, the author's extensive research offers a rare and enjoyable look at many improbable stories.
For politicians who worry about technology’s geopolitical impact, it’s tempting to get the government directly involved in subsidizing venture capital. But this is a mistake. In most cases, four simple steps will pay off more. Encourage limited partnerships. Encourage stock options. Invest in scientific education and research. Think globally.
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