How venture capital created the modern world
VENTURE CAPITAL (VC) is by far the most interesting form of capital — and, along with tech entrepreneurs, venture capitalists are the most interesting sort of capitalists. Over the past 60-odd years VCs have propelled Silicon Valley to the heart of the world economy. Now they are driving the rise of artificial intelligence and other clever technologies in China. Most capitalists focus on predictable returns. VCs are in the business of betting on the future. If capitalism is about creative destruction, as Joseph Schumpeter argued, then venture capital is creative destruction taken to the nth degree.
How does the venture capital industry work its wonders? Is there a replicable formula for successful VC investing, or is it just a matter of being in the right place at the right time? And how secure is Silicon Valley’s dominance of the industry? Sebastian Mallaby’s absorbing new book, The Power Law: Venture Capital and the Art of Disruption, seeks to answer these questions.
Mallaby, a veteran journalist and a senior fellow at the Council on Foreign Relations, has set himself the grand task of chronicling the rise of our current finance-focused version of capitalism, and does so in much the same liberal, optimistic spirit in which Thomas Macaulay chronicled the rise of parliamentary liberty in the mid-19th century. (Full disclosure: I was Mallaby’s colleague at The Economist for many years.) In More Money Than God he told the story of hedge funds. In The Man Who Knew he profiled Alan Greenspan and through him the Federal Reserve in its pomp. He now brings his trademark mixture of exhaustive research and clear analysis to his most interesting subject so far.
In our author’s view venture capital owes its success to two principles: the power of networks and the logic of what is known as the Pareto principle. This book is in a sense the story of two great economists, Ronald Coase and Vilfredo Pareto.
Coase, a Nobel Prizewinner, analyzed the modern economy in terms of the interaction of firms and markets: Firms make sense if the cost of doing things internally is lower than the cost of going to the market. Mallaby argues for the importance of a third force — networks.
In legal terms, venture funds are private limited partnerships that pool the partners’ money to fund particular ventures (they are very similar to the funds that financed individual sea voyages before the rise of the limited liability company). In practical terms, they are networks of contacts and expertise. Venture capitalists have achieved their disproportionate impact because they combine the strengths of both corporations and markets. They are like companies in that they can provide startups with management skills, corporate resources, and strategic vision, and like markets in that they are fluid and flexible. Networks don’t so much trump markets and corporations as supercharge both.
For his part, Pareto famously observed that 80% of the land in Italy was held by 20% of the people just as 20% of the pea pods in his garden produced 80% of the peas. In the world of the normal distribution curve, nearly all the observable variations in a data set cluster around the average and the tails of the curve get ever thinner until they disappear. In the world of the Pareto principle, or what was later called the power law, the tail extends and expands. The rich go on getting richer and the famous more famous. This is the world venture capitalists inhabit: The vast majority of startups end up being worth nothing, but a handful will become superstars, paying for all the dud investments many times over. “Venture capital is not even a home-run business,” Bill Gurley of Benchmark once remarked. “It’s a grand-slam business.”
Yet how do you build a successful industry on the power of networks and the logic of the Pareto principle? Venture capital is an inherently inexact business. There are no precise metrics to measure world-changing ideas in the same way that conventional investors can measure the book value of a company and hedge funders can discover hidden patterns in markets. VCs are in the business of making long-term bets on talent, but talent is impossible to measure with any exactitude. Sometimes jerks who appear to be geniuses turn out to be plain jerks. Sometimes people with astonishing ideas can’t hack it in business. Still, in reading Mallaby’s detailed narrative I counted five informal rules for success.
First: You need to be a consummate valley insider, preferably a former tech entrepreneur yourself,
like Peter Thiel, the PayPal cofounder who went on to create the Founders Fund in 2005. The venture capital firm Accel even had a “90% rule” — they should know 90% of what founders are going to say before they open their mouths.
Second: You need to combine two qualities that are not often found together, revolutionary zeal and patience. VCs are in the business of disrupting established ways of doing things,
but they usually have to wait years for their hunches to pay off. Today’s most revolutionary form of capital is also the most patient.
Third: You must understand that you are in the liberation business, freeing talent to do what it does best.
Arthur Rock created the modern VC industry in the late 1950s because he set himself the task of freeing talented scientists from the prison of Shockley Semiconductor Laboratory, where they were being driven to distraction by William Shockley’s egomania, and then providing the liberated scientists with the resources that they needed to turn ideas into products.
Fourth: You must understand that liberation takes the form of management as well of money. VCs must provide entrepreneurs with management either in the form of advice, expertise, or even an outside CEO. This task is rendered more complicated by talent’s ambivalence about liberation: It’s not uncommon for entrepreneurs to resist the imposition of a management team, particularly a new CEO, even if they have repeatedly demonstrated that, left to themselves, they can’t run a whelk stall.
Fifth: You need to be willing to disrupt yourself with the same ruthless enthusiasm that you disrupt other industries, including dismissing older partners if their networks age and their ideas go out of fashion.
Kleiner Perkins dominated the valley for a quarter of a century only to decline precipitously. Sequoia, one of the most persistently successful ventures, reminded itself of its mortality by producing a slide of “the departed”: partnerships that had flourished and then failed.
How secure is the valley’s global leadership of the industry that it invented? The most successful rising venture capital powers are small countries such as Singapore and Israel. Europe has failed miserably in getting into the game. The exception to this picture is the country that really matters, China. In the early 2000s the dot-com bust persuaded hungry venture capitalists to look elsewhere for growth, and no big market was growing faster than China. The Chinese, as is their way, quickly learnt from the masters, using their newfound skills as VCs not only to make money but to build strategic industries. In 2017 China overtook the US as the top country for venture returns measured by current returns on investment. China is leading the world in a growing number of new technologies, including drones, mobile payments, next generation 5G networking equipment, face recognition and AI. With the US military-industrial complex frozen in the 1950s, the Americans continue to pour billions into aircraft carriers while the Chinese mass-produce cheap, expendable, autonomous drones that, deployed in vast swarms, may render the floating hulks obsolete.
Mallaby nevertheless concludes that America’s venture-capital machine is “an enduring pillar of national power.” Here his argument is a bit too Whiggish for my taste: The 2020s are not the 1990s, and we deserve a bit of Oswald Spengler mixed in with our Macaulay. Is an economy based on the power law compatible in the long term with a political system based on democracy and equality? Is the domination of the tech industry by so many freaks and misfits a cause for concern? (Among the many extraordinary facts that our author has unearthed is that four of the six early PayPal employees built bombs when they were in high school.) And is there a connection between the Californian business elite’s success at producing technological marvels and the political elite’s failure to prevent social breakdown? I worry that the answers to these questions are dark ones, not least because, the last time I visited San Francisco, the streets were paved not with venture-capital gold but with human excrement and used syringes.
There is no doubt that California venture capitalists have been geniuses at thinking up new ways of making money, as Mallaby engagingly demonstrates. But when it comes to thinking about how to preserve a healthy civilization California’s politicians have been as thick as a brick.