The power law Venture capital and the making of the new future

Sebastian Mallaby

Book - 2022

"From the New York Times bestselling author comes the astonishingly frank and intimate story of success and failure inside Silicon Valley's dominant venture capital firms-and how their strategies and fates have shaped the path of innovation, and the global economy, writ large"--

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Subjects
Published
New York : Penguin Press 2022.
Language
English
Main Author
Sebastian Mallaby (author)
Item Description
"A Council on Foreign Relations Book."
Physical Description
482 pages : illustrations (some color) ; 25 cm
Bibliography
Includes bibliographical references and index.
ISBN
9780525559993
  • Introduction Unreasonable People
  • Chapter 1. Arthur Rock and Liberation Capital
  • Chapter 2. Finance Without Finance
  • Chapter 3. Sequoia, Kleiner Perkins, and Activist Capital
  • Chapter 4. The Whispering of Apple
  • Chapter 5. Cisco, 3Com, and the Valley Ascendant
  • Chapter 6. Planners and Improvisers
  • Chapter 7. Benchmark, SoftBank, and "Everyone Needs $100 Million"
  • Chapter 8. Money for Google, Kind of for Nothing
  • Chapter 9. Peter Thiel, Y Combinator, and the Valley's Youth Revolt
  • Chapter 10. To China, and Stir
  • Chapter 11. Accel, Facebook, and the Decline of Kleiner Perkins
  • Chapter 12. A Russian, a Tiger, and the Rise of Growth Equity
  • Chapter 13. Sequoia's Strength in Numbers
  • Chapter 14. Unicorn Poker
  • Conclusion Luck, Skill, and the Competition Among Nations
  • Acknowledgments
  • Appendix: Charts
  • Notes
  • Timeline
  • Index
Review by Publisher's Weekly Review

The venture capitalist mindset requires making crazy bets for outlandish returns, according to this sharp take on Silicon Valley's bankrollers. Washington Post columnist Mallaby (The Man Who Knew) recaps the roles of venture capital firms in the recent history of tech start-ups, including Sequoia Capital's 1987 funding of network router juggernaut Cisco, Kleiner Perkins's investment in Google in 1999, and Accel's early-2000s bet on Facebook. These storied deals followed a "power law" strategy, he argues: instead of seeking safe investments with reliable returns, VCs funded many risky ventures, most of which failed, in order to find a few successes that generated colossal returns. Capital firms provide services other than funding, he contends, as they dispense sound advice to novice entrepreneurs, help shape up management structures, and bring in talented executives and useful collaborators. This is no dry business treatise; Mallaby's colorful narrative foregrounds the eternal battle between investors and the often eccentric, even abusive, tech visionaries they fund, and their squabbles over how much stock an investment will buy. (WeWork founder Adam Neumann unloaded a fire extinguisher onto one investor, who duly ponied up more cash.) The result is a lucid, thoughtful, and entertaining account of high-wire capitalism at work. Photos. Agent: Chris Parris-Lamb, the Gernert Company. (Jan.)

(c) Copyright PWxyz, LLC. All rights reserved
Review by Kirkus Book Review

British financial journalist Mallaby delivers a circumstantial portrait of the venture capital revolution, with all its ups and downs. How does one go about getting a hand into the pot of gold that is the venture capital market? By convincing investors that the power law is in play--i.e., that a specific idea will scale up "at an accelerating, exponential rate," yielding riches for a relatively modest stake. For the maker of that idea, one has to hit on something that the world doesn't know it needs until it does. In this highly detailed and sometimes wearisome account, the author opens with one such idea: An inventor conceives an all-plant hamburger that smells and tastes like meat, approaches a venture capitalist with the promise "to make you even more insanely rich than you already are," and voilà: Impossible Foods was born. Mallaby, a former contributing editor at the Financial Times, locates the first venture capital funds in Silicon Valley but from a renegade source: In 1957, a group of scientists walked away from a lab and founded a group that was first known by the longer name "adventure capital." The author traces the evolution of venture capital into the 1970s post-hippie culture of the Bay Area, where former communards were now content with the thought of becoming insanely rich, their tinkerings soon to explode in the digital revolution. By anticipating the wave, funders grew rich indeed, "making Silicon Valley the most durably productive crucible of applied science anywhere, ever." Tracing the tumultuous rise of PayPal, Facebook, and other venture-funded projects, Mallaby reveals some of the inner tensions inherent in the game: Founders can be free spirits, but funders demand that they be controlled by outer boards and CEOs. The author closes with a projection into the future, with funders scattered well beyond Silicon Valley while fighting a long and perhaps losing war with an aggressive Chinese fund culture. Though it plods in spots, as forays into economics will, financial wonks will find it indispensable. Copyright (c) Kirkus Reviews, used with permission.

Copyright (c) Kirkus Reviews, used with permission.

Introduction Unreasonable People Not far from the headquarters of Silicon Valley's venture-capital industry, which is clustered along Palo Alto's Sand Hill Road, Patrick Brown strode out into his yard on the Stanford University campus. Atop a little hill behind his house, Brown got down on his hands and knees, a shaggy fifty-four-year-old professor in a T-shirt, peering at the vegetation through rounded glasses. Proceeding delicately, like a detective collecting samples that might yield a vital clue, Brown began digging out the roots of some wild clover plants. It might impress the ordinary gardener to know that those roots would soon yield $3 million. Brown was one of the world's leading geneticists. In 1995, his lab had published pioneering work on DNA microarrays, which help distinguish between normal and cancerous tissue. He had been elected to the National Academy of Sciences and the National Academy of Medicine. He was the recipient of a Howard Hughes award, which guaranteed no-strings-attached research funding. But his objective on that hilltop had nothing to do with genetics. The year was 2010, and Brown was using a sabbatical to plot the downfall of the meat-industrial complex. A friend had set him on this path by means of a stray comment. Possessed of a keen environmental conscience, Brown had been worrying that animal husbandry occupied one-third of the world's land, causing significant greenhouse gas emissions, water degradation, and a loss of biodiversity. The planet was clearly going to need a better kind of food for the growing population of the twenty-first century. Then Brown's friend mentioned that if you could make a vegetarian burger that tasted better than a beef burger, the free market would magically take care of the problem. Adventurous restaurants would serve it, and then McDonald's would serve it, and pretty soon you could eliminate meat from the food system. The more Brown pondered this, the more he grew agitated. If you could make a yummier vegetarian burger? Of course you could make a yummier vegetarian burger! Why was nobody treating this as a solvable problem? "People just figured we have this insanely destructive system and it's just never going to go away," Brown fumed. "They thought, 'Bummer, but there you are.'" In most places and at most points in human history, Brown's epiphany would have been inconsequential. But, as Brown himself reflected later, he had "the very good fortune of living in the epicenter of venture capital." Because Stanford sat at the heart of Silicon Valley, its golf course laid out along the edge of Sand Hill Road, Brown was digging up his yard with a clear purpose. Those clover roots contained heme, an iron-carrying molecule found in hemoglobin, which gives blood its red color. If Brown could show how this plant molecule could mimic the properties of bloody meat, there was a good chance that a venture capitalist would fund a plantburger company. Brown dissected the clover roots with a razor blade and blended them up to extract and culture the juices. Pretty soon, he had what he needed to fashion a vegetarian burger that smelled and sizzled and dripped and squished like 100 percent Grade A beef. "I got to a point where, though I didn't have much data, I'd enough to go and talk to some venture-capital companies-of which there are a ridiculous number in Silicon Valley-and hit them for some money." A scientist friend mentioned that Vinod Khosla, a venture capitalist who ran the eponymous Khosla Ventures, was interested in environmentally friendly, "cleantech" projects. What he didn't mention was that Khosla was also a preacher of the Valley's most bracing creed: the belief that most social problems can be ameliorated by technological solutions, if only inventors can be goaded to be sufficiently ambitious. "All progress depends upon the unreasonable man," the "creatively maladjusted," Khosla declared, borrowing eclectically from George Bernard Shaw and Martin Luther King Jr. "Most people think improbable ideas are unimportant," he loved to add, "but the only thing that's important is something that's improbable." If you were going to pitch Khosla an invention, it had better not fall into the incremental category he called "one sheet of toilet paper, not two." Khosla wanted radical dreams, the bolder and more improbable the better. Brown rode a bicycle to Khosla's office, a sleek designer building of glass and wood. He had prepared a slide deck that he admitted "in retrospect was ridiculous." The first slide laid out his goal: rendering the entire meat industry redundant. Those rounded glasses-the John Lennon, Steve Jobs, visionary look-seemed altogether appropriate. Khosla has large eyes and chiseled features and thick, cropped gray hair. He fixed his visitor with an impish stare. "That's impossible!" he said, delightedly. Silently, Khosla was thinking to himself, "If there is a one-in-a-hundred chance that this works, this is a shot worth taking." Brown explained how he proposed to out-beef the beef industry. He would break the challenge down into its component parts: how to replicate the smell, the consistency, the taste, and the appearance of a real beef burger. Once you analyzed each question separately, an apparently impossible ambition became a set of soluble problems. For example, the clover-root juices would drip like blood onto hot coals; they would turn from red to brown as they sizzled on a barbecue. Dr. Frankenstein had met Ray Kroc. Nobody would eat ground cow flesh again. Khosla ran through a test that he applied to supplicants. The onus was not on Brown to prove that his idea would definitely work. Rather, the question was whether Khosla could come up with a reason why it obviously could not work. The more Khosla listened to his visitor, the less he could rule out that he was onto something. Next, Khosla sized up Brown as a person. He was fond of proclaiming a Yoda approach to investing: empower people who feel the force and let them work their magic. Brown was evidently brilliant, as his credentials as a geneticist demonstrated. He was gate-crashing a new field, which meant he was unburdened by preconceptions about what conventional wisdom deemed possible. Moreover, Brown was clearly as determined as he was bright: he was ready to leave his academic perch-the prestige of a Stanford professorship, the blank check from the Howard Hughes foundation. All in all, Brown fitted Khosla's archetype of the ideal entrepreneur. He had the dazzling intellect, the willingness to put his own neck on the line, the glorious hubris and na*vetZ. There was one last test that Khosla cared about. If Brown managed to produce a yummy plantburger, would he generate profits that would be commensurately succulent? Khosla routinely put capital behind moon shots with a nine-in-ten chance of failure. But the low probability of a moon landing had to be balanced by the prospect of a large payout: if the company thrived, Khosla wanted to reap more than ten times his investment-preferably, much more than that. There was no point gambling for success unless the success was worth having. Brown had gotten to his final slide, where he stuck all the mundane market data that failed to interest a scientist. He noted matter-of-factly that "it's a trillion-and-a-half-dollar global market being served by prehistoric technology." Khosla latched on. If plant patties could mimic the experience that customers expected from beef-the taste, the consistency, the browning, and the bleeding as you flipped the burger on the grill-the potential was cosmic. Brown looked Khosla in the eyes. "I promise to make you even more insanely rich than you already are, if you give me this money," he told him. At that, Khosla bet $3 million on Impossible Foods, as Brown fittingly named his company. Recounting this story in 2018, Khosla happily noted Impossible's progress since 2010: the company would soon have more than $100 million in annual revenues. But the main message that Khosla emphasized transcended dollars and cents. "You can imagine, if Pat fails, the hubris of saying he could eliminate animal husbandry; he'll be mocked for that," Khosla observed. But, he continued, the mockery would be misplaced. Which is better: to try and fail, or to fail to try? Reasonable people-well-adjusted people, people without hubris or na*vetZ-routinely fail in life's important missions by not even attempting them; the way Khosla saw things, Brown should be hailed as a hero, whatever happened to his company. Truly consequential changes are bound to seem outrageous when they are first imagined by messianic inventors. But there is no glory in projects that will probably succeed, for these by definition won't transform the human predicament. Khosla was himself an unreasonable man, creatively maladjusted. As a boy in his native India, he rebelled against his parents' religion, declined to follow his father into the army, and refused an arranged marriage. On his wedding day, he set his watch alarm, declaring that the religious portion of the ceremony had to be done inside thirty minutes. As soon as he earned an engineering degree, he left for the United States, where he studied more engineering at Carnegie Mellon University. After that, he set his sights on Stanford Business School; learning that he needed two yearsÕ work experience to qualify for admission, he did two jobs at once and declared after one year that he had met the requirement. In 1982, after completing his business degree, Khosla teamed up with three computer scientists to found Sun Microsystems, whose powerful workstations stamped their mark on the evolution of computing. Cocky and obnoxious, Khosla was soon fired. He became a venture capitalist. Joining the storied venture partnership of Kleiner Perkins, Khosla discovered his true métier. His unreasonable impatience-his determination that anything might be possible and everything should work his way-made him one part tyrant, two parts visionary. In later life, he bought a village with forty-seven cottages on the California coast and fought a series of losing court cases to block public access to the beach, even though he never found time to spend the night there-not once, ever. But he channeled his contempt for conventional thinking into a series of dazzling investments, frequently losing his money and sometimes generating bonanzas. By the time he met Patrick Brown, everything about Khosla-his risk appetite, his love of hubris, his quest for improbable ideas-made him the living embodiment of the power law, the most pervasive rule in venture capital. Many phenomena in life are normally distributed: nearly all the observations in a data set cluster around the average. For example, the average height of an American man is five feet ten inches, and two-thirds of American men are within three inches of that average. When you plot height on an x axis and the probability that a man will have that height on a y axis, what you see is a bell curve: the greatest probability is that a man's height will be the average height, and the probabilities decline as you move away from that midpoint. The chances of meeting a man whose height is ten inches from the average-that is, less than five feet or more than six feet eight-are exceedingly small. Further away from the mean, the thin tails of the curve taper toward zero. Not all phenomena follow this pattern, however. A chart showing the wealth of Americans rather than their height looks very different. People who are richer than the median are sometimes vastly richer, so the far right side of the wealth chart features an extended fat tail between the curve and the x axis. Because the very rich are numerous enough and wealthy enough to impact the average for the whole nation, the average is pulled to the right: unlike in a normal distribution, the mean is higher than the median. In a normal distribution, moreover, you can remove the biggest outlier from a sample without affecting the average: if a seven-foot NBA star walks out of a cinema, the average height of the remaining ninety-nine movie-watching men falls from five feet 10 inches to five feet 9.9 inches. In a non-normal, skewed distribution, in contrast, the outliers can have a dramatic effect. If Jeff Bezos walks out of the cinema, the average wealth of those who stay behind will plummet. This sort of skewed distribution is sometimes referred to as the 80/20 rule: the idea that 80 percent of the wealth is held by 20 percent of the people, that 80 percent of the people live in 20 percent of the cities, or that 20 percent of all scientific papers earn 80 percent of the citations. In reality, there is nothing magical about the numbers 80 or 20: it could be that just 10 percent of the people hold 80 percent of the wealth, or perhaps 90 percent of it. But whatever the precise numbers, all these distributions are examples of the power law, so called because the winners advance at an accelerating, exponential rate, so that they explode upward far more rapidly than in a linear progression. Once Jeff Bezos achieves great riches, his opportunities for further enrichment multiply; the more a scientific paper is cited, the better known it is and the more likely it is to attract further citations. Anytime you have outliers whose success multiplies success, you switch from the domain of the normal distribution to the land ruled by the power law-from a world in which things vary slightly to one of extreme contrasts. And once you cross that perilous frontier, you better begin to think differently. The rethinking required is especially pronounced in finance. Investors who focus on currencies, bonds, and stock markets generally assume a normal distribution of price changes: values jiggle up and down, but extreme moves are unusual. Of course, extreme moves are possible, as financial crashes show. But between 1985 and 2015, the S&P 500 stock index budged less than 3 percent from its starting point on 7,663 out of 7,817 days; in other words, for fully 98 percent of the time, the market is remarkably stable. Because the distribution of price changes in these widely traded markets approaches normal, speculators concentrate on harvesting profits from the modest fluctuations that occur on most days. Like the seven-foot NBA star in the cinema, unexpectedly large price jumps are rare enough and moderate enough that they do not affect the average. Now consider the returns in venture capital. Horsley Bridge is an investment company with stakes in venture funds that backed 7,000 startups between 1985 and 2014. A small subset of these deals, accounting for just 5 percent of the total capital deployed, generated fully 60 percent of all the Horsley Bridge returns during this period. (To put that in context, in 2018 the top-performing 5 percent of subindustries in the S&P 500 accounted for only 9 percent of the index's total performance.) Other venture investors report even more skewed returns: Y Combinator, which backs fledgling tech startups, calculated in 2012 that three-quarters of its gains came from just 2 of the 280 outfits it had bet on. "The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund," the venture capitalist Peter Thiel has written. "Venture capital is not even a home-run business," Bill Gurley of Benchmark Capital once remarked. "It's a grand-slam business." Excerpted from The Power Law: Venture Capital and the Making of the New Future by Sebastian Mallaby All rights reserved by the original copyright owners. Excerpts are provided for display purposes only and may not be reproduced, reprinted or distributed without the written permission of the publisher.