Sebastian Mallaby’s “The Power Law” traces the early history of the venture capital industry up to the present day, highlighting its significant impact on the development of technology. Contrary to common claims that venture capitalists (VCs) are merely opportunistic lemmings following trends, the book argues that venture capital requires genuine skill and provides various examples to support this claim. It covers successful venture capital investments in tech giants like Amazon, Apple, Facebook, and Google, as well as notable failures such as WeWork and Theranos. Mallaby argues that these failures cannot be solely attributed to “traditional” venture capital, as non-traditional investors outside Silicon Valley played a significant role. The book also explores the expansion of China’s venture capital industry through the involvement of Silicon Valley VCs and offers recommendations for policymakers on navigating VC investment in China amidst recent political tensions.
Overall, “The Power Law” is a comprehensive and well-written history of the venture capital industry.
Origins
The venture capital industry can be traced back to the late 1930s. The term “venture capital” was first used by Lammot du Pont, the president of E. I. du Pont de Nemours & Company, in 1938 during a speech before the U.S. Senate Committee to Investigate Unemployment and Relief. He defined venture capital as capital that is invested in an enterprise without expecting an immediate return, but rather taking a chance on getting an ultimate return. Jean Witter of the San Francisco investment bank Dean Witter & Company also used the term in his 1939 address to the Investment Bankers Association of America. However, the term did not become widely recognized until the 1960s.
Fairchild Semiconductor
The first breakout success of venture capital was Arthur Rock’s Liberation Capital financing of Fairchild Semiconductor. According to Arthur Rock, venture capital was more than just financial investment. It involved unlocking human talent, creating incentives, and fostering a new kind of applied science and commercial culture.
Before venture capital, startups faced a catch-22 situation. They needed financing to generate cash flows, but they also had to show cash flows to get financing. Venture capital addresses this by providing funding to unproven firms, with the hope that a small percentage of those firms will generate significant returns. Fairchild Semiconductor was one such firm, founded by eight scientists known as the “Traitorous Eight” who left Shockley’s company due to his poor management style. Unable to secure traditional financing, they were fortunate to receive funding from Liberation Capital. This investment paid off handsomely, with the company ultimately being valued at over $100 million in 1960.
Arthur Rock went on to co-found the Davis & Rock venture capital firm. They raised $3.2 million from thirty “limited partners”, providing companies with the necessary funds to fuel aggressive growth. Ultimately, they achieved a 22x return for their investors, surpassing even Warren Buffett. One of their notable successful investments was in Intel. The success of the Davis & Rock model led to the emergence of several partnerships, driving the expansion of the venture capital industry.
Kleiner Perkins
Kleiner Perkins was founded in 1972 by Eugene Kleiner, a member of the Traitorous Eight, and Tom Perkins, an executive at Hewlett-Packard. Tom Perkins played a significant role in the establishment of Genentech and was the first venture capitalist to openly embrace the role of promoter and front man, signaling to scientists that they were part of something glamorous and ambitious, beyond academia. Perkins contributed to Genentech’s culture by creating an environment where everyone, from the janitor to the top executives, was invested in the company’s success. He ensured that Genentech employees, including key contractors, received stock options, which increased incentives for researchers.
Perkins also developed a strategy to mitigate risks associated with the venture, making it an attractive investment opportunity. He secured new financing rounds when necessary, attracting money from other investors by promising to achieve the next research milestone. This approach set the standard for stage-by-stage investing in startup companies.
Kleiner Perkins took an active approach to investment, going beyond traditional stock-pickers on Wall Street. They worked closely with the entrepreneurs they invested in and actively participated in the businesses. Following the example of Davis & Rock, they established a time-limited fund and committed some of their own savings. Notable investments by Kleiner Perkins include Genentech, Google, and Netscape.
Sequoia and Apple
Sequoia Capital was founded in 1972 by Don Valentine. Valentine introduced a hands-on activism approach to venture capital, supporting brilliant but unconventional entrepreneurs. One notable example is Nolan Bushnell, an early video game pioneer, who held board meetings in his hot tub. Initially focused on the information technology sector, which was a niche field at the time, Sequoia Capital became a master of finance in the technology-driven twenty-first century. The firm is known for its disciplined approach and ability to work with challenging founders. Despite facing risks and losses in many venture bets, Sequoia has consistently achieved success, with several investments generating significant profits.
Apple was a company with a unique founder. At the time, Steve Jobs was not the refined, turtleneck-wearing guru we remember him as now, but rather a long-haired hippy who didn’t shower frequently. They faced rejection from every venture capitalist, but luck was on their side when Nolan from Atari referred them to Don Valentine. Nolan believed Don might be a good fit due to his reputation for working with difficult founders. Back then, Nolan could have purchased a third of Apple for $50,000 but declined the investment, instead referring Jobs to Don to soften the blow. Another investor, Mark Markkula, a veteran from Fairchild and Intel, was introduced to Jobs by Valentine. Markkula is considered the first “angel investor,” independently wealthy individuals (usually through exits from successful tech companies) who decide to invest some of their money in startups. Markkula’s technical background allowed him to recognize the value of Apple’s technology, and his industry connections were invaluable in helping Apple secure further investments and publicity. Today, Apple is the most valuable company in the world.
At this point, certain trends are becoming evident. The success of venture capital largely depends on dense networks of both talent and capital, as well as the fortuitous connections that result from them. Through Markkula, we can directly trace a line from Fairchild Semiconductor, the first VC-backed startup, to Apple.
Growth Investing
Masayoshi Son, the founder of the Japanese firm SoftBank, pioneered the concept of “growth investing”. In 1997, he invested $100 million in Yahoo and doubled his money when the company went public the following year. Similarly, his $400 million investment in ETrade grew to $2.4 billion within a year. These investments far surpassed those made by previous venture capitalists, briefly making him the world’s richest man.
Tiger Global, another firm focused on growth investing, was established by Chase Coleman and Scott Shleifer. They applied hedge-fund and private-equity strategies to tech firms in emerging markets. Their approach involved identifying promising tech companies in these markets, often referred to as “the this of the that” (such as the Amazon of China or the Google of Russia), and making substantial investments as they entered their growth phase. This strategy helped Tiger Global become a highly profitable technology investment franchise.
The creation of Tiger’s private fund introduced a new type of technology investment vehicle. It moved away from traditional hedge-fund stock picking and instead focused on private technology investments. This model would later be successfully adapted by Yuri Milner in his investment in Facebook.
Tiger Global’s investment approach was not limited by geographical boundaries. For example, they invested $20 million in Chinese companies Sina, Sohu, and NetEase, despite not having visited the country. They were able to make these investments at a significant discount due to the SARS epidemic, which had deterred other investors. Within a year, the value of their investments in China grew by 5 to 10 times, increasing the fund’s value by $100 million. This investment strategy was inspired by Julian Robertson, the founder of Tiger Management, who believed that the best investment opportunities were often found abroad.
VC in China
American venture capitalists played a significant role in the development of the Chinese venture capital industry. The growth of Chinese venture capital followed a similar pattern to that of Silicon Valley: initially limited capital and investors, followed by an influx of money leading to an increase in venture capitalists and startups. Eventually, venture capitalists played a coordinating role in the face of intense competition among startups.
Shirley Lin, a pioneer of venture capital in China and a partner at Goldman Sachs, played a key role in bridging the gap between the U.S. and China. Fluent in both languages and cultures, Lin brought the U.S. venture playbook to China and supported several internet startups, including Alibaba. Initially, Goldman Sachs invested $1.7 million in Alibaba. Fifteen years later, when Alibaba had a successful IPO, that stake would have been worth an astonishing $4.5 billion. However, due to pressure from superiors at Goldman Sachs who viewed the Chinese investment as unprofitable, Lin gave up 17 percent of Alibaba, distributing it among four other investment companies. As a result, they did not fully realize the potential earnings.
Alibaba has emerged as a formidable enterprise and a breeding ground for ambitious individuals who have gone on to create their own startups, thereby fostering a culture of entrepreneurship and innovation in China. Alongside companies like Tencent and Baidu, which also received U.S. capital, Alibaba has become a pillar of China’s digital economy. The success of Alibaba has demonstrated to other entrepreneurs in China the immense potential that can be achieved, inspiring them to dream bigger and make significant contributions to the rapidly growing economy. As a result, there has been a surge in the number of startups and venture capitalists in China, mirroring the growth experienced by Silicon Valley around 1980.
Traditionally, Chinese laws have prohibited foreign ownership of Chinese companies, particularly in sectors such as website operations, in order to protect domestic industries and maintain control over the country’s economy. These laws did not recognize employee stock options or certain types of “preferred” stock that foreign investors, especially those from Silicon Valley, typically use to secure their rights in startups. Additionally, the listing of Chinese internet stocks on America’s Nasdaq market was considered illegal. These legal restrictions posed significant challenges for foreign investors, especially U.S. venture capitalists. However, over time, investors like Lin have developed workarounds to circumvent these limitations, such as establishing offshore entities and utilizing synthetic equity. Chinese officials have generally turned a blind eye to these workarounds, possibly because they have calculated that the benefits outweigh the costs.
The Youth Revolt and Yuri Milner
A colorful episode in the book recounts Zuckerberg’s appearance at a Sequoia pitch meeting wearing pajamas. Instead of pitching Facebook, he presents a side project. This was clearly a snub, influenced by Sean Parker’s disdain for venture capitalists, who had ousted him from his own startups multiple times. The book describes this shift in power from venture capitalists to young, often contrarian entrepreneurs as the “youth revolt”. The founders of Google had managed to raise $1 million solely through angel investments, allowing them to exert more control over their venture capital backers than usual. The revolt was further fueled by the emergence of new venture firms such as Founders Fund and Y Combinator, which took non-traditional approaches to venture investing, signaling that the venture industry itself could be disrupted.
Yuri Milner’s investment in Facebook finalized the enthronement of the entrepreneur. Milner, a Russian tech mogul, meticulously compiled a comprehensive spreadsheet on consumer-internet businesses across multiple countries. This spreadsheet tracked metrics such as daily users, monthly users, time spent on the site, and more. Milner’s international experience, particularly his investment in VKontakte, a leading Facebook clone in Russia, convinced him that the idea of Facebook’s market saturation was incorrect. He believed that while Facebook was not yet among the top five websites in the United States, it consistently ranked in the top three in other countries. Milner anticipated that if the U.S. followed the typical pattern, there was still significant growth potential for Facebook. Additionally, he believed that Facebook lagged behind foreign social-media sites in terms of converting users into revenues. Based on these analyses, Milner made a $300 million investment in Facebook.
At the time, Zuckerberg was in need of funds, but he was reluctant to surrender control to venture capitalists, possibly influenced by Sean Parker’s advice. In contrast to his traditional VC counterparts, Milner was satisfied with being a passive investor and did not even seek a board seat for his investment. Milner’s investment in Facebook demonstrated that a mature internet company could remain private and still raise substantial capital. This revelation led to the emergence of “unicorns,” private technology companies valued at over $1 billion.
Wework and Theranos
After Milner’s successful investment in Facebook, investors became more willing to give founders autonomy in running their companies, providing minimal oversight. However, this approach proved disastrous with the rise and fall of WeWork and Theranos.
Benchmark first invested in WeWork in 2012, primarily due to the charismatic co-founder, Adam Neumann, a former Israeli naval officer. WeWork’s business model involved renting out short-term office spaces with additional perks like fruit water, free espresso, and occasional ice-cream parties. Neumann’s marketing strategy successfully attracted a vibrant clientele to these office spaces.
At the time of Benchmark’s initial investment, WeWork had a plausible business model. It leased office spaces at affordable long-term rates and rented them out for shorter periods, marking up the prices. In 2012, the company even turned a profit. However, in order to justify the inflated valuations placed on it by later investors such as banks and mutual funds, WeWork had to grow rapidly. To achieve this, it reduced the rents charged to tenants. As a result, the company’s losses increased with each additional revenue.
By the beginning of 2016, Benchmark faced a dilemma. They had made a smart bet on a charismatic founder who was initially profitable. WeWork’s valuation skyrocketed from $100 million to $10 billion, a 100-fold increase. However, due to the arrival of reckless late-stage investors, led by Masayoshi Son, the founder was now losing money and accumulating conflicts of interest. The risk of WeWork’s inflated valuation collapsing towards its actual value became apparent.
Theranos was a health technology company founded by Elizabeth Holmes, a Stanford undergraduate. The company claimed to have developed a revolutionary blood-testing machine that could provide cheap and accurate results from a small amount of blood. Holmes managed to raise significant funding for the company, mostly from investors outside of the traditional venture capital community. She also recruited high-profile individuals from Stanford’s Hoover Institution to serve on the company’s board, adding credibility to the company.
However, an investigation by The Wall Street Journal revealed that Theranos’ blood-testing machines were fraudulent and its promises of cheap and accurate results were misleading. As a result, the company faced numerous lawsuits and its value plummeted from $9 billion to zero. Elizabeth Holmes, once compared to Steve Jobs, faced the possibility of imprisonment. The downfall of Theranos was seen as a critique of Silicon Valley and its tendency to overhype and underdeliver on technological promises. Holmes was accused not only of lying about her technology’s capabilities, but also of making premature claims about its potential. Mallaby states that in both cases, traditional venture capitalists either did not invest in these companies or divested once problems with their operations became apparent. Elizabeth Holmes raised very little money from practitioners on Sand Hill Road, the heart of the venture capital industry. While Benchmark initially invested in WeWork, they eventually pulled out when Neumann attracted significant investments from investors like Son. Mallaby defends traditional venture capitalists, arguing that they would not have allowed such fraudulent companies to thrive.
The Power Law
The book introduces several “laws” that govern VC investing. The most prominent one is the eponymous “power law,” a statistical concept that explains how a change in one variable can lead to a significant change in another. In the context of this book, the power law describes how a small subset of investments generates the majority of returns for a venture fund. This phenomenon occurs because successful companies often leverage their advantages to gain even greater advantages, such as economies of scale, first mover advantage, and network effects. These breakout companies come to dominate their industries. Venture capital investments play a crucial role in enabling these companies to develop a “flywheel” effect, where success begets more success. Certain markets exhibit “winner take all” dynamics, where a single company owns a significant portion of the market share, as exemplified by Google.
Returns among venture capital firms themselves also follow a power law, with top firms like Sequoia and Benchmark capturing the majority of venture capital returns. These elite firms have a larger network and stronger brand recognition among founders, which allows them to access the most promising early-stage companies. For instance, Bezos chose to work with John Doer from Kleiner Perkins, despite receiving a better term sheet, solely due to Doer’s legendary reputation. Additionally, these top firms are more successful at attracting other investors in later funding rounds and ultimately achieving liquidity on their investments. As the power law suggests, only a few firms can benefit from this flywheel effect, and the industry as a whole has an average return of approximately 10%.
Criticisms of VC
Venture capital has faced significant criticism, much of which Mallaby also highlights in his book. The industry is primarily dominated by white men from a handful of prestigious universities, although this is gradually changing. Another issue is the industry’s tendency to follow trends blindly, which can sometimes lead to disastrous outcomes. For instance, the recent collapse of Silicon Valley Bank, whose depositors were mostly venture capitalists and their portfolio firms, exemplifies this phenomenon. Fears of the bank’s collapse became a self-fulfilling prophecy within the close-knit community, resulting in billions of dollars being withdrawn from the bank within days.
Mallaby notes that venture capital-backed firms sometimes succeed in displacing established competitors, not necessarily because they have a superior product, but because they can undercut prices using their VC funding. Companies like Doordash and Uber heavily subsidized their services to consumers with VC funds. While consumers may benefit from artificially low prices in the short term, once these companies gain a significant market share, they can then increase prices.
Conclusion
Overall, I found this to be an enjoyable read and learned a lot about the origins and dynamics of the venture capital industry. The book could be seen as glorifying and defending the venture capital industry, but it also did a fair job of addressing criticisms against it. I didn’t realize the breadth of topics covered in the book until I started writing this review; there is a lot to unpack and I may not have covered all the main points. I believe most venture capitalists would benefit from reading this book, and I would also recommend it to founders considering venture capital to gain a better understanding of venture capitalists’ motivations, as well as to those interested in tech history in general.