A version of this article appeared in the spring 2022 issue Strategy + Business.
The Power Law: Venture Capital and the Making of the New Future
By Sebastian Malabi, Penguin, 2022
The reputation of Venture Capitalists (VCs) has been tough over the last few years. Misconduct, inequality, and poor governance have kept VC-funded large companies at bay, often identified as an activator of a reckless, fake-it-to-you-make-it culture among startups. In a critical essay New Yorker In November 2020, author Charles Duhig called VCs “increasingly greedy and insane” and accused them of “co-conspirators with hype-artists, handing out millions of dollars to them and encouraging their worst tendencies.” Duhig argued that contemporary VCs were using less prudence than their predecessors. Instead of getting their hands dirty to create promising ideas in effective companies, they are spraying money around as if they are creating “trading-floor bets”.
Economic historian Sebastian Malabi tells the story differently. He believes that the venture capital industry has had a “positive impact on the economy and society” and, more importantly, its innovative farming model has proved so successful that it has helped almost every major US technology company in the last 60 years. It’s the story of the men behind the art – and it’s almost entirely male – that forms the basis of his new book, Power law. Heavyweight and richly detailed, this is a career journey through the chaos of startup culture and an accurate assessment of how the relationship between founders and their financiers has evolved. But where Duhig sees VCs sleeping on wheels, Malabi believes that structural changes have only weakened their influence, and in fact it has sidelined VCs, forcing many companies to lose their way.
Considering that VCs are now struggling to heal their promising people, it is ironic that entrepreneurial capitalism began as a practice of liberation. Malabi traces its origins to the late 1950s, when eight Ph.D. Researchers working for a semiconductor company in California wanted to escape the breathless management style of their indomitable boss. Since the financial industry was still living in the shadow of despair and was extremely risk-averse, they believed that their options were limited to hiring by another firm. Instead, a family connection led them to a young broker, Arthur Rock, who suggested that they start their own company with a bold new structure. The founders will each deposit a conceptual amount of money for equal shares in the firm. Rock will take a slice, and the funds will be provided by an outside investor who had the option to buy all of the company’s stock at a later date for an agreed price.
The new company, Fairchild Semiconductor, was a roaring success. Owning a piece of it means that the “traitorous eight” – as they will be known later – focused as much on talking to potential customers as they did on lab work. Fairchild has been successful because it initially combines science and commerce. Proponents of her case have been working to make the actual transcript of this statement available online. Together with a new partner, Rock sets out to refine his concept. He persuaded 30 rich people to invest in a time-limited, equity-only fund that would, in turn, finance a small number of ambitious companies. Rock’s two choices were so overwhelming that when he closed the fund seven years later, its value increased from US $ 3.4 million to $ 77 million.
The rock’s stratospheric return encouraged other early VCs to focus on similar moon shots. This approach brought them into contact with some unusual characters, including Nolan Bushnell of Atari (“a high-tech Hugh Hefner”), Steve Jobs of Apple, and Leonard Bosack and Sandy Lerner of Cisco. VCs needed to roll up their sleeves to turn their embryo firms into financial powerhouses. “We’ll stay in it up to our elbows,” said Tom Parkins, the first VC who was “unabashedly delighted” in the role of “promoter and front man.” In practice, this means showing founders how to run a business: who to hire, how to find potential customers, and where to spend their money. To reduce the risk, Perkins and others paid cash in increments, “calibrated to support the company with each cautionary charge until it reaches an agreed milestone.” This type of hand-on activism means that in the 1970s and 1980s, VCs were advisors and mentors as a source of funding.
VCs needed to roll up their sleeves to turn embryo companies into financial powerhouses. In practice, this means showing founders how to run a business: who to hire, how to find potential customers, and where to spend their money.
This era proved to be a high point for VCs. They did not have such an impact on their founders or how their companies developed. Malabi marks the rise of Internet service providers as the moment when power shifted from the financier to the founder. Yahoo and Google have created code instead of hardware, which means they don’t need the same amount of capital to get started. Three decades of growth in the industry will increase the number of venture capital firms, giving founders more options. In 1999, Sergey Brin and Google’s Larry Page met John Doyer, one of the most respected VCs of the era. The presentation they gave was 17 slides long and illustrated with cartoons. Five years later, Mark Zuckerberg wore pajamas to a meeting with one of Doyer’s rivals. The VCO was not discouraged. But even though Rock claimed up to half of the company for his involvement, Doerr and his contemporaries were happy to own the eighth.
The arrival of growth investors has put more pressure on traditional VCs. While Rock and his successors were regularly involved in marketing a product long before, others finally realized that there were many more opportunities down the line and provided large amounts of capital to established companies that they believed were likely to grow many times over. These investors, who included Yuri Milner and Masayoshi Son, were irresistible to the ambitious technology companies. Unlike the VCs, who demanded equity in exchange for funds, Milner and son did not even want to sit on the board. Malabi argues that the injection of huge capital by growth investors (and VCs who have chosen to compete with them) results in greater control for entrepreneurs, but also weak corporate governance and ultimately excessive restraint and discipline. “Of course, at a time when technology companies were gaining momentum and the founders needed to feel more confident about themselves,” Malabi wrote, “the normal forms of private or public governance would thus be suspended.”
Nevertheless, Malabi is wary of highlighting the efforts made by VCs to rein in and even remove their founders. His chapter is instructive on the relationship between Uber’s Travis Callahan and his first VC supporter on the benchmark, Bill Gurley. As Uber grew older, Kalanik lost interest in Girl’s advice. Saudi Arabia’s Public Investment Fund proposes to invest $ 3.5 billion in the firm and expand the board with selected members of Kalanik, pushing Garley to further margins. Garley was upset about how the Saudi money would be spent (and what it would eventually do with the benchmark share price), and was given the results of an investigation into Uber’s work culture. Garley used its toxic content to confront what became known as the “religion of the founders” and eventually expelled Kalanik from the company. Kalanik’s successor, Dara Khasroshahi, followed Gurley’s recommendation to tighten corporate governance, and the company’s 2019 IPO was relatively good. Although it lowered the highest personal valuation of $ 79 billion, at $ 69 billion it became one of the ten largest IPOs of all time in terms of market cap — and gave the benchmark a 270x return on its investment. As Mallabi puts it, the VC’s precise direction took the company back from the brink.
The tools operated by venture capitalists are extremely powerful. A VC Mallabi has spoken of comparing his service to jet fuel. This energy has helped Cisco, Apple, Google and all the firms that work around them But if it is pumped into the wrong companies, it can cause spectacular failure. Arthur Rock once said that his decisions about which companies to support would “come from the top of the pants seat or hat.” Inside Power lawMalabi has made a strong case that VCs have since become more strategic and analytical in deciding where to place their powers, even if their goals are not always true.
- Mike Jackman Is a freelance journalist and has previously worked for the PwC and the Economist Intelligence Unit.