- In his new book, journalist Sebastian Mallaby breaks down the structures and processes of modern venture capital.
- But the book fails to mention the danger of funneling capital into a sector that seems destined to underperform.
- This is an opinion column. The thoughts expressed are those of the author.
In his new book, The Power Law: Venture Capital and the Making of the New Future, respected journalist Sebastian Mallaby has paired a deeply researched history of the venture capital industry with a full-throated polemic in defense of the social value of a venture market that doubled in size in 2021, as over $600 billion dollars in funding pumped into startups around the world. .
Coming just weeks after the conviction of Theranos founder Elizabeth Holmes reinforced the public's worst preconceptions of Silicon Valley arrogance, greed, and deceit, the book will undoubtedly spark vigorous debate. Mallaby sheds important light on the structures and processes behind what has become a powerful (and cloistered) force in American life.
But although the accounts of the key figures that established modern venture capital are often fascinating, his own excellent reporting does not fully justify the observations and policy proposals in support of the industry — like providing tax breaks for venture investors and government incentives for startup employees.
Understanding venture capital
The "power law" of the title refers to the fact that venture funds cannot achieve success without at least one bet so extraordinary that its gains return the entire value of the fund to investors, like Sequoia's early investment in Apple. A certain number of complete failures are to be expected, and precisely how well the rest that aren't home runs do is almost beside the point. "Each year brings a handful of outliers that hit the proverbial grand slam," Mallaby writes, "and the only thing that matters in venture is to own a piece of them."
This is in sharp contrast to private equity investing, a much larger sector of the economy about which Mallaby says almost nothing. (In 2021, private equity firms raised almost three times as much as venture). Private equity investors more modestly target doubling or tripling their money, and losing the entire investment — known as a donut — can be career, or even fund, ending. Venture capitalists, on the other hand, don't get out of bed without the prospect of making ten times their money on an opportunity, and a venture capitalist who hasn't experienced multiple donuts just isn't doing his or her job right.
Venture startup investors back "businesses" that can sometimes be little more than a concept, but they need conviction that, if the idea works out, it will create massive value. In the absence of any track record, this process of selection does not lend itself to traditional economic analysis — what Mr. Mallaby calls "finance without finance" — and success is ultimately about identifying and attracting the only real asset these enterprises have: talented entrepreneurs.
How the startup sausage gets made
Where The Power Law is most enlightening is in its detailed descriptions of the diverse approaches of the most storied venture capital firms: Accel emphasized specialization and research; Kleiner Perkins incubated its own startups; Sequoia was brutally disciplined with both its partners and its founders; Benchmark stayed small and highlighted its coaching and advising role; Founders Fund took a completely hands off approach.
The detailed stories of how the most iconic companies of the current era, from Apple to Facebook and Google, got financed in the first place make for a compelling read. At a variety of key points in the historic narrative, however, The Power Law goes strangely silent. For instance, the book vividly relates how Yuri Milner, a quiet, unassuming Russian digital oligarch who started Russian clones of Amazon, Yahoo, and eBay, changed Silicon Valley by beating out the incumbent venture capitalists to take a major early stake in Facebook. We are told that Milner's father was a Soviet management professor and that Milner returned to Russia after studying in the US and losing his banking job in the financial crisis of 1998. But, despite extensive interviews with him, Mallaby provides no clues to the mystery that has followed Milner for decades: Where did his money come from in the first place?
With respect to the fall of Theranos, Mallaby argues that the episode actually represents "a vindication for VCs, because almost none of the money that Holmes raised came from Sand Hill Road practitioners," but instead was sourced from "billionaire Valley outsiders." Fair enough. But his broader call for venture capital tax breaks and incentives for startup employees is undercut by the data on the sector he provides.
It turns out that not just venture investments follow the power law — the venture industry itself does as well. As Mallaby notes, "counting venture funds raised between 1979 and 2018, the median fund narrowly underperformed the stock market index, whereas the top 5 percent of funds trounced it." Indeed, unlike their private equity counterparts, the same few venture firms outperform over and over again. But these rarefied superstar funds have been closed to new investors for years.
So what is left for the rest of us?
Well, if the sector as a whole does worse than the market even incorporating the returns of these spectacular outliers, you don't need a finance degree to know that an invitation to participate in the remaining venture funds that are available should be politely declined. Yet the returns of the few increasingly attract the interest of the many as unprecedented sums of capital flow into the sector and unprecedented numbers of our most talented graduates eschew established companies for early-stage opportunities.
The venture/startup euphoria has become so pronounced that even industry stalwarts have begun to send up loud flares. "The numbers just don't add up," Fred Wilson of Union Square Ventures recently warned, referring both to the early stage valuations and the amounts of capital being raised for speculative ventures with questionable business models. And the societal cost of misallocating our financial and human capital disproportionately to a sector that seems destined to underperform overall is not insignificant. The Power Law performs a useful service in revealing the roots and accomplishments of a poorly understood but increasingly significant economic sector and cultural bellwether. Its central urgent claim, however, that "governments must do everything possible to foster technology startups" makes little sense when we're likely in the midst of a startup bubble.
Jonathan A. Knee is professor of professional practice at Columbia Business School and a senior advisor at Evercore. His most recent book is "The Platform Delusion: Who Wins and Who Loses in the Age of Tech Titans."