The Power Law: Venture Capital and the Making of the New Future

by Sebastian Mallaby

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.

He was fond of proclaiming a Yoda approach to investing: empower people who feel the force and let them work their magic.[8]

gate-crashing a new field, which meant he was unburdened by preconceptions about what conventional wisdom deemed possible. Moreover,

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.

Which is better: to try and fail, or to fail to try?[13] Reasonable people—well-adjusted people, people without hubris or naïveté—routinely fail in life’s important missions by not even attempting them;

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.

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.

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. Power Law Distribution

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

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.

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.[15] 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.[16]

“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.[20] “Venture capital is not even a home-run business,” Bill Gurley of Benchmark Capital once remarked. “It’s a grand-slam business.”[21]

dripping with disdain for incrementalism.

Of course, investing in what is categorically impossible is a waste of resources. But the more common error, the more human one, is to invest too timidly: to back obvious ideas that others can copy and from which, consequently, it will be hard to extract profits.

not to worry about the bets that went to zero. All he could lose was one times his money.[25] What Khosla cared about were the bets that did pay off, and in the mid-1990s he fastened on an especially audacious and contrarian notion: that, with the coming of the internet, consumers would not be satisfied with a mere doubling or tripling in the capacity of traditional phone lines. Rather, they would clamor for a step change in bandwidth, involving routers that handled data flows a thousand times larger. While the telecom establishment snickered at this sci-fi babble, Khosla set out to kick-start the companies that would make the step change possible.

Venture capital was not merely a business; it was a mindset, a philosophy, a theory of progress.

Experts may be the most likely source of incremental advances, but radical rethinks tend to come from outsiders.

“If I’m building a health-care company, I don’t want a health-care CEO,” Khosla says. “If I’m building a manufacturing company, I don’t want a manufacturing CEO. I want somebody really smart to rethink the assumptions from the ground up.” After all, he continues, retail innovation did not come from Walmart; it came from Amazon. Media innovation did not come from Time magazine or CBS; it came from YouTube and Twitter and Facebook. Space innovation did not come from Boeing and Lockheed; it came from Elon Musk’s SpaceX. Next-generation cars did not come from GM and Volkswagen; they came from another Musk company, Tesla. “I can’t think of a single, major innovation coming from experts in the last thirty, forty years,” Khosla exclaims. “Think about it, isn’t that stunning?”

successful nations benefit from sound rule of law, stable prices, educated people, and so on. Lately, however, the more pressing question is why some regions within countries leave other regions so far behind as innovation hubs and generators of prosperity. It has long been obvious that one area can outperform others, as Silicon Valley has done; but the rule of law and price stability cannot explain why the Valley is more innovative than Montana or Michigan.[39]

venture capitalists transform a mere agglomeration of smart people into an inventive network.

on 1951, when Fred Terman, the engineering dean at Stanford, created the university’s famous research park.

William Shockley, the father of the semiconductor, abandoned the East Coast to launch a company on Terman’s campus, bringing silicon to the Valley for the first time. But

most compelling origin story—the one that aims the spotlight squarely at the force that makes the Valley so distinctive—begins in the summer of 1957, when eight of Shockley’s young PhD researchers rose up in revolt and went out on their own. Shockley’s seniority, his fame, and even his Nobel Prize did nothing to deter the rebels; the “Traitorous Eight” were fed up with Shockley’s heavy-handed leadership and resolved to find a different home. It was that act of defection that created the magic culture of the Valley,...

The funding of the Traitorous Eight and their company, Fairchild Semiconductor, was arguably the first such adventure to take place on the West Coast, and it changed the history of the region. After Fairchild got its $1.4 million in financing, it became evident that any team in the Valley possessed of grand ideas and stiff ambition could spin itself out, start itself up, and generally invent the organizational form that best suited its fancy. Engineers, inventors, hustlers, and artistic dreamers could meet, combine, separate, compete, and simultaneously collaborate, all courtesy of this new finance. Adventure capital could sometimes be defection capital, or it could be team-building capital, or almost just experimental capital.[1] But whichever way you looked at it, talent had been liberated.

the famous military-industrial complex of the 1950s was primarily an East Coast alliance between the Pentagon and Cambridge, Massachusetts. The personification of that axis, Vannevar Bush, was dean of the MIT School of Engineering, founder of the Cambridge-based defense contractor Raytheon, and Franklin Roosevelt’s top science administrator during World War II.

Shockley’s engineers could either submit to the zeitgeist and languish unproductively under a suffocating manager or seize the opening created by his outburst.

Anything that helps you keep your confidence, when you have no reason to have confidence, is valuable.”[57]

Burgeoning pension funds were managing the “small man’s” money, increasingly assuming the effective ownership of great public corporations, but the small man’s money was not being channeled to small companies. The sources of capital were being democratized, in other words, but access to capital wasn’t, because the large pension funds that served as agents for the little guy had no practical way of scoping out startups. As a result, entrepreneurs struggled to find funding.

To qualify for maximum assistance, an SBIC’s fund had to be no bigger than $450,000; this deprived SBICs of the scale necessary to retain competent professionals. SBICs could not compensate their investment staff with stock options, nor could they invest more than $60,000 into a portfolio company, making it hard to prime startups with adequate capital.[2] Even the boss of the SBIC program grew exasperated. “The rules were drawn on

Indeed, everything about the fund’s design was calculated to support an intelligent but forceful growth mentality.

never wanted to be the richest corpse in the cemetery,” Rock said later.[23]

Modern portfolio theory, the set of ideas that was coming to dominate academic finance, stressed diversification: by owning a broad mix of assets exposed to a wide variety of uncorrelated risks, investors could reduce the overall volatility of their holdings and improve their risk-return ratio.

and most startups would fail; therefore, the winners would have to win big enough to make a success of the portfolio.[25]

The only asset of tech startups, and the only possible reason to invest in them, was human talent, or what Rock liked to call “intellectual book value.”

Self-contradiction, wishful thinking, a fondness for ingratiation at the expense of honesty: these were the clues that Rock should pass on an investment. Intelligent consistency, gritty realism, fiery determination: these were the signs that he should seize the opportunity.[33] “Do they see things the way they are and not the way they want them to be?” Rock would often ask himself.[34] “Would they drop what they’re doing at a minute’s notice to do something which would help the business, or would they continue their dinner?”[35] “When I talk to entrepreneurs, I’m evaluating not only their motivation but also their character, fiber,” Rock reflected.

Rather than merely identifying entrepreneurs and monitoring them, as Rock had done, the new venture capitalists actively shaped them: they told company founders whom to hire, how to sell, and how to structure their research. And to ensure that their instructions were implemented, the new venture capitalists came up with a second innovation: rather than organizing one large fundraising, they doled out capital in tranches, with each cautious infusion calibrated to support the company until it reached an agreed milestone. If the 1950s had revealed the power of liberation capital, and if the 1960s had brought the equity-only, time-limited venture fund, the advances of the 1970s were twofold: hands-on activism and stage-by-stage finance.

You had to go with the version of your invention that would earn you the fattest margin, and you had to open sales channels to as many customers as possible.

“We distinguished ourselves right from the beginning by saying: We are not investors. We’re not Wall-Street, stock-picker, investor people,” Perkins later said. “We are entrepreneurs ourselves, and we will work with entrepreneurs in an entrepreneurial way. . . . We will be in it up to our elbows.”[51]

“Why is this a big market, and how are you going to build a really strong position in it?”[62]

If Swanson and Boyer had insisted on raising all the capital they needed at the outset—the moment of maximum risk—they would have given more equity away and owned less of their own company.

All four companies had too much of a stake in the status quo to risk disrupting it. A startup that filled the resulting vacuum looked like an obvious bet for venture capitalists.

They observe that clusters develop deep labor markets in specialized fields, so a company needing experts in, say, a particular kind of database software can hire the precise skills that it is seeking.[4] But Saxenian was going beyond economists’ focus on productive matching between workers and employers. By emphasizing the porous boundaries between Valley startups, she was probing the quality of the relationships within a cluster and suggesting why some clusters pull ahead of others. A cluster that is dominated by large, self-contained, secretive companies will be characterized by tight relationships among insiders at each firm, but few links between professionals at one firm and similar professionals at another one. In contrast, a cluster that consists of transient startups will feature fewer deep bonds among colleagues, but it will be enriched by myriad, looser external connections. Saxenian’s contention was that a small number of tight relationships makes for less idea sharing and innovation than a large number of loose relationships. In this she was building on an insight from one of the most cited social science papers of all time.

a plethora of weak ties generates a greater circulation of information than a handful of strong ones.[5]

If porous boundaries and an abundance of weak ties make for a productive industrial cluster, what created these conditions in the Valley? There are two familiar answers. First, California law prevents employers from tying up employees in non-compete agreements; talent is free to go where it pleases, unlike in most states, including Massachusetts. Second, Stanford has been generous in allowing professors to take sabbaticals to work on startups, and this permissiveness has fostered ties between academia and business; in contrast, MIT professors have risked losing tenure if they spent too much time on side projects. Yet although an absence of non-compete clauses and the porousness of Stanford have contributed to the creative fluidity of the Valley, they are not the whole story. For one thing, some legal scholarship has sought to qualify the significance of non-competes.[8] For another, California tech startups are far more likely to involve Stanford grad students than Stanford professors.[9] The main answer to the Saxenian question—the reason why the Valley has a plethora of weak ties—is to be found elsewhere. It lies in the fact that one tribe of professionals is relentlessly focused on cultivating such ties. This tribe is the venture capitalists.

“Who is the absolutely best guy you’ve worked with?” Younger then made it his mission to meet that best guy—it was almost never a woman—and toward the end of the meeting he would repeat the question: “Who is the absolutely best guy out there?”[10] After a year of moving from one best guy to the next one, Younger had a list of about eighty superstars, and he cultivated each of them methodically. He would send one luminary a technical article that might be relevant to his research; he would call another to mention that an old colleague was asking after him.

“If you want money, you ask for advice. If you want advice, you ask for money,”

Metcalfe aimed to make them boost 3Com’s prospects and then pay him for the value that they had created.

By the start of 1987, Cisco had made enough progress to recruit a couple of extra people. But without venture backing, the company could not attain escape velocity. In

a lawyer like Leonard would not have bothered senior venture guys on behalf of some random half acquaintance. But Silicon Valley rainmakers were unlike rainmakers elsewhere: they positively wanted to be bothered. Making and taking introductions was their stock-in-trade. If Leonard