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

by Sebastian Mallaby

But alongside this deliberative culture, there were still plenty of venture investors who led with their gut, believing

that breakthrough ideas were by definition so shocking that no amount of mental preparation could anticipate them.

By embracing maximum ambition, he had probably harmed Kaplan’s prospects, steering him away from the sort of incremental advance that could have been achievable.

There was an annual black-tie dinner for telecom grandees, and the next day three hundred people would show up to hear speeches from industry seers.[15] During breaks in the program, entrepreneurs brought out slide decks and pitched investors. “Our strategy,” Jim Swartz said later, “was to announce a fund, get quoted on telecoms in the press, organize

a conference, and generally make a noise.”

They spoke internally of the “90 percent rule.” An Accel investor should know 90 percent of what founders are going to say before they open their mouths to say it.[18]

“Every deal should lead to the next deal,” was another Accel saying.[19] Swartz in particular liked to invest in successive iterations in a single product class.

VCs as individuals can stumble sideways into lucky fortunes: chance and serendipity and the mere fact of being in the venture game can matter more than diligence or foresight. At the same time, venture capital as a system is a formidable engine of progress—more so than is frequently acknowledged.

“There’s a poker game going on and I don’t have any chips in the game. I need to invest,”

He liked to think of venture bets as financial options. You could never lose more than your initial stake, but the upside was unbounded.

you succeed in venture capital by backing the right deals, not by haggling over valuations.

Yahoo stood for “Yet Another Hierarchical Officious Oracle.”

Don Valentine had overruled these objections because he had seen in Moritz a versatile learner, and he preferred to hire a hungry upstart than someone who was coasting on experience.[7]

Now, serendipitously, Moritz’s unconventional background was about to prove its value.

Like all great venture capitalists, he knew how to amplify the sense of destiny of even the most confident founders. It was the ultimate seduction.

The dirty secret was that Yahoo had no choice but to build a brand, because it was not much of a technology company. It boasted no patents and not much of an engineering edge: its directory was put together by surfing the web and classifying sites, and much of the work was done manually. As a result, it presented a negative illustration of Tom Perkins’s dictum:

because Yahoo entailed no technological risk, it involved a huge amount of market risk, because no technological moat protected it from competitors. What’s more, competition was bound to be especially ferocious because of the winner-takes-all logic of Yahoo’s business.

Rather, it had to remain buzzier than its rivals, which meant that it had to project an aura of momentum.

Traditional venture capitalists, observing a cash-burning business with no technological moat and nothing more substantial than a brand, might have refused Yahoo the lifeline that it needed. But by late 1995, tradition was passé. Netscape’s flotation in the summer had shown how the coming of the internet had changed the game: given the astronomical returns to be had from turbo-power-law companies, it was crazy not to gamble on them.

To borrow the language of hedge funds, he didn’t care about alpha—the reward a skilled investor earns by selecting the right stock. He cared only about beta—the profits to be had by just being in the market.

“If you are afraid of losing everything, you tend to take your chips off the table too early,”

Thanks to masterful procrastination, Yahoo generated more gains for Sequoia than all its prior investments, combined, and more than ten times as much as Sequoia had earned from Cisco. The secret, Moritz said laconically, “was just learning to be a little patient.”[39] But the true secret went deeper. Thanks to the Yahoo experience and Son’s example, Moritz came to see that a venture partnership must adapt constantly. He learned that huge, growth-capital checks conferred kingmaker powers and that it paid to think bigger than just the Valley. Later, Sequoia would apply these lessons with clinical efficiency, achieving a position of unrivaled strength in the business of financing technology.

the Benchmark model was about being nimble rather than large: the partnership made a virtue of the deliberately small size of its first fund, which weighed in at $85 million, or less than a single check that Son might write to one company. “God is not on the side of the big arsenals, but on the side of those who shoot best,” Benchmark’s prospectus insisted.[41]

Its hectic expansion was instead propelled by Metcalfe’s law: as the size of its auction network grew, its value rose exponentially. The more sellers listed stuff on eBay, the more bargain hunters were drawn to the site; the more buyers there were, the more sellers turned to it. Moreover, unlike telecommunications networks, which were stitched together with routers and switches made by a variety of firms, eBay captured 100 percent of the commissions generated by its auctions. It was profiting from a network effect. What’s more, it owned the network.

Kagle placed a bid and lost. But he recognized that feeling when a product connects with something in your brain. The lure had hooked him.

Much as with Barris’s hiring of Sidgmore, the question was how to persuade a fancy exec to make the leap to an obscure startup. Before Benchmark’s investment, Omidyar had tried to attract high-powered outside managers to eBay, but none had been willing to take a risk on a flea market. Now, however, Omidyar had the imprimatur of Benchmark, and Benchmark in turn had retained the services of Dave Beirne’s old executive search firm, Ramsey Beirne. The combined prestige of the two induced Whitman to agree to a meeting. She might need the relationship with the search guys if she wanted a new job in the future.

Returning for a second visit, she noticed something else. Unlike other retailers, eBay did not hold inventory. It had no carrying costs, no shipping costs, no hassles with storage. As a result, its profit margins were formidable.

In the years that followed, Benchmark repeatedly found that reckless later-stage investors seized effective control of its portfolio companies by stumping up tens of millions of dollars. Unable to muster equivalent sums, Benchmark lacked the muscle to protect startups from the hubris that came with so much capital.

Once the stock market embraced the logic of the power law, nothing checked the venture capitalists. Private financing deals were done at ever higher valuations, and startups raised capital in ever greater quantities. In 1997 an online grocer called Webvan landed $7 million from Benchmark and Sequoia, even though it was less a company than a concept. In 1998, Webvan raised a further $35 million, this time from SoftBank, to finance the building of its first distribution center. In 1999, with the distribution center still barely up and running, investors were persuaded to part with an astonishing $348 million. By this point, venture speculators had assigned Webvan a paper value of more than $4 billion, even though it was losing money. In sum, Webvan looked like GO on steroids, a fantastical venture-capital ego trip. And yet, given the euphoric stock market, the VCs were not the only culprits in this tale. Webvan staged a successful IPO in the fall of 1999, and its value shot up to $11 billion. With public-market investors prepared to value companies this way, the venture-capital frenzy was at least partly rational.

All over the Valley, entrepreneurs vied to join Team Doerr. “There’s this notion that if you get John and Kleiner Perkins as an investor you can practically buy your Ferrari now,”

The greatest mark of Doerr’s prowess was his investment in Amazon. In 1996, Doerr had snagged 13 percent of Bezos’s startup for $8 million; by the spring of 1999, Amazon was a public company with a valuation of more than $20 billion. But what was most remarkable was the way that this had come about and what it said about Doerr’s stature. Founded in 1994, Amazon was already going gangbusters by the time it sought venture funding. Would-be investors were calling so often that the company joked about resetting its voice mail: “If you’re a customer, press ‘one.’ If you’re a VC, press ‘two.’”[23] General Atlantic, a respected technology investment house in New York, pursued Amazon especially assiduously, presenting Bezos with a formal term sheet. But far from chasing after Amazon, Doerr himself became the object of a chase: his reputation was such that Amazon came after him. At first, Doerr was too busy to notice; the pager and the cell phone on his belt buzzed constantly. Eventually, after a CEO at a Kleiner portfolio company persuaded him to have dinner with Amazon’s marketing chief, the penny dropped: Doerr flew to Seattle, bonded instantly with Jeff Bezos, and stole the deal from under General Atlantic’s nose, even while offering a less generous valuation. Asked why he had accepted the lower bid, Bezos explained, “Kleiner and John are the gravitational center of a huge piece of the Internet world. Being with them is like being on prime real estate.”

Given Doerr’s investment in Amazon, and Bezos’s investment in Google, it was only a matter of time before Brin and Page landed a meeting with Kleiner’s celebrity rainmaker. They took this coup almost for granted. Other entrepreneurs, visualizing their Ferraris, might have stayed up all night preparing their pitch decks. But the Googlers did not strain themselves too hard: they showed up to see Doerr with a PowerPoint presentation consisting of just seventeen slides, three of which displayed cartoons and only two of which had actual numbers.[25] Yet what they lacked in presentational formality they made up for in sheer poise. Primed by Shriram, they had boiled their mission statement down to just eight words: “We deliver the world’s information in one click.”

Moritz’s misapprehension stood as a testimony to the sheer unpredictability of technological advance.

the Googlers cited the handful of successful founders who had retained management control—Michael Dell, Bill Gates, and their own angel investor Jeff Bezos. “What they didn’t see were all the others who had failed. That wasn’t in their data set,” one Doerr lieutenant observed tartly.[37]

The median venture fund launched in 1996 or 1997 had achieved an annual return of more than 40 percent, trouncing the return on public stocks. In contrast, the median fund launched in 1999 or 2000 lagged the public market and actually lost money.[40] The normally unflappable Doug Leone recalls the shock. “I woke up one day in 2000, and everything had changed. I was on twelve boards. One company more troubled than the other. Oh my God, what do I do now?”[41] Jim Swartz of Accel had similarly visceral memories of the collapse. “For the first time in my career, I had to walk into a board meeting and say, ‘Look, guys, we got X kajillion dollars in the bank but this model is not going to work in the new world. Let’s just liquidate the company.’”[42] “It was so depressing that it was hard to feel good even about the new deals that got pitched to you,” another VC remembered.[43]

“We’re not investing in business plans, we’re not investing in discounted cash flows, it’s the people,”

Schmidt felt simultaneously excited about the prospect of joining Google and anxious about entrusting his future to two mercurial twentysomethings. In the end, the balance was tipped by the trusted guardians of the Valley’s networks. “I had the surety that the venture guys would be kind to me if Larry and Sergey bounced me out,” Schmidt said.[58] If Google did not work out, Doerr and Moritz would slot him into an equally good job elsewhere. With the venture capitalists’ safety net stretched out beneath him, Schmidt took the leap. At last, Google had the experienced direction it needed to become a global company.

Following a precedent set mainly by family-owned media firms, they decreed that Google would issue two classes of shares. The first, to be held by the founders and the early investors, conferred ten votes on big company decisions. The second, to be held by outside stock market investors, conferred only one vote. Collectively, outside investors would receive shares bestowing only a fifth of all votes. Insiders, chief among them Brin and Page, would retain control over the company.[59] When the Googlers proposed this share structure, Doerr and Moritz raised two objections. First, outside investors might recoil at the prospect of second-class citizenship. Consequently, some might refuse to buy the stock, resulting in a lower share price and a less profitable VC exit. Second, enshrining founder control indefinitely seemed ill-advised.

A dozen years later, when tech behemoths were denounced for hoarding customer data and blurring the distinction between real and fake news, the alleged link between founder empowerment and the common good would come to seem dubious.

The Googlers’ second counterargument stressed long-term profits. Echoing a familiar critique of shareholder capitalism, they asserted that stock market investors were too shortsighted to back managers who compromised today’s profits to invest in tomorrow’s expansion. By implication, stock market investors should be disenfranchised for their own sakes: their interests would be best served if their influence was minimized. Of course, the analogous argument about political democracy—that the masses should be denied votes for their own good—would be met with derision. Nor is it obvious that stock market investors are incapable of understanding their own long-term interests; to the contrary, they frequently bid up the price of investment-intensive companies such as Amazon, Netflix, and Tesla precisely because they do value the future.[61] But the Googlers invoked the tendentious thesis of stock market short-termism with gusto.

whereas Google’s experimental pricing mechanism did not become the model for later Valley IPOs, the dual-class, ten-votes-versus-one share structure was copied by companies such as Facebook.[63] Google’s extraordinary growth after its flotation—over the next three years, the stock price quintupled—made the VCs’ objections to the dual-class structure look irrelevant. Evidently, investors were only too delighted to buy so-called second-class stock. And the idea that the founders enjoyed too much power was belied by the success with which they steered the company. As the most celebrated Valley star of the era, Google had a profound influence on the way startups raised money. Other entrepreneurs increasingly turned to angels for their early capital. They forced Series A investors to pay through the nose. They rejected the Qume model in favor of running their own show. They dispensed with shareholder democracy. In sum, entrepreneurs used every trick at their disposal to secure more of the wealth and—crucially—power.

The change in mood was crystallized by Paul Graham, a self-described hacker who became an influential guru among young startup founders. In 1995, together with a fellow Harvard grad student, Graham had founded a software company called Viaweb,

selling it in 1998 to Yahoo for $45 million worth of stock: it was a classic hacker-makes-good story. Then Graham had turned his hand to writing, expounding on everything from the virtues of the programming language Lisp, to popularity in high school, to the challenges of entrepreneurship. His essays, which celebrated coders and disparaged business types, appeared first on his blog and then, in 2004, as a book. The fact that Graham hailed from Cambridge, Massachusetts, underscored the significance of his teachings. The rebelliousness of the Google founders was part of a nationwide phenomenon. Graham’s first advice to younger hackers was to be wary of venture capitalists. “Spend as little as you can, because every dollar of the investor’s money you get will be taken out of your ass,” he told his readers. At Graham’s own company, one of the angel investors had been a fearsome metals trader who “seemed like the kind of guy who would wake up in the morning and eat rocks for breakfast.” When Graham’s startup had hit a bump, another of his investors had tried to seize his equity. As a result of such experiences, Graham had figured out how to stand up to rich guys. “You’re doing them a favor by letting them invest,” Graham told his disciples. Thanks to the Brin-Page example, the moneybags would always be thinking, “Are these guys the next Google?”[68]

With the coming of the internet, the hottest kind of company produced little more than code: it had no need for large amounts of capital with which to build manufacturing operations. Meanwhile, the open-source movement made chunks of software available for free, and the internet itself slashed the cost of marketing and distributing new products.[69] For all these reasons, the new generation of startups required relatively little cash, but venture capitalists were out of step with this development.[70] Thanks to the bubble of the late 1990s, they had grown used to managing big funds and collecting correspondingly big fees. As a result, they force-fed startups with more capital than was good for them, like farmers stuffing geese to make foie gras. The way Graham saw things, force-feeding by VCs created at least three problems. First, big investments meant big valuations for startups, which narrowed the odds of a profitable exit. Many founders might be happy to sell their company for, say, $15 million, but VCs who had already marked up the valuation to $7 million or $8 million would not be satisfied with a mere 2x multiple. Second, big investments meant that VCs took “agonizingly long to make up their minds,” and their dithering distracted founders from their highest calling, which was to write code and create products. Finally, big investments meant that nervous VCs were quick to eliminate the wondrous and weird features of startups. They installed humorless MBAs to oversee ...

Sequoia would be better off owning a small share of a grand-slam company than a large share of a failure, as he had put it to his partners.

Moritz told Levchin, “If you go forward with this merger, I’ll never sell a single share”—the implication being that a merged company would grow and grow forever. It was one of those classic VC call-to-greatness challenges. The senior venture statesman was asking the young entrepreneur, do you want to forge a major company that will be remembered years from now? Or do you lack the character to make your mark on the universe? Levchin was suitably impressed. He dropped his objections to a sixty-forty deal, subordinating his coding pride to Moritz’s grand vision. The path to a merger was now clear. The bloodshed would be over.

“Palace coup!” Moritz said to himself. He remembered the Cisco saga well, and he knew how it had ended. No venture capitalist could protect a chief executive who had lost the backing of his team. “We have seen this before,” he told himself silently.

“Peter felt abused by Moritz, very keenly, very personally,” one of Thiel’s allies remembered.

“All failed companies are the same,” he reflected. “They failed to escape competition.”[31]

Thiel felt that all great startups had a “monarchy aspect,” as one of his lieutenants put it. “It’s not the libertarian part of Peter that made Founders Fund. It’s the monarchist part.”