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

by Sebastian Mallaby

If “manufactured serendipity” could be said to exist, Sequoia was the master of it.

Moritz was an astute judge of character, and his questions to Patrick were designed to detect resilience and ambition. He understood the promise of digital payments; after all, he had backed PayPal. And he had faith in the prospects of challenger firms: having seen Google eclipse Yahoo, he was willing to wager that Stripe would eclipse PayPal. But on top of these advantages, Sequoia was assisted by that early tip-off from its scout network and its relationship with Y Combinator, and the combined result of all these factors was that, among Stripe’s early backers, the investor with by far the most conviction was Moritz.

Deploying the capital it raised in 2003, 2007, and 2010, Sequoia placed a grand total of 155 U.S. venture bets. Of these, a remarkable 20 generated a net multiple of more than 10x and a profit of at least $100 million.[52] The consistency across time, sectors, and investing partners was striking.

Meanwhile, Botha challenged Grady to be less negative about prospective deals. “Look, any smart person can come up with all the reasons to pass on an investment, but our job is to make investments,” Botha reminded him.[65]

ServiceNow combined a strong founder, a proven product, and a booming industry segment: it would triple its revenues once, twice, and then some. Besides, the skeptical case against a ServiceNow investment underestimated the value of Sequoia’s activist input. Luddy and his team had built excellent software, but other parts of the business lagged. If Leone and Grady could fix functions such as finance and sales, the company’s potential would be unbounded. Grady felt so confident about ServiceNow’s prospects that he had almost dispensed with the hallowed Summit procedure of modeling ServiceNow’s earnings. Late in the investment process, he had cobbled together a spreadsheet. But it was almost an afterthought.[67] In November 2009, Sequoia duly invested.

The question was how to persuade ServiceNow’s board to reject the $2.5 billion. The majority wanted to grab the offer with both hands, and Sequoia lacked the power to stop them. So, in another hands-on maneuver that would have been inconceivable at Summit, Leone came up with a legal tactic. ServiceNow, like most American companies, was registered in Delaware. Under Delaware law, Leone contended, a board could not go forward with an acquisition without soliciting bids from others. Ambushing his colleagues on a ServiceNow board call, he declared that a hasty sale would be illegal.

In 2018, nine years after Pat Grady had first addressed his partners on the shift of software to the cloud, the hedge funders noticed something strange: most types of code had completed the predicted migration, but communications software was lagging. This anomaly seemed bound to end. The increasing acceptance of remote working would make video calls and messaging systems part of everyday life. The recent bankruptcy of a hardware-based communications software company, Avaya, suggested that the cloud’s moment was arriving. The hedge funders duly made three cloud-communications bets: Twilio, RingCentral, and the videoconferencing company Zoom. The first two generated 4x and 5x over the next two years. Assisted by the coronavirus pandemic, Zoom emerged as one of the breakout tech companies of 2020, generating 9x. Meanwhile, Sequoia’s hedge fund was short legacy telecom companies that would lose out from the transition to the cloud. One thematic insight had generated multiple winning positions.

“You can’t raise money, your initial pick goes belly flop, but you persevere anyway.”[77]

The practice at university endowments was to divide investments into silos—stocks, bonds, real estate, commodities, hedge funds, and so forth—and to put a specialist in charge of each category. The way Johnson saw things, this made no sense.[78] The theory behind the silos was that their returns would fluctuate in an uncorrelated way, thus smoothing the performance of the overall portfolio. In reality, Johnson declared firmly, there was scant statistical evidence for this low-correlation claim. Nor was this surprising, because the investments in each silo blurred into one another.

If you invested in Japan’s public stock market index, for example, you would own a chunk of SoftBank, which in turn represented a bet on global tech that was neither Japanese nor public. Moreover, in chasing the mirage of safe diversification, the university endowments were paying a high price: by dividing the investment world into separate boxes, they were killing the culture of debate within their organizations. When the specialist in charge of commodity investments proposed a bet on nickel, for example, the other specialists were not equipped to push back. They focused only on their own boxes.

The Heritage fund would have to decide whether this was the time to buy Brazilian land, or Chinese tech, or stakes in hedge funds engaged in litigation in Argentina. Every potential investment would have to be evaluated relative to all others, so Johnson would have to recruit exceptionally versatile colleagues—“a team capable of comparing, in a very thoughtful and debate-oriented way, apples versus oranges.” In place of the old specialists, Sequoia would need investors with an appetite for learning everything. Or, as Johnson put it, “You bring in people who speak one of eight languages, and you ask them to master the other seven.”[79]

She was not so much lying as telling a “premature truth,” as the Valley parlance had it.

Theranos was a vindication for VCs because almost none of the money that Holmes raised came from Sand Hill Road practitioners.

None of these venture tourists was inclined to cross-examine Holmes or demand evidence that her blood tests actually worked. The comforting lesson, from Sand Hill Road’s perspective, was

that amateurs had failed. The pros had stayed out of it.

At one point during his negotiations with Benchmark, Neumann asked for a preposterously high valuation. “You only have three buildings,” Dunlevie objected. “What do you mean?” Neumann shot back. “I have hundreds of buildings. They’re just not built yet.”[7] The Benchmark partners loved Neumann’s premature truths, and their bet on him was

To maintain investors’ faith in him, Neumann generated a formidable stream of Silicon Valley clichés. WeWork was not a company but a “platform.” WeWork would benefit from “network effects.” WeWork was a “first mover,” a “thriving ecosystem,” “digitally enhanced,” and “scalable.”[19] To observers who were not inclined to think too critically, perhaps this sounded persuasive: after all, Silicon Valley behemoths from Google to Facebook had pumped themselves up to a commanding size before they had worried about profits. But the truth was that there was nothing particularly digital about an office-rental company, and the alleged network effects were weak, at best.[20]

“It’s not about the market that exists, it’s about the market we’re creating,”

Nor can it be argued that VCs somehow programmed irresponsibility into these companies when they were in their cradles. If anything, the opposite is true: the majority of VCs tend to push founders to be more careful about legal and societal constraints, not less so.

The poor performance of these green funds underscores the environmental passion of the VCs: arguably, they elevated their sense of social mission above their responsibility to their limited partners, many of which, incidentally, are universities and philanthropies.

According to one study, VC investments in cleantech deals between 1991 and 2019 yielded a paltry 2 percent per year, compared with 24 percent per year for software investments.[9]

But these critics’ subjective priorities could be interrogated, too, and it is not as though all non-venture-backed businesses are virtuous.

“You plant a seed, it needs some water, but if you just pour a whole fucking bucket of water on it’s going to kill it,”

“Blitzscaling isn’t really a recipe for success but rather survivorship bias masquerading as a strategy.”[30]

When venture capitalists pour money into blitzscaling, the result is a pack of unicorns that can sell their products below cost, disrupting incumbents not necessarily because they are technologically superior but rather because they are subsidized by venture dollars. In ride hailing, for example, venture capitalists paid for artificially cheap fares for passengers, forcing incumbent taxi operators to compete on a distorted playing field. The moral and political justification for tough market competition is that it should be fair. If the market is rigged, it loses legitimacy.

no economic system is perfectly free from distortions, and incumbent businesses generally have powerful advantages. They enjoy economies of scale, strong brands, government regulations that they have helped to shape, and established relationships with distributors and suppliers.

U.S. commanders understand AI’s potential equally well, but they seem locked into the weapons-purchasing habits that brought them dominance in the past—a sort of military version of the innovator’s dilemma.

China understands that the way to establish dominance in AI weapons is to dominate civilian AI businesses. Artificial intelligence, remember, is a contest of scale: you need big data, big computing power, and big investments in the scientific teams that perfect the algorithms.

Boulevard of Broken Dreams,

second policy lesson is that tax breaks for venture investors should be coupled with incentives for the employees of startups. Working for a startup can be brutal: one study finds that almost three-quarters of venture-backed entrepreneurs receive no money at all when they wind up their companies.[58] The gifted people who pour their energy into these ventures have other options: they could take salaried positions at big companies. To lure talent away from comfortable safety, the prize has to be large, and societies should want it to be large, because of

the positive spillovers that flow from vibrant startups.

Governments should therefore go out of their way to encourage employee stock options, which have emerged as the best device for cash-poor startups to attract world-class go-getters. Yet while countries such as Britain, Canada, China, Israel, and the Baltic States have embraced the...

In the United States, the Bayh-Dole Act of 1980 allows universities to patent inventions made with the help of federal research grants and to license these patents to startups.

broad policy lesson is that governments should think globally. They must compete to attract foreign scientists and entrepreneurs by handing out visas liberally. They should embrace internationally accepted tax provisions and legal forms with which foreign venture capitalists feel comfortable. They should encourage young companies to list on foreign stock markets if domestic ones are underdeveloped. They should not privilege their own firms at the expense of open global competition. The more a country can link itself to other economies, the greater the incentive for venture capitalists to scout out startups: a

Israel has flourished partly because its startups aim from their inception to make something that Americans will buy. Europe’s standout successes such as Skype and Spotify have made it big by taking capital from U.S. VCs and selling to U.S. consumers.

China is a military competitor bent on siphoning intellectual property out of other advanced economies.

China’s authoritarian political culture is ultimately at odds with freethinking entrepreneurship: a government with a vested interest in the status quo won’t risk upsetting the apple cart by unleashing disruptive innovation.

in China, the idea that an internet tycoon could publish a daily diet of critical antigovernment reporting is unthinkable. Spend time with venture investors in China, and you sense the pressure that they feel.