The Power Law
Venture Capital and the Making of the New Future
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“When people write about the venture business, they’re always writing about the startups we back. They never write about the most important investment that we make, which is in the business." – Michael Moritz, Sequoia Capital
A few weeks ago, Citadel Securities, a leading global market maker, announced a fundraising backed by two venture capital firms, Sequoia and Paradigm. The announcement came as a surprise because Citadel Securities is well established in its industry and had never before taken external capital to fund its growth. Less newsworthy, but perhaps more surprising, was this nugget, buried towards the bottom of the press release:
In aggregate, Sequoia-backed companies account for more than 25% of NASDAQ’s total value.
That’s quite a statement. The aggregate value of all NASDAQ-listed companies is around $25 trillion, so if a single investor has been involved in creating a quarter of that, it’s a big deal. Sure enough, Sequoia’s fingerprints can be found on Apple (which it backed in 1977), Cisco (1987), Google (1999), Airbnb (2009) and many more.
Indeed, you’d be hard pressed to find another investor anywhere in the world with that kind of impact. The Chinese state sits behind 40% of the market value of Chinese listed companies, but its performance hasn’t been nearly as good. While Chinese state-owned enterprises have tended to underperform, Sequoia-backed companies have largely outperformed.1
Such success begs a question: how much of the value created is Sequoia responsible for? And more generally, is success in venture capital a product of some lucky bets or is it a business of replicable skill?
There are two contrasting arguments about the role firms like Sequoia play in creating value.
One is that venture capital simply rides the wave of activity flowing through places like Silicon Valley. Venture capital helps founders bring their ideas to life, but the ideas would surface anyway. According to this line of thinking, Silicon Valley owes its success to a range of factors unrelated to the financing opportunities available: military spending, proximity to Stanford, California labour laws. Sociologist AnnaLee Saxenian attributes Silicon Valley’s rich entrepreneurial culture to a decentralised industrial system that encourages experimentation, collaboration and collective learning. Venture capital has successfully penetrated this system and profited from its growth, but it is not foundational.
The second argument places venture capital at the very centre of the system. In this framing, social networks are the key feature underpinning the system and venture capital is the force that nurtures them. Without venture capital, Silicon Valley wouldn’t be the hotbed of entrepreneurship it is. Venture capitalists aren’t just cheerleaders, they are among the most important players on the field.
This second argument is one Sebastian Mallaby develops in his authoritative new book, The Power Law. Mallaby’s book traces the history of venture capital from its roots under industry pioneer Arthur Rock through to the present day. “In getting California’s innovation flywheel started, Arthur Rock mattered as much as the presence of Stanford or the flow of defence contracts.”
The book weaves together the histories of major venture capital firms – Arthur Rock’s Davis & Rock, Sequoia, Kleiner Perkins, Andreessen Horowitz, DST, Tiger Global, Benchmark, Accel, Founders Fund and other related models such as Y Combinator. But having been around for fifty years, Sequoia enjoys a dominant position in the narrative and provides a rich set of stories to illustrate the argument.
Sequoia’s role as a super-connector in the network underpinning Silicon Valley stems from the influence of its founder, Don Valentine. One of Sequoia’s first investments, back in 1975, was in video games maker, Atari. The company had tried to raise venture capital before, but it was deemed too chaotic for most investors. Don Valentine saw potential in the business, but only if it shifted its strategy. So he worked with the company’s management to craft a new business plan, encouraging them to develop a home version of their popular Pong game and seek a distribution deal with a well-known retailer. He pushed and prodded until they delivered the new game, and personally secured an introduction for them with Sears. Within 18 months of investing, Valentine arranged for Warner Communications to buy the company for a 3x return on his investment.
Valentine’s interventions similarly bore fruit at Apple. Through his Atari contacts, he was introduced to Steve Jobs in 1976. At the outset, Valentine insisted that the company employ someone with marketing experience. He introduced Jobs to Mike Markkula who invested some of his own money and joined the team. The following year, Valentine invested. Valentine’s only mistake was selling out too early, in 1979, for a 13x return. Nevertheless, the gain contributed to a strong return in his first fund, enabling him to raise a second fund of $21 million, followed by a $44 million fund two years later.
Over time, Sequoia has institutionalised these networking skills. “Serendipity on the surface, systemic effort deeper down,” is how Mallaby describes it. The firm’s investment in Stripe is a case in point. Sequoia cultivated close ties with Y Combinator, a seed funding programme for startups that incubates hundreds of new companies a year. It also operates a global network of scouts, incentivised to introduce promising prospects to the firm. Both of these nets caught Stripe’s founders very early in their development. Sequoia was the biggest investor in Stripe’s seed round and provided nearly all the money in its series A. At its latest valuation, the firm’s stake is worth around $15 billion.
To some, the approach may seem formidable. Just this week, the founder of Bolt, a payments company, accused Stripe and Y Combinator of behaving like “mob bosses”. A Sequoia partner hit back, but the episode illustrates the influence that venture capital has over the fledgling tech industry.
Mallaby’s previous book More Money Than God, is about the hedge fund industry and his analysis of that industry informs the way he tackles this one. “I started out curious to understand how venture capitalists allocate capital in the face of extreme uncertainty: startups offer none of the quantitative guideposts that steer public-market investors.”
He notes that sourcing deals like Stripe and managing them like Atari require a whole different set of skills to those practised in public markets. So while some of the hedge fund managers he met researching his prior book could be quite aloof, because “social skills won’t change the bottom line on your portfolio,” that isn’t the case in venture capital. There’s a saying in public markets: the stock doesn’t know who owns it. Startups by contrast know exactly who owns them and who they want to be owned by; social skills matter.
More fundamentally, the difference in investing patterns lies in the distribution of returns: “other financiers extrapolate trends from the past, disregarding the risk of extreme ‘tail’ events. Venture capitalists look for radical departures from the past. Tail events are all they care about.”
This notion gives rise to the Power Law of the book’s title.
It’s well known in venture capital that most investments fail to strike a return while a few yield supernormal returns. Chris Dixon, a partner at Andreessen Horowitz, published an analysis a few years ago that shows around ~6% of investments, representing just 4.5% of dollars invested, generated ~60% of the total returns in a 20-year sample of fund data. Even within that, the tails have disproportionate impact. He shows that for good funds, ‘home run’ investments make around 20x on their initial investment; for great funds, they make around 70x.
Importantly, the great funds also make more loss-making investments than the good funds. This reflects something Mallaby quotes in his book: “Because they were making fewer bets that went to zero, they did not feel compelled to drive their winners to 10x or higher.”
These dynamics are evident in Sequoia’s track record. Across the funds it raised in 2003, 2007 and 2010, the firm placed a total of 155 US venture bets. Nearly half of them lost money, but the ones that performed well, performed very well: 20 investments generated a net multiple (after fees) of more than 10x and a profit of at least $100 million. Over the whole period between 2000 and 2014, Sequoia generated a net return of 11.5x on its investments, with the top three single investments driving 5.4 points of that (among them was WhatsApp).
Sequoia’s own performance touches on another power law that may be at play in the industry – among the firms themselves. If top entrepreneurs flock to successful firms, those firms are in a better position to sustain their success. Sequoia reckons it has been invited to consider around two-thirds of deals that ended up getting funded by top firms, giving it access to privileged deal flow. Venture firm Accel has a refrain recounted in the book: “Every deal should lead to the next deal,” which suggests an attachment characteristic of a power law.
Mallaby dwells on the survivors of the industry but points out that persistence isn’t guaranteed. A chart at the back shows the shifting fortunes among top firms over the past fifty years. Arthur Rock was unsuccessful after his Apple investment (albeit after a 378x return); Kleiner Perkins dominated the industry for 25 years up until 2005; Mayfield, an investor in Netscape and 3Com, faded from sight. However, he concedes that most new firms get off the ground because of the founders’ experience and status, rather than originality of their methods.2
Tom Perkins, the founder of Kleiner Perkins, had a saying: you succeed in venture capital by backing the right deals, not by haggling over valuation. The past year has seen a big rise in valuations: seed investments attracting multi-million dollar valuations, early-stage valuations doubling. While this may lead to more dispersion in performance in the short term, Mallaby is confident of the longer term structural underpinnings for venture capital. In particular, he highlights the growing role of intangible capital in economic activity and argues that venture capital is singularly well suited to finance it. The father of venture capital, Arthur Rock, used to talk about financing “intellectual book value”. The rate at which intellectual book value is being created is only going up.
The Power Law by Sebastian Mallaby, Allen Lane £25/Penguin Press $30, 496 pages
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A 2020 paper by Josh Lerner and Ramana Nanda, Venture Capital’s Role in Financing Innovation: What We Know and How Much We Still Need to Learn, contains some good numbers on the overall venture capital industry. Although firms backed by venture capital comprise less than 0.5% of firms that are born each year in the US, they represented 47.0% of the number of non-financial IPOs between 1995 and 2019 and 76.2% of the market cap as at end December 2019. In China, the divergence of state-backed companies from the rest can be seen by comparing the WisdomTree China ex-State-Owned Enterprises Index to the main index.
The chapter, A Russian, a Tiger, and the Rise of Growth Equity, is a fascinating look at how DST and Tiger Global were able to break into the industry deploying some of the practises more common in public market investing.