Are venture capitalists misunderstood?
The Law of Power: Venture Capital and the Construction of the New Future
by Sebastian Mallaby, Penguin, 2022
The last few years have been tough on the reputation of venture capitalists. Poor governance, discrimination and malpractice have harassed large companies funded by venture capitalists, which have often been characterized as catalysts for a reckless and reckless culture among startups. In a critical essay published in the New Yorker in November 2020, author Charles Duhigg called VCs “increasingly stingy and cynical” and accused them of becoming “co-conspirators with hype artists, giving them millions of dollars and encouraging their worst tendencies. “. Duhigg argued that contemporary venture capital firms exercise less discretion than their predecessors. Instead of getting their hands dirty to turn promising ideas into viable businesses, they are spreading money as if they were making “bets on the floor.”
Economic historian Sebastian Mallaby tells the story differently. He believes that the venture capital industry has “a positive effect on economies and societies” and, moreover, its model of cultivating innovation has been so effective that it has helped almost all major American technology companies over the past 60 years. It is the story of the men behind the industry – and they are almost entirely men – that forms the basis of his new book, The law of power. Heavy and richly detailed, it is both a professional journey through the chaos of startup culture and a sober assessment of the evolution of the relationship between founders and their financiers. But while Duhigg views VCs as asleep at the wheel, Mallaby believes that structural changes have only weakened their influence, and indeed that it is the sidelining of VCs that has led many companies to to park.
Given that venture capitalists are now struggling to keep their protÃ©gÃ©s in line, it’s ironic that venture capital began as an exercise in liberation. Mallaby has its origins in the late 1950s, when a group of eight doctoral students working for a California semiconductor company sought to escape the stifling management style of their bossy boss. As the financial industry still lived in the shadow of the Depression and was very risk averse, they believed their options were limited to being hired by another company. Instead, a family bond led them to a young broker, Arthur Rock, who offered to start their own business with a bold new structure. The founders would each pay a theoretical sum of money for equal shares in the company. Rock would take a share and the funding would be provided by an outside investor, who had the option to purchase all of the company’s shares at an agreed price at a later date.
The new company, Fairchild Semiconductor, was a resounding success. Owning a share of it meant that the “Eight Traitors” – as they would later be called – focused as much on talking to potential clients as they were on lab work. Fairchild succeeded because he combined the scientific and the commercial from the start. Its lessor exercised its option within two years, offering Rock and the eight founders a return of 600 times their investment. With a new partner, Rock set out to refine his idea. He persuaded 30 wealthy individuals to invest in a time-limited, equity-only fund which, in turn, would finance a small number of ambitious companies. Two of Rock’s picks paid off so dramatically that when he closed the fund seven years later, its value had risen from $ 3.4 million to $ 77 million.
Rock’s stratospheric feedback encouraged other early VCs to focus on similar lunar shots. This approach put them in touch with unusual characters, including Nolan Bushnell of Atari (“a high-tech Hugh Hefner”), Steve Jobs of Apple, and Leonard Bosack and Sandy Lerner of Cisco. Turning their embryonic businesses into financial powerhouses forced the VCs to roll up their sleeves. “We will be in it up to the elbows,” shouted Tom Perkins, the first VC to “unashamedly rejoice in the role of promoter and leader.” In practice, this meant showing founders how to run a business: who to hire, how to spot potential customers, and where to spend their money. To mitigate the risk, Perkins and others distributed the cash in increments, “with each conservative infusion calibrated to sustain the business until it reaches an agreed milestone.” This kind of practical activism meant that venture capitalists in the 1970s and 1980s were as much advisers and gurus as they were sources of funding.
Turning embryonic businesses into financial powerhouses forced VCs to roll up their sleeves. In practice, this meant showing founders how to run a business: who to hire, how to spot potential customers, and where to spend their money.
This era turned out to be the highlight for VCs. Never again will they have had such an influence on their founders or such an influence on the development of their companies. Mallaby identifies the rise of internet service companies as the time when power definitely shifted from financier to founder. Yahoo and Google created code rather than hardware, which meant they didn’t need the same capital to get started. Three decades of growth in the industry would lead to a proliferation of venture capital firms, giving founders more options. In 1999, Google’s Sergey Brin and Larry Page met John Doerr, one of the most beloved VCs of the day. The presentation they made was 17 slides and illustrated with cartoons. Five years later, Mark Zuckerberg wore pajamas during a meeting with one of Doerr’s rivals. No VC was deterred. But while Rock demanded up to half the company for his involvement, Doerr and his contemporaries were happy to own an eighth.
The arrival of growth investors has put traditional VCs under pressure. While Rock and his successors were regularly involved long before a product hit the market, others finally realized that there were opportunities later and provided vast amounts of capital to established companies that they claimed. , had the potential to grow several times larger. These investors, including Yuri Milner and Masayoshi Son, were irresistible to ambitious tech companies. Unlike venture capitalists, which demanded equity in exchange for funding, Milner and Son didn’t even want to sit on the board. Mallaby argues that the huge injections of capital by growth investors (and the VCs who have chosen to compete with them) have resulted in greater control for entrepreneurs, but also weaker corporate governance and, ultimately, reach. excessive and poor discipline. âPrecisely when tech companies reached escape speed and founders were likely to feel too sure of themselves,â writes Mallaby, âusual forms of private or public governance would thus be suspended.â
Yet Mallaby is careful to underline the efforts of the VCs to curb, if not suppress, their founders. His chapter on the relationship between Travis Kalanick at Uber and his first VC funder, Bill Gurley at Benchmark, is instructive. As Uber grew, Kalanick lost interest in Gurley’s advice. Saudi Arabia’s Public Investment Fund has offered to invest $ 3.5 billion in the company and expand the board with members chosen by Kalanick, pushing Gurley further to the sidelines. As Gurley worried about how Saudi money would be spent (and what that would eventually do to the value of Benchmark’s share), he received the findings of an investigation into the work culture of Uber. Gurley used its poisonous content to confront what became the “Founder’s Cult” and ultimately pushed Kalanick out of the business. Kalanick’s successor, Dara Khosrowshahi, followed Gurley’s recommendations to strengthen corporate governance, and the company’s 2019 IPO went relatively well. While it underperformed its maximum private valuation of $ 79 billion, at $ 69 billion, it became one of the 10 biggest IPOs of all time by market cap and delivered to Benchmark a return on investment of 270 times. As Mallaby recounts, the VC’s sober advice pulled the company from the brink.
The tools available to venture capitalists are extremely powerful. A Mallaby VC speaks to compare his service to kerosene. This fuel helped create Cisco, Apple, Google and all the companies around them. But if it is injected into the wrong companies, it can cause dramatic failure. Arthur Rock once said that his decisions on which companies to support “would come either from the seat of the pants or from the top of the hat.” In The law of power, Mallaby argues that VCs have since become more strategic and analytical in deciding where to exercise their power, although their purpose has not always been true.
- Mike Jakeman is a freelance journalist and previously worked for PwC and the Economist Intelligence Unit.