Legal Matters: Arthur Rock on the Early Venture Capital Decisions That Sparked Decades of Innovation – Legal Matters – Stanford Lawyer Magazine

JOE GRUNDFEST: Arthur, let’s begin with Silicon Valley’s genesis story and your role in forming Intel, where you were central not only to the company’s founding but, much more significantly, to establishing a model for how venture capital could help nurture startup companies, a model that included a company’s financing compensation arrangements and its governance mechanisms.

ARTHUR ROCK: Well, I expect you’re interested in the
options we gave employees.

GRUNDFEST: Absolutely. I suspect few people know of the elegant four-page document you drafted that describes the terms of the convertible note you used to fund Intel and explains the Intel philosophy for employee compensation and operational governance. From my perspective, your Intel memo is the Magna Carta of the venture capital industry. That memo is the first major financing organizational document from which everything else flows. Virtually every other subsequent venture capital deal in Silicon Valley follows a structure that traces back to that Intel structure. Can you tell us why you structured the Intel investment as you did?

ROCK: Well, Gordon [Moore] and Bob [Noyce] and I were sitting in one of their offices and trying to figure out how we could motivate our employees. We knew that we were paying less than what these employees could make elsewhere but that they wanted to be with us at Intel. We didn’t think that was quite fair [to underpay them]. And we really, among the three of us, decided that the employees should get options. But at what price and when did they get them? We kicked that around quite a bit and finally decided that we would give options to employees who had been there at least a year and that they would be at a price that could make them some money.

read the Intel Convertible Note by Arthur Rock

GRUNDFEST: So basically, Intel’s major innovation in 1968 wasn’t only that it built the world’s first commercially successful microprocessor, but that it introduced a new compensation model for its employees that wound up being the model for the rest of Silicon Valley. That’s the one-year cliff with the four-year vest.

ROCK: Right.

GRUNDFEST: And it built a team culture that invested all employees in the company’s success.

ROCK: Correct.

GRUNDFEST: And after Intel introduced options, it became common practice in Silicon Valley—options for everybody with that one-year cliff and a four-year vest period. That basically was your invention.

ROCK: That’s correct.

GRUNDFEST: And the strike price for the options would be on the common, so lower than the strike price for the preferred, which would give employees a strong incentive with a lot of upside for their efforts.

ROCK: That’s right, and then eventually companies got sobig that you couldn’t really do that. You had employees who really would not benefit, wouldn’t earn their options. So that disappeared after about, I don’t know, five or 10 years.

GRUNDFEST: But early on, that was a key part of the
structural motivation.

ROCK: Absolutely.

GRUNDFEST: And when you were pulling this deal together and combining novel compensation arrangements with the preferred/common structure, and the novel governance structure, was there any self-awareness that you were constructing a model that would define the future of Silicon Valley?

ROCK: No, not in the least. I just thought of it as something that would work here.

GRUNDFEST: And it worked so well that everyone copied it.

ROCK: That’s correct.

GRUNDFEST: And I have to say, I don’t think that there is any other single document in the history of venture capital that’s as prescient and formative as these four pages that lay out a model of how you do venture capital investment.

ROCK: Yes. First, the lawyers got into it, and I said, “The hell with that.”

GRUNDFEST: But the document is elegantly written, and it’s my understanding that you wrote it yourself.

ROCK: I wrote it myself.

GRUNDFEST: And you gave it to the lawyers and you told them to make this happen.

ROCK: I don’t think I needed to tell them that when they read it.

GRUNDFEST: Now, one of the other fascinating aspects of your approach to venture capital, of your relationship with Intel, and of so many of the other deals that you’ve done is this concept of “intellectual book value.” Sebastian Mallaby’s history of Silicon Valley, The Power Law, frequently cites you and repeatedly refers to your concept of intellectual book value as central to your investment philosophy. Arthur, what is intellectual book value?

ROCK: Well, we know what book value is.

GRUNDFEST: Yes. Well, sometimes we do, yes.

ROCK: Mallaby wanted me to articulate what else enters the mix for a successful venture, and I said, well, what you want is intellectual book value.

GRUNDFEST: How do you calculate intellectual book value?

ROCK: Intellectual book value is the difference between what the marketplace is on a company and what the actual market is. It can be whatever anyone wants to read into it, but for me it’s the value that you put on what people produce that isn’t in dollars.

GRUNDFEST: So, it encompasses skills like leadership and motivation.

ROCK: Right, exactly.

GRUNDFEST: Intelligence, integrity, and all of the human factors that are essential for success.

ROCK: Human value is the correct definition.

GRUNDFEST: So, it’s what people bring to the table that accountants and the financial analysts miss.

ROCK: Well, they don’t miss it. It’s not in their book. They’re not asked to look for it.

GRUNDFEST: Right. It’s not anything they’re assigned to measure, but it’s something that you, as a venture capitalist, have to measure if you’re going to be successful.

ROCK: Correct.

GRUNDFEST: And were there particular aspects of human nature and of character that you thought most important to calculating this intellectual book value?

ROCK: Intellectual honesty.

GRUNDFEST: Talk about that.

ROCK: Would they try to put one over on you to get something done? That’s anti-intellectual value.

GRUNDFEST: I have to ask this. How would you rate Elizabeth Holmes on the scale of intellectual book value?

ROCK: Zero.

GRUNDFEST: Can I suggest a negative number?

ROCK: Well, yeah, for someone like Elizabeth Holmes, yes. The big mistake I made was in the MRI company I helped to start. I helped start the first company that made an MRI machine. And we were pretty successful until it turned out that the person that headed up the company was dishonest.

GRUNDFEST: If you’re a venture capitalist, you’re always at the mercy, as a practical matter, of something going on behind the scenes that you don’t know about.

ROCK: Absolutely. But that’s not as true today. Today, I think, many venture capital firms have enough staff to explore all aspects of management. And I doubt if there are many examples of people doing something as dramatically wrong.

GRUNDFEST: And one of the intriguing aspects of the current venture capital environment, and perhaps closely related to your concept of intellectual book value, is a recent statistic documenting that out of 582 unicorns in the United States—companies valued at more than a billion dollars pre-IPO—55 percent have a founder or co-founder who’s an immigrant.

ROCK: That’s a different story.

GRUNDFEST: It is. But two-thirds are either immigrants or, like you, first-generation children of immigrants. The immigrant population is massively overrepresented among successful pre-IPO companies. Any thoughts on that and how it relates to intellectual book value?

ROCK: I think that this country isn’t hungry anymore.

GRUNDFEST: How does this relate to the over-representation of immigrant energy in successful venture firms?

ROCK: Well, that’s the whole point. These people come over here and they’re hungry. They’re hungrier than our people are.

GRUNDFEST: So, it’s basically the immigrant community that’s generating the innovative energy and also the willingness to take risk.

ROCK: Absolutely. Look at one of the most successful venture capital firms—it’s run by three people. One is a Brit, the second is Italian, and the third is South African.

GRUNDFEST: You’re talking about Sequoia. And then they also have their Chinese arm.

ROCK: Yeah.

GRUNDFEST: So, basically you have four leaders of one of the world’s most successful venture capital firms, and all are immigrants and all bring their own unique form of immigrant energy, having something to prove being here in the United States.

ROCK: I think that’s right.

GRUNDFEST: This question of immigrant energy wouldn’t be alien to you, personally, because you’re first-generation. You’re the son of a Yiddish-speaking Russian immigrant. Does your personal experience fit the notion of immigrant energy?

ROCK: I probably worked harder than the average person.

GRUNDFEST: And how much of that was related to your family’s immigrant status? Was that part of it?

ROCK: Yes. Undoubtedly.