How Venture Capital Made the Modern World (with Sebastian Mallaby)

AZEEM AZHAR: Welcome to Exponential View with me, Azeem Azhar. As an entrepreneur, investor and analyst, I’ve been an insider in the technology industry for over 20 years. In that time I’ve watched exponentially developing technologies change our world. A huge number of those innovations have been driven by venture capital, which I believe is one of modernity’s great transformational forces. My guest this week has spent five years researching and writing a book about that industry. It’s called The Power Law. He writes about how venture capital came to shape our world, what makes it unique and why its best proponents play an outsize role in changing the way we live. He’s had a storied career as a journalist and author, and is currently a senior fellow at the Council on Foreign relations. I’m thrilled to have him here to talk about one of my absolute favorite subjects. Sebastian Mallaby, welcome to Exponential View.

SEBASTIAN MALLABY: Great to be with you, Azeem.

AZEEM AZHAR: Venture capital is a really alluring subject, and the venture capitalists themselves have this mystique around them, an aura. What makes it so interesting, so sexy, so enticing a subject matter?

SEBASTIAN MALLABY: I think the act of building thing out of nothing is sexy and fascinating. And that’s what startup founders do, and that’s what their investing partners do when they get into the trenches with them. So it’s that thing about inventing tomorrow, which is irresistible. I think it really came into its own certainly on the West Coast with the foundation of Arthur Rock’s venture capital partnership in 1961. And so from that point on, you’ve got six decades. And it’s remarkable that now it’s grown to a point where, when you look at all of the companies that have gone public in the United States since 1995, three quarters of the market cap derives from venture-backed companies.

AZEEM AZHAR: So that in the sense gives us an idea, some idea of its impact, but of course the story is not as simple as that. And as we have our conversation, we’ll start to unpick whether that’s luck, whether that’s skill, whether that impact is real, whether it’s a problem of survivorship bias. But before we get to those sorts of questions, one of the things you were able to do in your book was go off and talk to people who are extremely busy. Despite often being well known, they’re often not on every single chat show. So you were able to take us and talk to people who we don’t often get access to. Would you highlight a couple of your favorite conversations when you were doing your research where you thought, “Wow, this is a really special moment. I’m lucky to be telling this story”?

SEBASTIAN MALLABY: I guess my distinguishing tactic as a writer is to allow myself unbelievable amounts of time. The value of taking five years over these projects is that you have time to work your way into the network and to get to see people other people have not had interviews with. So Tiger Global would be an example. When I went to interview the two trigger pulling partners, Chase Coleman and Scott Shleifer, and then was invited back for another round of interviews with them. I think I was the first writer ever to have met them. So I did get extraordinary access. Scott Shleifer, who built the private tech investing side of Tiger Global, and he described to me, when he first was getting into China, he began with these public stocks. And then he discovered that the customers of those public tech companies were growing at a terrific rate and he wanted to invest in them, but they were private. So he took a trip to China, it was in the middle of SARS, funnily enough. And he landed in China with a bunch to face masks. And his mother had pretty much tried to talk him out of going to China at all because of SARS. So he wore this face mask, and he went to his first meeting with the founder of one of the companies he wanted to take a stake in. And the guy says to him, “If you want to do business with me, take that damn mask off.” So he’s got his competitive instinct in one ear saying, “Take the mask off, do the deal.” And then his mother’s voice in the other ear saying, “Keep the mask on, stay safe.” And he says, “What the heck? Life is risk.” He takes the mask off and never puts the mask back on for the next two weeks.

AZEEM AZHAR: And Tiger Global since then has gone from a relatively small fund to dominating with a completely new paradigm of how one should invest in tech companies. So I guess he took the right risk at that point.

SEBASTIAN MALLABY: Yes, that’s right. At the time he took the risk, I guess there were two of them there at Tiger Global and they were both in their mid to maybe even early 20s, super young, tiny shop. And now of course, it’s 40 billion plus under management.

AZEEM AZHAR: 40 billion plus, and of course, just hundreds of deals done every year, which, in the world of VC, is an extremely high number. When I first started to meet venture capitalists in the mid ’90s, it was a much smaller industry and I was lucky to meet some of the people you talk about in your book, Kleiner Perkins and Mayfield and Accel. And these partners were perhaps doing two or three deals per year. And the fund as a whole might be doing 20 a year. And now we have this world in 2021, ’22, where Tiger Global does hundreds a year. That suggests that there has been some sort of turning point or set of turning points in the history of venture capital. I think back to 1995 or ’96, the first time I visited the Kleiner Perkins website, Kleiner Perkins, one of these story venture firms, and all it said was KPCB on one page, Kleiner Perkins Caufield & Byers, KPCB, and that was it. And there was no contact us, there was no address information, there was just this one thing. And of course, now venture capitalists write books, they have blogs, they’re on Twitter, they do Clubhouse audio sessions. And the nature of these firms is rather different to the one that I remember in the mid ’90s, driving down Sandhill Road and seeing these low slum buildings and they were all the same sort of configuration. What do you identify as the main turning points in the history of this industry?

SEBASTIAN MALLABY: I guess I’d choose two to answer your question. In relation to the Tiger Global effect, this huge velocity of big check deals, I think the key inflection point came in early 2009 when Facebook was keen to raise a round of around $200 million plus. I think it was valued around 10 billion at the time. So this was a mature deal and they just could not raise it because the 2008 financial crisis had blown the obvious suspects out of the water and nobody was willing to write checks. Mark Zuckerberg had sent his CFO off to Dubai and the Middle East to try to pass the hat around, no luck. And then all of a sudden they get this call from somebody that at the time, nobody in Silicon Valley had heard of, namely, Yuri Milner. And Yuri Milner is a low profile entrepreneur who started a Facebook clone in Russia. But he’s heard on the grapevine that Facebook needs some investment. And so he calls up the CFO of Facebook and gets blown off, “Who are you? Never heard of you? Don’t waste my time.” He flies to San Francisco and he calls the guy again and says, “Okay, I’ve flown to San Francisco. Now, will you see me?” And he talks his way into a meeting with Mark Zuckerberg, makes an investment of 300 million, which is very cleverly structured. That becomes 1.5 billion in profit within 18 months.

AZEEM AZHAR: Yeah, it’s not bad.

SEBASTIAN MALLABY: And once that was done, every single technology investor paid attention and wanted to write these big checks. And that’s where Tiger Global came in very quickly afterwards, Andreessen Horowitz started in 2009, the same year of that Yuri Milner deal. And a lot of their early investments were big growth rounds. And so I think that’s the inflection point. There’s another inflection point, which maybe gets to the point that you were making around the communication strategy of venture capitalists. In the early history of venture capital, capital was relatively scarce and you needed quite a lot of it to build your company because you were probably doing hardware, and you think about deals like Fairchild Semiconductor, Intel, Apple, Compaq. Then, with the rise of software and the internet, you didn’t need much capital to build a company like eBay that would create astonishing amounts of value in a very short time. Once the software coders figured that out, they realized they could say, “No, capital is plentiful, we don’t need much. So now you’re going to dance to our tune.” And there was what I call the youth revolt, which in a way was crystallized by the moment when Mark Zuckerberg showed up at Sequoia, then, as now, a venerated partnership, he showed up in pajamas, he showed up late, he presented a pitch deck, which had 10 reasons why you should not invest in my company. One of them being that I’ve shown up in pajamas and I’ve been late. So he was just making fun of them. And right around that time is when Founders Fund was started in 2005. Of course, the name tells you that it was about founders first. That’s when YCombinator got started? Paul Graham having pre-pounded his universal theory of VC suckage, saying that VCs drown us in money and we don’t want that. That was when a whole bunch of things came together that told VCs that if they wanted to get into deals, they would have to publicize themselves. They would have to differentiate themselves, hence the A16z method of providing a lot of services. So the game changed.

AZEEM AZHAR: That’s a really interesting analysis. And if I look back, particularly at that second inflection point, I guess the way to think about it is that in the old days, the pre-internet days, the days of funding router and switch companies and tablet computing companies, you required a lot of capital to do anything, to prove anything. And the moment you’re able to take lean startup style models, where you build your value through software, and eBay being a great example with its network effect, but also in a sense, Yahoo and things that came after that. The founders require less capital, and that changes the bargaining chip. Because you can go to your investor having already de-risked large parts of the journey. And that means that you can reach more investors and you actually need less capital. So that’s a really interesting way of looking at it. It then forces investors to be able to provide more value through specialization, so we only do this one thing or through a whole array of services, so you look more like a management consultancy in a way. I think that’s an important thing to realize, the original partnerships were a dozen partners and a dozen support staff. So 20, 30 people in total, and some of these new funds have hundreds of people in them because of the support crew. There was something else that happened, of course, which was the amount of a company that venture capitalist could own also diminished. I think the benchmarks in the ’60s and the ’70s were these very early venture capitalists, whether it’s Rock or whether it’s Tom Perkins were perhaps owning 25%, 30%, 45% of a company at each funding round. And that also diminish, is it as a result of this second inflection point you talk about where the VCs now hold less ownership in these companies?

SEBASTIAN MALLABY: Yeah, you’re exactly right. If you chart that course, Arthur Rock in the 1960s wanted 45% of the company. Sequoia and Kleiner Perkins, when they got started in the ’70s, often took about one third. Fast forward to Google’s Series A in 1999, they basically built the search product and it was terrific and it was clearly a winner, and they could dictate terms. And so they did, and they said to Kleiner and Sequoia, “You’re going to invest jointly,” which of course, neither of them wanted that, “but here’s the deal. Take it or leave it. You can take 12% of our company each and you’ll have to make due with that. But we want a lot of capital for it.” And John Doerr Kleiner Perkins complained that was the most he’d ever paid for the least shares in a startup ever. But of course it was one of his best ever investments, so he couldn’t complain. And then if you go forward to Facebook, Facebook having made fun of Sequoia by showing up in pajamas and all that, when it finally took Series A capital from Accel in 2005, it gave away only 1/8 of the company to Accel. So you’ve gone from 45% to 12% over that 50-year period.

AZEEM AZHAR: And at the same time, what you are backing, it’s a little bit more vociferous, right? When you back a semiconductor company or a company making computers or routers, you are getting patterns and hardware and chip designs. Perhaps there’s also a factory and there’s some CapEx and there’s some physical assets. When you go off and you back Facebook or a Tinder, you’re getting this bundle of weird intangibles that you can’t even prod or put your hands around. That seems to be another distinction in what’s being bought and what’s being sold.

SEBASTIAN MALLABY: Yes. In a way we’re talking here about Perkins’ Law, in other words, “The technical risk is inversely proportionate to the commercial risk.” If you can crack the tough technical challenge, then you’ll have a mode. If there’s no great technical challenge, you better invent some other mode and it’ll be probably slippery. And that’s where you get into these races for first mover advantage and blitzscaling, because you are betting on the network effect. And if you’re not the front runner, that won’t work out for you. So you’re totally right, that is part of the shift. In this discussion, what we should resist is some sort of simple teleology because it’s not the case that VC today is only about software. Software dominates the headlines and it’s created to so much value that people lose sight of everything else. But of course there is hard tech, deep tech going on as well, whether it’s batteries for electric vehicles or whether it’s food tech, Impossible Foods type stuff, or nuclear power stuff. There’s lots of things going on, which don’t fit the software template.

AZEEM AZHAR: You talk a little bit about, this was a great deal for John Doerr, and in the book you talk about how people had very good deals. Just for listeners what does a good deal mean for a venture capitalist?

SEBASTIAN MALLABY: Well, I mean, the sky is the limit. I’m trying to remember the exact numbers, but I’m pretty sure I’m right to say that Masayoshi Son spent 20 million in 2000 on his investment in Alibaba. And 14 years later, the exit was 58 billion. So that means the value of his investment grew by 40, 50% every year. Hedge fund invested like Julian Robertson would say that a fabulous investment was one that did 3X over three years. In venture capital space, you’re looking for at least 10 times your money before you call that a home run. And sometimes you’re getting a hundred times your money.

AZEEM AZHAR: If that’s the case, 40, 50% IRR every year, 100 times your money, it begs a question as to why venture capital is as small as it is. Now, it’s grown significantly over the last 20 years from a couple of 100 billion, a year to 650 billion of venture capital investments made in 2021. But in the context of global assets, under management, which run to some 100-trillion, it’s really, really small and it’s fractions of 1%. Why is it so small?

SEBASTIAN MALLABY: The first answer is that although three quarters of the market cap created in the U.S. over the last 25 years or so does come from venture-backed companies, venture only backs like half a percent of all companies that get started. So it’s small in terms of the money that gets shelled out, it’s huge in the impact of the money. And if you’ve got a type of investment that makes that much impact with that little cash, it tells you something about how much cash the general partner really want to raise. Now, this is changing and this is where the answer to your question gets interesting. Traditionally, a partnership like Benchmark famous for backing Uber and a bunch of other things-

AZEEM AZHAR: And eBay of course, right?

SEBASTIAN MALLABY: And eBay, that’s right. Got started in 1995 explicitly saying that they wanted a fund, which would be less than 100 million. And they said, “The prizes go to the people who shoot accurately, not to the people who arrive with a machine gun,” or some metaphor like that. They didn’t want to spray and pray, they wanted to be highly precise. And they made a virtue of smallness. Most venture partnerships agreed with that. They wanted to raise 200 million, 300 million in the fund, and they wanted to be super careful about how they deployed the money. And they were not interested in high velocity, high volume. Now, as you mentioned before, that’s changed. Tiger Global has changed the game. It’s putting out these checks at an absolutely huge rate and velocity has also done that. Is telling us that some people think the right answer to your question, Azeem is, it’s been a stupidly low amount of money under management in this venture space. It ought to be increased 100X, 1,000X, and let’s get going with that. And let’s just raise huge funds and show the money out the door because you know what? Technology isn’t just about carefully chosen alpha. It’s about massive beta. If you just get huge exposure to a big portfolio of emerging tech, you’re going to win because that’s how society’s changing. So I think we’re at an interesting moment where there is this bifurcation between those who want to keep carrying on with the spirit of the old Benchmark vision, “Let’s shoot accurately.” To those who say no, “Let’s spray bullets all over the place, just get a huge crate war chest here.” And that’s the way to win.

AZEEM AZHAR: My take, and I put this in my book, is the types of technologies that we’re going to be developing over the next few years lend themselves to the risk profile that venture capital has become good at supporting. Whether it is businesses that are baked in around intangible assets or whether it its businesses that are baked around very deep technologies where the metrics of progress are harder to put your hands around. And that happens to lend itself much more to the type of skills that we’ve seen coming out of venture capital than we might see out of a high street bank offering a commercial loan or traditional shareholder-based capital. My sense is that this is an industry whose growth rate will continue to look quite healthy. Is that your sense of the picture?

SEBASTIAN MALLABY: Yeah, totally. I think you put it really well, and you can tell that we’re going to be on the same wavelength, given that your book is called Exponential and mine is called The Power Law, and we’re talking about the same thing.

AZEEM AZHAR: Sure.

SEBASTIAN MALLABY: I really do agree that the shift to intangible capital means in a profound way that you need to be a hands-on investor to get it right. Because you don’t capture the value of intangible assets on financial reports very well. If it says, “We invested 200 million and in this software development program,” well, it could be worth zero if the software is rubbish or it could be worth two billion if it’s genius. And you can’t tell the difference, unless you are pretty close to the software and you are the type of investor like a VC who takes a board seat and who really pays attention to what the company is doing. And probably has the technical background to understand what the code and how it’s being developed and whether it’s genius or rubbish. So I think intangibles really support this story. I think that innovation since we’re into a world where demographics in advanced economies are going negative. But one thing we can do is improve on technical education, and so that lends itself to building of technical companies, which can try to drive growth through productivity gains rather than just more workers. And that world of building new technologies, it’s best done through iterative experiments conducted by multiple startups. And that’s what VCs are great at. And so I think both because of the nature of intangible assets and because of the nature of just innovation taking experiments. And I think that kind of stuff is just going to continue.

AZEEM AZHAR: That takes us into this question of the idea of in this new economy, where the build has to happen, not simply through the provision of capital, but through the provision of a certain class of expertise. When you are judging a startup, even at a growth stage, the judgment of that business is very, very different to the way that a public market investor will decide about making an investment. And just the availability of equity analyst, ratings and bond ratings, and so on. They don’t exist in great stage companies. When you go to earlier stages, it’s even harder. There’s two graduate students leaving their desks, wanting to set up a new company based on their research, much too much harder to judge. So there is this sense, perhaps that there should be skill. There is a particular skill that gets developed. Another argument is simply to say that this is really about luck, that this is really about being able to get into the door of one of these firms who’s established a reputation. And because they have that reputation, they’re seen as king makers, because there’s no evidence or data to support any of these companies. The startups that get backed by the king makers are going to become the kings. And 50 years on, this is less about competing on our skill and on our wits, but more around the ivory tower that’s been built over the, the last 50 years and our ability to anoint the winners. So skill versus luck.

SEBASTIAN MALLABY: I grappled with this question, partly because I came at venture capital having written about hedge funds before. And with hedge funds, if you have a fund that does well, let’s say beats the market over a 10-year period and nine out of those 10 years, it’s done well. You have to be fairly churlish to say, “That’s just luck.” And the other thing is that in hedge funds, there’s no obvious path dependency, So every year is a new year. And if the bets are good, you’re going to beat the market. And if they’re not good, you won’t. And so there’s no reason to suppose that a luck in year one or year two would create a path dependency that then carries forward. Whereas in venture, these things are much harder to show because first of all, it’s not like any venture capitalist is right most of the time because of this parallel distribution of returns. It’s all about these tail events that drive all of your returns. And that makes it intrinsically harder to recognize skill because even a scope of person is going to be wrong a lot.

Secondly, as you were saying, there is this reputation effect. If you were to imagine an experiment where you have ten venture capitalists who starting year one, one of them through sheer luck, that’s something that becomes a unicorn, then has a reputation for a hot hand. More entrepreneurs flock to him and you get this better deal flow. And that sustains it into the future. So I really did take seriously, this idea that it could just be luck. And initially a lot of the stories I got told about how venture deals happen reinforced the idea that this is just weird serendipity. I go see Jerry Yang of Yahoo right at the beginning and I say, “Well, why did you take money from Michael Moritz of Sequoia when others were happy to invest?” And he said, “Well, Michael had soul.” It’s like, “Soul? Soul? Is this the basis for an investment discipline that you have to show soul?” And there are lots of stories like that, which just make it all sound like serendipity. But as I got closer in, you can disentangle the cute stories from the reality. And I think Sequoia is a great case study in this because they do a range of things, starting with the prepared mind strategy where you see in the emerging technology come and you figure out ahead of time, “Okay, so cloud computing is arriving. Let’s figure out what are the security vulnerabilities they’re going to emerge in cloud computing that we’re going to have to solve for. And therefore, what are the online security companies that should be created? What kind of new writers, what kind of new semiconductors, what kind of new business models does this imply?” So that’s one kind of skill.

And then another kind of skill is, we understand from decision science that we are biased as human beings in the way that we make decisions. We tend to anchor for example. And so, if we pass on a Series A and then the Series B opportunity comes to us, we’re quite likely to say no just because we want to make ourselves feel okay about having said no the first time you don’t want to admit you were wrong. And so you have got to fight against that anchoring. We are also famous for having loss aversion, so we will gamble to avoid a loss, but we will not reach with the same amount of risk appetite for the upside. And so Sequoia builds into its investment decision memos, a pre parade section, which is obligatory. And in that, you have to imagine the best things that could happen. And you have to say, “What would happen to this company if everything went right?” And the reason you are obliged to write that section of the memo is that we are as human beings, disinclined to be embarrassed. And so we don’t want to stick on that side, and so reveal how excited we really are. But if you approach it that way, you won’t gamble adequately for the upside. Or even another example is Sequoia has really thought deliberately about building a network. Deal flow comes from networks, so you they go off and they build the Scouts Program where they give small amounts of capital to existing entrepreneurs to fund the next cohort that they spot. And in fact, Stripe was an example of this, now worth $95 billion. Got onto the radar of Sequoia super early, because Sequoia had deliberately built a network that flagged Patrick Collison and John Collison when they were like 20 and 18 years old. So there’s a huge amount of deliberate skill. It’s just not evident until you really get under the hood.

AZEEM AZHAR: You use phrase, deliberate skill. We could also say de deliberation. One of the things that strikes me about the top performing venture capitalists, who you chronicle in your book. But also the very good ones I’ve had a chance to work with over the last 20 years or so, is that sense of deliberation, of reflexivity, of introspection, of challenging the assumptions that they have made. And I think one of the reasons why venture capitalists use networks so extensively is that a network in of itself is a reputation signal. So if your assumption is that, look, I’m a generalist investor, I’m looking at things in the microbiome and in nuclear fusion and in semiconductors and in billing software in the same day. I’m not going to be able to tell these things apart necessarily. However, if I have trusted people who I’ve worked with over decades who do know something of about those areas, when they make a recommendation, it’s worth something, more than the random knock on the door. That’s a sensible strategy from the investor. That sense of deliberation. There’s so much uncertainty in what you’re doing, you need some positive signals to help you with the decision you’re about to make. But it also talks a little bit about access and about who can then reach those networks and make their way into the consideration table. And one of the things that we know about venture capital is that venture capitalists have largely and virtually everyone that you talk about are hes [men] with the exception of a couple of names. They are white hes from the U.S. Very few female partners in venture capital in the U.S. although the number rose strangely after Ellen Pao, was a female venture capitalist took her firm on for discrimination a few years ago. There are very few black and Asian investors as well. And it gets reflected back in on profile and makeup of the founders who get backed and the founders who ultimately are successful through the venture capital route. So to what extent do you think that these heuristics they have to use as well as these acts of deliberation, the soft pattern matching contributes to that homogeneity, that lack of diversity both in the types of firms that receive venture capital backing, but also the makeup of the VC firms themselves.

SEBASTIAN MALLABY: I think you’ve put your finger on a really important issue, in the world of venture capital where you are pitching face-to-face and you are relying on recommendations from your network, the biases are quite hard to exclude. And I think it’s taken a long time for venture capital partnerships to really wake up to that properly. I think it’s happening now, but it’s been late and coming. One of the contributions I hope I’ve made to this debate through my book is to point out that it’s not enough simply to hire and promote women or black investors. Black investors account for only 3% of the total, which is way lower than their share, not only the population in the U.S. but also of other elite professions, and women are just at 16%. So it’s scandalously low. What I’ve tried to show through the story of Kleiner Perkins and the Ellen Pao suit is that, that wasn’t… It was a complicated story because John Doerr, the lead partner at Kleiner had actually stuck his neck out to go against the industry conventions by hiring more women and promoting more women. But the problem was he didn’t actually pay attention enough to fix the culture of the partnership in a way that would allow women to flourish, to avoid discrimination, to avoid harassment. And so the story of Kleiner tells you is that you can have good intentions, but you really have to follow through with the culture. And that actually broadens out into a bigger point about venture partnerships and what distinguishes good ones from bad ones. The internal glue in the team, I think is just tremendously important. And one of the differentiators between the successful teams and the less successful ones is that we are talking about teams, and you have to be deliberate in how you promote younger partners. You have to proactively let them be the person who sits on a board of a company that’s going to do 10X plus. Sequoia has got that right, and Kleiner for a while did not get it right. And that’s why one of them declined precipitously, and the other one just went from strength to strength.

AZEEM AZHAR: To what extent though are these the lessons of the elite? The firms that you write about, and the partners that you write about are the Nadals, and the Federers, and the Messis, and the Ronaldos. They aren’t the long tail of venture capitalists because of course, there are now thousands of firms in the U.S. and Europe and China. Is this more a story about the head of that Power Law distribution, the very best of the best of the best? Or are these messages that can be picked up and applied or patterns that we would see elsewhere?

SEBASTIAN MALLABY: Well, my theory of the case is that by describing the best or the best, it hopefully teaches lessons which are helpful to people who are starting out, who want to become the best of the best, and some of them will. So I plead guilty to focusing on the stars. I still think it’s helpful to do it that way.

AZEEM AZHAR: Okay. So of course, the other thing is you don’t tend to see the blow ups in venture capital that we do in the hedge fund world. The hedge fund world will give us Bernie Madoff, it’ll give us LTCM, give us superstars like Paulson, who does really well and then disappears off a track and in a couple of years. But I guess venture in venture partnerships are slightly different. Unless there’s something particularly scandalous, they tend to dissipate with a whimper rather than the screen of the Bloomberg turning red and the power being cut off.

SEBASTIAN MALLABY: Yeah. And they’re also protected by the fact that data around venture partnerships performance is obscured deliberately. And in the course of reporting the book, I had to be pretty careful because the numbers you get served up are sometimes shocking in their dishonesty, frankly. I took a lot of care and a lot of academic advice on sorting out the nonsense from the truth. But because the truth takes a while to emerge in terms of venture performance, that’s not duplicity, that’s just the name of the game. You invest and you don’t get an exit for five to seven years. It takes a while for a performance to manifest itself. You can raise a fund and potentially raise the second fund before you can be measured. In hedge fund space, you can blow up overnight. As you said, in VC space, it takes five or six years for ineptitude to manifest itself.

AZEEM AZHAR: We talked a little bit about the challenges of exclusion. Founder-level exclusion, exclusions from the partnerships. There’s another dynamic that also leads itself towards exclusion. Veg Capital creates an in all almost amount of wealth, of course, for the general partners who are successful, but also for the limited partners, the underlying investors who get to participate in these funds. How can public investors get access to the benefits of this exponential growth? It is easy for me to buy a share in Apple or NVIDIA. It’s really tough for me to share in some of the upside of Sequoia. Is there a problem with that and how does it get fixed?

SEBASTIAN MALLABY: That is a problem and it’s pretty hard to see a fix other than through the big picture of tax policy. And I think this is one thing which is troubling about the rise of growth investing. I have a couple of criticisms of growth investing in the Yuri Milner revolution I described before. One criticism is that, the way that Yuri Milner gets into deals, and also the way that Tiger Global conducts itself is to say to the entrepreneur, “We’re not going to get in your way. We don’t need a board seat. We don’t need to vote our shares against you ever. We will be totally passive. In fact, we are the alternative to going on the stock market, except you won’t have to do a quarterly earning score and no one can short your stock.” For the entrepreneur, it’s very attractive because it cements the control over the company, but for the world, I’m not sure that’s a good thing. I think even the best entrepreneurs could do with some governance. And I think all this stuff about super voting shares for founders and all that is actually destroying checks and balances that would be good for everybody. So that’s my first concern about growth capital. But the other is that we’ve gone from a world in which Amazon did well in the ’90s and went public at evaluation of something like $480 million. Now, Amazon would stay private until it was worth 100 billion like Stripe is doing. And that means that all of the growth between half a billion and 100 billion is not accessible to stock market investors. And that’s bad because as you’ve just said, ordinary individuals can’t just go on the stock market and buy a share if they want to. It’s also bad from this perspective of just, if you think about progress in finance, it has to do with reducing the cost of intermediation. And if you go from a world where even a big institution, whether it’s a pension fund or a university endowment used to be able to hold these growth companies by buying the stock on the stock market and paying zero fee to anybody, you just buy the stock. Now they’ve got to pay two and 20 to some growth investment shop. Is that progress? I’m not sure it is.

AZEEM AZHAR: There’s another interesting dynamic in the industry, which is in many countries, there’s very, very favorable tax treatment for venture capital. As specifically, the investment gains are treated not as income, but as capital therefore attracts a lower rate of tax than had they been treated as income. Is that kind of tax incentive, tax loophole important for this industry?

SEBASTIAN MALLABY: When you look at how much the venture space has grown in terms of capital available, your point would sound correct. Money’s flooding in so why do you need a tax incentive to have even more money flood in? On the other hand, you could say, relative to the opportunity, given a shift towards intangible assets and our desire for productivity gains through innovation and our belief that innovation is best pursued through iterative experiments by small companies backed by VCs. Maybe we do want more capital to flow into VC, maybe not into the growth space as I was just saying. But I think in early stage, there is plenty of room for this model of financing to spread globally and to spread also regionally within countries that have it. So Silicon Valley may be saturated, but what about Denver? What about Austin, Miami are coming up, but. there’ve got to be a lot of other cities. Carnegie Mellon is in Pittsburgh, it ought to have a terrific VC scene. So I think actually that some tax subsidy for an industry that is essentially promoting applied science is justified. But I am concerned at the same time about inequality, and I think that really has gone too far. And therefore I would be in favor of other kinds of tax reform, notably in the United States, I’m talking about the estate tax, which is basically gutted in the last 20 years. It should be restored to what it was in the 1990s. And it’s perhaps not surprising that in the 1990s, most Americans said they like capitalism and now they don’t.

AZEEM AZHAR: Right. Fair enough, yeah. So the other thing that has happened actually of course, over the last 25 years is that venture capital has started to go global. So back in ’96, the first time I went down Sand Hill Road, 99% plus of venture capital dollars were coming out of the U.S. And since then, we’ve seen local clusters grow in Israel, in the UK, in Sweden, and of course in China. I looked at some data for 2021, which suggested that now just over half of all venture capital was deployed outside of the U.S. Some of that was from American firms deploying outside of the U.S., but it shows that there is a transition that there is now a global economy to sit between the possibilities of science and the realities of their business, which I think is the job that the startup founder does. I think it’s the job that the venture capitalist helps get done. What should those configurations actually look like? I’ve sat in discussions for 25 years with people saying, “We need to build the next Silicon Valley.” And I’m not sure if you go and actually visit San Francisco in Silicon Valley, and you come from a beautiful culture town like Paris or London, I’m not sure you want to take that and bring that to your neighborhood. But there are aspects clearly of commercializing the applied science, of driving higher skilled work, of bringing innovations into different parts of industry that do matter. So what is the lesson for the policymaker, for the city, for the university administrator around how to make that happen?

SEBASTIAN MALLABY: I think we’ve got to the point where people have not only understood how to bottle the secret sources of Silicon Valley, it’s actually happening. And the key here is to understand how Silicon Valley started and then how China, the big other example followed. And what I was surprised to discover when I started doing the research, I would hear these stories that Silicon Valley took off because Stanford was fantastic, but actually at the takeoff point, the truth is that MIT was better. But there was Berkeley, yeah, but Harvard was better. Well, there were a lot of defense dollars in Silicon Valley. Actually the military–industrial complex was more about collaboration between MIT and the defense department. More defense dollars went into the Boston area in the cold war than into Silicon Valley. “Oh, well, California has this special potion in the water or something you breathe in the air, it’s this entrepreneurial pazal, something about the hippies. It goes back to the 1849 Gold Rush.” Yeah, right. All of these explanations were pretty soft, but the one thing that turned out to be super true – and I crystallized this in the story about the inventor of Ethernet cables – Bob Metcalfe gave rise to the Metcalfe law. It’s that the nature of venture capital on the West Coast was fundamentally different to the venture capital business in Boston. The West Coast was just much more willing to take risk, more willing to embrace the power law and lose on eight out of 10 bets. More activist in how it rolled up its sleeves and back to entrepreneurs that it invested in. And so when Bob Metcalfe who had I think been to MIT and came out of the Boston region, went to look explicitly for Boston venture capital and didn’t want California venture capital. He wasted months and months tearing his hair out and there was this thing, they owed by the way syndrome. In other words, you would think you had a term sheet and then there would be this condition that came up, “Oh, by the way,” and then there would be about the Boston VC wanting to have something in the term sheet that protected them from dilution or from loss or whatever. And ultimately there was no deal. And Metcalfe went off to the Valley, got a deal within about half an hour and moved on with his company which was called 3Com and was a great outcome.

The key thing about the valley is the VC was more risk-tolerant, and then also more networking. The famous book about the difference between MIT and Boston on the one hand and Silicon Valley and the success of that ecosystem on the other is by AnnaLee Saxenian of Berkeley when it’s about the porousness of the boundaries between companies. Like Silicon Valley had these small companies, people move from one to another. The network was more effective creative because people and ideas and money moved around the network faster and more effectively and more creatively in Silicon Valley than it did in Boston, which had these vertically integrated secretive companies. But what made the circulation of ideas so rapid? Why were there those small companies? Well, the answer is venture capital. Ideas were circulated because venture capitalists got up in the morning and had breakfast with one person, and then had 14 cups of coffee with different people before they went to bed. They were the bees who brought the pollen around the garden. Why were there lots of small companies? Is because venture capital was there to fund them. Why did engineers take a risk on joining a startup in Silicon Valley? It’s because the VC would say to them and look at them in the eyes and say, “Look, this startup might fail, but don’t worry, I’ll get you a job in another startup because I believe in you.” Eric Schmidt told me a story about why he joined Google. He had been the CEO of Intuit, another company, and he was joining this small startup with a couple of grad students who had the voting shares to fire him if they didn’t like him. And they made it quite clear that they might fire. So why would Eric Schmidt go to Google? It’s because John Doerr, the VC said to him, “Eric go do this job and if they bounce you out, I’ll get you a great job somewhere else.” So people take risk, not because of the culture. People take risk because VCs are underwriting the risk. When you look at why China took off and you’d ask, what is the top venture capital partnership in China? It’s Sequoia, it’s Sequoia, China. It’s the same people who arrive for the same playbook, every single early Chinese digital company. Whether was Baidu, Alibaba or Tencent, al of them got American capital. All of them were incorporated by American lawyers from Silicon Valley. All of them had the same structures, Cayman Island, parent company dispute supplement under New York law, often board meetings in Silicon Valley and crucially, they had equity options for the early employees that was entirely American VC created invention. And then VCs pollinated the ecosystem and managed the network in China in the same way as they had done in Silicon Valley. Now you look at Europe, which is taking off, and you have huge growth in the number of unicorns. Why is that? It’s because American style VC has showed up here. This is basically the DNA of Silicon Valley being transported to Europe. Same thing is now happening in Latin America. So I think this is going global, and the difference now is that it used to be the policy makers who are saying, “We’d like to do a Silicon Valley in Dresden.” That’s not going to work. What works is when the VCs show up with their techniques and they arrive in Europe, for example, which has more coders in total than America has coders, and has terrific computer science programs than Oxford and Cambridge and ETH in Zurich. And that’s the formula that works. You’ve got the technical skills, you’ve got a big rich consumer market. You bring in the American style VC and it’s going to take off.

AZEEM AZHAR: The thing that I’m curious about is venture capital is about disrupting industries. That’s what it does, and I mean that in a rather neutral sense. You come up with the new internet router that is much better than the previous internet routers and those ones nobody uses. You come up with the online auction service and people don’t go to car boot sales anymore. Yet many of the prescriptions of venture capital are the same now as they were 20 years ago. Many of the firms are the same, the way you raise money is the same. The way that decisions get made are the same, the way the partners get paid are the same. How is venture capital resisted its own disruption?

SEBASTIAN MALLABY: I’m not sure I agree with the premise. I think some of the tools that were invented at the very early stages that you only use equity and you do the financing stage-by-stage, and you go on the board. Those things have stuck far and large, but there’s been a huge amount of innovation. Angel investing didn’t used to exist, incubators didn’t used to exist, growth equity didn’t used to exist. It used to be that you had VCs who were unspecialized. Now, just about every venture capitalist you might meet will either be doing SaaS businesses or they’ll be doing some kind of biotech, but people do because they recognize that technical capacity is important. The deliberation that Sequoia puts into its decision-making process around decision science that I described, that’s that’s new.

AZEEM AZHAR: Those are new, but they’re evolutions. They’re the kind of iterations you would expect a successful industry to go through. Specialization, improved internal processes, someone comes in and says, “Hey, we’ve been making a repeated systematic error in the way we assess this kind of thing. Let’s change that.” That’s what you would expect to happen in a car production line over 50 or 60 years. The question is really about that idea of disruption, which is a completely different way perhaps of funding and stewarding companies that does to this evolved model what the first cars did to the most evolved horses and buggies. Is that possible to happen? Are there indications of things that might do that?

SEBASTIAN MALLABY: I think we’re debating an issue of degree. Isn’t an electric vehicle a disruptor to the old engine? Yes and no, it’s still got four wheels and steering wheel. I think VC has changed quite a lot, even if the core methods have stuck. It reminds me a little bit with hedge funds, the basic ideas are going long and going short, having fully incentivized investment managers, who we get a share of the carry and trying to be flexible and the tools that you can wield. Those have stuck, but they’re applied to just markets that have completely changed out of all recognition since the model was invented. So sometimes you get a financing platform like hedge funds or like venture capital, which in itself may remain fairly unchanged, but the application of it and the practice of it is constantly refined. To me, that is evolution or innovation, or even disruption. When you have enough evolution, maybe it’s called disruption. So I don’t know, I think we’re just debating whether it’s 5X difference or 10X difference.

AZEEM AZHAR: But there are ideas, when we look at how projects in Web3 and Cryptoland start to get funded now, they don’t necessarily go through a traditional venture capital route although, there are VC funds that have created vehicles that allow them to invest in Web3 projects. So do you look at that and say, “Well, this could be a way of funding that applied science, the idea of tokenomics and earlier participation by Ordinary Folk”?

SEBASTIAN MALLABY: When I started doing my research in around 2017 or so, we had the ICO boom, companies funding themselves by inventing their own tokens, and so forth. And I remember sitting down with a friend who said to me very earnestly, “This is the end of venture capital.” It wasn’t. I have a similar feeling about DAOs and all that. This innovation, it’s super interesting, I’m fascinated by it, but I also think that there is a human organization, there are some constant patterns. One of them is a tragedy of the commons. And if you don’t have leaders or important figures in an organization that are really incentivized and you rely on collective goodwill, free writing creeps in, and I’m skeptical as to whether that really displaces the intensity of focus and motivation you’re going to get out of a traditional VC structure. So if you ask me, what’s the future of funding Web3? I do believe Web3 is going to be a real thing. I’m just betting on the Andreessen Horowitz Web3 investment strategies more than I am on DAOs being the funding vehicles.

AZEEM AZHAR: Yeah. There is something about how does one navigate the uncertainty of the early stages of a company. There are so many things that you can’t control in terms of what engineering ends up working, when, and which customer will finally use this. And this idea of having a directed search through that space where you have a founding team and perhaps investors who’ve walked that journey before, it’s an appealing idea. The sense of actually feeling your way through this dark forest is best done with someone who’s done it in the past, whereas the approach of the DAO is a sense of, “Well, can the collective intelligence of people with very differentiated incentives somehow exceed that other directed search? I guess that’s what we’re going to learn over the next few years.

SEBASTIAN MALLABY: Yeah. It’s a fascinating experiment. I guess I feel that collectives are good at knowledge creation, but when it comes to action, that’s perhaps different, but we’ll see. I’m fascinated to watch.

AZEEM AZHAR: When historians are looking back over this period of time from 50 years out, how do you think they will write about the venture capitalists who have touched many of these companies?

SEBASTIAN MALLABY: You go through different eras when different technologies arise and therefore different scales and types of business organization are appropriate. So if you think about the United States before around 1850, there wasn’t steam and there wasn’t rail, and there wasn’t really the technology to support scale. So just about every business was a family-owned business and you could fit the employees into one room. Then along come these new technology, steam, electricity, railways, and all of a sudden you can distribute over a large scale. You can build a factory with steam, you can make things that require big corporations. And so now you need a legal kind of financial arrangement that will finance that. And that is the limited liability joint stock company, invented in the late 19th century and spread through Britain first and then the U.S. And that becomes the defining legal financial invention that in the view of some writers I’ve read, was as important as the steel or the steam or the railways. Without the joint stock company, how would you have actually turned any of these things into actual facts on the ground? You needed to be able to organize a company to do that. So then you go forward in time and into the 1950s, you’ve still got organization man, the big corporation, the hierarchy. And then along comes with the rise of the personal computer, the ability to basically manage information in a totally different way, cut out layers and layers of white collar, middle ranking employees. Because you’ve got spreadsheets and you’ve got computers and you can share information and just do it much more efficiently. So now you need to re-engineer. So what do you get? You get the junk bond, you get the buyout, you get a new financial set of tools that cause companies to be bought out and then radically re-engineered. And then, fast forward to this century, I do think that the defining innovation is venture capital because the new technologies are intangible, it’s software. It’s other kinds of intellectual property. It’s these things which as we were saying before, they’re hard to value if you just look at the financial statement. So you need to be a hands-on investor and VC, it’s putting it stamp on the shape of the economy in the same way that the joint stock company invention did or JPMorgan did, or Michael Milken’s junk bonds did. And so that’s what makes it so exciting.

AZEEM AZHAR: Listeners, we’ve just been treated to a remarkable, brief history of the last 130 years of capitalism and the next 20 with my expert guest. Really pleasure to speak with you, Sebastian. I enjoyed your book, The Power Law. I think you’ve made a strong case in your last answer as well as to just why it’s important to understand this phenomenon of venture capital. Thank you so much for taking the time today.

SEBASTIAN MALLABY: Thank you, Azeem. It was a pleasure.

AZEEM AZHAR: Now, if you enjoyed today’s episode, you are in for a treat of back catalog has so many conversations with venture capitalists, practitioners, and also the academics who study them. So look out for the conversations with Leila Rastegar Zegna, Matt Ocko, and Bill Janeway amongst others. To become a premium subscriber of my newsletter, go to www.exponentialview.co/listener, where you’ll get a 20% discount. And to stay in touch, find me on Twitter, I’m @azeem, A-Z-E-E-M. The podcast was produced by Mischa Frankl-Duval, Fred Casella and Marija Gavrilov. Bojan Sabioncello is our sound editor.