A History of Systematic Serendipity and Grand Slams (The Power Law by Sebastian Mallaby)
"Silicon Valley is gripped by the cult of the individual. But those individuals represent the triumph of the network." Matt Clifford
In 2002, a young hedge fund analyst was sifting through the rubble of the dotcom bust for ideas. After three years at Blackstone, Scott Shleifer had joined upstart Tiger Global, formed by Chase Coleman after his mentor Julian Robertson had shut down legendary Tiger Management at the peak of the bubble (see my thread).
In The Power Law, Sebastian Mallaby recounts how Shleifer dug through a list of technology stocks until he stumbled upon a group of Chinese internet companies. Sina, Sohu, and NetEase were not yet profitable but they were growing rapidly and their stock prices had imploded. When he started modeling their financials, trailing profit margins were of little use. Instead, he looked at incremental margins — how much of future revenue growth would fall to the bottom line.
Shleifer set up calls with management and threw out the idea that revenue growth would soon slow down. But the response was that online ads in China were just getting started, and costs would grow much more slowly than revenues. When Shleifer heard that he was the first Western investor to call in some time, his ears perked up. He continued his work and realized that within a few years these companies could be trading for as little as one or two times their profits.
He visited Coleman’s office with the words:
“Sina, Sohu, and NetEase. Let’s dance.”
By the summer of 2003, Tiger Global’s Chinese positions “were up between 5x and 10x.” This success led Shleifer and Coleman to visit China during the SARS epidemic and make their first venture investments.
They were not interested in emulating traditional venture capitalists who embedded themselves in local networks to find promising startups and original ideas. Rather, Tiger Global would take its hedge fund DNA and global view and bet on companies that emerged as winners in their respective categories and geographies. Coleman and Shleifer divided internet companies into segments such as “portals, online travel, and e-commerce,” Mallaby wrote. “The trick was to go country by country, identifying the firms that were emerging as the winners in each category.”
They were looking for a proven business model in an untapped new market such as “the eBay of South Korea” or “the Expedia of China.”
“The this of the that,” they called it. It was a powerful formula at the time and led to the birth of Tiger Global as a dominant crossover and growth investor (which just raised its latest $11 billion venture fund).
It’s one of my favorite anecdotes from Mallaby’s new book and illustrates his strength as a researcher and storyteller. He explores the evolution of an industry by carefully reconstructing key trades through extensive interviews. The same formula made More Money Than God the best book on the history of hedge funds (I interviewed Sebastian about it last November). This time he tackled investments in companies like Apple, Cisco, Facebook, and Uber; as well as legendary investors and firms like Sequoia, Arthur Rock, Peter Thiel, Masayoshi Son, and John Doerr.
“The distinguishing genius of the valley lies not in its capacity for invention, countercultural or otherwise,” Mallaby wrote. “No single geography dominates invention.” Rather, “when it came to turning ideas into blockbuster products, the valley was the place where the magic happened.” He makes the case that venture capitalists were often a key piece of that magic.
“We don’t live in a normal world, we live under a power law.” Peter Thiel
Mallaby calls the power law “the most pervasive rule in venture capital.” Whereas public market investors can make bets on mean reversion, in early stage technology “the winners advance at an accelerating, exponential rate” and a small number of bets account for most of the gains. Between 1985 and 2014, 5 per cent of venture capital deployed drove 60 per cent of returns. Bill Gurley called venture capital the “grand-slam business” and Mallaby adds that “tail events are all they care about.”
The internet took this phenomenon to a new level. Sequoia, which had backed firms like Apple, Cisco, and Atari, generated more gains from Yahoo than from all its prior investments combined. This was also because Michael Moritz had realized that the firm had sold Cisco stock much too early and was pounding the table to hold on to Yahoo stock for longer. “The secret was just learning to be a little patient,” he mused. Sequoia’s new evergreen fund is merely the latest step in firm’s evolution and the desire to participate in the extreme outcomes under the power law.
“If you are afraid of losing everything, you tend to take your chips off the table too early.” Michael Moritz
A great illustration of the need for patience is Alibaba. Goldman seeded Jack Ma with $5 million. But during the dotcom bust, Goldman’s senior management pressured its dealmakers to unload the stake. The firm realized a 6.8x profit which Mallaby called “one of venture history’s worst exits.” Meanwhile, Softbank’s Masayoshi Son invested $20 million in early 2000. Upon Alibaba’s IPO, his 20 per cent stake was worth $58 billion.
“Spend as little as you can, because every dollar of the investor’s money you get will be taken out of your ass.” Paul Graham
Traditionally, the most successful venture firms turn their early successes into a kind of “structural alpha” which reinforces hegemony by providing access to the most desirable companies. Entrepreneurs recognize the value of the venture capitalist’s prestige to de-risk future funding rounds. And the venture capitalists use their network to bolster the startup’s access to talent. John Doerr once called himself a “glorified recruiter” while Jeff Bezos explained his reasoning for wanting Doerr as his investor by comparing Doerr and Kleiner Perkins to “prime real estate.”
This leads to a wide dispersion of returns. As Dan Rasmussen noted in his review of the book, “between 1979 and 2018, the median [venture capital] fund underperformed the S&P 500, while the top 5 per cent of funds nearly tripled the index’s performance.” Nevertheless, Mallaby shows how this hegemony is regularly disrupted by new entrants. These newcomers often contributed to a long-term trend evident throughout the book: the shifting power balance between capital and talent, between venture capitalists and entrepreneurs.
Prior to the development of venture capital, ventures were funded by wealthy individuals and corporations. Capital was expensive. When the Traitorous Eight left Shockley Semiconductor, they were funded by Sherman Fairchild's Fairchild Camera and Instrument. While the founders received equity, Fairchild had the option to buy the entire company for $3 million — which he did once it became successful. In another example, Georges Doriot, the founder of American Research and Development and one of the fathers of venture capital, funded Digital Equipment Corporation in 1957 with $70,000 in equity and a $30,000 loan. ARD owned a 77 per cent stake that was worth $380 million by 1972. It accounted for 80 per cent of all gains at ARD, illustrating both the power law and the early imbalance of power.
Today, startups are able to raise capital at eye-watering valuations as money is rushing to enter the space. The rise of angel investors and YCombinator provided less dilutive early financing. Most startups have also become asset-light with a pervasive shift from hardware to software and access to cloud infrastructure. Meanwhile, the internet’s scale has super-charged power law outcomes which investors are happy to underwrite as long as the boom lasts.
This resulted in the current generation of venture capitalists becoming decidedly more founder-friendly. While some traditional firms routinely paired technical founders with professional CEOs or sometimes even replaced the founders altogether — Apple and Cisco come to mind — Peter Thiel vowed to never stand against a founder. And when Yuri Milner made his Facebook investment in 2008, not only did he not take a board seat, he even gave Zuckerberg the right to vote his shares. Likewise, Tiger Global and other crossover investors are very hands-off.
While there is undoubtedly cyclical excess, and, amazingly, Masayoshi Son is right in the middle of it again, the secular trend seems unmistakable and is perhaps a necessary result of the power law pervading the world. The limiting constraint is no longer capital but the small number of truly great talent and ideas.
“The great challenge at venture partnerships is that the principals must refrain from killing each other.” Michael Moritz
When Arthur Rock left New York to start venture investing, he was frustrated with Wall Street’s focus on a company’s earnings history and tangible value. “It's the future, not the past, that makes money for companies,” he declared and pointed at the “intellectual book value” of his startups. With no background in technology he focused on people and once told an audience that “the single most important factor in the long run for any company is, of course, management.”
The industry has come a long way since and The Power Law is rich in examples of how cultures and strategies at various partnerships evolved. Some were hands-on, such as when Don Valentine helped Atari write a business plan to bring Pong from the arcade halls to the living rooms. He connected the company with Sears for distribution and later organized a sale to Warner Communications.
In today’s founder-focused environment, Andreessen Horowitz prides itself on providing entrepreneurs with a wide range of resources as well as coaching around key issues such as pricing and hiring. When SaaS company Okta was flailing in 2011, Ben Horowitz got involved in the revamp of its sales team. “This is the last hire you are going to make if you get it wrong,” he told Okta’s CEO about a candidate for the role as head of sales. Andreessen Horowitz’s team had already identified a qualified candidate and effectively de-risked the decision for the company.
Accel stands out for its sector specialization and “prepared mind” exercises in which its partners dissect new trends. This was key in its homerun investment in Facebook. The firm had recognized both the importance of social media and the fact that its startups were often led by highly unorthodox founders. Rather than be thrown off by their antics, Accel would focus on the data. Mark Zuckerberg had shown no interest in conforming to VC expectations and appeared for a meeting at Sequoia in pajamas. At Accel he wore flip-flops, barely spoke, and gave out a business card with the job title “I’m CEO … bitch!” But Accel recognized Facebook’s potential and made a team effort, including its co-founder, to beat out Don Graham and the Washington Post. At the time of Facebook’s IPO, Accel’s $13 million investment returned $9 billion.
The most prominent example of a winning culture is the valley’s dominant player, Sequoia. Mallaby highlights the firm’s “uncompromising focus on culture” and its relentless “quest for excellence.” Sequoia’s values of teamwork, discipline, and immigrant grit have stood the test of time (for example, Moritz was born in Wales, Doug Leone in Italy, and Botha in South Africa). Credit is given to the team rather than individual rainmakers, which helped the partnership prosper through multiple leadership transitions. The firm prides itself on a culture of coaching with regular check-ins and off-sites to develop its young talent and help them through the inevitable “valley of despair” of early failed deals.
Sequoia has evolved from a venture firm to covering technology from inception to maturity with its scouting program, partnership with YCombinator, growth funds, and even an endowment-style go-anywhere vehicle.
“If you are Amazon, you have customers, warehouses, infrastructure, a whole bunch of things. If you are Sequoia, you have a few investors; you have nothing. So you better take the shot. The only way to stay alive in my opinion is to risk the franchise continuously.” Doug Leone
Mallaby concludes that Sequoia’s integrated style — teamwork and a wide network of allies — allows it to outperform its rivals.
“When people write about the venture business, they’re always writing about the startups we back. They never write about the most important investment we make, which is in the business.” Michael Moritz.
“All progress depends on the unreasonable man. Most people think improbable ideas are unimportant. But the only thing that’s important is something that’s improbable.” Vinod Khosla
Mallaby argues that venture capital “as a system” was integral to Silicon Valley’s success and is a “formidable engine of progress.” It was part of what gave the Bay Area its unique combination of “laid-back creativity and driving commercial ambition” with both “progressive open-mindedness” and a “workaholic focus.”
And while he admits that individually “the story of every bet can seem to hinge on serendipity,” he argues that over the long run, “the best venture capitalists consciously create their luck.” Individual venture capitalists can “can stumble sideways into fortunes” and at times it seems like luck beats diligence and foresight. The best however, “work systematically to boost the odds that serendipity will strike repeatedly.”
Mallaby is optimistic about the continued importance of venture capital. Yes, he cautions that venture capitalists, who are “first and foremost networkers,” can’t afford to speak out about bubbles as they happen. “An investor who publicly questions a mania is spoiling the party for others.” But more importantly, he argues, the revolutions that will define our future, the ones that “create wealth, anxiety, scramble geopolitical balance and alter human relations,” can’t be predicted. They can only be “discovered by means of iterative, venture-backed experiments.”
This then is the book’s real message: to take more risks in the form of small iterative bets that allow us to discover the future. It’s something we benefit from collectively and that will create fortunes for a select few. In a world dominated by the power law, we are encouraged to take more chances. “The rewards for success,” Mallaby concludes, “will be massively greater than the costs of honorable setbacks.”
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