By James
Pethokoukis and Sebastian Mallaby

When economists and politicians talk about creating new Silicon Valley-style tech hubs, they often focus on research universities, government R&D funding, and entrepreneur-friendly regulations. But what often gets left out is the role of venture capital financing, which supplies the means for new ideas and products to scale up and enter the marketplace. Sebastian Mallaby joined me on a recent episode of “Political Economy” to discuss the importance of VC funding in the past and present, as well as the future.

Sebastian is the Paul A. Volcker Senior Fellow for International Economics at the Council on Foreign Relations and author of “The Power Law: Venture Capital and the Making of the New Future.”

Below is an abbreviated transcript of our conversation.
You can read our full discussion here. You can also subscribe to my podcast on Apple Podcasts or Stitcher, or download the podcast on Ricochet.

Pethokoukis: What
do you say to the critique that venture capital financing distorts the market?

Mallaby: Let’s say a disrupter like Uber comes along, is
getting tons of venture capital dollars to go and disrupt the existing taxi
market. So the incumbent taxi guys have to compete against ride-hailing
companies that have subsidized capital. Basically, every time you got an Uber
in the first 10 years of that company, you were paying for two-thirds of the
fare. And the other one third of the cost was being met by some venture
capitalist who was just eating the loss. And that’s not a level playing field,
so goes the argument.

I actually pushed back against those critiques because it
seems to me that incumbent companies have tons of other advantages. They often
have the regulators in their pocket. They have existing brand. They have
existing customer relationships. The incumbents always have the upper hand. And
in some sense, if the challengers are getting subsidized venture capital dollars,
that levels the playing field, it doesn’t distort it. So, I’m not persuaded
that it’s a bad thing to push for scale. Of course, some entrepreneurs don’t
want to do that kind of bit-scaling growth. That’s perfectly within their
rights. They can refuse venture capital dollars.

What do
venture capitalists bring to the table other than just supplying capital?

They get involved in the company. They advise it on how to
scale up. They often get involved in making the first four or five hires. They source
people from their own network of useful engineers or sales executives who could
be brought into the startup. They help to interview those people. And
importantly, the brand of the venture capitalist is reassuring to those early-stage
hires because it’s risky to join a startup. Startups fail all the time. So the
venture capitalists de-risk the choice of joining a startup both for the
entrepreneur who starts the company because capital is provided and for the
early hires. I call venture capital a machine for manufacturing courage.

It’s a cliche to say of somebody who does well in life,
“Oh, well this person did well because they had money and connections.” The job
of the venture capitalist is to find somebody who’s really smart, who’s got a
good idea for a new product, and bring those money and connections to that
person.

Do you see a
legitimate competitor to the Bay Area?

Yes, I do. I think what’s happened in the last 10 years is
that the formula for creating Silicon Valley, which in my view is really about
the venture capitalist coming along and de-risking entrepreneurship, has been
understood. And the process of spreading it out to other regions has been tried
and it’s worked.

Now it’s now happening all over the place. Silicon Valley
is taking its model to India. It’s coming to Europe. It’s coming to Latin
America, and it’s spreading within the United States. I absolutely do think
that Austin, Miami, New York, Boston, maybe Chicago can do this. And what you
need is, you need to have some flow of technical people coming out of
preferably a good local university. And I think once you’ve got that flow of
technical people, if the venture capitalists move to them and set up shop
locally, you can build an ecosystem that’ll flourish.

There have
been efforts to create more innovation hubs in America’s “left behind” areas.
Can’t we have successful clusters in the middle of Ohio or pick whatever state
you want?

I think this is where there is some bad news, because there’s
an important saying in venture capital, “If it’s not 10x different, it’s
not different.” If you are trying to persuade people to switch from some
product they understand, or some service they’re familiar with, to use a
completely different product, you’ve got to deliver something that’s really
quite seriously new. Stuff either really works big time and goes 10x, 20x your
investment or it fails.

And so it’s difficult to say, “I’m trying to do Silicon
Valley light. I’m going to do some startups, but I’m not going to be too
ambitious about it.” It’s kind of an all-or-nothing game. You’ve got to really
shoot for the big ambitious outcomes if you’re going to break through and do
that 10x different and achieve success. I think the bad news is that the more
humble vision for a cluster is probably not going to work, but what can work is
that in surprising places, you do get ambitious people who break out.

What role do
you want government to play here?

I think the best illustration of how to set up this answer
is the internet. It’s true that DARPA funded the early internet and built it to
a point where there were 50,000 users or something. Who created the internet we
know today? Venture capital did. Venture capital discovered a sort of
hobbyistic little company called UUNET and scaled it to the point where it just
basically connected up America. And then venture capital, by the way, created
Netscape.

I think the answer to your question about the role of
government is that early-stage basic science is the role of government. I’m
extremely in favor of more for the National Science Foundation. I think it’s
great to have more funding for scientific education in K–12. For post-docs, for
people who are doing engineering and physics and math: I think we fund life
sciences very well with NIH, but we don’t fund the NSF enough. But I’m not in
favor of the government trying to pick winners when you get to commercializing
this stuff. So I would focus on the early stage.

James Pethokoukis is the Dewitt Wallace Fellow at the American Enterprise Institute, where he writes and edits the AEIdeas blog and hosts a weekly podcast, “Political Economy with James Pethokoukis.” Sebastian Mallaby is the Paul A. Volcker Senior Fellow for International Economics at the Council on Foreign Relations and author of “The Power Law: Venture Capital and the Making of the New Future.”

The post 5 questions for Sebastian Mallaby on the importance of venture capital appeared first on American Enterprise Institute – AEI.