By James
Pethokoukis and Sebastian Mallaby

Venture capitalists are derided as incompetent gamblers
whose mistakes prop up worthless startups and whose successes are more the
result of luck and branding than any actual skill. But some of Silicon Valley’s
most valuable companies were backed with early VC financing. So what market
function does venture capital serve? And what can trends in VC financing tell
us about the future for startups? To answer those questions and more, I’ve
brought on Sebastian Mallaby.

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.”

What follows is a lightly edited transcript of our conversation. You can download the episode here, and don’t forget to subscribe to my podcast on iTunes or Stitcher. Tell your friends, leave a review.

Pethokoukis: Now,
I generally avoid two questions during these podcasts. I don’t like asking the
guests about the title of the book or why they wrote the book. But I’m going to
make an exception here because I actually really want to know the answer to
those questions. We’re going to start with the name of the book, because I
think it’s important for how we think about the subject of the book. “The Power
Law”: Where does that come from?

Mallaby: The best way to explain the power law is to start
with what it is not. It’s not a normal distribution. That’s one where you have
a bell curve distribution. Most of the observations in a data set are near the
average. The power law distribution refers to a skewed distribution, and so
just to illustrate this, let’s just take the height of American men. The
average man is five feet, 10 inches tall. Nearly all American men are within
three inches of that average. And so if you think about a movie theater and
there’s an NBA player right at the back, and he gets bored of the movie and
walks out. Although he was seven feet tall, the average height of the residual
men doesn’t really change. He’s not so way off the average that it really
changes things. Now flip the example and think about the average wealth of
American men.

Imagine that movie theater again. This time you’ve got
Jeff Bezos at the back, he walks out. The average wealth of the residual men
will crash. That’s because the distribution is way more skewed when it comes to
wealth, and a power law distribution like that is what you get with venture
capital investing. Most startups go to zero because most startups fail. But a
handful, maybe one or two out of 10, will deliver exponential growth and returns
of 10x or 20x your money. So all of the profits in venture investing come from
that tail of sort of exceptional companies.

Most of the
books that I see these days about capitalism broadly seem to be about an explanation
of why it’s failing — why the key institutions have failed, why we’re in a stage
of so-called late capitalism — and maybe there’s some speculation on what the
post-capitalist world is going to look like. That is not the book you chose to
write. Why did you write this book about something which is a pretty important
institution of modern capitalism, but one we maybe don’t know that much about?

Well, a couple of things, actually. First of all, there’s
just an intellectual mystery I was fascinated by, which is all investing
involves tricky bets on an uncertain future, but in venture capital investing,
you are dealing with these startups and there are no data. There are no
profits. You can’t work out the price-earnings ratio. There aren’t any
earnings. You can’t do the price to book value, because there’s no book value.
None of the normal stuff applies. So how do you even start to allocate capital?
And I try to unravel that mystery by telling lots of case study stories about
how the good venture capitalists do it. But the second thing kind of gets to
your question, Jim, which is that I wanted to explain the impact of venture
capital on society and on economies. I believe it’s fundamentally positive.

I think this notion that we’re in late capitalism or
capitalism is failing misses the fact that actually corporate forms and
financial arrangements always evolve. I think there’s sort of an optical illusion
created by the fact that Adam Smith came up with the idea of the invisible hand
in the late 18th century and market price signals have not changed. So we think
of capitalism as almost a static thing, but that’s wrong. The business side of
capitalism, the shape of corporations, has changed a lot over the years. Most
of those changes are driven by a combination of technological shifts and then
on top of that financial shifts. So when you suddenly had an argument for having
scale in corporations, because steam and electricity rail had been invented, then
you have the invention of the joint-stock limited liability company in the late
19th century.

And that’s why you get big companies. Then equally with
the arrival of the personal computer in the 1970s and early 1980s, there’s
suddenly a case for de-layering the company, un-bundling, re-engineering. And
those things are made possible by a combination of junk bonds and the leverage
buyout. I think now we’re in a phase where capitalism is not late stage, but
just the new phase of it is that we have lots of intangible capital and to
value intangible capital, things like software and brands and patents and
business processes and customer relationships. All of those things are valued
only by investors if the investors are pretty close to the company, because you
can’t see those things by reading the financial disclosure. So you need to be a
hands-on investor and that’s where venture capital and private equity come into
play. I think that’s just the new optimal type of finance for a new phase of
corporate structure because of this rise of intangible goods.

When people
think about venture capital, they think about them funding these disruptive
companies that will disrupt a particular field in the technology sector, but
you’re saying they also disrupt the basic capitalist structure of a country.
They’re disrupting what the corporate form looks like and it is not a static
thing and that is ongoing today.

Yeah, and then I’d also say something in addition to that,
which is that Ronald Coase got the Nobel prize partly for this distinction
between price signals on the one hand, that coordinate human economic activity
through the arm’s length transactions that generate price signals and tell
people what the market wants more of, what the market wants less of. That’s one
kind of organization. Then the other kind that Coase pointed to in his Nobel
work was the corporation, a way of internalizing that organizational structure.
You have top-down management and so forth. I think that venture capital is
really interesting because it’s like a middle ground between the two.

On the one hand, a venture capitalist is like a strategic
sort of planning department inside a big corporation because the venture
capitalist is deciding which experiments get funded, which kinds of research
get assets and get talented people, and is shifting money and people and ideas
around. That’s a bit like a sort of corporate organization function, but then
also there’s a price signal because venture capitalists tend to fund things for
six or nine months. And then if the startup doesn’t reach its next milestone,
there’ll be a price discovery thing where nobody wants to pay the price for the
next tranche of the startup and then it’ll just be closed down. So I think it
combines price signals and corporate strategy. And that’s another sense in
which venture capital is super interesting as a new kind of capitalist form.

If someone
asked me to name the ultimate American capitalist, I think I’d say Warren
Buffet. And when I think about Warren Buffet, I think about somebody pouring
through lots of annual reports. And then the other day I was following a
venture capitalist on Twitter who said, “I’ve never looked at a balance sheet.
I’m not sure I could read an income statement.” If that’s not where the skill
lies in a venture capitalist, like the Warren Buffet set of skills, then how do
they do what they do? Would Warren Buffet make a good venture capitalist?

Well, Jim, that’s a fantastic question. Because, first of
all, it illustrates exactly this distinction I’m kind of getting at, where
Warren Buffet can sit in Omaha, Nebraska with his financial statements and be
very far away from where these companies are that he’s investing in because he
can find out what he wants to know by looking at those financial disclosures
and by analyzing them. And that’s great if you are a traditional value
investor, but if you are doing the opposite kind of investing, in other words,
growth and extremely high-charge growth in the form of these early-stage tech
startups, it’s the opposite.

You’ve got to be hands on. And this is to get to your
question. The way you value the software of a new software startup is that you
are on the board of that startup. You yourself as the investor understands
computer science. You can evaluate the code. On the disclosure, it might say “We
have this project software, we’ve spent 10 million on it,” but it could be
worth zero if the code is rubbish, or it could be worth a billion if it’s
fantastic. Only the hands-on, venture capital–style investor who understands
code and has actually got his hands into the company can tell the difference.

In the book
you described the creed, if that’s the right word, of Silicon Valley as,
“The belief that most social problems can be ameliorated by technological
solutions. If only investors can be goaded to be sufficiently ambitious.”
Has that creed held back any success in Silicon Valley? Is that still a valid
creed that is useful?

There is a critique of this creed, which is that venture
capitalists come along and they are too ambitious and they drive entrepreneurs
to take too much risk. Then because the entrepreneur is being pushed to expand
their company too fast, it blows up. They make mistakes that they would not
have made if they had gone slower. Furthermore, this is not just bad for the
entrepreneur, so the critique goes, it’s actually also bad for the economy at
large, because what you are getting . . . 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. And I quote one venture
capitalist in my book saying, “I sell rocket fuel. Some people don’t want
to build a rocket, that’s up to them. They shouldn’t take VC dollars and that’s
fine. But for the really ambitious companies, it’s the best way to go.”

You mentioned
the rocket fuel, which has been very important to the success of the American
tech sector in Silicon Valley. It’s not just the funding that’s important to
the success. They do a lot of other things other than just supply capital,
right?

Yeah. They get involved in the company. They advise it on
how to scale up. Typically, a startup founder might have a fantastic product
idea, but often even if it’s a good idea, it’s going to have to be adjusted and
adapted before it really fits the market. But on top of that, once you get the
product market fit you’ve got to then scale up your sales operation, and many
founders haven’t done that before. Whereas venture capitalists have seen
countless other examples of startups that have gone through the growth process
and they know how to help that to happen. So, they act as mentors and coaches.
They often get involved in making the first four or five hires.

They would source people from their own network of useful
engineers or sales executives who could be brought into the startup. They would
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. I’m always struck by the story that Eric
Schmidt told me about why he agreed to be the chief executive of Google. It was
a risky move for him. He’d been the chief executive of Intuit, another company,
before. And he was joining this startup called Google where the two founders
were these punks. Larry and Sergey, PhD students who were incredibly arrogant
and had very low regard for anybody over the age of 30.

In fact, Larry and Sergey had admitted that the only CEO
they would accept would be Steve Jobs and he was not available. So for Eric
Schmidt to take that job was risky, and the only reason he agreed to do is that
the venture capitalist involved, John Doerr said, “Look, Eric. Yeah, it’s
true. It’s risky. They might fire you. But if they do, I’ve got your back and
I’ll slot you in as a CEO to some other company because my venture capital
partnership, Kleiner Perkins, is funding new startups 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, so you take
the risk with somebody else’s capital, and for the early hires. I call venture
capital a machine for manufacturing courage.

Well, I think
what that story also highlights is how it creates the connective tissue between
the company and potential executives. Everywhere, they help create those
linkages that make it all work. Every city in America, every state would love
to have their own Silicon Valley, and even having lot of the ingredients
doesn’t quite work unless you can all connect them together in the right
recipe. And venture capital is pretty important for making sure that happens.

Yeah, and you could see this as actually quite a sort of
leveling the mechanism because 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.” Venture capital is the machine for delivering 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. So venture capital is often accused of perpetuating
inequality and one can debate that, but in some sense it’s a super democratic,
super leveling, super egalitarian thing.

Is there a
potential real competitor for the Bay Area? Especially since there are governance
problems in San Francisco. We have remote work. We’ve heard a lot about Miami
becoming the new Silicon Valley. 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. The biggest example is China where Silicon Valley venture
capitalists went around 15, 20 years ago and they successfully built up an
amazing digital economy in China. It’s not about the government’s long-term
planning. Don’t believe that story. It’s about the fact that Baidu, Alibaba, Tencent,
Ctrip — all of these early Chinese digital companies received American venture-style
investments and were structured by American Silicon Valley lawyers with dispute
settlement under New York law, a Cayman Islands parent, and the ability to
issue Silicon Valley–style stock options to the early employees.

It was just basically taking the Silicon Valley formula
and taking it to China. Now it’s now happening all over the place. Silicon
Valley is taking its model to India. Since my book has come out, I’ve been
flooded with emails from venture capitalists in 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. Texas has a bunch of those:
Rice as well as Texas A&M. I think there’s enough of a flow of people
there. I don’t see why it shouldn’t be true of Pittsburgh with Carnegie Mellon.
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.

You can have
a successful ecosystem without it being Silicon Valley. Just because you cannot
duplicate something as wildly successful, does not mean you have not created a
successful tech ecosystem. But what about more of the left-behind areas in the
United States? There have been efforts to create more innovation hubs there.
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
although what you were saying earlier, that you don’t have to be as successful
as Silicon Valley to be successful, is sort of true, 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, which is going to annoy them initially because
they don’t know how to work it and it’s going to be expensive, they’re going to
buy it and maybe it’ll just be a waste of their money because it doesn’t really
work — to get over those hurdles, you’ve got to deliver something that’s really
quite seriously new. Then if you succeeded in delivering that thing, it’s very
difficult to do it, but if you succeed, you’re normally going to get
exponential growth. And it comes back to what we began with, the power law
idea.

Stuff either really works big time and goes 10x, 20x your
investment or it fails. This is a skewed distribution. 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. And so a great example is a company called UiPath, which
is the global leader in robotic process automation software, which is a big
category.

And it was begun in Romania. The guy who began it actually
taught himself to code without a computer because there weren’t enough in
Romania at the time. He couldn’t get one, so he used some secondhand computer
manual, which he borrowed from the library or something, and taught himself how
to code before he had a computer. It can happen in the most crazy places. There
is Drive Capital, which is a Sequoia spin-out in Ohio. But I think the point
is, it’s not looking for sort of reasonably good startups, even if it’s in
Ohio. It’s looking for the breakouts.

Given what
you’ve said though, and given the title of the book, we should not expect to
have lots of successful tech hubs evenly distributed across the United States.
We should expect there to be a few of them, maybe more than we have now. And
they may arise, even though there are other things government can do, for sort
of happenstance reasons.

Yeah, I think the power law idea is useful to
understanding this issue. The power law operates on multiple levels, which is
why it’s such a cool concept and it’s kind of the secret sauce of the whole
sector. All startups, whether they have anything to do with tech or not, just
the fact is that many startups fail and then a few do well. It operates on the
level of technologies. So, when a technology really works, it tends to grow at
this exponential rate. Think about Moore’s law for the way that semiconductors
grow in power, doubling in power every couple of years.

Then it’s true also of things like the internet networks
where you get these network effects, where the value of the network rises as
the square of the number of users. And Metcalfe’s law, which is that network
law on top of Moore’s law. So you can have both. If you think about an internet
router, it’s got Moore’s law going on because it’s using semiconductors inside
the router. It’s reaping the benefit of the router becoming more powerful
because the semiconductors are more powerful. On top of that is getting the
benefit of Metcalfe’s law because the internet is multiplying the value or
squaring the value, as more users join. It’s got that startup effect anyway of
a power law effect.

Then on top of that, you get investors who invest in
companies building routers. And those investors are going to experience power
law effects in their portfolio. Because of that, some venture capitalists are
going to reap most of the gains in the entire venture capital area. So, there’s
a power law effect if you distinguish the outlier of venture capital firms from
the rest of them. And there is this final effect, which you’ve just alluded to,
which is that there will be some clusters that dominate. It doesn’t mean there
has to be one cluster in America. China has some activity in Beijing, some
activity in Shanghai, some activity in Hong Kong, and some in Hangzhou and
Xinjiang. So I think it can be distributed, but it’s not going to evenly
distributed.

What role do
you want government to play here? Do you want subsidies? Do you want tax
breaks? Is it just very basic kinds of public good stuff? Investment, lots of R&D
research to create that feedstock of ideas? What is the role of government?

I think the best illustration of how to set up this answer
is the internet. The people who really believe in industrial policies say the
government created the internet. They say DARPA created the internet. This is
both true and sort of misleading. True in the sense that, yes, 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, which is part of everybody’s
life and has basically changed the way we live? Venture capital did. Venture
capital discovered a sort of hobbyistic little company called UUNET, which was
building routers that connected engineers who wanted to hack into the
government internet. Venture capital got behind that and scaled it to the point
where it just basically connected up America. That’s the story.

And then venture capital, by the way, created Netscape,
which was the thing that allowed the internet to be useful to people who didn’t
want to type in complicated digits every time they wanted to access a website.
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.

Sebastian,
thanks for coming on the podcast.

Jim, it’s been a pleasure. Thank you.

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.”

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