310: What’s the Big Deal about Venture Capital?

Buck: Welcome back to the show, everyone. Today, my guest and Wealth Formula Podcast is best selling New York Times author Sebastian Mallaby. Now, Sebastian is currently the Paul Volcker Senior Fellow in International Economics at the Council on Foreign Relations and a Washington Post columnist. He’s the author of the current book. His current book is The Power Law, Venture Capital and the Making the New Future. Now, I could go on a long time about all the things that Sebastian has done in the past, but suffice it to say, he’s a very accomplished author, having written multiple books in the financial space, including a book that, as I said, was a New York Times bestseller. He’s written about Alan Greenspan and certainly has a significant breadth of knowledge in this space. So, Sebastian, welcome to Wealth Formula Podcast.

Sebastian: Great to be with you.

Buck: I am going to focus today on the topic of the latest book, which was really about venture capital. I’m curious. Tell me how you chose this topic with venture capital and how you got interested in the first place.

Sebastian: Sure. I mean, there’s two things that drew me into the subject. The first is really that bench capital is the most exciting type of finance right now with the tech boom and all that. Of course, we might be running into difficulty with that, but we can come to that later. But essentially, DC venture capital has not that enormous amount of money under management. Fewer than 1% of the companies that get started in the United States every year actually raise venture dollars, but the impact is considerable. So if you look at all of the companies that went public since 1995, roughly about half were VC backed. And three quarters of the market cap arising from that group was because of VC backed companies. So this tiny fraction of startups get the money and then it has this huge backwards. And I just wanted to grapple with that. The only thing I would just add is that there’s an intellectual mystery at the heart of venture capital, which I kind of find fascinating. Most kinds of finance, you might start by discounting the future cash flows of the asset to figure out what it should be worth. There is no cash flow to discount. You’ve got to start up and all you have is two legged mammals who walk into your office with a dream and a vision of what they might build. But they haven’t built it yet.

Buck: Let me back up for a second here, Sebastian, because I know when people are listening to this, many people have not participated in venture capital. And you have this image of what our VCs is, this group of powerful people sitting in Silicon Valley deciding what to invest in. I mean, is that basically what it is to give us sort of the infrastructure of how VC actually works versus what we might be imagining?

Sebastian: Yeah. It’s not far off to say that it’s a bunch of people sitting in Silicon Valley figuring out what to invest in. There’s a lot of that going on. The other part, though, is that there’s also after the investment, there’s the involvement. Right. The hands on stuff. You go on the board, you try to mentor the startup founder, you make introductions, you help with the first five engineers that are going to be hired. You might help to put in a new marketing team, whatever it is that’s needed. So it’s a more activist form of money management than other kinds.

Buck: One of the things that I find fascinating, which I think you allude to in your book a little bit about, is how VCs are so cloistered and that there’s so much influence from these people of these major VCs that are ultimately putting money into Silicon Valley or in Boston, and they are ultimately, in a way, choosing the future of technology. And because of that, they’re almost sort of dictating the future of humanity. I’m curious, kind of your take on what I just said. If you think that that’s true or overstated, what perspective do you have on that?

Sebastian: Yes. Some time ago I wrote a book about hedge funds, and people used to call those guys the Masters of the universe, but really they’re just the Masters of the market. Right. With venture capital, as you’re saying, this is inventing the future for all of society. I mean, it’s a fundamentally different thing. If you think about how you now think research, find information, it’s Google, it’s other online services. And so the way that you even arrive at Epiphanies has been altered by venture backed companies.

Buck: And that has its pitfalls, too. Right. I mean, if you have a group of people who are ultimately sort of focused and dictating various technologies, when you look at things that are happening, I would imagine that that type of groupthink has its pitfalls as well.

Sebastian: Yeah. I mean, group think is definitely there. I mean, one dimension of this is that venture capital is not as diverse as it should be. So of the investing partners in Silicon Valley venture shops, only 16% are women and only 3% of black investors. And again, if you’re going to try to invent the future for all of society, you should probably try to represent society a bit better. So that’s one thing. There’s also just the bubble potential. If you were to invent a machine for inflating bubbles, you would say, okay, all right, I’ve got the idea. We’re going to put all of the investors in one road and they’re basically going to go to the same one hotel restaurant because there won’t be another restaurant to go to, and they’re going to syndicate into each other’s deals, and they’re not allowed to go short the market because you can’t do that in private positions and you’d be describing Santa Road. So that’s another cause of concern.

Buck: Yeah, sure. And then on top of that, and you also have presumably in some of these situations, reliance on each other for information. I guess the story that comes to mind for those people who don’t know is the Theranos saga. Right. I mean, isn’t that an example of sort of one of the things that people have to be careful of in venture capital?

Sebastian: I mean, Theranos is an interesting example because it’s a bit of a mixed story, right. There was one recognizable venture capitalist who invested right at the beginning when Theranos was just an idea. He put in like half a million bucks, which in VC terms is nothing. And backing an experiment is a legitimate thing to do as you’re an angel investor. So I don’t think there was anything wrong with that. The scandal came later when the so-called product was generating results for patients, and that was just a lie. It was a fraudulent thing. And that’s the outrage. And at that point, the company was being funded by what I would call venture tourists, not venture capitalists. Right. These are people like Rupert Murdoch, like the Walton family of Walmart Fame, not real tech investors, but people who just wanted to kind of play in that space because it was sexy. So I think in a way, that they ran the story, although it’s shocking, is not an indictment, really of venture capital.

Buck: Tell me a little bit more about your experience while writing this book. I’m curious about the groups that you work with. Sounds like you had an opportunity to sort of get on the inside with a lot of these players. What are some of the things that you learned about the VC world, some of the conclusions you made?

Sebastian: Well, when I write these books, I take a long time over them. It will take five years or so. And the reason is I’m determined to get to actually see and talk to and understand the key protagonists. Otherwise, what value am I really delivering to the reader? And so, for example, I spent a lot of time in the end with people from Sequoia Capital. That’s probably the top venture capital partnership in the world. And I got to understand what the skill was. Why is it that Sequoia outperforms the average venture fund by like six fold? If you look back at the investments they’ve made this century and you get to understand things like how they’ve incorporated decision science into their way of choosing investments, we all know that we suffer from loss aversion, meaning that we would gamble to avoid a loss, but we wouldn’t be willing to take as much risk in reaching for the upside. So they’ve built that insight into their decision process. So when a partner writes a memo ahead of a decision whether they’re going to invest in a startup or not, the partner is required to write what’s called the preparade section of the memo. And that is where you imagine the parade, imagine everything went right with this company. How big and how great and how much money could it generate? Right. And the reason is that people are normally embarrassed to stick their neck out and imagine how fantastic someone could be. So you have to require it to give permission for people to dream about what the upside might be. And that’s a way of just one example of Sequoia’s methodical skill and explains why it does.

Buck: Well, that’s fascinating. So it’s really sort of taking the asymmetric risk and emphasizing the potential and the upside just to understand what it is that you’re doing, because obviously in the VC world, you’re investing in moonshots. Maybe you could talk a little bit about that. Why are they always talking about moonshots? Yeah.

Sebastian: So I called my book The Power Law, and some of my friends who don’t follow finance say, Geez, this is about electricity. Is it about the legal system? No. The parallel I’m talking about is the moonshot paranormal, which is basically saying that the distribution of returns in venture capital is extremely skewed. You have a portfolio of, say, ten bets. It’s likely that eight will go to zero, which would be a horrible, almost unimaginable, career ending disaster if you invest in public markets. But one or two will hopefully do really well and make back the entire fund and more. So they’ll do tenx, 20x your money. And that distribution of returns where most startups fail. But a few do incredibly well and force venture capitalists to be reaching for these moonshots. They sound crazy and hubristic when they say things. Gee, I’m going to back an attempt to disrupt the hotel business. And this is going to be a start out where the idea is people will have absolute and total strangers to stay on their couches and then in their spare rooms. You might think that sounds crazy, but of course, it’s Airbnb and it worked. And you have to go for those improbable ideas because those are the only ones that are going to be the successful moon shops. If it’s like a normal idea, then ten other people will do it, too. And there will be a lot of competition. You won’t have margins, you won’t have pricing power, and the investment won’t be successful.

Buck: I’m curious in terms of, like, I mean, I don’t know exactly the time period in which you were spending time with them, but it seems like there’s a huge buzz on Web Three in general. Do you feel like that’s where the focus is right now with digital, with the cryptocurrency world and Web Three?

Sebastian: Yeah, it’s clearly been a growth area. I mean, when I began looking into VC, actually around 2017, five years ago, Bitcoin was pretty hot. But all these other things like Metaverse, NFTs, web, three, all that stuff are completely unheard of. Then Bitcoin crashed in 2018 and then it recovered. And in this new iteration, we have all these add ons with Ethereum and all these other coins. So I’ve seen a bit of an up and a down and up on this stuff. So it’s been fascinating to watch.

Buck: Obviously, we talk about VCs and I alluded to this before, which is like Silicon Valley or Boston and all that. But there’s VCs in China too, and other places. How do you think the VCs are different in some of those other Chinese versus the American VCs?

Sebastian: Well, what’s sort of amazing and actually I think not really understood is something I discovered when I went to China for the book and I figured out who the top DCs were. And the answer was pretty much the same gang as doing really well in Silicon Valley, because I mentioned Sequoia before. They are the top company in Silicon Valley. Guess what? Sequoia China is the top company in China. And basically the US VCs went to China around 2000-2005 and they brought the entire playbook. They brought the Silicon Valley lawyers. So all of the early Chinese digital companies, Baidu, Alibaba, Tencent, as well as Ina, Netties, Sea Trip, all of these early success stories took American venture capital with American lawyers structuring the deal with a parent company in the Cayman Islands so that you could have the various types of stock that Chinese law would not recognize. And so then you could have employee stock options. And that enabled a company like Alibaba to hire American coders and American business people to help them grow. And I really think that without those world class recruits, Alibaba would not have become a world class company. So some people say the Chinese system is built on the fasting Chinese state. That’s nonsense. The truth is, actually American venture capital has a lot more to do with it.

Buck: A lot of the Chinese VCs probably went to Stanford anyway. Exactly. They did. So let me shift topic a little bit. You stressed this a little bit in your book. But if you want to talk a little bit about what you see is venture capital impacts on the bigger picture, whether that’s capitalism in general or income inequality, tell us what you discovered.

Sebastian: Income inequality. It’s a good question because the answer is quite nuanced. On the one hand, obviously VCs themselves are making enormous amounts of money. If they’re successful and the people they back if they’re successful, the entrepreneurs become 100 millionaires, billionaires and so forth. So that’s clearly exacerbating inequality. But the interesting thing is that it’s doing it through disruption. And so it’s actually quite good for class mobility. Right. And in that sense, it’s creating new opportunities where the incumbents, who are the existing rich people, are being challenged by the up and coming challenger who want to be rich people. So it depends if you care about just equality or like equality of opportunity, how would you read that?

Buck: Ultimately, it’s almost like it’s about as American as it gets, right? If you think about it, it’s like a democratization of an opportunity where these kids who are really good at things, create things and all of a sudden can become billionaires and you just don’t see that. And that to me, is ultimately so American. It’s wonderful. And it’s also in terms of driving the economy. Right? I mean, when you look at the VC impact on capitalism or the growth of economies, tell us a little bit about what you feel like. What the role and importance of that is.

Sebastian: Yes, it’s huge. Like I was saying earlier, if you look at the public companies that have gone on the market in the last 25 years, three quarters of the market cap comes from these companies that were backed by venture capitalists. If you look at patents, a high share of patents are filed by VC backed companies. And what’s more, the quality of those patterns, as measured by citations, is higher than the average, quite a lot higher. So I think in a world where value is shifting from the old kind of capital, physical capital, to the new kind, which is patents, intellectual property, software, business processes, basically ideas. That new kind of intangible economy is highly connected with the rise of venture capital because it’s venture capitalists who understand whether a 3 million investment in a software development project is either worth zero because it’s rubbish or worth 3 billion because it’s genius. Right. If you’re just looking at the financial statements from a company and you say, oh, this say $3 million in a software project, you’d have no idea how to value that.

Buck: I guess shifting again, who are the investors? Did you get a chance to understand, like, even with the venture groups. Right. They have their own limited partners. I don’t know for sure that every one of these companies are working on that model, but I assume they are. Did you get a chance to understand that culture at all?

Sebastian: Yeah, I talked to some of the limited partners, and the leading ones are the usual suspects, the big University endowment funds, whether it’s Yale or Harvard or Stanford or what have you. And then the smaller ones are muscling in. And so often it’s the case that the smaller colleges that have really good performance on their endowments, like Bodent, for example, in New England, it’s because they have a high allocation to venture capital. And then you have some pension funds that are trying to get into the game. And, of course, venture capital funds are quite keen on entrepreneurs as LPs because those folks have their own networks, their connections, they can introduce deals. And so you see quite a lot of people who began as entrepreneurs, and then they turn around and indirectly invest in entrepreneurs through becoming LPs in VC partnerships.

Buck: So some of these larger ones, like Sequoia, for example, are actually sort of competitive. An accredited investor with a million or a couple of million Bucks can’t necessarily participate in that. Is that right, or is it generally competitive on that end?

Sebastian: Yes. It would be very hard to get them to accept your money. When you go to their offices in Menlo Park, most of the conference rooms are named after the LPs. So you walk into the Harvard Room and then the Ford Foundation room and so forth. So that tells you who the LPs are.

Buck: Okay, so let me ask you this, and I think this is just for the sake of who this audience is. If you’re an investor and you’re a credit investor, you’ve got some money, but obviously you’re not in an endowment. How do you participate in this movement, like in these types of opportunities if they’re so obviously, they’re so selective about who can participate?

Sebastian: Well, it is a dynamic and Darwinian space. So you’ve got new companies being set up all the time, new investment partnerships. So I think there’s an opportunity to get in. If you identify a good one early, the question is, do you have enough information to know who’s good? Can you see how embedded they are in the network? Are they going to get good deal flow? What’s their background? You can probably evaluate that if you have some sense of how Silicon Valley works, and I think that’s the way to get in.

Buck: So I want to finish up with your book a little bit more and just ask you this in terms of what you felt like you learned from this experience of writing this book. What are the two or three things that you were most impressed with or surprised by?

Sebastian: What I was amazed to really solidify in my analysis. And this gets to your question before about how it affects capitalism. I went to Silicon Valley with a pretty open mind, and people told me, well, it was founded on defense contracts. It was founded on Stanford University or various other theories about, California had the gold rush of 1849, and it’s always had this more entrepreneurial culture. And so I looked at all these theories, and you quickly realized that most of them are just completely unpersuasive. Right? So in the 60s and Seventies, when Silicon Valley was a lesser player than the Boston ecosystem, the truth is that MIT was a better University than Stanford for engineering. Defense dollars were flowing into Boston more than in the Stanford area. And the whole thing about entrepreneurship is in the air. It’s a bit vague. What really made a difference is the nature of the venture capital on the West Coast was more risk taking. And when venture capital started to expand at the end of the 70s because there were a couple of fantastic bets. Apple went public in 1980. Genentech, the first biotech company, went public in 1980. And after that demonstration effect, a lot of capital flowed into VC and it changed the ability of entrepreneurs to start new companies. It changed the willingness of engineers to take a chance on a new startup. And that really was when Silicon Valley overtook the route 128 Boston area as being the top innovation center in the world. So that’s the main thing I think I learned from the research is how venture capital drove the innovation cluster, explains why Silicon Valley is better. And then when you go and look at China and you try to figure out why they have such a strong digital economy, as I was saying earlier, it’s because the same VCs went and did the trick again. So I think looking forward, if you want to see whether Europe might emerge as an interesting digital economy center, you just have to look at which VCs are arriving there. And guess what? Sequoia just set up an office there a couple of years ago and other companies like General catalyst, Lightspeed, Accel, these sort of famous Silicon Valley names, they are also moving into Europe. So Europe has a base of good engineering and a rich consumer market. So I think if you mix in a bit of DC with that, you’re going to see Europe catching up a bit in digital economy terms.

Buck: Fascinating stuff. Sebastian, I want to thank you again for being on the show. The book is called the Power Law, Venture Capital and the making of the new future. Obviously, it is going to be available just about everywhere, right. And I want to thank you again for being on the show and good luck with the book and we’d love to have you again on the show sometime for your next book.

Sebastian: Great. Nice chatting with you. Thank you.

Buck: We’ll be right back.