Sebastian Mallaby, an English journalist and author known best for his coverage of the finance sector, has written what is sure to be one of the standout books about the technology space this year. In The Power Law
, Mallaby brings an outsider’s perspective to meticulously trace the lineage of venture capital back through its earliest days and founding characters, starting with the first principles that informed the industry’s pioneers.
The very first of these is of course based on the book’s eponymous title, the power law distribution itself, which comes into effect in spaces where “winners advance at an accelerating, exponential rate, so that they explode upward far more rapidly than in a linear progression… Anytime you have outliers whose success multiplies success, you switch from the domain of the normal distribution to the land rules by the power law” (8). This belief in taking big risks to find disproportionate winners – ones that have a chance to provide outsized returns on investment – is twinned with an equally important second belief in the early history of venture capital: that these big, truly outsized winners can only emerge outside the bounds of conventional analysis – “the revolutions that will matter – the big disruptions that create [winners] – cannot be predicted based on extrapolations of past data… but emerge as a result of forces that are too difficult to forecast” (11). Between these two twinned principles, Mallaby believes, are the ports of departure for venture capitalists in their consideration, and staking of, moonshot investment opportunities, and a modality of thinking that eschews incrementalism that has come to define Silicon Valley.
Lesson 1: Developing a new finance fit for tech, free of capital-F Finance principles
What we know as conventional wisdom in venture capital today was not also so. In fact, the earliest days of venture capital required several of the finance industry’s sacred cows to be sacrificed in rapid succession. In the early 1960s, financial professionals Arthur Rock and Tommy Davis, ostensibly bored with stable financial services careers and seeking “new growth stocks at attractive prices” (44), made a bold bet on changing how innovative technologies could receive financing. The two men, tired of the traditionally risk averse investing ethos of their profession, and believing that speculative technology investments that interested them should be able to access capital as well, set up a new limited partnership that eschewed traditional finance metrics used to determine a ‘sound’ investment. To enable this risk appetite, their key innovation was to flip the model of investment on its head – rather than identifying startups and then seeking investors, they would do the opposite: first raise capital (the fund) and render usual corporate investors unnecessary. The two founders compensated everyone, including all of their employees, with equity, another novel concept for the time, and their San Francisco based fund helped pioneer the approach to risk management that has become standard in modern venture capital: rejection of modern portfolio theory and diversification, in favour of concentrated bets on fewer companies. The result: in seven years, their initial fund of $3.4 million had returned an astonishing 22.6x and was worth $77 million. A fit-for-purpose model of finance was born.