A conversation with Sebastian Mallaby is fascinating because you don’t know what direction he’s taking. His latest book, The Power Law, is an exhaustive, optimistic account of venture capitalists, and exalts their role in the economy- the humble trailblazers who fund disruption and innovation in our lives. Yet, you don’t know where he is going because while the idea of praising already-pompous, popular and prosperous VCs can seem a bit redundant, Mallaby also fears that Tiger Global may be bad for capitalism, founders may be getting too powerful and is highly skeptical of cryptocurrency’s far sweeping ambitions.
In an interview with Moneycontrol’s M. Sriram over Zoom, 57-year-old Mallaby, an author of five books, and Paul A Volcker, senior fellow for international economics at the Council on Foreign Relations, spoke about venture capital’s history, what has changed, how is China different, and how he got insider access at Sequoia Capital, among other things. Edited excerpts -
Why did you start writing this book? What was your state of mind when you decided to write such a book?
So I had done other kinds of financial history - hedge funds, development economics for the World Bank, and then central banking through the Greenspan biography. But two things about venture capital stood out. One is the international mystery- how do you even allocate capital, in the face of so much uncertainty when you have no quantitative guidelines? And all you've got is the entrepreneurs who walk into your office with a promise about what they're going to do tomorrow. There's just so much uncertainty, how do you begin? And is it in fact, just luck? Those questions about skill and luck were the starting point. And secondly, the impact. Just the fact that so little capital goes into VC funds relative to other kinds of finance. But the outcomes are so enormous in terms of market cap. In the US three quarters of market cap created in the last 25 years comes from venture backed companies. So the mystery of how you allocate, and then the social impact.
You started writing this book, what, five years back? The venture world itself has changed a lot since then. So when you started writing the book, what were things like? SoftBank’s Vision Fund, Uber and WeWork’s fallout, those were yet to happen.
So when I began, it was already clear that Silicon Valley had transformed the world. That companies coming out of this culture of venture-backed startups just change how we discover information, how we think, etc. People didn't know about how you allocate capital. And I remember writing in the proposal I sent to the publisher, five years ago, that venture capital is growing in three dimensions- growing geographically, along the lifecycle of companies and growing into new sectors that have been disrupted by startups.
Some sectors were thought of as non-tech sectors, like the food industry (Mallaby’s introduction to the book is about the founding of Impossible Foods, the plant-based-meat firm, and its funding by Vinod Khosla). But now obviously, it isn’t. But new things happened along the way. I think the growth equity space got huge and overheated. Things like WeWork happened. Globalization continued, which is a good thing. And you would know much better than me, but the Indian startup/venture ecosystem must have grown enormously in the last five years. So things have changed. But I think that the two basic impulses were already there.
In 2017-18, one of the things people were saying to me was that- oh, you're writing about venture capital, but it's already out of date. Because you know, there are these ICOs (Initial Coin Offerings) and nobody's going to raise money through venture funds, they're going to raise it by issuing coins. And I didn't believe that at the time. And while crypto is certainly here, ICOs are not really.
You mentioned growth investors, like Tiger and Coatue, whose hands off style of investing, massive cheques and rapid diligence has been disrupting the industry. Every VC has been wondering about the fallout from their approach. How do you see it?
Tiger has calculated that it has data on later stage tech companies, it knows which business models are working, which companies have momentum and that the people running those companies know what they're doing, because otherwise they wouldn't have got to Series D or E or F (round of funding). So you can cut out both a lot of the pre-deal diligence and all the post deal oversight. Sometimes it will go wrong, but on average is going to go right. And this is a terrifically efficient way of capturing beta (volatility) in the technology market. Because you just have a huge amount of exposure to something that's in general going up. And you know, there is some alpha (generating returns compared to market index) because they’re not buying everything.
I suspect Tiger will have a rough period this year because interest rates are going to rise and tech companies will be repriced. But once interest rates normalize I think Tiger will be a successful company, because I think is momentum alpha strategy is going to work.
However, I don't think it's necessarily good for capitalism writ large because I do think that companies need governance. And I'm troubled by this. And I think WeWork and Uber show this. But even the well run unicorns could do with independent directors. The Collison brothers at Stripe (valued at $100 billion) have a board with independent directors who they’ve chosen because they’ll ask intelligent questions. But I still think that actually, it might be healthier if the founders had a bit less power.
You know, I've talked to other founders who run successful decacorns and they say, look, why would I? If I can have super voting shares, why wouldn't I? And I get that from their point of view? But is it really good for capitalism? Is it good for the companies?
I think companies either need to have the oversight of being a public company, and then somebody can short that stock or be an activist investor and force change, or do an M&A deal and force change. There's all sorts of discipline mechanisms if you're a public company.,
Or they should be an early stage company with an investor who takes a board position seriously. And I think that this unicorn thing, where there's none of those checks and balances, is not a good idea. I don't know how you fix that, because I think all the parties involved are perfectly happy to have it continued. So Tiger Global, as I said, will probably continue to be a successful company. And founders who are great founders will want to have super voting shares. And Tiger will do that deal. And so I suspect this is going to continue, I'm not sure it's a great thing.
Got it. So when your book spoke about VCs through the decades, what struck me was that they fundamentally haven’t changed. The fundamental premise of providing early capital, supporting with hiring, management, providing guidance and support, that’s still the core. What were your takeaways on how a VC has changed over the years?
I agree. I think the core tools are still there. You know, only ever use equity, debt is stupid. A time limited fund is a second one I identified. Of course, Sequoia has gone away from that just recently. The power law mentality is definitely still there, in fact even more now.
So I write about the hands-on style of investing with Sequoia’s investment in Atari and Kleiner Perkins' investment in Genentech. Clearly hands on is not the style of Yuri Milner and Tiger global. So the growth guys that have come in, in the last 10 years or 12 years, that has changed, they're not hands on. I think that's a mistake. I suspect that the early guys had the right idea. And perhaps if there's a proper equity shakeout in the markets this year, which punishes the growth investors, perhaps they'll be more careful in future. And then another element is the stage by stage financing. That was one of the early tools that's still clearly there.
And then I think the final thing in my account of the early venture capital ecosystem was the importance of the network and the idea that the sum of multiple VCs is bigger than just those individual VCs by themselves. the network kind of creates a sort of almost a price discovery mechanism and a kind of sifting mechanism. I think that's still there, although clearly, we've just recently gone through a period where the remote working revolution has kicked in.
And so I was chatting with a VC last week in London, who was bidding on a deal in Europe. And he said, his three competitors were in Silicon Valley, and they were doing it over Zoom or Google Hangouts or whatever. So we'll see if the importance of the network is reduced by remote working.
One interesting thing is that in China, or Europe, the agglomeration effects are less stark than in Silicon Valley. The geographical proximity seems to be less important. So China, you know, the venture capital world is split between Beijing, Shanghai, Hong Kong, Hangzhou and so there isn't one dominant center quite in the way that there is in the US. Even with people moving out in the last two years from Silicon Valley, I think the Valley is still head and shoulders, the place where the most venture capital collects.
London is dominant, but it's not as dominant as Silicon Valley's in America. So as a capital center for venture capital, I think it is pretty dominant as a as As the sort of the funding destination is not is not dominant. I mean, South England is strong in startups. But you know, so are Sweden, Germany, France, etc.
Early in your book, you also say that New York and Boston were VC hubs, before the Valley emerged. You also ask, why is the Valley more important than say Montana or Michigan. How do you explain that?
Well, I think one important structural difference is in the non-compete clauses. California is unusual in the United States, because the courts are reluctant to enforce non-compete agreements. So if you fund a company, and you give it six to nine months of runway, and then the company identifies the ideal chief of marketing to come on board. But that person cannot actually start for six months because of a non compete. That's a killer. You've used up your runway before the guy even starts.
So California does not enforce non-competes. I think that's an advantage. Having said that, the West Coast’s tradition of venture capital was its biggest advantage, because it was much more entrepreneur friendly. There were fewer difficult clauses in term sheets, and they funded things faster, and were ready to take more risk.
There’s this idea of the Qume model I talked about, (Sidenote: Sutter Hill Ventures invested in Qume, which made the daisy wheel printer. Sutter Hill liked the technology, but reserved the right to replace the CEO with someone they like and give him equity) where the venture capital on the West Coast would fund the technical entrepreneur and say you've got a great idea for a product and you're a great engineer but you need somebody who will be the chief executive officer, and we'll find you that person from our network. And then we'll pair you with that outside person. And then you'll have a real company.
In Boston, the equivalent VCs would have said, you come to me with a team, including your chief executive officer, and then I think about funding you. And even then there would have been slower. You know, this character from Greylock I talked to (a Boston-rooted VC firm) who said to me very, very proudly, I made 40 investments in my career. And only one of them or none of them lost money. I mean, on the West Coast, that would be regarded as an absurd admission of being too risk averse. But in Boston, that's a boasting point.
I try to illustrate that point through the story of how 3Com, the early networking company started by Bob Metcalfe, was funded. So I wrestled with whether this is too much detail about a company which people have forgotten now, even though people haven’t forgotten Metcalfe's Law and the Ethernet. But I included the story because it really illustrated why West Coast venture capital in the 1980s was fundamentally different to west to East Coast venture capital. And therefore, why Silicon Valley overtook the East Coast in terms of tech business, I really think that's the main explanation. And although I did say that non-competes matter, clearly, they only matter if you've got venture capitalists in the first place who were trying to take people out of the established companies and move them into startups. You know, so I regard the non-compete as a kind of force multiplier for venture capital. By itself, it wouldn't be quite so important.
Got it. So, talk me through your bit on reporting on India. What were your findings there?
Yeah. Look, I mean, you said in your review, that there should have been more about India. And that I told just one story (About Sequoia India’s early days and funding Kunal Shah’s Freecharge) that was a bit convenient. Yeah, I think that's a fair criticism. You know, I'm not going to argue with you about that. I just say that I barely talk about Europe and the reason is that, you know it's space, there's a limited amount of pages you can write. And so, you know, 85 percent of my book is about the US. Maybe you know 10 percent is about China And there's a mention of Israel. And Europe is left out. I had to make choices.
So I met Shailendra Singh (Sequoia India and Southeast Asia’s managing director and head) in California at the Sequoia headquarters in 2019. I followed up during COVID. Without COVID I might have come to India, but with COVID I spoke virtually.
Right. Sebastian, when you reported on China, was there anything that surprised you? In terms of what you knew and what you found out?
So one thing that American interviewers often ask me is about more women VCs in China. That’s true. Also, I previously knew that venture capital mattered. But I didn’t know the other theories about why Silicon Valley overtook Boston. A lot of people mention Stanford (University) as a reason, but it doesn't explain why Silicon Valley overtook Boston because MIT was a stronger engineering school. And equally, I don't think it was defense contracts, because there were more defense contracts in Boston.
The reason why you had this network of small companies was because VCs were so active on the West Coast. So I wasn't expecting to find quite how important venture capital was to Silicon Valley's growth. And then when I went to China, I was astonished to find that the same thing was true again. So I had read Kai Fu Lee’s books on the Chinese tech economy, and it stresses the government's role in backing Beijing as an artificial intelligence and tech hub. And then Lee says Chinese entrepreneurs work harder, etc. But he doesn't really talk about venture capital.
And yet, when I went to China, and I actually talked to people, notably, Shirley Lin, who actually has moved back to the US-- She's partly in Taiwan, partly in the US. But, you know, she was a Goldman Sachs banker in the late 90s, doing some sort of big ticket privatizations and M&A. And some small venture deals. But she was involved in the Shanghai competitor to TSMC (Taiwan Semiconductor Manufacturing Company). Shirley and Goldman Sachs were involved in advising on that. And it went nowhere because the government was very keen to do industrial policy supporting semiconductors but they couldn't make it work.
Then the government ignored consumer internet because who cares about consumer internet? Just a bunch of cute ecommerce sites, or travel websites like CTtip. Nobody cared. But of course, those are the ones that did really well and grew enormous- Alibaba, Baidu, Tencent,Sohu, NetEase, JD.com. That's what built the Chinese digital economy. And all of them were backed by either American venture capitalists or America- influenced ones like SoftBank. The slight exception is Kathy Xu of Capital Today. But even she had a formative time in a kind of Western institution in Hong Kong before she did JD.com And then you look at the specifics of something like Alibaba, and you see that the reason why Alibaba took off is that they became what they became a world class company, because they hired world class people.
Who were the world class people? Well, Joe Tsai. Why did he join, giving up his very big salary (at a private equity firm) for $600 a year? Because of the stock options. Why were the stock options possible? Because the venture capitalists and their lawyers had made it possible for Alibaba to have stock options. You know, stock options were not a thing in China before the Silicon Valley crowd showed up. And then you ask about who else apart from Joe Tsai , Well, you know, John Wu was the lead technologist at Yahoo, a hot company at the time in the valley. And he quit Yahoo and joined Alibaba because, again, stock options. I talked to him and he was very emphatic about that. And then not only did he get stock options, he was given more stock options to hire a team to work with him at the Yahoo operation in Silicon Valley.
So Jack Ma’s two key early hires were done explicitly with stock options. And their stock options wouldn't have been there without venture capital. So you start to see how Silicon Valley's story about venture capital being at the center was true again, with with China, and, you know, Alibaba is a great illustration of this but you can go further, you can say, Look, you know, the way that jd.com grew was, you know, that Kathy Xu provided more money than the founder had thought he wanted, and then encouraged him and coaxed him into hiring a different kind of person. You know, there had been this rule at JD.com that, you know, if you were hired into the company, you couldn't be paid more than the people who were there from the beginning. And, you know, that meant you couldn't really have excellent people who knew about scaling into a larger size. And when Kathy persuaded the founder to get rid of that rule and her more expensive, better people, it transformed JD's path.
The story of the Meituan-Dianping merger (China’s two biggest food delivery companies) is another story about how venture capital can be the guardian of the ecosystem. And turn a hyper competitive, too chaotic and too competitive rule-of-the-jungle kind of place into a reasonable merger. And that merger was orchestrated, to some extent by Sequoia and Tencent
I did not expect to find this. It is one thing to tell a story about how venture capital was central to the creation of one ecosystem. If you can retell the same story with respect to the second biggest ecosystem in the world, China, then it becomes much more persuasive as a theory of change that venture capital is really essential. And I've done that a little bit with Europe, in the case of the Financial Times piece I did recently, though not in the book.
How did you deal with people being reticent and obfuscating information while you were reporting for this book?
You know, at the beginning of my research, I went to see Sequoia and I had an introduction to Michael Moritz because he's originally British, a former journalist- and I'm British originally, although I lived in America a long time. And I'm a journalist so we had friends in common. And so one of these friends introduced me to him. And, you know, he said, Sure, I'll have coffee with you. And I said, I wanted to do a book. And he said, Well, that’s nice, I like books. But there's just no way that Cisco wants to talk to someone like you, because why would we? We can raise as much money as we want. We don't need to tell our competitors what we're doing. Have a nice day.
So then I went away and I talked to every single person who used to work at Sequoia and I spoke to investors from other VCs who served on the boards of companies with Sequoia, I talked to entrepreneurs who have been backed by Sequoia. And at a certain point I had enough information. And another person made another introduction to Doug Leone, Sequoia’s steward at the time. And this time they realized that I had done enough research, that they probably ought to talk to me. And they arranged three or four interviews. And then at the end of that, they said, Well, we think you should come back.
And they said, you've got a high ROI (Return on Investment), which I guess is a nice compliment in a business world. And then they gave me a lot of access. So that's just one story. I had to go through some version of that process with all of the (VC) partnerships.
You’re demonstrating that you're a serious person who does his homework and doesn't go away and give up. At some point Michael Moritz said to me, “Writing a book like this is a bit like doing a startup; you're going to suffer rejection at the beginning. And you're going to be specialized in some rather narrow topic, and many of your friends will think you're crazy. But you got to persist, and you've persisted. So we respect that.”
After the book was done and you took a step back, what stood out for you?
So the big theme of this book is how innovation happens. And there’s one example that stands out. It was a bit long, but it is a company that disappeared in the 1990s. People have forgotten about UUNET, the startup that created the pipes of the internet. I wanted to tell this story because where internet innovation comes from is a contested story. So there is a view that the internet is DARPA’s (the US’ research agency to find new technology for military use) greatest success and proof that industrial policy works, and that the government is really the main venture capitalist. And so other VCs are just riding on research conducted by taxpayer money.
But it was Mitch Kapor who as an angel discovered UUNET, introduced them to Accel, Menlo Ventures and NEA which funded them. And UUNET and its VCs are what took the internet from a niche government utility to a mainstream option. UUNET built the backbone which allowed AOL, Windows95 etc to connect to a lot of people. They took UUNET from a chaotic, slightly hobbyist, bumbling organization, into something that was really professionalized.
The government is certainly important to innovation but venture capital helps turn a basic science into something millions of people use and which transforms how we live.
Do you think we’re in an era where VCs need to be held to a higher level of scrutiny? It currently looks like they are sharing in the enormous upside, but escaping the hard questions when a company fails on governance or business metrics.
Well, look, if there's a blowout, and they lose money, they will be facing questions from the LPs. If there's a blowout, and they don't lose money, because they're doing early stage venture, and that's not so directly affected by a public market correction, then they weren't get so many questions, but they shouldn't get so many questions, because actually, what they've been doing is building early stage companies that are going to be valuable.
If things implode I think LPs will ask questions. But then let me say something about Sequoia. I'm actually not a huge fan of this shift towards long term capital which they've done, precisely because it's harder for the investors (LPs) to ask questions. (Sequoia’s new structure, explained here)
What the new structure says is- The limited partner puts money into this Evergreen fund, and then from the Evergreen fund, money will flow into this specific venture funds. So LPs are not going through this sort of intermediary. And there's one layer of protection. So if there's a scandal it's tougher for the LPs to get angry. Right, because they're spread across different funds. They're not directly in a particular fund.
Also, forget financial returns for a minute. If 1 out of 15 companies is fraudulent, you may make enough money to cover the one, but it still doesn’t excuse presiding over a fraudulent company right?
If we talk about venture generally, and how much of a scandal is it if something goes wrong? My view is, it's not a scandal. Because startups are really, really messy. And I say that about UUNET. Within about a couple of weeks, VCs discover that all of the financial reports that they based the investment on were wrong because a whole bunch of unpaid invoices had been lost by the company, and then when they found them, they realized that actually they owed a lot of money to suppliers. That's not quite fraud, but it's incompetence on a big scale. If a VC has too many frauds on his watch, he's going to lose money and will probably be out of business and should be out of business. If one out of 15 companies is fraudulent, it is a bit less serious.
And the beauty of the power law mentality is that you can tolerate some losses, you should try to be a good board member. But at the same time the board is not the CEO, and you're supposed to exercise some oversight, and you should, for your own interest, because you're more likely to get a good outcome if you do that. But it won't be perfect. And there will be messes, and that's part of the game.
And I don't think we should condemn venture capital, based on a few frauds. And even if there were like, three frauds in a portfolio of 15, if the portfolio is still making money, it suggests that overall it is working for multiple stakeholders.
Got it. Last question. Do you think crypto will change the investing field in any manner?
No, I don’t. There's two kinds of claims. One is an Initial Coin Offering, where these crypto tokens represent share ownership in the company, or they can get discounts on products. That was a popular argument in 2018. And it proved to be wrong then.
But I just think that a world of many many tokens is contradicting a basic feature of money. Money works best when it is as widely spread as possible because there are network effects. Because of money you can compare the value of a computer and a consultant’s advice. They are denominated the same way. And now if you vulcanise the economy into multiple different tokens, you are destroying that role that money plays. And I just think this is so economically backward, that it's not going to fly.
The second theory is that these Decentralized Autonomous Organizations (DAOs), which will mobilize skilled people, money, and that they will sort of provide a way of mobilizing expertise and capital that turns out to be superior to having a venture capitalist on your board. Now this is new and one would be ridiculously arrogant to dismiss this prospect.But my bet is that these sorts of collectives normally suffer from the tragedy of the commons. It is very hard to sustain really strong commitment and motivation when you have a collective where it is not totally clear who's in charge, what the governance mechanism is, Do you vote on all issues or some subset of them? These can work where things are young and idealistic. But after a while, individualism and individual incentives are pretty important to human nature. And that ends up beating the collective. I’m not 100%, but 60% confident crypto won’t supplant venture capital.