CFR Fellows' Book Launch Series: "The Power Law"

Monday, January 31, 2022

Paul A. Volcker Senior Fellow for International Economics, Council on Foreign Relations; @scmallaby


Cofounder and Co-chairman, The Carlyle Group; Chairman, Board of Directors, Council on Foreign Relations

It is the nature of the venture-capital (VC) game that most attempts at discovery fail, but a very few succeed at such a scale that they more than make up for everything else. That extreme ratio of success and failure is the power law that drives the VC business, all of Silicon Valley, the wider tech sector, and, by extension, the world.

In The Power Law: Venture Capital and the Making of the New Future, Sebastian Mallaby has parlayed unprecedented access to the most celebrated venture capitalists of all time into a riveting blend of storytelling and analysis that unfurls the history of tech incubation, in the Valley and ultimately worldwide. By taking us so deeply into the venture capitalists’ game, The Power Law helps us think about our own future through their eyes.

The CFR Fellows’ Book Launch series highlights new books by CFR fellows.

RUBENSTEIN: Thank you all and thank you very much for joining. Today we’re going to have a really enjoyable conversation with Sabastian Mallaby on his wonderful new book about venture capital. The book is entitled The Power Law: Venture Capital and the Making of the New Future. I have read it and highly recommend it to all of you. We’re going to give you an appetizer about the book today. For those who don’t know, Sebastian is the Paul Volcker senior fellow for international economics at the Council. He’s been a distinguished journalist at many different places, including the Washington Post, the Financial Times, the Economist. The author of a number of books, finalist several times for the Pulitzer Prize, graduate of Oxford, and he is coming to us today from his home in London. I’m in New York.

So, Sebastian, let me begin by asking you, what prompted you to want to write a book on venture capital, because it seems to me from the things you’ve written about in the past, which are usually economics related or financial related, they’re not quite venture capital oriented. What prompted you to be interested in this subject?

MALLABY: Well, I guess two things, David. The first is, I think venture capital right now is the most exciting area of finance—if you call it finance at all. It’s small in size, but enormous in impact. If you think about the size, actually way less than 1 percent of companies that get started every year in the United States receive venture capital dollars. But then if you look at the output when companies go public, looking at all the companies back to 1995, half of them, roughly, were VC backed, and three-quarters of the market cap comes from those that were VC backed. So that’s the first thing, a huge impact.

And the second thing is just the intellectual mystery, right? I mean, most areas of finance, you know, the first thing you learn is to value the asset you just count the cash flow. So venture capitalists are dealing with companies that have no cash flow. They don’t even have product sometimes. So all they’ve got is two-legged mammals who walk into the office with a dream, and they’ve got to figure out how to value that. And it’s just a—it’s a mystery that I wanted to pick apart.

RUBENSTEIN: OK. And how long did it take you to research and write the book? And were you having to do this during COVID?

MALLABY: Yeah. It took me five years. My kids say I’m absurdly slow. I say I’m just perfectionist. Luckily, I’d done all the trips to Silicon Valley before COVID began, so I just had to follow up on Zoom with people I’d talked to before, and that was pretty easy.

RUBENSTEIN: OK. So if somebody heard the title The Power Law they might not immediately think this is a venture capital book. So can you explain to everybody what The Power Law refers to?

MALLABY: Right. I’m glad you asked that, because people say it must be either about electricity or the legal system. And of course, power law that I’m talking about is actually different. It’s the secret sauce of venture investing. And what it refers to is notion that outcomes in venture capital are highly skewed, investments either going to startups that fail, in which case the return is zero, or they tend to be huge winners. So, I mean, ten-X your money or twenty-X your money. And that’s a much bigger skew then you would find in stock market investing. And it really changes the way you have to think about the world. If you were a venture investor, you can’t just invest in things that might do kind of OK. You’ve got to swing for the grand slam.

And that’s why venture capitalists often seen absurdly ambitious and even hubristic. I mean, they’re backing crazy companies. They want to do stuff like, you know, start a company that will take on the hotel business and the premise is people will have complete and absolute strangers sleep on their couch or in their spare room. Of course, that’s Airbnb, and it worked. But that ambition isn’t just because venture capitalists are crazy. It’s because the power law demands ambition.

RUBENSTEIN: So presumably you had some views of the venture capital world before you started. Did you come away with more impressive views of the venture capital industry, or less impressive views as a result of all your research?

MALLABY: I started, you know, not having very strong views, actually. More curiosity than a kind of bias. I quickly figured out that when you looked at the origins of Silicon Valley, venture capital had been way more important in contributing to the takeoff than people realize. And so that was the sort of first surprise. You know, most of the theories about what made venture capital—what made Silicon Valley special—you know, there was Stanford University, or there were defense contracts. On a close inspection, those things are more true of Boston. And what really distinguished Silicon Valley was that it had this aggressive risk-taking venture capital culture which allowed entrepreneurs to start companies easily.

But the real surprise was that the same thing was true when I went to China. And that was the big—and what I completely had not expected, is that people say, you know, the Chinese tech ecosystem has done well because, you know, the government is far-seeing, it’s backed technology investment, and so on. Actually, all of the early Chinese tech companies—Baidu, Alibaba, Tencent, Sina, Sohu, NetEase, Ctrip, you name it—they had venture capital backing. And that was crucial to how they got started.

RUBENSTEIN: So did you emerge thinking, I should have gone into a venture capital career instead of a journalism career? Or you weren’t that impressed, such that you thought you should have had a career change?

MALLABY: I was impressed, but I’m happy doing what I’m doing. I mean, some people criticize what I write for being too sort of in the shoes of and sounding like the venture capitalists that I’m writing about. But I kind of plead guilty to that. When I get involved in these projects, which take, you know, five years, as I was saying, my goal and my curiosity drives me to kind of get into the cockpit with the venture capitalists, fly over that landscape, figure out how it looks from their perspective, and then explain that to the world. I’m more interested in that than, you know, attacking or, you know, forming judgements that almost require the venture capitalists not to be venture capitalists, to be fair. So I—you know, some people say I sound like a venture capitalist when I write. Whatever. I don’t want to be a venture capitalist because I’m happy being a writer.

RUBENSTEIN: OK. Were there one or two venture capitalists who stood out to you as being particularly impressive and you might want to talk about? Including one of them who was a journalist. I assume you might have been impressed with that on as well, particularly.

MALLABY: Yes. The journalist you’re referring to is Michael Moritz, the leader of Sequoia. And I would pick him out. And I would also pick out Bill Gurley from Benchmark. Mike Moritz I would pick out because he was willing to take franchise risk with Sequoia. Namely, he wasn’t content to just let Sequoia remain as an early-stage technology investor confined to Silicon Valley. He drove Sequoia to get into China, to get into India, then recently to get into Europe. He drove Sequoia to set up a hedge fund. He drove Sequoia to get into growth equity investing, so bigger checks into more mature companies. They set up an endowment—internal endowment at Sequoia. So all of this innovation which really transformed the company and then, by extension, is transforming the role model for other venture partnerships, which might want to be like Sequoia. That’s very impressive.

And then I mentioned Bill Gurley. And that’s a slightly different point. In a way, Benchmark is the antithesis of Sequoia. It’s remained keen on being a relatively small, tight-knit partnership focused just on early-stage bets. But when Bill Gurley did the Uber investment, I do think that’s kind of a case study in what makes an early-stage investor great. I mean, first of all he had stage one, which was: Think abstractly about network businesses. And see that they have the sort of flipping of the typical microeconomic rule. And normally in company economics you make more of something, the price goes down. In network businesses, because you’re delivering more value to the user when it’s a network, actually you can raise the price, not let it fall.

So he saw that. Then he said, OK, let me find a company that will do this for taxis. He was very patient about that. He passed on the first two options because they were no good. Then he backed Uber, and that worked out. But then the final phase came when he was invested. Travis Kalanick this year was bidding to drive Uber sort into the moral ditch. And Gurley had the guts and the courage to defy the cult of the founder and to get Kalanick fired. And I think that made him a great figure.

RUBENSTEIN: So you’ve mentioned Silicon Valley a couple times. But when venture capital started, there was a big push to have it around Boston area, Cambridge area, and Route 128, as it’s called. Why did Route 128 in the end lose out as the center of venture capital to Silicon Valley in our country?

MALLABY: So the best explanation of this I think in the literature I read as I was preparing to write my book was from AnnaLee Saxenian of Berkeley, who was a sociologist not a communist. And her argument was that lots of small companies in Silicon Valley contrasted with the big, vertically integrated, and quite secretive companies of the Boston area. And that when you have lots of small companies, information can circulate around the cluster and people can circulate. And that circulation of ideas, and money, and people is really what makes Silicon Valley better at running many experiments.

What I’ve tried to add with my book is to say, OK, that high circulation, where did it come from? And my answer is the venture capitalists. Venture capitalists are the people who were incentivized to get up in the morning, have breakfast with one entrepreneur, and then have fourteen cups of coffee with different people who may be useful for the startup they backed last week, or maybe an entrepreneur they might back next week, and just moving ideas and people around. They’re the super-connectors in the cluster. And so that’s what I’ve tried to communicate in this book.

RUBENSTEIN: Well, some people might say the United States itself is a venture capital investment. The settlers in Jamestown came over to kind of make money for their backers. But in modern times, where do you really see the beginning of venture capital in the United States? After World War II?

MALLABY: Yes. There were some early experiments set up in 1946 on the East Coast. There was American Research and Development, a company in Boston, and then sort of rich families, almost out of philanthropic motivation, the Whitneys and the Rockefellers and so on, they started to invest in technology startups. But I think it really took off in the late ’50s and early ’60s when Arthur Rock came from the East Coast to the West Coast, backed Fairchild Semiconductor by liberating the eight traitors who left the Shockley Laboratory—this is sort of a famous origin story in Silicon Valley.

But it was that act of funding people who wanted to set up their own company and quit an established one which sort of blew up the old model of hierarchy, and authority, and loyalty to your company, and retiring with a gold watch. And that sort of shook everything else. And then that talent was liberated, and the revolution was afoot.

RUBENSTEIN: So historically in the world of money management for hundreds of years money managers got paid a fee for managing money. And it was maybe a 1 percent fee, or something. How did the venture capitalists convince their backers that they deserve, let’s say, 20 percent of the profits, if not 30 percent of the profits, which hadn’t really been done before in the money management world? How did that happen?

MALLABY: Well, the first hedge fund was set up on that principle in 1949 by A.W. Jones. And the first venture capital fund that I write about, which had the same two and twenty sort of structure, was set up in 1961 by Arthur Rock. And exactly where this two and twenty comes from I think goes back to sort of exploration voyages both in Europe, discovering the new world, where the captain of the ship who literally carried the bounty back from the new world to Europe, would be getting 20 percent of the carry—the goods that he carried, the gold or whatever it was he brought back from America. And then there was another phase with whaling in the nineteenth century in Nantucket. So there’d been this early tradition of funding risky ventures on this two and twenty model. And that got carried over into money management after the Second World War.

RUBENSTEIN: Now, the controversy on carried interest with respect to buyouts or other industries, real estate, is that it’s not taxed adequately. Can you explain what that controversy is?

MALLABY: Well, the 20 percent part of the renumeration that the money management gets, that means that of the capital gains on the fund 20 percent of the capital gains flow to the general partners, the fund managers. And they are taxed as a capital gain. They’re not taxed as if it’s income. And a lot of people think that it should be taxed like income. This is what these people do for a job. They get income from their job. It should be taxed like income, which would be a higher rate of tax. When I wrote my book about hedge funds, I agreed with that perspective because I thought that, you know, hedge fund managers tend to be plenty rich, and they could pay a bit more tax.

In writing about venture capital, I have a slightly different view, which is that actually there is a—what we would call a positive externality from venture capital, having more applied science in the society is a good thing. And, you know, fostering innovation is a good thing. And so society might want to support that through tax policy. And although I know at the moment there’s tons of money for an intervention, it doesn’t look like you need tax incentives to have any more, nonetheless I think in the normal state of affairs when you haven’t just had massive QE, some element of tax subsidy for this early stage applied science might be legitimate.

RUBENSTEIN: Now, how do you explain that your part of the world, where you came from—England and, let’s say, the continent of Europe—hasn’t been as active a force in the growth of venture capital as the United States has been, or China, or India? Why do you think that is?

MALLABY: So I would just extend kind of what I was saying earlier about, you know, Silicon Valley got going because risk capital arrived and it was willing to underwrite entrepreneurial risk. And then risk capital went to China. Venture capitalists from Silicon Valley set up in China and brought the idea of equity options for employees. And the whole playbook of how you do VC was transported lock, stock, and barrel by companies like Sequoia, who set up in China and did the same thing. And China took off. Now what’s happening is that the same companies are setting up in Europe. So just recently Sequoia set up in London. So did General Catalyst, so did Lightspeed. Accel, which is a big value player, has had an office in London for a while. Index Ventures is another example.

And my belief is although Europe has lagged and people say, oh, it’s the culture, people are risk-averse, and so forth, all those cultural explanations are wrong. And it’s not that you breath something in the air or you drink something in the water that suddenly makes you go out and be, you know, willing to take risk. It’s the nature of the financing which leads to the willingness to take risk. And I think venture capital is coming to Europe right now, and therefore you’re going to see the startup ecosystem in Europe take off.

RUBENSTEIN: Now, Silicon Valley, for at least twenty-five years, has been the center of venture capital in the United States, and you could argue in the world. Do you think there’s any chance that other places, like Miami, or Austin, or other—New York City—can really replace Silicon Valley as a center of venture capital in the United States? And secondly, will the United States remain as the center of venture capital, wherever it is in the United States, compared to China or India?

MALLABY: So I think that Miami and Austin and, you know, already New York and Boston can grow their venture capital systems. There’s no reason why this formula cannot be bottled and copied elsewhere, as I’ve been arguing with China and with Europe. So I think there’s a bright future for these other cities. They won’t displace Silicon Valley because there’s still more VC in Silicon Valley and there’s no particular reason, I don’t think, unless California politics gets even more dysfunctional than it is already, I don’t think people are going to leave en masse. I think there’s enough stickiness to the cluster that it will probably remain quite vibrant. So I see venture capital spreading. I don’t see Silicon Valley being displaced.

RUBENSTEIN: And what about China and India?

MALLABY: China has done really, really well, partly because of the arrival of the U.S. model of venture capital and partly because China is a huge domestic market that was growing, back then, at 10 percent a year. And as one VC said to me, you had to just sprinkle capital on that and stir and, you know, pretty much you would—you would make good returns. I think China now is a different question, because the government is really clamping down.

If you had a mental model that said China’s tech sector is flourishing and has flourished because the far-seeing government has cleverly picked winners, then you wouldn’t be bothered by this clampdown. I don’t have that mental model. I think that entrepreneurship and VC explains why the digital economy did so well in China. So I have a less optimistic view now on China’s economy and digital economy going forward. India, I’m more positive on because I don’t see the government clamping down on startups and VC there. So I think India, with a huge domestic market and the advantage of the English language, is going to do very well.

RUBENSTEIN: So since you—your book is written and it’s coming out officially—when is the official publication date?

MALLABY: Tomorrow.

RUBENSTEIN: Tomorrow? OK. So it comes out tomorrow officially. Since you wrote it and, you know, have been getting ready for this launch, the tech valuations have plummeted in many Silicon Valley investments. Do you think that the geniuses of Silicon Valley are not quite as smart as they once were, or this is a temporary phenomenon, and the values will come back?

MALLABY: Well, I think the NASDAQ might be down, what, 10 percent this month? I think year on year it’s probably flat. So there was this enormous COVID-generated QE, which created a runup in all these assets. And now there’s a correcting. And because tech is generally more volatile than the normal established industrial economy, it’s going to come down faster, just like it went up faster before. So I think this is a normal correction. I think the secular trend—I’m going to qualify this one point—but I think the secular trend is that, look, more and more of the U.S. economy is driven by intangible capital—intellectual property, patents, business processes, just innovation in general. Not tangible stuff you can drop on your foot, but ideas.

And who understands how to invest in ideas? Well, you’ve got to be hands-on to do that. You’ve got to be close to the company. You can’t just be an arm’s length stock market investor. So I think that at the early stage venture capitalists are going to continue to do well because they are hands-on. And maybe private equity, you would know better than I, will do well because it’s hands-on. And you need to be hands-on when you’re dealing with these hard to value intangible assets. I think the qualification is that late-stage growth investment—so investments into the unicorns—that did become overheated. That is where the so-called geniuses were maybe not such geniuses.

And I think that bit, you know, needs to have a wake-up call, because there were too many big checks being written by people who didn’t want to go on the board, didn’t want to oversee the company they were investing in. And look, either a company is public, in which case the stock market can try to discipline it because investors will just sell it if it’s being mismanaged, or a company is private, in which case you better have investors who go on the board and take it seriously. And I think the problem was that unicorns were kind of neither camp. And that was dangerous.

RUBENSTEIN: So many of the people you interviewed in your book look like you and me. They’re white men. Where are all the women in the venture capital world? Did you not have time to interview them, or there aren’t that many?

MALLABY: I did interview some. I wish I’d interviewed more. But the truth of the matter is that of Silicon Valley investment partners in all VC firms, only 16 percent are women. And that’s, you know, up a bit in the last few years, but it’s still a shockingly low number. And it’s lower, by the way, by quite a lot, than other professions that you might choose—whether it’s banking, lawyers, what have you. Women are seriously underrepresented, as are minorities. You know, only 3 percent in investment partners in Silicon Valley are Black investors. And I think when an industry is purporting to invent the future for all of us, and for all of society, it ought to look more like society. So I do think that’s a problem.

RUBENSTEIN: So when a venture capitalist is looking for a good investment is he or she looking for something that will make the world a better place, or just something that will make them twenty times their money?

MALLABY: Obviously, twenty times their money. I mean, this is not a charity. Often venture capitalists serve charities because they are the limited partners. If you go to Sequoia’s offices, all the conference rooms are named after various endowments from which they draw their capital. So there is a charitable beneficiary, you know, back in the stack, as they say. But the way that the investments are done is absolutely about making a lot of money, no question about it. That doesn’t mean it’s bad for the world, right? So there are people who say, well, you know, if they were not profit seeking there would be less software investing and more climate investing, or something. Well, maybe. But, I mean, there’s plenty of climate investing, actually. And when companies—when venture capitalist invest in companies that are trying to make profits, they obviously do that on the theory that the company’s producing something that people will willingly buy. So presumably it’s serving some sort of utility.

RUBENSTEIN: So you previously wrote a book on hedge funds. And now you have a venture capital book. Who has bigger egos, venture capital people or hedge fund people?

MALLABY: Wow. I would say that venture capitalists. And the clearest distinction is between the sort of slightly introverted hedge fund person, who is really making intellectual calls on the market, doesn’t need to talk to anybody if they don’t—if he or she doesn’t want to. And such that when Louis Bacon, one of the famous macro investors in the hedge fund world, bought a private island, people joked that it didn’t make any difference since he was so insular already. Whereas venture capitalists have to be out there meeting people all the time, schmoozing people, connecting people. You can’t be insular as a personality.

On the ego question, I would say maybe hedge funds have—hedge fund people have bigger egos. And the reason is that you sort of see your results all the time, right? So you do your investment, at the end of the month you know if you’re up or down. And if you’re up, you feel pretty good about that. Whereas venture capitalists are constantly dealing with struggle and failure. Most of the companies they do do wind up as failure. And so you have your teeth kicked in a bit on a regular basis. And that teaches a bit of humility.

RUBENSTEIN: So as you’ve met many prominent venture capitalists, and they’re described in your book in quite detail, what would you say are the characteristics they have in common? High IQ? Low IQ? Low work quotient, high work quotient? What are the characteristics that they tend to have in common?

MALLABY: I think EQ is a big thing. I mean, you need to land an investment, because ultimately the entrepreneur is picking you over somebody else. Everybody’s money is the same color, namely green. And if you want them to take your number, you generally have to be offering some value but also delivering it in a way that is attractive to the entrepreneur because they don’t hate you as a person. And you’re basically getting married for the next ten years, or whenever it is until there is an exit. So EQ is important. And there are lots of story about that. I mean, when, you know, Jerry Yang of Yahoo was asked, why did you take money from Michael Moritz and not from somebody else? He said, well, Michael Moritz had “soul,” quote/unquote. Soul. I mean, it’s almost—I mean, it’s so mysterious as to be ridiculous. But there is that thing of getting on people’s wavelength.

RUBENSTEIN: Now, it used to be the case that venture capitalists would get some venture—or, give some venture capital money to entrepreneurs. And then after five years if the company was OK it would go public, because the investors wanted their money back, and the employees wanted to cash out their stock options to some extent. But that changed a bit with Facebook. Can you describe what happened with Facebook, and how that changed private—I’m sorry—venture capital a bit?

MALLABY: Yeah. So there was this fantastic moment in early 2009 when Mark Zuckerberg of Facebook was, you know, very keen to raise more capital, but he was having a very hard time because the 2008 crisis had just happened and none of the normal suspects were willing to write him a big check. He needed—you know, this was a growth round. He wanted to raise a couple of hundred million or so. So he was having all this trouble. He was sending his chief financial officer off to visit people in the Middle East and all that. And all of a sudden, this unlikely charactered called Yuri Milner calls up from Moscow and says: I want to invest.

And at first, the chief financial officer says, get lost. Who are you? Never heard of you. What are you talking about? Have you even been to the Valley? And Yuri Milner says, no, I’ve never been to Silicon Valley, but I’m coming. And he gets on a flight, and he flies into San Francisco. And from the airport he calls up the CFO again and says, OK, now I’m in California. Now will you see me? And so, you know, out of a mixture of being impressed and kind of feeling sorry for the guy, Yuri Milner gets this. He talks his way into this meeting with the CFR of Facebook.

And then it turns out that Yuri Milner has this multi-country spreadsheet with every single social media company in the world, how it’s monetized, and all the tricks it can use to monetize. And he uses this to talk his way into a meeting with Zuckerberg. He gets the go-ahead to make an investment. He puts in something like 300, or a bit more than that, million (dollars). And then in about eighteen months he’s up about 1.5 billion (dollars). And this coup in terms of growth investing makes so much money so quickly that after that every single investor in the United States who was vaguely interested in technology wanted to copy that.

And so there was this flood of big checks into technology. Andreessen Horowitz, which set up a new venture partnership the same year, 2009, you know, some of its biggest early investments were these multi-hundred million dollar checks into established tech companies, not early-stage stuff. And that really changed the game. It meant you didn’t have to go public. And in fact, why would you go public when you could take this enormous great check from a private investor? It would be much more simple and you wouldn’t have to do a quarterly earnings calls with difficult public market investors.

So that changed the game. It meant you had unicorns. And it meant that all the early stage investors, like Benchmark and Sequoia, reached a fork in the road where they either had to raise their own growth funds and copy the Yuri Milners of the world, or they could remain early stage but then they would lose control of the companies they invested in because the bigger guys would come with bigger checks and buy out more shares.

RUBENSTEIN: So this is now called the growth capital industry, is that right?

MALLABY: Yeah, exactly.

RUBENSTEIN: And the venture capitalists are in that as well. They have sister funds, or something like that, right?

MALLABY: Yeah. Many of them do. A few of them have chosen to stay small, but that’s a tough road because, as I was saying, you know, you lose control when the bigger investors come in. Michael Moritz again—I keep on quoting him, but he’s quite quotable—wrote a memo to his partners Masayoshi Son raised his famous Vision Fund, $99 billion. And Mike gave me this memo he’s written to his partners at the time. I think, you know, for another purpose. But in the memo, which I was allowed to quote, he compares Son to Kim Jong-Il of North Korea, sort of lobbing these missiles at the traditional venture industry. And basically, if you don’t muscle up and have your own missile to shoot back, you’re going to be blown out of the water by these big funds.

RUBENSTEIN: So let’s suppose that venture capitalists were compensated the way journalists are compensated, which is not with carried interest. Do you think the industry would still have grown to the level it has, and been as big and profitable, and attracted as many young, talented people?

MALLABY: No. I think financial incentives are not the only thing that motivates people. And, as you say, journalists are a testimony to that. But it does motivate some talented people. And if you want to get really talented people working really hard at this in a sustained way, I think compensation, you know, has to—has to match that. And there’s risk in this game, right? I mean, you don’t know beforehand if you’ll make a deal that will really work. So would you invest five, ten years of your time in something if there wasn’t the potential of really a big payout? You could argue the payout doesn’t need to be quite as big as it is. And that’s why we have a taxation system. But I think some level of carried interest is reasonable enough.

RUBENSTEIN: Now, some people would say that the venture capitalists have the best image of the kind of investors who are, you know, let’s say, private equity investors, buy-out investors may not have the greatest public image, some might say. And hedge funds, some might say, don’t have the greatest public image. But why is it that venture capitalists who make a lot of money as well, why do they have such a good public image?

MALLABY: You might be, you know, suffering from a grass is greener effect, David. I mean, I’m still thinking slightly recently that the, you know, halo’s wearing off, as the techlash has taken place and people no longer like, you know, Facebook and some of the other tech giants. There’s kind of a, you know, let’s condemn everything in tech attitude. And so I’m finding that, you know, not everybody agrees with my view that venture capital is a positive force. I try to argue, of course, that if you don’t like big tech, then you ought to love small tech because, you know, small tech backs—you know, venture capital-backed small technology companies are a way of challenging the power of the established tech incumbents. So anyway, that’s my line. But I’m not sure everybody buys it.

RUBENSTEIN: By the way, who came up with the phrase “venture capital”? Where did that phrase come up—where was it developed?

MALLABY: I think it was the—one of the very early VCs from New York was talking about wanting a new name. He didn’t want to be called an investment banker. So he thought, you know, what sounds romantic? And he said, what about adventure capital? And then adventure capital got abbreviated to venture capital. It’s a bit like how initially hedge funds, you know, the name came from hedged fund, because in theory it was a long-short and you were hedging out your market exposure, so you were hedged. But then people dropped the D, and it just became hedge fund.

RUBENSTEIN: They also dropped the hedgings as well, to some extent.

MALLABY: (Laughs.) Yes.

RUBENSTEIN: But let me ask you, if you were a young person who says, I want to be a venture capitalist, what does that young person need to do to be attractive to a venture capital firm? Is it high IQ? Good grades? High board scores? Extracurricular activities? Technology background? What is it that takes—does it take to be hired by one of those firms, and to actually succeed at that business?

MALLABY: You know, I think on the whole it’s not the best entry-level choice. You need to get some experience under your belt. There are exceptions to that. There are big, more institutional VCs now that do hire young people. But I think that’s the exception. The typical background is, you know, you have a—preferably a technology formation. But if you don’t have that, you have an entrepreneurial one so that you’ve seen what it’s like to build a company. And then once you’ve, you know, cut your teeth on being a startup employee or a startup founder, and you see what it takes to scale a company, then you have the standing to be an investor who proports to advise other startups.

RUBENSTEIN: So of the venture capital investments you described in your book, I think the one that had the highest difference between the initial valuation and the IPO valuation, was that Facebook?

MALLABY: Yeah. I mean, probably in America it was Facebook. I think the best one globally may have been Alibaba. I mean, Masayoshi Son in 1999 paid—or, in 2000, actually. In 2000 paid 20 million (dollars) for a stake, which was then worth 58 billion (dollars) fourteen years later. That probably gets the record. And it was brilliant timing, since he’d lost all of his money in the 2000 NASDAQ crash, which happened about a month after his investment in Alibaba. So that was a stroke of luck for him.

RUBENSTEIN: Well, you described in your book a company that might break the record for all of those kind of standards, and that is a book—a company called Stripe. Can you describe what Stripe is, and who is behind it, and why it’s so potentially the most valuable of all the unicorns?

MALLABY: Sure. So Stripe is founded by two Irish-born brothers, Patrick and John Collison. And we were used—you know, by the time they founded their company, which I think was probably 2009-2010, you know, young founders were not a surprise anymore. But they were really very, very young. I think one of them was twenty-one, one was nineteen, or something like that. And they essentially dropped out of Harvard and MIT, moved to the Valley, and got discovered by Sequoia, who invested in them. And now they have a company that’s worth, I think on the last valuation, 95 billion (dollars), but it shows no sign of slowing its growth.

What it does is to process payments. So Stripe designed a clever piece of code that was easy for website developers to build into a website or an app. If you were doing ecommerce and you wanted to accept payment from customers for a service, you could put in the Stripe code, and it would make that very easy and smooth. So that was the original product. They’ve now built out into other things, like the Stripe credit card and various other products. But it’s a brilliantly sort of designed strategy because once your embedded in the payment system for all of ecommerce, you’re taking a small fraction of each transaction. It’s sort of the new Visa and the new Mastercard, only it charges a much smaller take. But that’s the low take of an enormously expanding ecommerce pie. And that’s why it’s so valuable.

RUBENSTEIN: So you’ve now tackled the hedge fund industry and you’ve tackled the venture capital industry. What about the private equity industry? Is that your next book?

MALLABY: Well, you tell me, David? Should it be?

RUBENSTEIN: Well, I don’t know. I’ll have to see what the options are. But it’s a great subject, you might cover, but anyway. (Laughter.)

We’re now able to take questions from our members. So why don’t we begin that process? And I’ll interrupt from time to time if I have an additional question, OK?


OPERATOR: (Gives queuing instructions.)

We’ll take our first question from Ken Morse.

Q: Thank you very much for writing this book and for pulling together all of the research. There was one word I was hoping you would use, Sebastian, which didn’t come up. And that is ambition. It’s my view that the ambition of the founding team is a critical success factor of almost any venture. Of course, who they choose for their venture backers is another success factor. What’s the role of ambition? And is there is enough ambition in Europe today?

MALLABY: That’s a great question. I agree about the ambition. And I think the ambition comes from the founders, and also comes from their backers. You know, the venture capitalists sometimes enlarge the ambition of the founders and say, look, you shouldn’t sell out yet. You can get bigger. You can do better. That was the case, for example, when PayPal almost sold itself too early, and the VCs persuaded it to wait a bit.

Europe—you know, I kind of go back to my argument earlier that, you know, all of these things, whether it’s risk taking or, indeed, ambition, change when the finance changes and creates new possibilities. You know, DeepMind, a leading artificial intelligence company, was started maybe twelve or so years ago in London. Was extremely promising but sold out to Google at a valuation of about 500 million (dollars), rather than scaling to be a unicorn. That was in 2014, that they sold. And that was because there just wasn’t an ambition in the culture. No one had really done it before, building a unicorn or a deca-unicorn. And so, you know, DeepMind was willing to say: This is probably as big as we’re ever going to be without accepting a new parent in the form of a Silicon Valley giant.

Today they probably wouldn’t sell because the capital available in Europe is so much bigger. Spotify, you know, achieved a valuation of, you know, $65 billion. So there are lots of role models of deca-unicorns in Europe. And the willingness to sell out early is gone.

OPERATOR: We’ll take our next question from Paula Stern.

Q: Hi. Thank you so much, David and Sebastian. This was—oh, so much to learn.

But I want to ask you a question related to the work I’ve been doing the last seventeen years for the National Center for Women and Information Technology. NSF funded us. We’re trying to deal with the American culture to encourage greater participation of women, underrepresented groups—racially, et cetera, disabled. And I want to bring you back to the use of—to a question, Sebastian, you answered of David’s about characteristics. What does it take? And the words you used were “soul,” it’s kind of mysterious, almost as to be ridiculous. And I wanted to use your words, because the notion of diversity is really a social scientist, behavioral scientist thought process that I think plays, as you suggested with your own words, a very important role.

And the fact that there are only 16 percent of women, as David had suggested and the data that you had used in your article—in your book too, Sebastian, tell me that there’s really a problem here when we’re developing new technology in these venture capitalists. And I’m just wondering if you have, based on your—both of your personal experience—ways in which those women and underrepresented groups, who are not personally interacting in Silicon Valley to the same extent, can break in. What will it take to—and what difference will it make? I think it will make a lot, if there was a greater participation in developing the kind of tech, the kind of patents that get then monetized.

So I’d like to—your personal viewpoint on this. Because I know the social scientists that I work with do have strong ideas on this, but I think what matters is your personal views.

MALLABY: Well, Paula, first of all, I have a daughter who’s doing an astrophysics Ph.D. in Chicago. And so this issue of underrepresentation of women in the hard sciences is something I hear about. And I applaud the work you’re doing to try to do something about that.

I agree that, you know, as I said, if you’re trying to invent the future for society you should look a bit more like society. And I do think it’s true that if you’ve got investors who are not diverse, they’re going to miss some technologies or miss some angles that would benefit the groups that they’re not thinking about, because they don’t put their heads into the space that is inhabited by other people. I mean, a great example of this, you said, again, be personal, I’ll cite evidence from the house magazine at my home, which is the Economist, which published an amazing article about how the devices you put on your finger to judge your oxygen level, an oximeter, which were important in diagnosing the severity of COVID and therefore were determining whether or not you’d be allowed into the intensive care unit, obviously—you know, when you say it it’s obvious. But the infrared signal that goes through your skin and your finger works differently if your skin is light compared to if it’s dark.

So this thing was systematically excluding African Americans from critical care when they needed it because the device was not designed and tested on Black skin. I mean, it’s an outrage. So I firmly agree with you, that things need to be done about this. I think it will happen. And I think—you know, I tell a story in my book about a specific example of Kleiner Perkins, the venture capital partnership which tried to promote women but then ended up with a sexual harassment suit. And I think it was because, you know, you really have to be deliberatively, purposeful about not just promoting women but creating a culture which avoids harassment and which avoids sexism once the women start working there. If you just promote women and then leave the culture unchanged, it’ll just be really difficult.

And many of the smart women who joined Kleiner in that phase of trying to promote women wound up quitting and starting their own venture capital partnerships and doing very well. But they couldn’t really thrive within Kleiner Perkins. I think that’s a message that, you know, I’m hoping my book will do a bit to spread. And I think it’s something that VC partnerships can do better at.

OPERATOR: We’ll take the next question from Harold Schmitz.

Q: Hi. Yeah, my name is Harold Schmitz. I’m with the University of California, Davis, and also a GP at a venture fund, March Capital U.S.

I would be curious—you know, one of the sort of emerging spaces seems to be the food technology area. So alternative proteins and, you know, emerging diagnostics from the adjacent sector of health care to, you know, more nutrition and food-oriented solutions, so on and so forth. So curious to hear your views on, you know, what appears to be this sort of diamond in the rough or emerging crown jewel, or whatever. But it still hasn’t really taken a shape yet. And it is a peculiar sector that’s different than, you know, the big money-making sectors, you know, history to date that you’ve seen. So I’m curious to hear your views on this new sort of emerging VC sector.

MALLABY: Yeah. I’m glad you brought that up because, you know, one of the points I’m keen to get across is that venture capital is not merely about software. There’s been this extraordinary period of twenty, twenty-five years when software has just made tons of money, and you can do it with rather little capital input, and you can scale products superfast. So that’s been so dazzling—you know, successes like Google and Facebook and so forth—that people lose sight of the other kinds of investments that VCs can make. And they’re quite diverse. You know, they include, as you say, the food sector.

And in fact, the lead story in my book is about Impossible Foods, which is, you know, this alternative burger company. You know, it looks like a burger. You put it on the grill, and it appears to bleed, and that red juice turns to brown, and it makes that satisfying sizzling smell. And this is all engineered by a geneticist who turned his hand to this. And, you know, the thing that makes that hemoglobin-type blood-like smell is drawn from the roots of clovers. So it’s genius stuff. It can be backed by venture capitalists. Impossible Foods has turned out to be a great investment. And I really think it won’t be the last. So I would say it’s an emerging diamond, not a rough—(laughs)—not a rough area. I think there’s a lot of promise there.

RUBENSTEIN: I would just add that, you know, since people have been coming out of caves as homo sapiens 400,000 years ago, for most of that time they didn’t realize that eating certain food would make it possible for them to live longer or be healthier. Now over the last, I would say, fifty years or so, there is a science that has grown up—and, obviously, University of California, Davis has been a leader in it—showing that eating healthy food can lead to a longer life, and a healthier life. And so there’s a now big investment area of healthy good. And the one you just cited, Sebastian, is one of those. I unfortunately passed on investing in it, but I have a daughter who’s got a fund that does this kind of investing. And I’ve learned a lot about it as a result of it. And I think this will be a big growth area over the next decade or so as more and more people get wealthier, and more and more people live longer, and more and more people realize that by eating healthier food they probably can live a bit longer.

OPERATOR: We’ll take the next question from Seema Mody.

Q: Hello. Good afternoon. This is Seema Mody, global markets correspondent at CNBC Business News. Sebastian, wonderful book. And it’s great to hear your insight today.

While venture capital has played a significant role in building and bringing new technologies to market, I’m curious what your thoughts are on the rise and fall of companies like Theranos, WeWork. Have these huge stories, and the subsequent decline, played—or, served as a learning lesson for venture capital? Has it changed the way investors view prospective investments going forward?

MALLABY: Yeah. It’s a great question. I mean, I think that they’re slightly different cases. So Theranos, you know, the vast majority of the dollars that went into that company were not from sort of traditional, recognizable VCs. There was an early seed investment from a VC called Tim Draper, but, you know, if you make a half-million dollar seed investment around the idea of a concept before the company’s really even started, that’s just a sort of speculative sprinkle of money. You know, in the VC business, you expect eight out of ten bets to go to zero, and so giving experimental capital to try out this idea wasn’t crazy.

The scandal with Theranos came later when, you know, the blood test results were fictitious, and patients were being given incorrect data about their health. And that was a scandal. And, you know, the founder, Elizabeth Holmes, deserved to be convicted recently. But I don’t think that the early-stage bet was a mistake. But the mistake came a bit later when people put in bigger checks of money and failed to exercise oversight or ask tough questions. And if you ask—if you ask where that money came from, you know, it was the Walmart family, or it was Rupert Murdoch, or it was other sort of not venture capitalists, but venture tourists.

You know, WeWork is a different case, because there the serious A investor was Benchmark, you know, an absolutely top Valley venture capital company. And I looked at that case quite carefully, because I do think it raises troubling questions. And the troubling questions are essentially that, you know, in this world of huge growth capital checks, as I was describing after Yuri Milner’s investment in Facebook you have all this new money flooding into the Valley. So Benchmark made an early investment in WeWork. That’s probably OK. WeWork actually was making money at the time and was not such a crazy company.

And then in came the sort of nontraditional investors. In this case, it was Wall Street banks like JPMorgan that threw money into the company, allowed Adam Neumann to have super voting rights, which gave him the ability to outvote his board members, and therefore do whatever he wanted. And he got crazier and crazier, and more and more hubristic. And the Tarzan hair, you know, became more indicative of who he really was. And, you know, the whole thing was a disaster.

But I think it was—I think the lesson for venture capitalist there is: If you make a small early investment, and then other people come in with a different agenda and they’re not interested in overseeing the company, then you really may go off the rails. That’s the lesson.

OPERATOR: We will take our next question from Kahlil Byrd.

Q: Hi, David. Hi, Sebastian. Wonderful book. Wonderful articles read today.

So it would be a given that a young person who wants to make it just jumps into Goldman or jumps into McKinsey and, in this case, jumps into a venture firm. Are venture firms still as hot with the younger cohort as a guaranteed way to be successful? Or are they competing with all of the other opportunities that exist right now for young people who are trying to make it?

MALLABY: I think it’s one of various opportunities. As I was saying, I’m not sure it’s the best one to go for when you’re right out of college, because I think that, you know, to be an investor requires the stature to tell the startup what to do. And so you need to be able to say, look, I’ve done this. I’ve had experience. You know, I have an engineering, you know, degree. I scaled a startup myself. I understand product market fit. I understand how to build a sales team. You know, I’ve seen things. And so I’m not sure it’s the best sort of first move.

And of course, there’s competition from lots of other things that young people can do. So that’s all healthy. I think probably the sort of more typical path is that people are coming out of college with coding abilities, and they’re going into Google or Facebook as coders. And then maybe after a few years they try to spin out and start their own startup. And then if that does OK, they’ve got a track record as an entrepreneur, and then they become a venture capitalist.

OPERATOR: We’ll take our next question from Alexis Crow.

Q: Thanks so much for a fantastic conversation. Alexis Crow. I lead the geopolitical investing practice at PricewaterhouseCoopers, and at Columbia Business School as well.

A question on the sectoral allocation by geography. Some criticism of some of the Silicon Valley, you know, VC startups has been that it’s, you know, designed to order a pizza better, and therefore your remark about utility—it’s designed toward consumption. And I wondered in your research if you see any trends in—or patterns in terms of sectoral allocation of VC in China versus India. Obviously, we’re seeing a lot in the financial services space in Latin America.

MALLABY: Yeah. And there are specialties that emerge by geography. So, you know, the Boston area is strong in life sciences. London is strong in fintech. China right now is making a big push into artificial intelligence, because the government perceives that to be a big priority. And VCs now in China kind of have to take their cues from the state. So there are these, you know, as you would expect, clustering is a powerful force. And there are differences between different regional clusters.

OPERATOR: Our next question from Sean Randolph.

Q: Hi, Sebastian. Sean Randolph with the Bay Area Council Economic Institute in San Francisco. Great presentation.

I gather from something you just said about nontraditional investors that you would feel that the huge influx of nontraditional investors—you know, private equity, sovereign wealth funds, and others—into the venture field in the last year to two years might pose a systemic risk. So one question is, what’s your interpretation of that? But what I wanted to ask was about venture in China. With so much government money pouring into the venture sector for many years now in China, do you see venture behaving differently in China than it does in the U.S. or in the West?

MALLABY: So let me see if I can remember these questions. So on the first one, sorry, remind me. Are you still there, Sean?

Q: Here we go. Huge volume of nontraditional investment coming in the last year.

MALLABY: Sorry. Sorry, sorry. Yeah. OK, so yeah. I do think that’s dangerous. And the reason is that companies, in my view, need governance, right? Somebody has to be looking over the shoulder of the CEO and checking that, you know, the job that’s being done is good. You know, that rules are not being broken, the law isn’t being infringed, that financial controls are in place, and the strategy kind of makes sense. Doesn’t mean that you usurp the CEO’s authority, but you need some sort of governance. And in the public markets, the way that works is that, you know, if you’re doing a bad job people will sell the stock, the price will go down, and sooner or later either you’ll be taken over in an acquisition by somebody who’s going to manage it better, or maybe an activist hedge fund shows up and demands that you change your strategy. But something will happen to make you change your path.

In the private markets, hopefully, you’ve got private investors who take it seriously enough that they go on the board, and they pay attention. Where I’m worried is where the private investors invest, and they don’t go on the board, and they don’t pay attention. And that’s what you’ve got in tech unicorns. And they kind of sort of—you know, they embed their refusal to pay attention by giving the founders super voting shares, so that even if they did go on the board, and they paid attention, and they gave advice, the advice could be disregarded because the founder could out-vote everybody else. That strikes me as just not healthy.

Now, on China, what’s amazing is not the difference in the way between how VC works in China to how VC works in the U.S. It’s like the similarity. It’s the fact that, you know, the early Chinese internet startups, you know, featured Silicon Valley investors who came in and brought Silicon Valley norms. And they structured this thing with a Cayman Islands parent and a dispute settlement under New York law, an aspiration to go public on the NASDAQ. Sometimes they had board meetings in Silicon Valley. The whole thing was just the Silicon Valley playbook copied completely. And that’s why it worked. Now, you know, over time, you know, China’s indigenized the system. It understands perfectly well how to do it. If American investors pulled out of China tomorrow, the Chinese investors would do a great job without them, because they’ve understood how it works. But basically, the model is the same.

RUBENSTEIN: Sebastian, we have hit 2:00, and I think we’re going to have to end. But—and the title of your book is The Making of the New Future. The new future is more venture capital or less venture capital?

MALLABY: More venture capital, David. This is the intangible economy. That’s what it needs.

RUBENSTEIN: OK. So I want to thank you, Sebastian, for a very interesting conversation. As I said at the beginning, I did read your book and I really enjoyed it, learned a lot from it, and I highly recommend it to others. And thank you for giving us this time, Sebastian. And thanks for the other things you do for the Council.

MALLABY: Thank you.


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