Venture Capital and the Future of Innovation, With Sebastian Mallaby

Sebastian Mallaby, CFR’s Paul A. Volcker senior fellow for international economics, sits down with James M. Lindsay to discuss how Silicon Valley’s venture capitalists are shaping the future of innovation and the global economy.

February 1, 2022 — 33:07 min
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Host

James M. Lindsay

Senior Vice President, Director of Studies, and Maurice R. Greenberg Chair Full Bio

Episode Guests

Sebastian Mallaby

Paul A. Volcker Senior Fellow for International Economics

Show Notes

Sebastian Mallaby, CFR’s Paul A. Volcker senior fellow for international economics, sits down with James M. Lindsay to discuss how Silicon Valley’s venture capitalists are shaping the future of innovation and the global economy.

 

Enter the CFR book giveaway before February 16, 2022, for the chance to win one of ten free copies of The Power Law: Venture Capital and the Making of the New Future by Sebastian Mallaby. You can read the terms and conditions of the offer here.

 

Books Mentioned on the Podcast

 

Sebastian Mallaby, More Money Than God: Hedge Funds and the Making of a New Elite (2010)

 

Sebastian Mallaby, The Man Who Knew: The Life and Times of Alan Greenspan (2016)

 

Sebastian Mallaby, The Power Law: Venture Capital and the Making of the New Future (2022)

 

Sebastian Mallaby, The World's Banker: A Story of Failed States, Financial Crises, and the Wealth and Poverty of Nations (2004)

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Transcript

Jim Lindsay:

Welcome to The President's Inbox, a CFR podcast about the foreign policy challenges facing the United States. I'm Jim Lindsay, Director of Studies at the Council on Foreign Relations. This week's topic is Venture Capital in the Future of Innovation

Jim Lindsay:

With me to discuss how Silicon Valley's venture capitalists are shaping the future of innovation in the global economy is Sebastian Mallaby. Sebastian is the Paul A. Volcker senior fellow for international economics at the council. An experienced journalist, Sebastian, was previously a contributing editor at the Financial Times and is a two time finalist for the Pulitzer Prize. He has written five books, the newest of which is, The Power Law: Venture Capital in the Making of the New Future. It has just reached bookstores. Sebastian, thanks for being here. Congratulations on the publication of The Power Law. It's getting some great early reviews.

Sebastian Mallaby:

Thank you, Jim. Great to be with you.

Jim Lindsay:

Now, Sebastian, I have lots questions to ask of you, but first I want listeners to know how they can win a free copy of The Power Law. To do so, all they have to do is go to cfr.org/giveaway, to repeat, cfr.org/giveaway. There, they can read the terms and conditions for the giveaway and register their entry. The registration will be open until February 15th after which we will randomly give away 10 copies of the book. And for any listeners trying to jot down this information, please note that you can find a link to the giveaway in the show notes for The President's Inbox on cfr.org. Sebastian, where I'd like to start is with a tutorial about venture capital or VCs, as they are often called. There are a lot of different communities in the financial world as I've discovered over the years. You wrote a terrific book called More Money Than God, which looked at hedge funds. I often meet people who say they work in private equity. So can you tell me exactly what venture capital is and how does it differ from other communities in the financial world?

Sebastian Mallaby:

Sure. Hedge funds to begin with are mostly investing in public securities. So the stock market, the bond market, the currency market, stuff where you can see the numbers moving on the screen. Private investing is investing in companies which have not yet gone on the stock market. So their value is a little bit tougher to see. You can't just look it up on Yahoo or whatever. And private equity is technically a kind of broad term that could be any private company, but normally when people say I'm in private equity, they mean big private companies. Whereas when people say I'm in venture capital, it means they are backing early stage smaller technology companies, which are private and not yet the stock exchange.

Jim Lindsay:

As I mentioned at the outset, Sebastian, you've written a lot of books. You've written about hedge funds. You've written biographies about a former World Bank chairman, James Wolfensohn, and a former Fed chairman Allen Greenspan. Why are you writing about venture capital?

Sebastian Mallaby:

Two things, Jim, I mean, the first , is that intellectually, venture capital presents a sort of investment mystery. How does somebody evaluate which startups to invest in when there are zero quantitative metrics serving as guideposts of which to back. So in most kinds of investing, the first thing you would do is you would say, what is the cash flow that I'm going to get my hands on if I buy this bond or this share in the stock market? With venture capital, you have two legged mammals, right, walking into your office with a dream about what they might do in the future. There is no cashflow, there are no assets in the company. There is just a plan, a story. How do you even begin to think about allocating capital under so much uncertainty? I wanted to unravel mystery.

Sebastian Mallaby:

And the second thing, Jim, is that right now venture capital is spreading in all directions and it's really becoming the most exciting kind of finance out there, it's spreading globally. So, you know, Asia has quite a thriving venture capital ecosystem, particularly in China, but also India and Southeast Asia. Europe is getting one. Israel has had one for a while. Latin America is getting one. This is really going global and it's spreading also into new kinds of industries. So, new kinds of ways of making food like a meat free hamburger.

Jim Lindsay:

This is the Impossible Burger?

Sebastian Mallaby:

The Impossible Burger. Exactly.

Jim Lindsay:

I've had several.

Sebastian Mallaby:

There you go. It's affecting your life. It's affecting your diet, Jim.

Jim Lindsay:

Well, my daughter's a vegan and so I eat less meat.

Sebastian Mallaby:

So we're grateful to those technologists who did it and they wouldn't have done it unless they'd been backed by somebody who underwrote the risk, and that person is a venture capitalist. And matter of fact, that's the opening story in my book. So venture capital is spreading. Geographically, it's spreading into new types of sector and it's spreading along the life cycle of companies into a period when they're worth more than a billion, the so-called unicorn phenomenon. Companies used to go public much earlier on, now they stay private. They're still in the hands of these venture capitalists. So in three different dimensions, venture capital spreading and becoming more important and more exciting.

Jim Lindsay:

So give me the names of some companies that are now household words that were started by venture capitalists.

Sebastian Mallaby:

Apple was backed by venture capitalists at the start. Facebook was, Google was, Amazon was, so a lot of the most famous companies and the dominant ones on the stock exchange, which are really changing the way that we communicate with each other, the way we access information, the way that we arrive at epiphanies, the way think really owe their origin to venture capital.

Jim Lindsay:

So is venture capital limited to companies that do software?

Sebastian Mallaby:

No. That's a great question because some people think that is the case. Software has been the dominant, exciting medium in the last 10 or 15 years, but there's a whole prehistory about hardware investments. So semiconductor companies like Fairchild Semiconductor at the beginning, and then Intel later on, of course, Apple was a personal computer maker. There were companies that built the internet, the physical pipes and connections like Cisco, which were venture capital backed. And then there are pharmaceutical companies like Genentech was the first one that made artificial insulin in the late 70s. But that goes right forward to today's breakthroughs like Moderna, which built one of the key coronavirus vaccines. That was a venture backed company as well.

Jim Lindsay:

So you title your book, The Power Law, which means I have to ask, Sebastian, what is the power law?

Sebastian Mallaby:

Well, it's easiest to start with what it isn't. So many phenomena in life follow a so-called normal distribution, like in a bell curve where most of the observations are close to the average observation. So the average height of an American man is 5'10" and two thirds of all American men are within 3 inches of that i.e they're between 5'7" and 6'1". On the other hand, other phenomena in life are not distributed in that bell curve kind of way. Instead, think about the wealth distribution in the United States. There are some people, a few hundreds of thousands or a million or whatever it is, who are way, way, way wealthier than the average and they in fact, distort the average and pull it upwards away from the median. So if we think about a movie theater, if the tallest man walks out of the movie theater, it's not going to affect the average height of the ones who are still left.

Sebastian Mallaby:

Even if the tallest man is an NBA star, it's not going to have a big effect on the average height, but if the wealthiest man walks out and that man is Jeff Bezos, the average

Jim Lindsay:

Changes your numbers.

Sebastian Mallaby:

Yeah, it's going to plummet. And the point is that venture capital investing is a radical example of this power law distribution, where many companies that you might back go to zero, they fail, you get zero money back but a few, just in few are going to break out into the stratosphere and they're going to deliver a return of 10, 20, 30 times your capital.

Jim Lindsay:

So if I can involve a baseball analogy, it seems to me as if venture capitalists are going to the plate, not expecting or trying to hit singles all the time, and they're not even trying to hit home runs, they're trying to hit grand slams and they're willing to live with a lot of strikeouts to get those grand slams.

Sebastian Mallaby:

Exactly. This is a very asymmetric world and almost the sort of cost of entry into this world is that you reorganize your human instincts, which after all include loss aversion. Right. People in experiments conducted in the 70s were shown to be unwilling to risk for upside. They're much more likely to gamble to avoid a loss. You have to rewire yourself and be willing to gamble, for enormous upside, make low probability but high outcome bets.

Jim Lindsay:

So let's say 9 out of 10 times you lose money, but on that 10th time, you make so much money, it makes it worthwhile given what you've lost.

Sebastian Mallaby:

Exactly. And that has a big implication for the kind of company you might back. There's no point backing something that looks sort of a bit cool because it's not going to be a breakout. If it's not 10x better, it's not better. It's a fundamental axiom in this industry. And so you've really got to go for the crazy stuff. People say jokingly, venture capitals are hubristic, you know, venture capitalists back flying cars. Well , you know, flying cars might be a bit out there. But if you think about the idea that, "Hey, let's have a company that is going to be premised on the idea that will destroy the hotel business because ordinary individuals will take complete strangers and let them sleep in their homes on their couches." I mean, you know, that's Airbnb and it worked, or you know you mentioned Impossible Foods, I mean the idea of making a beef burger that you could put on the grill and it would sort of bleed and there would that be that red would go to brown and that whole smell would come out. It felt like a crazy long shot, but it worked. And those are the kinds of breakout, difficult bets that venture capitalists specialize in.

Jim Lindsay:

So talk to me a little bit, Sebastian, about where venture capitalist firms came from, what were their roots? What were their origins?

Sebastian Mallaby:

Well, the origin story is around an individual called Arthur Rock, who came out of a New York brokerage company, so a company that invites investors on buying shares and pretty normal east coast stuff. And he came to Silicon Valley before it was called Silicon Valley in 1957 and he financed the creation of Fairchild Semiconductor. And that was sort of a breakthrough moment because he realized when Fairchild Semiconductor did extraordinarily well, that backing technology firms was risky, but it could have enormous payouts and so he kind of understood this parallel idea of skewed returns and he raised a fund do these kinds of bets in 1961. And he pioneered this industry. When he first began, people thought he was crazy but by 1968, when he'd returned 22 times the capital in the fund to his backers, people didn't think it was crazy and that's what set off a boom of imitators that then seeded the valley with venture capital and made it the most productive innovation center anywhere in history.

Jim Lindsay:

Sebastian, you mentioned Silicon Valley. In The Power Law, you compared Silicon Valley to where I grew up the Route 128 beltway around Boston. Both were high tech hubs back in the 60s and 70s. One took off and became a place associated with venture capital, namely Silicon Valley, same thing didn't happen in the Route 128 corridor. Why was that?

Sebastian Mallaby:

You know, the Boston financial sector had a tradition of sort of prudence. In fact, that's where I think Fidelity is based. I know that's true.

Jim Lindsay:

Yes, it is.

Sebastian Mallaby:

Prudential maybe there as well, I forget. But anyway

Jim Lindsay:

Yes, it is. There's a tower there.

Sebastian Mallaby:

Right. So the names, the names, tell you something, Fidelity, Prudential it's about avoiding losses and being careful and sober and responsible. And there wasn't that same power law style, risk appetite in the tradition of Boston finance. And so, although there were some early experiments with venture capital and some pretty good venture capital partnerships have grown out of the Boston area like Greylock and Charles River Ventures. They were not quite as go-getting as the west coast variety. And I think that explains a lot about why Silicon Valley overtook Boston in the 1980s.

Jim Lindsay:

So this isn't a story of the difference between Stanford and MIT?

Sebastian Mallaby:

Well, MIT was a stronger engineering center than Stanford, for sure, in the 60s and 70s and Harvard was a stronger center than Berkeley and so the story that Silicon Valley is just Stanford Valley and Stanford explains why Silicon Valley has been this breakout innovation hub, it's just not historically true. The truth is that what distinguished Silicon Valley from Boston and what created the business culture that was more risk taking and go-getting that was venture capital. Venture capital made it possible for people to break out of big companies and start small ones and take risks because the risks were being underwritten by the capital from the venture capitalists.

Jim Lindsay:

Now, as you know, Sebastian, venture capitalists have lots of detractors. One critic has asked whether venture capitalists are soulless agents of Satan, or just clumsy rapists. Paul Graham, one of the people you profile in The Power Law wrote a manifesto on The Unified Theory of VC Suckage. Another venture capitalist says that venture capital kills more businesses than it helps. Your overall take on venture capital is positive. You call it an enduring pillar of national power. What is it that detractors are missing?

Sebastian Mallaby:

I think the first way to answer the question is to go back to this question of, you know, Boston falling behind Silicon Valley. I said, just in passing a minute ago, that you know it was because there were these venture capitalists, but let me just flesh that out. The best scholarly take on the regional advantage in Silicon Valley has been that of AnnaLee Saxenian of Berkeley, a sociologists, who pointed out that people in Silicon Valley move from one company to the other quicker, so ideas moved around the valley, talent moved around the valley, and that allowed for lots of experiments, which ended up being more creative and productive than having these vertically integrated large hierarchical secretive companies, which dominated the Boston ecosystem. And I fully agree with that. What I'm trying to do in my book is to add another layer of the analysis and say, okay, so ideas circulated better in Silicon Valley. People circulated better. Why was that?

Sebastian Mallaby:

And my argument is that the group of people who were incentivized to help that circulation of ideas and talent, that was the venture capitalist. A venture capitalist incentivized to get up in the morning, have breakfast with one entrepreneur to see whether or not that company's worth backing, and then have 14 cups of coffee with different people before they go to bed. Because you're always looking, as a venture capitalist, for the next engineer that you might hire into the startup that you backed two weeks ago, the next marketing executive, you might look for the next deal you're going to do. You are moving around like a bee in a garden pollinating all the flowers. And so that hyper connectivity, that circulates in a rapid way, these inputs for innovation, ideas, people, and money, that high velocity of circulation is driven by venture capital networkers.

Sebastian Mallaby:

And I think that's what makes it so productive. And I was astonished to find when I did the research that in China, the same story is true. The reason why China has become the single biggest challenger to Silicon Valley in terms of the digital economy is because the same venture capitalists from Silicon Valley went to China and started doing the same thing with equity options for employees, plans to go public on the NASDAQ, dispute settlement for companies under New York law, the entire playbook was transported from Silicon Valley to China and that's why China took off.

Jim Lindsay:

Okay. I want to pursue the China angle in a moment, but I want to finish talking about a venture capital here in the United States. Another criticism, of venture capitalists, is that they focus on things that make money, not necessarily innovations that empower the economy. They are really good at getting apps and games that allow people to fritter away time, but we're not investing in industries that are A. going to employ people or provide a long term productive advantage in a very competitive international global environment. How do you respond to that?

Sebastian Mallaby:

Well, a key pillar of US power and this current tension with China is superiority in semiconductors. And of course the semiconductor industry is the first thing that venture capital has backed and helped to build. And that's true by the way of the newer generation of semiconductor companies, whether you're looking at Nvidia which got going in the 90s with backing from venture capitalists or a really cutting edge company, like Graphco backed by Sequoia Capital building AI chips. So it's just not the case that it's all about software. Of course, there are some companies that have come out of the venture capital world, like Facebook, which have gotten a lot of negative attention. And I sympathize with some of that critique of Facebook, whether it's about screen addiction or corrupting political debate or what have you.

Sebastian Mallaby:

And those things should be regulated by government. But I think on balance, the technologies that venture capitalists back have been positive. And if you take an example like climate tech, you know next generation batteries that make possible electric vehicles are being backed by venture capitalists with a lot of success. So it does stretch into hardware and I firmly believe that we want innovation. Of course its disruptive, but the alternative to disruption is stagnation and that wouldn't serve either US national interest nor even you know US prosperity.

Jim Lindsay:

And I think you're right, as you've written that the fact that some startup companies backed by venture capitalists get very big in perhaps have monopolistic practices is not an indictment of venture capital itself. It's an indictment of the failure of regulatory policy by the federal government. Correct?

Sebastian Mallaby:

That's right. And I would even add that if you don't like big tech, because you're worried about monopoly, then you should be all the more keen to support small tech. Small tech backed, meaning small companies backed by venture capitalists is one way of challenging the market dominance exercised by the mature tech companies that were backed by VCs years ago.

Jim Lindsay:

Okay. One last question, Sebastian, about venture capital in the United States, again, it was associated with Silicon Valley, there's Sand Hill Road where some of the first firms set up, has American venture capital spread out beyond Silicon Valley and also is American venture capital biased toward funding things that are being developed in Silicon Valley, as opposed to Des Moines, Iowa or Baton Rouge, Louisiana?

Sebastian Mallaby:

I'm glad you put the question that way as a sort of double question, because if you look at the data I was able to find, you still see California and Silicon Valley dominating where the venture dollars are raised and it's possible that the lockdown and the past couple of years have started to change that. Anecdotally, you see a lot of people on venture capital Twitter going on about Miami, going on about Austin.

Jim Lindsay:

Love Austin, by the way.

Sebastian Mallaby:

Yeah. I love Austin too. Although unlike you, I never quite got the chance to live there, but-

Jim Lindsay:

Unfortunately I sold all my property before the market was affected by the influx of venture capital. It changes the market price considerably.

Sebastian Mallaby:

I'm sorry. So I think perhaps as we collect more data, we're going to see that the pandemic has caused fundraising in VC to spread out of the Silicon Valley a bit. But the bigger phenomenon, the clearer phenomenon is that Silicon Valley based venture capitalists are more willing to jump on a flight and back a company somewhere else in the United States. There's a sensation that you know Silicon Valley itself is kind of full. I mean you know expensive to hire engineers. The real estate is super expensive.

Sebastian Mallaby:

Innovation may bubble up anywhere these days. And so there used to be a saying, in fact, I think there's one particular venture capitalist, Peter Thiel, who crystallizes this point. You know, he would get on the stage at Stanford, 20 years ago and say, I don't know what the next big thing will be, but I do know it will be half an hours drive from here. And today he would say, I don't know what the next innovation will be, but I'm pretty sure it won't be in Silicon Valley because he's negative on the valley and he thinks that the more you know original ideas are coming from elsewhere. So I think that is changing.

Jim Lindsay:

Peter Thiel was the founder of PayPal. Correct?

Sebastian Mallaby:

That's correct. And then he founded Founders Fund, which is a venture capital partnership.

Jim Lindsay:

Okay. You just made me realize, Sebastian, I didn't ask you an important question that should have come up at the top of our conversation and that is where do venture capitalists get the money that they invest?

Sebastian Mallaby:

They go to big savings institutions, primarily, and college endowments are the number one go-to source of capital, especially for the sort of most established and prestigious venture capital partnerships. Then you're going to get a mix of other people. There'll be some rich individuals. There'll be some exited entrepreneurs who have made money by selling their tech company and now they're investing in venture capital. So it's a bit of a mixture, but big savings institutions are the leaders.

Jim Lindsay:

So we're talking things like pension funds and the like?

Sebastian Mallaby:

That's right. Pension funds and then you've got the you know college endowments. Then you've got some charities like the Ford Foundation, so forth.

Jim Lindsay:

Organizations of endowments may invest in these to maximize or boost their endowment returns. The reason I ask that question is because it suggests that while most Americans have no direct experience or exposure to venture capital, many of them are affected by it because the retirement plans have at least a share of their investments in this field.

Sebastian Mallaby:

Yeah, that's correct. I wouldn't want to overstate the pension plan aspect because I think that one feature of venture capital is that traditionally the amount of money that could be deployed was quite small because you're looking at startups, they don't really need more than $5 million and then it's pretty labor intensive once you've done the investment to mentor that startup and bring it to... So the capacity traditionally of these funds was limited and so since endowments for various reasons historical have been at the front of the line, there is some pension money in venture capital, but I wouldn't over claim that?

Jim Lindsay:

Okay. So let's talk about the copycats, the countries that are learning from America's pioneering development of venture capital. You talked about how successful China has been in essentially copying the American playbook. Where do you see that taking Chinese innovation and beyond that, what does it mean for American innovation?

Sebastian Mallaby:

Well, the story here is that the top venture capital company in the United States and Silicon Valley is Sequoia Capital and if I were to ask someone to guess, what is the top Chinese venture capital company? You know the answer would be Sequoia Capital. It's the same company, a different branch of it and they operate actually quite independently, but it's the same playbook, the same methods that have been taken to China and that's given China a huge boost in creating the early internet companies. And now you know venture capital is kind of indigenized in China. So they've learnt the method, Chinese are terribly good at this. They copy the special sauce, they bottle it, they reproduce it and now you know American investment could dry up, it wouldn't really matter for China because they know how to do it. I think the question going forward about Chinese digital innovation is that the government in the last two years has clamped down on technology companies.

Sebastian Mallaby:

And has you know for example, with the online tuition companies has basically said, we don't want that industry to flourish. We're kind of regulating you out of business. They made a big intervention in terms of screen time for teenagers on video games and social media and they've made it very clear that they want venture dollars to flow into certain sectors like semiconductor development. And all of this has sort of taken some of the freedom out of venture capital and I think there's a question about whether that will distort the playing field, cause some of the talented people to say, they'd rather go try to make money as venture capitalists or as entrepreneurs in the United States or somewhere else, not in China. So I think that's the question looking forward is whether the kind of creeping hand of government in venture capital in China is going to undermine its productivity.

Jim Lindsay:

So what does that mean for American venture capital? There seems to be one tension here, which is that if American venture capital firms are looking to find the next big thing overseas in China, that is going to run smack into a cross-cutting current, which is efforts in the United States to at least selectively decouple the United States economy from China's. How will that play out?

Sebastian Mallaby:

Well, I think we're going to see more decoupling going forward because it's just not a good medium term bet. I mean venture capital bets have a duration of five, seven years or so. You know to...As an American investor, to go into China and believe that you can do a startup, own that startup for five to seven years and then actually cash out and get your money out of the country feels like a pretty risky proposition. So I think there'll be more decoupling where Chinese startups are funded by Chinese capital and also the American investors won't want to be caught in the crosshairs of American regulators who say, why are you out there funding a company like DFJ, the Chinese drone maker when the Pentagon has security concerns about DFJ manufactured drones flying in American airspace. And at the same time, I would advocate for a policy that would make it very hard for Chinese investors to come into the US and invest in US startups, because I just don't see the upside.

Sebastian Mallaby:

I mean there's plenty of capital, we don't need the Chinese capital to back American startups. And why have Chinese venture capitalists sitting on the board of startups that are developing cutting edge technology, if the Chinese investors may then bring that insight back to China and use it to build their tech sector, which is then competing with the American one. Remember a lot of these technologies are dual use. So when you have a big AI company, it might be doing civilian AI for facial recognition so you can log into your computer security or it might be doing surveillance or indeed targeting weapons or what have you. So I do think that decoupling makes sense in this area and so... Although the story of the digital economy, China started with a close link to the United States, I think that link from will atrophy.

Jim Lindsay:

Do you see venture capital firms trying to get ahead of the political current in Washington and to proactively delink or worry about these dual use issues or are they likely to be slow in reacting to the political current you just mapped out?

Sebastian Mallaby:

I think the smart ones, which is actually most of them understand this is clearly happening. I mean a big pivotal moment was that Sequoia Capital had invested in the big tech company ByteDance, which owns TikTok. And when TikTok started to take off with American teenagers, these are sort of you know short form videos that you can share, and it's a bit of a competitor to YouTube or Facebook. Congress was not pleased to see a Chinese owned company having that much of a footprint in the United States and so there was you know a lot of pressure on Sequoia as the backer of ByteDance. And that was a wake up call that you couldn't just blindly go off in China and invest without expecting blow back from American regulators.

Jim Lindsay:

After spending several years investigating venture capital and thinking about how the industry operates, its pluses and minuses, what advice do you have for policy makers in thinking about venture capital? Again, I begin with your overall conclusion that venture capital is sort of a pillar of American innovation. How do you maintain that innovation given that the secret sauce, as you call, it has gone on to other countries? What is it that the federal government should do and perhaps just as important, what shouldn't it do?

Sebastian Mallaby:

I think we want more venture capital in the United States because it does seed these iterative experiments with new technologies. We want that venture capital not to be coming from the government. We don't...I think one can overdo the enthusiasm and if the government starts putting money into early stage bets, that historically has not worked out terribly well. What does work much better is giving sort of tolerant tax treatment of venture capital partnerships. I mean, right now, most of these partnerships are structured with what's called a pass-through entity so that when a venture capital partnership makes an investment in the startup, the startup as well, it generates a big fat capital gain. The tax on that capital gain is paid by the outside investors into the venture capital fund, but there is no tax on the fund itself.

Sebastian Mallaby:

It's called a pass-through entity and that's a benefit. It makes it simpler and also reduces the tax rate. It is a subsidy for a venture capital. If you don't like venture capital, you would be against that. But since I view it as productive, I think that's the kind of tax favoritism that I'm happy to live with.

Jim Lindsay:

Is there anything the federal government should be doing on the tax front or otherwise to promote venture capital, working to develop clean tech given that climate change is real it's happening now and the cost to us and the globe are going to be astronomical?

Sebastian Mallaby:

I think in general, the best way for the government to support venture capital beyond what I just said about tax treatment is to support basic science. I mean venture capitalists are great at applied science and commercializing science. They don't do basic blue sky fundamental research and that's where the government needs to make grants to universities and other research centers. We're pretty good at that in human life sciences. So NIH has got a lot of money. It's more spotty when it comes to hard sciences, and I think the National Science Foundation could use more money to spend on both doctoral fellowships, postdocs, lab resources, and so forth to really double down on basic science in the United States.

Jim Lindsay:

Let me close with a final question, Sebastian, you talk to a lot of people and it's remarkable how many people were willing to sit down and talk about this industry, which is opaque for most people. Do you have a favorite story, favorite person, favorite anecdote that you came away from your many, many hours speaking to people in the venture capital business?

Sebastian Mallaby:

Wow. It's hard to pick one, but you know this is the first one that comes to mind. So when Google was starting, there were these two brilliant computer scientists you know Larry Page and Sergey Brin-

Jim Lindsay:

Graduate of the University of Michigan?

Sebastian Mallaby:

Doctoral students at Stanford, but you may well be right about Michigan before that.

Jim Lindsay:

I'm speaking about his undergraduate degree, which is what I care about.

Sebastian Mallaby:

And there they were, they built this fantastic search engine, Google, which was beating all the other ones hands down, but they had no idea how to make money from that and not much idea how to build a company and so you needed an experienced business leader to come in and it had to be somebody pretty good because these smart founders were not going to tolerate a second best and in fact, they said, we've thought about it very hard and there's one person were willing to have as our CEO and that is Steve Jobs. And you know Steve Jobs was not available because he was running apple. So then they had to be persuaded to take somebody else. And Eric Schmidt was the person who was identified to be the CEO, identified by the venture capitalists, of course, because the VCs, one of their roles is to find talent, to be the talent recruiter.

Sebastian Mallaby:

And I asked Eric Schmidt why he agreed to go work with these pushy young grad students who might fire him at any moment and in fact, they were quite open about their general contempt for business people. And Eric Schmidt explained to me that the reason he went to Google and took the risk with his career was that he knew the venture capitalist had his back, he knew that if Larry and Sergey fired him, which was quite possible, John Doerr, the venture capitalist would slot him into another startup. And I think what that tells us is that the reason people take risks with their careers in Silicon Valley is not some magic substance in the water that they're drinking or in the air that they breathe. The risk happens because venture capitalists de-risk it. And if there's one thought I'd like to leave with listeners is that this venture capital influence on risk taking is truly pervasive and truly profound.

Jim Lindsay:

See, I thought you were going to tell me this story, that four of these six founding members of PayPal built bombs in high school, but I'll take your story in your conclusion and on that note, I'll close up The President's Inbox for this week. My guest has been Sebastian Mallaby, the Paul A. Volcker senior fellow for international economics at CFR. His new book, The Power Law: Venture Capital and the Making of the New Future is out. Sebastian, as always, thanks for coming on The President's Inbox.

Sebastian Mallaby:

Thank you, Jim.

Jim Lindsay:

As a reminder, you can win one of 10 free copies of The Power Law. Just go to cfr.org/giveaway by February 15th to enter and to see the terms and conditions governing the giveaway. You can also find the link to the giveaway on the show notes for The President's Inbox on cfr.org. Please subscribe to The President's Inbox in Apple Podcast, Spotify or wherever you listen and leave us your review, they help us get noticed and improve the show. You can find the books mentioned in this episode, as well as a transcript of our conversation on the podcast page for The President's Inbox on cfr.org. As always, opinions expressed in The President's Inbox are solely those of the host or our guests not of CFR, which takes no institutional positions on matters of policy. Today's episode was produced by Zoe Collis with senior producer, Jeremy Sherlick. Zoe did double duty as our recording engineer. Thank you, Zoe. Special thanks go out to Margaret Gach for her assistance. This is Jim Lindsay. Thanks for listening.

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