The VC Power Law with CFR senior fellow Sebastian Mallaby

Danny Crichton:
I think we are armed and ready to go. Chris, anything else?

Chris Gates:
No, that's it. I think we are ready to go.

Danny Crichton:
Okay, sounds great. I'm going to count myself in because... Well, I guess you're employed to do that so we can-

Chris Gates:
Yeah.

Danny Crichton:
... use you here. Look at that.

Chris Gates:
Look at that.

Danny Crichton:
Unbelievable.

Chris Gates:
Okay, Danny, you ready-

Danny Crichton:
Yeah.

Chris Gates:
... for a count-in? Ready three, two, one.

Danny Crichton:
Hello and welcome to Securities by Lux Capital, a podcast that looks at science, technology, finance, and the human condition. I'm your host, Danny Creighton. And today we have a special guest. First we have co-founder and managing partner of Lux Capital, Josh Wolfe, and senior fellow with the Council on Foreign Relations and the recent author of The Power Law, a look at the venture capital industry, Sebastian Mallaby. Sebastian, welcome to the program.

Sebastian Mallaby:
Great to be with you.

Danny Crichton:
And so Sebastian, you recently wrote this new book, The Power Law just published, I want to say, two months ago, focused on sort of the history of venture capital from the 1970s to today, but prior to that you had written a book called More Money Than God, which was sort of the same kind of book but focused on the hedge fund industry. And I'm curious, when you sort of went from the hedge fund industry into the venture industry, how did you approach it from a writing project? How did you get access to this industry? How did you build up a rapport with the sorts of folks in both categories?

Sebastian Mallaby:
There were different challenges in approaching hedge funds to venture capital. Hedge funds, the challenge was to actually get in the room with people who really didn't want to be bothered and who viewed secrecy as one of their main professional weapons. Why would you tell anybody else about your trading strategies when that would allow others to copy them?

But once you were in the room, people who are very crunchy and analytical about explaining how you beat the market, how you get alpha, how you think about some inefficiency in the market that others haven't spotted. It's a highly analytical world. Emotional intelligence is not a big part of it. It's all about some sort of formal theory of market inefficiency.

With venture capital, it was relatively easy to get to see people because it's a networking kind of business. Everybody introduces everybody to everybody else, and it's kind of impolite to refuse an intro if you're connected over email, because I kid in the book, VCs, what they do is they make and they take intros, right? They get up in the morning, they have breakfast with one person, and then 14 cups of coffee. Hopefully decaffeinated.

Josh Wolfe:
15 over here.

Danny Crichton:
I was going to say, that that's like a 2010 amount of coffee, not a 2020 these days.

Sebastian Mallaby:
Okay, all right. Well, so it's decaf chai or something. But there are a lot of meetings, right? That's what you need to do in VC. You need to constantly build your network, constantly be thinking about who might you invest in next, who could be the first five employees for the company you backed last week. It's about connecting the dots in human terms.

And so, getting to see people was I think a bit easier but then understanding what the secret sauce was, was a whole lot harder. Because I think venture capital is not a particularly self-analytical world. There's a lot of instinct, there's a lot of subjective judgment in choosing which projects to back. At least on the surface there were a lot of, "Oh, I met this founder and we kind of connected because he liked biking and I liked biking," and that really is not how you generate alpha.

So, I had to get beyond the surface stories and that was, maybe took a bit more legwork than it did in the case of hedge funds.

Josh Wolfe:
One of the interesting things in dissecting a hedge fund manager and AVC manager, hedge fund manager, you can look and they can dissect the trade, they can dissect the valuation of a company. There's actually quantitative data that they might have as an input that leads to an output of a decision to buy or not buy or how much they're going to buy, how they're going to size a position. Oftentimes when we're funding, and I imagine the vast majority of the folks that you spoke to, there is no data.

It is often before a company's even formed. There's no revenue, there's no profits, there's no multiple you're applying to earnings. It is the sort of subjective judgment about a person. What were some of the traits that you saw as common characteristics in talking to all the different venture folks, and through generational changes over the different VCs that you talked to that were at their peak 20 years ago versus today? What were the traits that they saw in founders, and what was the traits that you saw in them?

Sebastian Mallaby:
I think the type of founder that venture capitalists look for varies and should vary by industry type, company type. So at the beginning of my story in the '60s and '70s, it was hard science projects, semiconductors, writing equipment, and there was a large premium placed on people who had come out of the right engineering school or the right engineering background. So, if we take the founders of Fairchild Semiconductor and then Intel, they had been hired by somebody who'd been at Bell Labs who got a Nobel Prize.

That kind of hardware networking pedigree was very important. When you fast-forward into the more recent history when you're building, let's say, a social network like Facebook, the actual coding was a bit challenging, but that was not the main thing. The main thing was to have an idea for a product and to scale it very fast before other people competed with you, to move fast and to break things. And that took a more kind of young, driven, obsessive rebel as opposed to an older, credentialed, absolutely top-quality engineer.

The Mark Zuckerberg profile was different to the Gordon Moore or the Bob Noyce profile, different kind of company, different kind of founder.

Josh Wolfe:
In public market investing and in hedge funds, the liquidity pool, whether you're doing a macro trade or you're buying gold or you're shorting the [inaudible 00:05:57], they're enormous, they're non-zero sum. Obviously somebody wants the intellectual credit, they want to be first, they want to be earlier. Whereas in venture, there it's a total zero-sum dynamic.

And what's interesting is you talked before about the secrecy of a lot of the hedge funds, right? They're very secret about their trades. They don't want other people to know. And maybe that's because everybody else could do it, whereas in venture, people tend to be of course more boastful once you're in, because it doesn't matter that other people can't get the access. And it's a weird thing because you want to claim ownership very early on, but you're often gamed theoretically doing lots of syndication.

You are inviting co-investors in with the expectation that in future deals or future rounds that there's going to be some sort of reciprocity. Any insights on that dynamic of the game theory of the zero-sumness of venture?

Sebastian Mallaby:
It's interesting how you put that because you're right that in some ways you are either in the venture deed or you are not. And if you are in, probably somebody else got squeezed out. And so it's zero-sum in that sense. In another sense, venture is positive-sum, right? Because somebody else can come into the next round and you are creating wealth when you're doing startups, you're creating new businesses. And so it's very much positive-sum as a sector.

So it's interesting, but I think you're right that differences between the two sectors wind up driving different kinds of behavior. In hedge funds you can be this sort of solo secretive operator, whereas in venture capital, having other people come in in the next round is kind of what you want. In hedge funds space, having other people come in after you is really not what you want because the trade will be crowded and it'll be dangerous and difficult to get out. And it's actually much better for you if you're alone in discovering a source of profit in the public markets.

You've got secretive actors in hedge funds, you've got more open actors in venture capital. You've got in some ways I think more zero-sum oppositional behavior in hedge funds because if I win, the other trade is lost. Whereas in venture, although there's that kind of competition to get into the deal for the rest of the time, this great technology tide will lift all the boats.

Danny Crichton:
I mean I would add in as well in the hedge fund industry versus venture, you're dealing with continuous investing versus discrete investing. In venture, there's these moments once a year, once every two years for a particular company where you can buy equity, get around the cap table, everyone sort of shows up as part of that process. Whereas in hedge funds you don't have to do the entire trade in an hour if you don't want to, you can space it out, you can do it over six months, you can do it over a couple weeks.

Josh Wolfe:
You can reverse it.

Danny Crichton:
You can reverse it-

Josh Wolfe:
Right.

Danny Crichton:
... you can undo it. So you have a lot more flexibility of scaling up and scaling down. I really noticed this when I was helping out a venture firm in the crypto space because that world kind of fuses these two together. You have this active trading on tokens where you can sort of buy and sell at any time, but you're also buying equity and you have that discrete, I have this moment now I'm going to do my pro rata. Do we go in or not? And I'm not going to be able to reverse that decision basically ever unless you do a secondary trade.

But Sebastian, my colleague Alex pointed out his favorite phrase in your book, The Power Law was, "He sees a machine for manufacturing courage." And that is not a phrase I think we would ever use to describe the hedge fund industry. I don't think anyone's ever said the hedge fund industry is manufacturing courage except for maybe an activist trader at some sort of Milken conference or something of that scale. I'm curious what you meant by that.

Sebastian Mallaby:
When I'm thinking about entrepreneurial courage and what I'm sort of trying to suggest is that it's really tough to be an entrepreneur, and it's super risky. It's quite lonely, and you may well work incredibly hard for a few years and end up with nothing. And indeed, we know from the statistics that most startups fail, it's really daunting.

And the way to reduce the hurdle to being an entrepreneur is to have an experienced venture capitalist who comes along and doesn't completely de-risk it, but does do some de-risking. So a conversation might go, the would-be founder who's thinking about whether to set up a company says, "If I do this project, I'm going to need to hire five really great engineers to help me build a project and I just don't know where we're going to find them." And the venture capitalist says, "Yeah, well, I've got a network and I'll help you to identify who you want to hire."

And then the would-be entrepreneur says, "Yeah, but it's risky to join a startup. And these great engineers that I'm going to want to hire have wonderful jobs at Google. They're being paid a lot of money. It's very secure. Why would they join me in my startup when it could just go down the tubes?" And the venture capitalists will say, "Yeah, it's true. Startups do fail, but I'm going to tell these people, 'Listen, startups might fail, but I'm backing several of them. And if you do well at this one, even if it goes wrong, I'll find you a job at a different startup.'"

And so people often say, "Gee, Silicon Valley has this amazing culture. People there think that failure is just a learning experience. They must be drinking something crazy in the water." And my answer is, "No. They're not drinking something crazy in the water. They are being backed by venture capitalists who give you a second chance." Eric Schmidt said to me he would not have joined Google as chief executive officer if the venture capitalist John Doerr had not said to him, "Eric, if those young founders Brin and Page bounce you out, I will get you another job as a CEO at another Kleiner Perkins portfolio company."

That's what I mean by "Machine for manufacturing courage." It still takes guts to be in the startup world, but I think it's easier to do if you've got the venture capitalists at your back.

Josh Wolfe:
I do think in both of these books chronicling More Money Than God, the hedge fund industry and now in Power Law: VC, you got incredible access to some of the great historic leaders and figures in these fields that as you note were historically secretive. What in this process, when you went in, and you didn't come in as a total neophyte, what was most surprising or shocking? What sort of tidbit did you not put in the book that you could share with us? Something that sort of shocked you about a person, a decision, something that sort of hasn't come out publicly?

Sebastian Mallaby:
Well, there was a funny moment when I was doing research on Arthur Rock, who is the sort of origin founder of the West Coast venture capital industry. And he's a pretty straight-laced guy who came out of Harvard Business School, went via a New York brokerage company, and then set himself up as a venture capitalist on the West Coast in 1961. Not an effusive character, quite a 1950s sort of figure.

And I was doing this research in his office, reading his archives and going through all the letters he wrote to the founders of Fairchild, which then morphed into Intel and asking him about his investment in Apple and so forth. And I was in his office in San Francisco and I suddenly saw this check, a hundred-dollar check written to him and signed by Hunter S. Thompson. And it was framed and I said, "Hunter S. Thompson, what's up with that? Did you know him, Arthur?"

And he said, "Oh yeah, he was a good friend." I invested in Rolling Stone Magazine. This led me on a path where I looked up with the help of a researcher, all of the references to Arthur Rock in Hunter S. Thompson's writings. And it turns out there's quite a few of them. And there's this story about how when they first met in Aspen, Hunter S. Thompson shows up with a ruck sack full of raw meat, which he dumps on the floor by Rock's feet to try to gross him out and make him, it basically was a test for this stiff, traditional financier.

And Arthur Rock just ignored the disgusting smell coming from the ruck sack and carried on talking as if nothing was strange until finally Hunter says, "Don't you realize there's a bunch of maggot-filled meat at your feet?" And Rock smiles happily because he's won the game of chicken. So there was a whole riff about this, and I wrote about, I don't know, three or four pages about the relationship between Hunter Thompson and Arthur Rock. But in the end it was an amusing digression. It was also a digression. It didn't really teach you anything about investing.

So I cut it out.

Josh Wolfe:
Fear and Loathing in Los Altos.

Sebastian Mallaby:
Exactly.

Josh Wolfe:
What were you most skeptical about as you met sort of modern captains of industry in the venture world out in the Valley or out and about? What were you most skeptical of the claims that some of the partners were making?

Sebastian Mallaby:
Well, there's one specific, very provocative line of argument that Peter Thiel makes, which is, it's a total waste of time for a venture capitalist to try to engage with a portfolio company after investing. Peter Thiel makes a logical case for this, and he basically says, "The founders who are going to want your help are going to be the ones who are in trouble. And the ones who are in trouble are never really going to make a difference to your portfolio returns. And the ones who are going to hit it out of the park and do 20x, 30x times your capital, those guys are too good. They don't need your help."

And so therefore, if you make it a rule to basically ignore all calls for help, your investing will go much better than if you waste time trying to help people who will never really make it.

Josh Wolfe:
This is how you sleep train a baby, by the way. Ignore all cries for help.

Sebastian Mallaby:
So that was the provocative thesis that Peter Thiel explained to me. And I was always a bit skeptical about Thiel's claim, even though I could see the logic. And recently I had the opportunity to go speak to him and he kind of said, yeah, he'd backed off that view and he wasn't so sure that completely ignoring founders was the right approach.

Josh Wolfe:
One of the interesting things as you talk about that with Don Valentine and Cisco, one of the reasons I think that the path dependence in venture capital is not only reputationally where a founder says, "Oh, from the VC that brought you," just like in the movie business, they want to work with people that confer success and status on them. Is that, if you take something like Cisco, Cisco acquired just under Mike Volpi, something like 70 companies during the.com boom and the optical networking boom in the late nineties, early two thousands.

And then Volpi would go on to become a partner, very successful at Index. A ton of Sequoia companies were acquired by Cisco. And in the same way that their backing of Google, a ton of Sequoia companies were acquired by Google. It's a very interesting path, positive feedback where a big successful exit maybe get a whole series of future big successful exits, even unattributable to the individual partner.

But having the key decision-making apparatus in place, having begot success and conferred it to somebody that's now in a position of power inside of a large tech company to make future acquisitions is a very interesting phenomenon.

Sebastian Mallaby:
I went to speak to Mike Volpi about that, and I had heard all kinds of stories to the effect that these Cisco, they called them "spin-ins," I think, where basically they would back an outside entrepreneur to develop the next iteration of optical networking. And then if it worked, they would spin the company in. In other words, they would just buy it.

And there was said to be a certain amount of pre-planned collaboration with Sequoia because Don Valentine, the Sequoia founder, having initially backed Cisco, Cisco then went public and he remained on the board somewhat unusually, of Cisco, long after it was public. So he was privy to all the planning in terms of what was the next wave of technology that they wanted. So he was in a position then to get Sequoia to fund these outside entrepreneurs who might then be acquired by Cisco later.

Josh Wolfe:
And interestingly, it is at that point of conception of a company or funding of it, it is legal form of inside information and a very powerful one.

Sebastian Mallaby:
I was thinking of writing about this in my book and turning it in into a story of kind of network entrenchment. Sequoia is very good at network entrenchment, meaning even if you already have a fabulous network, you think of ways to make it even more fabulous. And they did that by founding the scouts program. So network entrenchment is a big story, but the reason I didn't go down that path in my book writing about Cisco is that funnily enough, the venture capital operation that made the most money out of selling stuff to Cisco was undoubtedly Kleiner Perkins.

Because by doing the same thing, but in an adversarial way, Vinod Khosla, who was actually the most successful of all the Kleiner Perkins partners, even more successful than his partner John Doerr, he would back fledgling networking ideas. He would refuse to sell them to Cisco on the first offer. He would turn down the second Cisco offer, and then he would sell it for like $7 billion on the third offer. So he had three amazing outcomes by selling stuff to Cisco during the 1990s. It made him the top venture capitalist in the world. And so actually the kind of collaborative thing going on between Sequoia and Cisco matted less than the Kleiner Perkins adversarial approach.

Danny Crichton:
I mean, we're talking about Sequoia Kleiner, and you've covered the industry for 50 years. We had big news recently that Sequoia was moving over its top leadership. Doug Leone, who has been the senior steward for a decade, is moving on and is being replaced by Roelof Botha as senior steward. And I'm curious, when you think about succession planning, I mean, it's not something that I think we hear often in the hedge fund industry. There's not this sort of, at least from my perspective, as someone who doesn't focus on the hedge fund industry very often, there's not this same sense of continuation.

New fund managers go and start their own shingle. They go out on Wall Street and just trade with their own cash. Whereas in the venture industry of these established franchises that try to renew generation after generation, I'm curious, are there secrets to that generational renewal? Have folks figured out the playbook in some cases? Why is the venture industry so focused on that versus going out and building your own thing?

Sebastian Mallaby:
When you have a partnership, you're some of the way towards creating franchise value. In other words, the value of the VC firm is bigger than just the sum of the expertise and excellence of the individual partners. Because when they collaborate together and they team up together on deals and they advise each other on how to help portfolio companies, they're actually creating something bigger and better than they could have done individually.

Which is why I think, by the way, parenthetically, the solo VC model, which is extremely trendy right now, has limitations. I don't really believe it's going to supplant the traditional partnership structure. Venture capital partnerships are, I said, "some of the way" to creating franchise value, they're not as far along that path, let's say, as a thematic quant fund, right? In hedge fund space, when you train the algorithms to trade for you and then the computers are pretty much doing the trades by themselves, and you just need to hire a strong team of computer scientists to keep updating the algorithms with new signals.

I mean, that is serious franchise value. You've got, the trigger puller is the computer at this point. So venture capital is in this middle space. Is it a franchise or was it a kind of gang of individuals? And Sequoia is a great example of a partnership that's managed to push it towards real franchise value because it creates talent internally really, really well.

And Roelof Botha told me stories about how this worked when he joined as a young investor at Sequoia. He was around in his late twenties. He had an incredible background for being a venture capitalist. I think he was top of his class at Stanford Business School, and he'd been the CFO at PayPal. He then joined Sequoia and he was this super talented guy, but he'd never done an investment. Sequoia deliberately set out to turn a talented person into a talented investor.

And so for example, when Roelof Botha brought his first investment in, which was a remittances company called "Xoom" with an "X" at the beginning, there was a partnership established between him and the oldest partner, Pierre Lamont, who went to the board meetings of Xoom together. Initially Pierre Lamont was the board member. Roelof was the understudy. And the idea was that Rudolph would learn by watching. And then if Xoom looked like it was heading for a successful exit, they would switch positions so that when the exit came, the glory would accrue to the younger guy Roelof, and his brand would be burnished, and that would set him up to do more prestigious deals in the future.

So that tie-up with Pierre Lamont helped Roelof to become a branded investor. And so there are a bunch of things that are done within Sequoia to nurture talent and then therefore raise the next generation that can take over the franchise.

Josh Wolfe:
What were some of the repeated mistakes that you saw, not just in looking at the successes and the best practices, and whether it was self-admitted by the partner you were interviewing or your own observations, that caused some of the great franchises over time to not, as Danny was noting, succeed successfully, that did not continue? What caused their decline?

Sebastian Mallaby:
The archetypical case study is Kleiner Perkins, which was the dominant partnership in the 1990s. As of 2001, the Midas list showed Vinod Khosla as number one in the world, and John Doerr his partner at number three. They were super dominant. And if you then look 20 years later at the Midas list, you find only one Kleiner Perkins partner in the top hundred. And that was John Doerr somewhere around number 77, a real transition from hero to zero. And what went wrong?

What went wrong was that instead of a balanced partnership, Kleiner evolved into a one-man band. John Doerr had in the 1990s had his sort of magnetic messianic brilliance balanced by Vinod Khosla, who was equally charismatic. And so there were two visionaries at the top. They didn't always agree, and that was a good balance. And then in addition, there were other investors at Kleiner who were perhaps a bit less on the visionary side, but had the standing that they could challenge both Khosla and Doerr and sort of point out the negative possibility, the failure that might happen.

And so there was a real discussion around the table. Then you move into the early 2000s and all those experienced players, apart from John Doerr himself, basically, don't all, but most of them leave. And their shoes are filled by either young people starting out who don't have the stature to challenge John Doerr, or seasoned tech professionals who have been well-respected as senior salespeople at big software companies, but did not have investment experience.

And the result was that when John Doerr decided he wanted to go all in on cleantech, there was nobody there to challenge him, to reign him in to say, "Okay, but let's be careful about certain kinds of risks." And so Kleiner just overdid it. And the Cleantech thing went badly. There was an internal cultural problem and that's why I kind of went from the top of the game to somewhere around the middle of the pack.

Danny Crichton:
Sebastian, I know we're running out of time and we're coming to the end of the show. You've written about hedge funds, Alan Greenspan, venture capital, all these very, very interesting aspects of the modern economy. I'm curious, as you project for 2020s next book project, next research line of inquiry, what what's intriguing you these days?

Sebastian Mallaby:
I can't help being very intrigued by the whole crypto Web3 blockchain world, exactly what storyline to take. I'm not quite sure yet. And clearly the challenge for me is going to be that some of the potential angles will turn out to be nothing, right? 'Cause it's so fast-changing, evolving all the time. Something that feels exciting in 2022 may be forgotten by the time any book I write would come out. So it's a challenge, but I'm going to find my way through that and figure out a way to do it.

Josh Wolfe:
Sebastian, you will be pleased to know that just as you were speaking, we minted the first NFT of your to-be written book and we are the proud owners of it.

Sebastian Mallaby:
And I can buy it for a mere $50,000, right?

Josh Wolfe:
We'll discuss offline.

Danny Crichton:
Well, thank you so much, Sebastian Mallaby, senior fellow at Council on Foreign Relations and the author of The Power Law, recently published, a history of the venture capital industry. Thank you so much for joining us.

Sebastian Mallaby:
Great to be with you.