Bankers—the intermediaries between people who have more money than they need for immediate purposes and those who have less—tend to be conservative types. They dress soberly: The classic uniform of a British banker is a navy blue three-piece suit, a bowler hat, and a furled umbrella. They have steady, moderate habits, showing up at work and leaving at the same time every day, five days a week. Above all, their business model is conservative. They furnish money only to people they carefully scrutinize. A systematic study of the borrowers’ assets and credit histories must give the banker confidence that those borrowers will repay the loans they receive, along with the interest on the loans that is the source of the banker’s profit. Conventional financial intermediaries usually distribute capital to many recipients, and almost all of the distributions generate moderate returns. The sum total of a great many such investments creates a safe, reliable business.
One group of financial intermediaries, however, does not conduct its business at all like this. When the people in this category of bankers advance funds to recipients, they do not charge interest, instead taking equity stakes in the projects they are financing. They do not scrupulously evaluate the assets of recipients, who sometimes have no assets to speak of. They do, however, engage in the far more subjective analysis of the character of those to whom they provide money, often seeking traits of personality—boldness and a penchant for risk-taking, for example—that to conventional bankers would be a flashing red light, warning of projects to be avoided.
The common name for this unconventional group of financiers emphasizes its dissimilarity to ordinary finance. Its practitioners call themselves “venture capitalists” (VCs)—the first word being an abbreviation of “adventure;” and in their professional lives, adventurous is the last thing that standard, conservative bankers wish to be. In a further departure from conventional banking practices, venture capitalists do not expect all the projects they support to become profitable and repay the money they have advanced. To the contrary: They anticipate that most of their investments will fail to do so.
This unusual business model depends on making a few spectacularly successful investments along with the vast majority that do not pay off. Not unlike Hollywood movie studios and investors in Broadway plays, VC portfolios consist of many failures and a few blockbusters. As in the entertainment industry, the VCs do not know, at the outset, which projects will be hits and which ones will be flops; they therefore have to accept a lot of losses to come up with a few winners. Among the few winners, however, there are sometimes spectacular successes. The pattern that governs the VC business, in which the vast majority of the profit—a standard figure is 80 percent—comes from a small fraction—20 percent, or even less—of the investments, is called the “power law.”
This pattern has made the leading venture capitalists, most of them located in Silicon Valley, very wealthy. In becoming wealthy, moreover, they have helped to change the world. They have funded many of the most successful and, in their impact on society, the most influential companies in the United States and the world of the past four decades: Apple, Google, Facebook, eBay, and Uber, among many others.
The Power Law is the title that Sebastian Mallaby has given to his lively, informative, and provocative history of venture capitalism from the late 1950s to the beginning of the present decade. With this book the author, a London-based senior fellow of the New York-based Council on Foreign Relations, continues his career as an astute and authoritative chronicler of contemporary finance. The subjects about which he has written in the past include the World Bank (The World’s Banker, 2004), hedge funds (More Money Than God, 2010), and the longtime chairman of the American Federal Reserve, Alan Greenspan (The Man Who Knew, 2016). In the current book he describes how the venture capital industry has evolved over the decades. He gives special attention to its most successful practitioners, some of them almost as colorful as the entrepreneurs, such as Steve Jobs, whom they have assisted in becoming multibillionaires.
The power law governs the activities of venture capitalists because they are in the business of funding not simply better or cheaper versions of what is already available in the marketplace but instead new, different, sometimes transformative products and processes. Because the successful projects of this kind have little or no serious competition in the markets they enter, or sometimes actually create, they become the only game in town, establishing highly lucrative monopolies. Venture capitalists and their clients, that is, are in the business not of building a better mousetrap but, as one of them put it, of “discovering the future.”
The digital revolution forms the technological context in which venture capitalism emerged. Most of the companies it has helped to build have had something to do with silicon, microprocessors, computers, and the Internet. The very first firm over whose launch the earliest venture capitalists presided was Fairchild Semiconductor. In addition, two particular features of venture capitalism have made major contributions to its success.
First, unlike most conventional bankers, venture capitalists supply more than money to the start-up companies in which they invest. They act as coaches, furnishing advice on staffing, management, marketing, and other aspects of each business. The entrepreneurs in whom they invest often need such advice, since many have inspired ideas but lack experience in managing a functioning company. Second, the venture capitalists are in a position to provide these services because their firms are embedded in a network of like-minded people with relevant skills, whom they can connect with the fledgling businessmen and women.
Will this unusual form of financial intermediation continue to play a major role in the American and the global economies? If it does, it will not be confined to Silicon Valley. Venture capital firms have appeared in other parts of the United States and in other countries—notably China—as well. There are, moreover, reasons for skepticism that this particular financial model will endure.
The start-up entrepreneurs that the venture capitalists have funded were able to flourish in part because of what is known as the “Innovator’s Dilemma.” Larger, better-established, richer companies in related fields were reluctant to develop new products that would displace the ones they were already selling and on which their financial health depended. This left room in the marketplace for newcomers. The large tech companies that venture capital initially supported, however, seem either not to be swayed by this consideration—they invest a great deal in the search for disruptive products—or are able to overcome the problem by using their massive resources to purchase and control start-ups that have the potential to threaten their profits.
More broadly, it is conceivable that the evolution of technology is entering a phase in which economic advances will depend on marginal improvements emerging from big investments by large firms or governments rather than great leaps forward based on the ideas and visions of exceptional individuals. The “green” technology necessary to move the world away from reliance on fossil fuels, for example, seems largely to fit this description. To the extent that this turns out to be the case, the VC business model won’t work. Mallaby himself takes the contrary view. He expects venture capitalism to continue to flourish, because, as he puts it, today “much corporate investment is intangible: capital goes into R&D, design, market research, business processors, and software. The new intangible investments fall squarely in the sweet spot of VCs.”
Mallaby has written a compelling account of venture capitalism from its origins to the present. Whether The Power Law turns out to be the story of one particular episode in the history of finance, in which an eccentric but important kind of banking rose and fell, or instead the chronicle of just one part of the history of venture capitalism, a history that extends well into the 21st century and perhaps beyond, will have to be left to the future to reveal.
Michael Mandelbaum is the Christian A. Herter Professor Emeritus of American Foreign Policy at the Johns Hopkins School of Advanced International Studies, a member of the editorial board of American Purpose, and author of a forthcoming history of American foreign policy, The Four Ages of American Foreign Policy: Weak Power, Great Power, Superpower, Hyperpower, which will be published in June.
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