A history and defence of venture capital in “The Power Law”

The Power Law. By Sebastian Mallaby. Penguin Press; 496 pages; $30. Allen Lane; £25

NOT EVERYONE is a fan of venture capitalists (VCs). One academic famously questioned whether they were “soulless agents of Satan, or just clumsy rapists?” Paul Graham, the co-founder of the Y Combinator startup incubator, published a “unified theory of VC suckage”, in which he likened the industry’s investment process to a body-cavity search by someone with a faulty knowledge of anatomy. Venture capitalists, he concluded, resembled classic villains: “alternately cowardly, greedy, sneaky and overbearing”.

More recently, VCs have been blamed for propagating some of the ills of Big Tech: the monopolisation of markets, the erosion of privacy and the degradation of workers’ rights in the gig economy. By prioritising growth over governance at all costs, they stand accused of feeding a recklessly aggressive capitalist culture that contributed to scandals at Uber, WeWork and Theranos.

In “The Power Law”, Sebastian Mallaby acknowledges some of the industry’s shortcomings, most notably its shocking lack of diversity. But he zealously defends the overall achievements of the VC industry, which has funded many of the modern world’s most useful inventions (search engines, smartphones, vaccines), disrupted cosy monopolies and generated eye-popping wealth. He even claims that VCs have emerged as a “third great institution of modern capitalism”, combining the organisational strengths of companies with the flexibility of markets. Little surprise that the VC model has now gone global, with particularly striking results in China.

In his well-researched book, leavened by lively portraits of leading figures, Mr Mallaby explores the history of the VC industry and the reasons for its vitality. A journalist at The Economist in the 1980s-90s (and husband of the current editor-in-chief), he previously wrote a study of the hedge-fund industry and an acclaimed biography of Alan Greenspan.

Some histories of Silicon Valley, such as Margaret O’Mara’s “The Code”, have emphasised the importance of American military spending in seeding the west-coast tech industry. Mr Mallaby’s focus is overwhelmingly on the entrepreneurs, investors and firms that nurtured its growth. Much of the VC industry’s success is attributed to its mentality. In evaluating investments, VCs still take after the pioneering Arthur Rock, who zeroed in on the “intellectual book value” of a company rather than the financial kind. They accept extreme financial risk, embrace immigrants and tolerate nerds and misfits, who account for so many successful entrepreneurs. Four of PayPal’s six early employees reputedly built bombs in high school.

While VCs love backing companies that enjoy so-called network effects, they benefit from their own version of this phenomenon, too. Sand Hill Road, where many of the leading VC firms are clustered, may have the air of a row of gentlemen’s clubs but it has enabled the free flow of ideas, favours and connections. That is partly why the Silicon Valley model has been so hard to replicate elsewhere.

As the author describes, the VC world has experienced considerable churn in the past 60 years and has lately been disrupted as much as it has been disruptive. Capital-rich outsiders, including DST Global, SoftBank and Tiger Global Management, have all muscled in on what was once a cottage industry. By deploying masses of money later in the investment cycle, these indulgent newcomers have enabled startups to delay listing on public markets. In Mr Mallaby’s view, that trend partly accounts for the misgovernance at some scandal-ridden tech companies because it has cut the ties between interventionist VC investors and freewheeling entrepreneurs.

Some west-coast VC firms, such as Sequoia Capital and Andreessen Horowitz, have responded to the new challengers by raising ever-bigger funds and diversifying, both geographically and sectorally. This has only fuelled talk that Sand Hill Road is becoming the new Wall Street. Yet even the biggest traditional VC firms remain tiny compared with giant public-market funds. Some investors wonder why they should bother with risky VC bets when the returns in public markets can be so spectacular.

Take Apple, which recently popped above $3trn in market value compared with the $1.8bn it was worth when it floated in 1980. It seems improbable that the VC industry, which has helped so many startups to “blitzscale”, can ever do so itself. ■

John Thornhill We identify the reviewers of books connected to The Economist or its staff. Mr Thornhill is Innovation Editor of the Financial Times.

This article appeared in the Culture section of the print edition under the headline “Risky business”