Sebastian Mallaby: harnessing the Power Law for private companies

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The heroes of American ‘big tech’, those who get kudos for its extraordinary success, are the founder-leaders – the likes of Jeff Bezos, Mark Zuckerberg and Elon Musk. Sebastian Mallaby argues that their early backers also deserve much of the credit.

We meet in central London, where Mallaby is taking part in a Baillie Gifford clients event themed on private company investment opportunities. He recently wrote The Power Law: Venture Capital and the Art of Disruption and is there to share his expertise on the role VC firms play in the broader private markets ecosystem, in which Baillie Gifford is active.

The ‘power law’ of the book’s title is also called the Pareto principle and is based on the idea there is an 80-to-20 precept at work in the universe. For example:

• 20 per cent of the population owns 80 per cent of the money
• 20 per cent of a business’s customers typically account for 80 per cent of its profits
• 20 per cent of drivers cause 80 per cent of traffic accidents

The actual numbers may not be pinpoint precise, but the general ratio holds true.

Mallaby explains that Silicon Valley ‘adventure capitalists’ know the distribution of their returns from investing in startups obeys the power law. Most will fail completely.

“But,” he adds, “each year brings a handful of outliers that hit the proverbial grand slam, and the only thing that matters in venture is to own a piece of them.” For venture capitalists, that means making audacious private bets on companies, often without a track record on which to judge them.

Mallaby grew up in Britain before moving to Washington, DC to work for The Economist and later The Washington Post. His previous books include an account of James Wolfensohn’s time as the World Bank’s president, a prize-winning biography of Federal Reserve chairman Alan Greenspan, and a history of the hedge fund industry.

For a his latest take on modern financial history, he sought to explore an asset class that he says was rising in importance but underexplained.

“I thought venture capital was the most exciting part of private markets,” Mallaby tells me.

“But I felt as if it was very opaque. There was a mystery story that had to be unravelled.” So, he organised some introductions from friends and colleagues and went to Silicon Valley.

Investing with intuition

Once there, Mallaby quickly sensed that the venture guys (and they were mostly men) invested in people as much as technology. The most original would-be entrepreneurs tended to be the most difficult characters – “arrogant, misanthropic or borderline crazy”, in one memorable phrase.

Valley investors are on the lookout for evidence of staying power and “immigrant grit”, as Michael Moritz, former chief of VC firm Sequoia Capital, once put it, often having a preference for entrepreneurs born outside the US.

They also network relentlessly, cooperating and sharing ideas rather than hoarding them. “Network entrenchment, which gives you deal flow, is one thing that differentiates very successful venture capitalists from the rest,” Mallaby comments.

Other types of investors also back private companies. But venture capital does it early and when there is high risk involved, often using money raised from large institutions such as sovereign wealth funds, family offices and trusts. (Members of the public typically can’t invest directly.)

For example, the payment company Stripe attracted ‘seed’ investment from Valley venture firms Sequoia Capital, Andreessen Horowitz and SV Angel just months after its founders Patrick and John Collison had committed to it full-time in 2010. And Sequoia followed this with further capital over subsequent funding rounds.

The Collison brothers ticked a lot of venture boxes. They were immigrants from Ireland (tick). They had already launched and sold another business (tick). Their technology had a large target market with natural protection against competitors (tick).

The Collisons think they ticked another box (“pluck”) when Sequoia’s Michael Moritz learned Patrick cycled everywhere and clocked a keen time on a tough local hill climb. Sequoia was alerted early on to the Collisons thanks to its assiduous networking. One of the scouts who tipped off the venture firm was Sam Altman, later chief executive of artificial intelligence researcher OpenAI.

Mallaby notes that by 2021, Stripe was valued at $95bn and Sequoia’s stake $15bn. Baillie Gifford first invested in Stripe, now one of its largest private holdings, in 2019.

Manufacturing courage

Openness, aggression and belief in the power law distinguish Silicon Valley from the other home of US venture capital, the more secretive Boston, Mallaby suggests. And that helped give the west coast variant the upper hand in the 1980s.

Mallaby recalls a Boston venture capitalist who boasted that only two of his 40 investments had lost money. “If you said that in California, they would think you were an idiot,” he says. “Silicon Valley thinks failure is a learning experience and is willing to give you a second shot.”

Early Silicon Valley venture deals centred on capital-intensive industries, including silicon chips and other electronics hardware. Then, the focus shifted to less capital-intensive code. “Software is eating the world,” as Valley investor Marc Andreessen put it.

Some venture software successes were epic. Sequoia and Kleiner Perkins each invested $12m for 12.5 per cent of Google in 1999. When it floated in 2004, the search firm was worth $23bn.

Kleiner Perkins performed another service, which became part of venture capital’s repertoire, by persuading experienced businessman Eric Schmidt to become chief executive. It did this by promising him if the move didn’t work out, it would find him an equally good job elsewhere in the Valley.

“They derisked the decision to start the company, and then they derisked Schmidt’s decision to join,” Mallaby says. “Venture capital is a machine that manufactures courage for entrepreneurs.”

Entrepreneurial evolution

Some entrepreneurs went from courting the leading venture capitalists to disdaining them – calling them “greedy” and “overbearing”. Mallaby tells of how Facebook’s Mark Zuckerberg turned up late for a meeting with Sequoia in 2004, wearing pyjama bottoms and with a slide deck of 10 reasons why the VC firm shouldn’t invest in his company.

One of Zuckerberg’s partners had previously fallen out with Sequoia, so he had no intention of accepting its investment. Facebook could do this because sources of capital had diversified with the arrival of more venture capital firms and ‘angel backers’ – successful entrepreneurs supporting other startups.

Mallaby says that trend accelerated after the 2008 financial crisis, once regulators restricted Wall Street’s public trading profits. Over the following decade, he notes the number of US venture investors more than doubled, as did the number of startups they backed.

Other later-stage investors have also become involved. That has allowed private companies to stay private longer, focusing on their long-term goals rather than quarterly financial reports. However, Mallaby raises concerns as to whether this sometimes leads to less external oversight of the firms’ management.

“If you care about your returns, across a whole bunch of these growth companies, you probably want the sector as a whole to have better corporate governance. So, I think there is a discussion [to be had],” he says.

And indeed, this was one of the topics later covered at the clients event in the context of Baillie Gifford’s own focus on the importance of high-quality conversations and other engagements with its holdings.

AI and biotech

While private markets flourished during the low interest rate years, higher rates have done them no favours. Mallaby thinks this needs to be put into perspective, however.

“For venture capital, the prospects for a particular technology are much more important than the cost of money,” he insists. “Innovation and disruption can massively outpace anything as mundane as higher interest rates.”

Disruptive companies will continue to be the story of the future, he suggests, as artificial intelligence develops and biotech gets even more exciting.

“Technology is going to remain the exciting story in how you generate growth,” Mallaby concludes.

“It’s not going to be leverage, it's not going to be globalisation. It's going to be tech.”

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