The Power Law with Sebastian Mallaby

Greg Dowling: 0:05

Welcome to the FEG Insight Bridge. This is Greg Dowling, head of research and CIO at FEG, an institutional investment consultant and OCIO firm serving nonprofits across the U.S. This show spans global markets and institutional investments through conversations with some of the world's leading investment, economic, and philanthropic minds to provide insights on how institutional investors can survive and even thrive in the world of markets and finance. For the past couple of summers, the FEG research team has selected a book to read and discuss together. This year, we selected the book, The Power Law by Sebastian Mallaby. With as much interest as there's been with the private markets, we decided to open it up to our clients and our friends. Sebastian Mallaby is the Paul Volcker senior fellow for international economics at the Council on Foreign Relations. He began his career as a journalist working at the Washington Post, before spending 13 years at the Economist. He is best known as an author, publishing five books. His most notable book, The Man Who Knew: The Life and Times of Alan Greenspan, was the winner of the Financial Times book of the year. And my personal favorite is More Money Than God. Today. I get the chance to get into the mind of Sebastian. I have the opportunity to ask the author about his background, his craft, the latest book, and thoughts on the venture capital industry. So do not miss a minute. Sebastian, welcome to the FEG Insight Bridge.

Sebastian Mallaby: 1:38

Greg, thanks for having me.

Greg Dowling: 1:39

Well, as we talked about, we selected your book for our research teams' summer book club . So this must be the highest of honor for you.

Sebastian Mallaby: 1:47

I've never experienced quite anything like that.

Greg Dowling: 1:49

[laughs]

Sebastian Mallaby: 1:50

It's amazing. You know, there was a time when I was at the start of my career and I was the Economist magazine's correspondent in Africa, and I was standing outside this jail house in South Africa and Nelson Mandela walked out. And relative to that, I would say that being selected for your team has got to be higher. Right?

Greg Dowling: 2:09

I'll take that. Right after Nelson Mandela

Sebastian Mallaby: 2:11

[laughs]

Greg Dowling: 2:12

All joking aside, it is fantastic. I mean, how often do you get to choose a book as a discussion tool and then actually interview the author? So we're super excited for this.

Sebastian Mallaby: 2:22

Me too .

Greg Dowling: 2:22

Let's just start off. What was your inspiration for writing a book on venture capital?

Sebastian Mallaby: 2:27

Well, I'm a repeat offender on this book writing thing, and these books always take me a while . My kids say that I'm lazy and inefficient, and I say I'm a perfectionist and I try to get it right. I've done these four books before The Power of Law. And three of them are different slices of financial history--book about the central bank , in the form of a Greenspan biography; a book about hedge funds; a book about development finance told through the story of the World Bank. And then I wanted to write about the most exciting frontier of finance I hadn't done yet, and clearly that was technology investing. Obviously in the 2010s, the markets in private tech were going crazy and it was spreading all over the place, moving to China, moving to India, even to Europe. So this sort of relatively poorly understood an opaque segment of finance was becoming so big, so broad, and so influential that you couldn't possibly continue to just not understand it that well. And I tried to fill that gap in the market.

Greg Dowling: 3:25

How do you research these books? I mean, you're an ex -journalist, does that help? You start pulling on strings and you find someone who knows somebody else, and you just keep going?

Sebastian Mallaby: 3:33

Yeah. And I think that method actually is not restricted to journalists. It's kind of what venture capitalists do too, right? They're always introducing each other to the next person you might want to hire to a startup or the next customer you could introduce your startup to. And so I began--I had written this book about hedge funds some years before, and that had some carryover kind of brand effect into private investing. A lot of the venture capitalists had read my book on hedge funds and a lot of the hedge fund people I had gotten to know also invested with venture investors. So it was pretty easy to use the hedge fund network to get a first set of introductions, to show up in the valley and to have the first 10, 20, 30 conversations. And then those people passed me on to others. And at first, I'm always looking for, like, "Is this even a story?" Is this a book? And the thing that I had to get past with venture capital was the fact that a lot of the initial stories I heard about where is the alpha in venture capital was sort of so trivial and cute and insubstantial as to make me think, "Well, if that's all there is to it, I'm not sure there's really a book." There is this inherent mystery in early-stage investing. You can't do quantitative analysis. You can't calculate a price earnings ratio, because there are no earnings for an early stage company. You can't do price to book because there's no book value in an early stage company. The whole approach is different and it's just two-legged mammals walking into your office with a dream. I needed to kind of start to grapple with: "In the face of that enormous uncertainty, how do you even begin to think about it? Where is the alpha, where's the skill?" And initially I got stories about, "Yeah, you know, I met this entrepreneur and we kind of hit it off. And so I did the investment." That's not a coherent explanation of why you've done well and somebody else didn't do well. It took me a few rounds of conversations before I started to feel I'd hit the real juice, and then I was hooked on the subject.

Greg Dowling: 5:23

You mentioned the hedge fund book, which was a great book, More Money Than God. I think of hedge funds being potentially a little bit more closed-lipped because they deal in informational arbitrage. How was it venture, where their whole job is networking versus someone who's trying to exploit some arbitrage--was their information easier to get than on the hedge fund side?

Sebastian Mallaby: 5:44

So as you might guess, getting meetings in Silicon Valley was easier, because Silicon Valley people, that's what they do. They pay it forward. They have meetings. They network with each other. It's just that kind of culture. And I was struck actually that people I knew a bit who were at Stanford, but were not into venture capital would say to me, "Oh yeah, I'll introduce you to venture capitalists, I know lots of them ." And then they never did. But people who were on the West Coast who actually were in entrepreneurship or venture capital or some related part of the ecosystem, those people really would introduce you, that's just how they are. So that was a contrast with hedge funds who are harder to get in front of. The difference on the other side though, is that with hedge funds, once you get the meeting with Stan Druckenmiller or, you know, a Porter de Jones, you get a pretty coherent story about how they do their business because it's a highly analytic type of investing, it often has a quantitative basis. So you can in a crunchy way, explain, "I think my alpha is as follows and here are three examples of where I used it, and here is how the trade worked out." Whereas in Silicon Valley, not so difficult to get into the meeting with the venture capitalist, but quite difficult to get a substantive answer that actually [ laughs ] made sense. I remember going on one of my first trips and I had an introduction to Jerry Yang, the founder of Yahoo. And I said, "Why did you take money from Michael Moritz of Sequoia when you could have taken money from various other people who were offering you a term sheet?" And Jerry says to me, "Well, Mike had soul."

Greg Dowling: 7:17

[laughs ]

Sebastian Mallaby: 7:17

I'm like , "Soul? Soul? Is that how you make alpha?" I don't think... The difficulty in Silicon Valley is not to get the meeting it's to get the substantive meeting.

Greg Dowling: 7:27

I would think that'd be very difficult. You're having all these great meetings, but you're trying to find that thread to weave all these stories together and have purpose, and "soul" doesn't necessarily mean success. You'd never hear that on the hedge fund side. You wouldn't go and talk to a hedge fund titan and say, "Why did you make this investment?" And they're like, "This stock had real soul." I mean, you'd never hear that.

Sebastian Mallaby: 7:50

Yeah. There's a little bit in public market investment where--old-school pit trading , they would say things like, "I felt the market was ready to turn." And it's like, "What do you mean? You felt the market? Like you put your hand on the wall of the market and you like felt what it felt like?" No , come on. But obviously if you're in the pit and you can see the whites of the eyes of the other people who are going to move the market and you see three of them chatting in one corner and then coming out together... I understand what it means to feel the market . So you would need to unpack that as a writer, if you're trying to understand the offer , but there can be some hocus pocus in the lingo in public markets sometimes.

Greg Dowling: 8:27

Talking about your craft a little bit. So we've learned already, it takes you a long time write books . So , how long did it take from start to finish?

Sebastian Mallaby: 8:34

Pretty much five years.

Greg Dowling: 8:36

Five years. Is that typical?

Sebastian Mallaby: 8:38

It is . The one before took me six years, but it was a longer book probably, maybe too long. It was a biography of Alan Greenspan. Once you start to chronicle the life of somebody who was at or near the center of public finance for four decades, you're locked into a fairly long process. You can either just tell the story of the person, but that's kind of narrow and boring, but if you want to do the figure and the landscape, you want to understand the landscape, and I wanted to tell the story of the making of modern finance through the character of Alan Greenspan. And I think it worked out well. It's the book I'm in some ways the most proud of, but it did weigh in it at just over 600 pages. So I guess [ laughs ] , that's why it took me six years, not five years.

Greg Dowling: 9:18

So basically a year per hundred pages.

Sebastian Mallaby: 9:22

[laughs] The other thing I would say in defense of the long length though , is that part of what I try to do in my books is combine satisfying intellectual payload, where I'm really explaining how alpha is developed; how venture capital, for example, makes an impact on innovation and therefore our standard of living; how it relates to the geopolitical struggle between China and the U.S. I'm trying to make a serious argument, of course, but I'm also trying to entertain, to factor in personalities, to tell chronological stories that have some narrative momentum to them. And if you want to do both those things, you do end up with a slightly longer book, but maybe the one that's more fun to read.

Greg Dowling: 10:05

This book is really fun to read. Now I was going to ask you about... This is sort of your craft. Being a financial guy at heart, an analyst, we're just the facts, right? You want something quick and easy that tells you "buy" or "sell." You do such a great job of providing the color and the background--and this is early in the book, but this really struck me--when you talked about Patrick Brown, who was the founder of Impossible Foods. This burly guy on his hands and knees looking at the roots of wild clover to try to get a specific color that would better replicate real meat in this kind of faux meat . The detail is very different than what we see in the financial world. You weren't there, so how do you get that degree of detail and tell that story authentically?

Sebastian Mallaby: 10:51

Well, I have lots of conversations with people. That's why it takes five years. Most of that time is not writing, it's networking to get to see the key players and then sitting down with them for two hours at a time and recording everything when I'm talking to them. And they tell me some interesting story, like to make impossible burgers where it's red when you put it on the barbecue and then it turns to brown and it has that sizzling smell, you need to get a certain type of chemical out of clover roots . You say, "Wait, wait ! Stop there, stop there! How did you find the clover roots ? Tell me the moment when you realized this?" And you try to make people tell stories. Now, it has to be said that not everybody is a storyteller. So you can play that trick and two out of three times, you probably won't get a story--either because the other person can't remember, or because they're just not wired to tell stories. But now and again, you meet somebody who really likes telling stories and they're good at it and it flows. And then you know you've got gold dust. And that's why it's essential to record every conversation, because you never can tell in advance where the subject may just start to tell a story that's pure gold dust for me. And I could never take notes fast enough to get all the details. So you want to capture every single last drop of that magic flow when it comes. And so in this case, I was talking to Vinod Khosla, who's a wonderful, charismatic venture investor, a great storyteller, and just a super lively person to engage with, and he told me the story. And then I went back and I have a--I'm lucky enough to have a very smart research associate working with me at all times, and he, I think, went and checked if there were any other descriptions of that moment of discovering the heme in clover. And sure enough, there were one or two press accounts, so you can borrow and check and cross-check. And then I went to see Patrick Brown. In the story there's... The venture capitalist who gets the story from Patrick Brown, so of course I went to see Patrick Brown and checked everything with him and see if he could add any details, and he'd added a few. And once you've done every possible angle on the same anecdotes, you've got the best you've got. Right? And you can sometimes do tricks, like somebody says, "Well, I was in a restaurant and this person sat down opposite me and we started talking." And you say, "Okay, well describe the scene," and they can't really do it. So then you physically go to the restaurant.

Greg Dowling: 13:11

Yeah.

Sebastian Mallaby: 13:11

Then you can describe the scene . So this stuff is accelerated and facilitated by Google images. Sometimes you can pull up the image of some public place where a meeting took place, and that's helpful. So it's a triangulation, it's a kind of building up of a picture by going to a resource you can think of.

Greg Dowling: 13:30

I love it. Maybe it resonates with me more because I'm in the industry so I've been to a lot of these places, and when you're reading about it and it's described in such a way, you're like, "Oh my gosh, I was there, it was just like that." It's pretty neat. I wanted to talk a little bit about the place that is the Valley. People kind of ascribe greatness to the Valley, like the Valley by itself created venture capital. Is that true? I think about ARD--it started in Boston--that may be one of the first venture funds. You had all the families in New York, Rockefellers who backed a lot of venture companies. But the Valley, something's magic about the Valley. Is it truly magic or is that overhyped?

Sebastian Mallaby: 14:06

My view is that the magic came from the venture capital. That the early pioneers of West Coast venture capital, like Arthur Rock--who set up a fund in 1961, having earlier financed Fairchild Semiconductor, and then went on to do both Intel and Apple and various other hits--that he brought to the Valley a style of investing that was just fundamentally different. And what that did was that empowered people to set up companies and to take big risks when all they had was a kind of engineering vision. That was fundamentally different to anything that was going on in New York or Boston, and that made the difference. Now that was not the conventional wisdom when I began my research. People would tell me, "Hey, Silicon Valley, it's really Stanford Valley. It's all about Stanford being a fantastic university that allowed people to spin out and do companies." As I looked at the evidence for that, it struck me as wrong, because back in the 60s and 70s when all of this got going, MIT was clearly a better engineering school than Stanford. And if you want to throw in Berkeley, then I can throw in Harvard. Just, there was a better academic research base in Boston. Other people would say, "It's defense dollars." That defense dollars flowed to Northern California, and that explains why Silicon Valley became the Valley. But actually more defense dollars flowed to Boston, because that was the heart of the military-industrial complex. That's where Raytheon, the defense company, got started. That's where Lincoln Labs was. The whole kind of personal centerpiece of the military-industrial complex was Vannevar Bush, who was FDR's military advisor during the war, or kind of engineering, tech advisor during the war, but had also been at MIT, I think as the head of the engineering school. So the defense dollar story is wrong. The Stanford story is wrong. The other contender is, "Well it's because California law does not allow you to enforce a non-compete agreement; therefore, you can leave a big company and join a startup , and it's much easier." And that's true, and significant, but Southern California had the same provisions and Southern California in the 60s was actually ahead of Northern California in tech. It had aerospace. And by the way, it had more military dollars. And so why did tech not take off in Southern California if it was just about non-competes? And so I'm left with this view that what was distinctive about Northern California was Arthur Rock and the people who then copied him. And these were Tom Perkins, who started Kleiner Perkins; Don Valentine, who started Sequoia. And that style of investing, which allowed an entrepreneur who wouldn't have had the guts to leave a big company to actually do so, that was enabled by West Coast venture. It was a machine for manufacturing courage .

Greg Dowling: 16:47

Interesting. Then I question why that hasn't been replicated back in New York and Boston. And it is, like there is a growing VC ecosystem in Austin, in Boston and New York for a while , there is one in Israel, there is one in Shanghai. It's become global, but probably other than China, none can really lay claim to the amount of success as the Valley. Is it because it just builds on itself and it reinforces, and it gets stronger over time? Why haven't we been able to build a VC ecosystem in Liverpool or Milwaukee?

Sebastian Mallaby: 17:23

Greg, that's a great question. So I would say part of the answer is what you just said, that it does build on itself. When you have a startup that scales and goes public, there are going to be, 100 people, say, who had joined that startup pretty early on, the first 100 people. And they experience this unbelievable wealth creation and success and excitement, and it's addictive. Once they've done it once, they kind of want to do it again, either by starting their own company or by being a VC-backing company, or by an angel, or perhaps just being the chief product officer or the chief marketing officer or something at another startup that's going to do the same thing. And so you get this cadre of experienced company scalers who really understand how to build startups. And each generation--if there are 100 people at their first [inaudible] of this, they go off and let's say they create another 10 that do the same thing, and now you've suddenly got 1,000 people who have been through that experience and they're going to create 100. So I think it does build on itself. But the other important answer to your question about why did other regions not replicate Northern California earlier, is that to replicate, you needed to kind of get your head around some counterintuitive stuff that people are resistant to. The chief idea is this power law idea, which is my book title.

Greg Dowling: 18:44

We should probably stop here, and you should probably explain what the power law is.

Sebastian Mallaby: 18:48

Sure. Put simply, it's the idea that if you make 10 investments as a venture investor, 7 or 8 are going to go to zero, you're going to lose--the startup will fail. The hope is that 1 or 2 will do 10x or better and you'll make all your money on this right -hand tail of atypical examples. And so it's not a bell curve, which is the distribution where the average return is also the median return. Like everything clusters around the average, so you get that hump in the middle of the curve.

Greg Dowling: 19:20

The bell-shaped distribution.

Sebastian Mallaby: 19:21

Yeah. The bell-shaped distribution. Instead, it's a distribution where most of the examples are zeros, and then you've got this right-hand tail that accounts for all of the profit . For an investor to approach investing with the mindset that, "Yes, 8 out of 10 of my bets will go for zero." That's just not a normal thing to do. That's just not how people are, they don't want to get their heads around that. And in fact, one of my aha moments came when I went to Boston and talked to the people who were involved in early venture there in the 60s and 70s who were by now retired, and one of them said to me, "I had a great career. I did 40 investments as a venture investor and none of them lost money." And I thought, "Oh my goodness, that is such an admission that you were not going for the really risky bets that were either going to be zeros or 20x." Nobody on the West Coast would boast about having zero bets that failed; it would be a certain sign that you were not taking enough risk. And so that encapsulated, for me, the difference between the Boston venture capitalists, who were core venture capitalists and they had funds, and... On the surface, it looks the same, but actually under the hood, it was a fundamentally different mindset and a different business. And so I tell stories in my book about certain entrepreneurs who try to raise money in Boston, nobody would fund them, there were all these conditions and clauses, and there was just too much risk aversion. But then the same people would go to the West Coast and raise money immediately and be off to the races. One sort of detail here is that in the 70s, Sutter Hill, one of the early venture shops, created what they called the Q model, which is where they backed a promising engineer who had the idea for a daisy wheel printer. And this engineer had a good idea, but he was absolutely not somebody who could build a company. He was classically sort of engineering, introverted, not into marketing at all. And so on the East Coast in Boston, this person would've been told, "Yeah, nice idea, but go find yourself a business partner." And on the West Coast, the VC said, "Nice idea. We're investing and we'll find you a business partner." So the venture capital partnership worked, its network found somebody who was working at a Fortune 500 company running a division who was the business school buddy of one of the VCs, and they brought that person in and they created what they called the Q model, because the company was called Qume . And that combination of the brilliant technologist and the brilliant business builder created a great outcome. So that's why the model was not spread from Silicon valley to other places, because the power law mindset is counterintuitive. But I would say that since about 2005, people have got the message, because Silicon Valley generated so much wealth, particularly in the tech boom in the 90s, and the internet was such a big thing. And people kind of woke up and they said, "Whatever they're doing in Silicon Valley, we need to understand it and we need to do the same thing." And also, even more importantly, Silicon Valley firms got to a stage where they were wealthy enough and big enough that they could realize their ambition of setting up an office in China or setting up an office in India. And that's what they did. So companies like Sequoia--you know, Sequoia is the top venture partnership in California. If you ask the question, "What is the top venture partnership in China?" The answer is: Sequoia. And if you were to say, "What is the top venture partnership in India?" It might not be Sequoia, but Sequoia would be in the top four or five. And now they've set up an office in Europe and they're going to do same thing there. The VCs themselves have started to spread the model globally. So I think the special source is being exported.

Greg Dowling: 22:52

Well , let's talk about that model a little bit, because you start off, and rightfully so, with Arthur Rock. It starts out with basically--I don't know if this was his words or your words-- about betting on the jockey versus the horse. And there just wasn't a whole lot there, right? It was just like, "I met somebody, they really had it. They had soul." Whatever that is. And that's changed a lot over time. An example might be stage-by-stage investing. Talk about how that model has changed from the early days of Arthur Rock to the Tiger Global model of today.

Sebastian Mallaby: 23:26

One of the nice things about writing a chronological history of venture investing is partly that you get these storylines, which are fun, but also that you can show how over time the model of venture investing became more sophisticated. And so, in a sort of explanatory way, the nice thing is that, with Arthur Rock, the model is super simple. "I'm going to raise a fund. I'm going to have this power of law mentality. I'm going to manage risk by embracing it by leaning into long shot , risky bets on the theory that it's better to have 1 of those than to have 10 medium companies." Then the other key insight with Arthur Rock was it's all about equity. There'd been some earlier experiments which involved debt, clearly you don't want to give debt to a startup company that's going to use all the money it's got to grow, because they don't want to service any debt. They don't want to pay dividends. They don't want to pay debt service. So it has to be an equity culture, and that includes giving equity to early employees so that they have skin in the game. And Arthur Rock got all of that. And that was the foundation for the VC success that came later. Then in the 70s with the foundation of both Sequoia and Kleiner Perkins packs, you had two more innovations. First was the idea of stage-by-stage investing. There are some ideas which are so risky that you wouldn't want to bet 10% of your fund on them, but you'd be okay with betting 1% of your fund. So better to give 1% initially and then give another 9 points later if the white-hot risks that confront the project are taken off the table. So an example would be Don Valentine, the founder of Sequoia, met Atari, which was the kind of original gaming company,

Greg Dowling: 25:04

Which is a great story. [laughs] This is probably the craziest story in the book.

Sebastian Mallaby: 25:08

Yeah. They had a wild culture. You're right, Greg. They would have their board meetings in the hot tub and the investor would have to take his clothes off to get into the meeting.

Greg Dowling: 25:17

[laughs ]

Sebastian Mallaby: 25:18

Luckily Don Valentine was a former Navy water polo player, so when he took his shirt off, his authority went up, not down . So that's how he managed to put it off. The point about Atari is that they had this game called Pong that was making inroads into the market. They had product-market fit, they were rolling out other video games. But they were also chaotic. The engineers were mostly stoned, they had this hot tub culture and nobody looked after the basics of the accounts and stuff like that. And so the first question was: could this group even write a business plan? I mean, were they so chaotic that they would never do that? Could they have a strategy about how they could pivot from just selling these games to bars, which is what they were doing, and they had to go and collect the quarters by sending out one of the young employees of Atari with his girlfriend who would carry an axe.

Greg Dowling: 26:11

[ laughs]

Sebastian Mallaby: 26:11

I mean, like a wood chopping axe, on the theory that even when you were going into a rough bar in some area on the wrong side of the tracks in the Bay Area, a woman with an axe would make people get out of your way. So could you pivot from that--from selling the thing through stores, to people's homes? So Don Valentine made a small investment initially, and then when they agreed, the Atari people agreed to work with Sears to try to market products to American households, then he made a bigger investment. So that stage-by-stage thing allowed him to de-risk what would've been an impossible bet into something a bit less risky where he could make a bigger bet. The other idea in the 70s was the hands-on idea, and I've kind of given you what I mean by that with Valentine got in there to the hot tub and he kind of knocked heads together a bit and changed the culture of the company to make it more successful. Tom Perkins had the same attitude when he invested in Tandem, an early computer company, where he brought in the consultants that brainstormed the architecture that Tandem would use to make a fail-safe computer. He did the same with Genentech, the first biotech company, where he sort of designed the way in which Genentech would do the first experiments to see whether the technology of gene editing--gene recombination, I guess it was then--was even possible, whether you could make artificial insulin. So he de- risked it with the first experiments that he helped to design. So those innovations, stage-by-stage and hands-on, were the 1970s upgrades

Greg Dowling: 27:44

Moving that a little bit forward, it seems like--I think of the terminology, "the prepared mind." So maybe a little bit more quantitative rigor with some of this. And then the later stage--is that the next couple phases? Or are there a couple steps along the way from the 80s until the 2020s?

Sebastian Mallaby: 28:01

Well, the 80s as you correctly say, was about the prepared mind, at least in the story the way I tell it. Accel was a partnership founded in 1983. By '83, the venture world was populated enough that a new upstart had to kind of put it's stake in the ground and say, "We're different, and we're going to do things differently. And that's why people should invest with us." They came up with this idea of the prepared mind that basically said, "We're going to combine a sort of opportunistic and a bit haphazard 'if we meet a good entrepreneur, we'll back them,' kind of attitude to stepping back and doing a consultancy-type report on an emerging tech wave and say, 'Okay, our view is that there are going to need to be, let's say, new kinds of multi-protocol routers .' So we're going to actively look for entrepreneurs that are doing that." So that was an innovation, and others copied it after Accel did it. Another change in the 80s and 90s was specialization. There'd been these generalist investors who would do everything from Tandem to Genentech, as I was saying with Tom Perkins. And there came a time when there were enough VCs out there that to have an edge, it was helpful to be deep in one area of tech. And so firms started to specialize. I'd say another shift in the 90s was the advent of angel investors. By the 90s there were enough entrepreneurs who had made enough money that they kind of liked writing friendly checks to young engineers who reminded them of what they were like when they were PhD students. Google was sort of a breakthrough example where they raised fully a million dollars in sort of angel finance before they even went to the VCs.

Greg Dowling: 29:39

And that was a little bit different too, right? I mean, I think of Google, and maybe there's a story prior to that, the model before that was, you have a great idea and then you professionalize the business and bring in the adults, and they help run the business. And that may mean having a different CEO and maybe the founder eventually even leaving the business. Cisco is a great example of this power couple that are a little off-kilter and eventually they kind of get moved out. But was Google the time where the founders are like, "You know what? I'm going to run this business because I have angel capital." Is that where those two stories converge?

Sebastian Mallaby: 30:12

Yeah, exactly. Because Google had raised that runway of a million dollars , they could progress their company to a point that when they went to raise the series A, they were in a very strong position because they already had the best search engine out there and they knew they did. They didn't really have a business model yet for how to monetize it, but they did have a great, great product. And so they decided, "We want to take investment from our two favorite venture investors who are Sequoia and Kleiner-Perkins. Those guys don't like to share the series A deal, but we're going to force them to , because we have that amount of power." And they did force that; they forced it, moreover, at valuation that left the founders with more control over Google than pretty much any other startup founders had had before. This was made further possible by the fact that software had a different characteristic, you could scale software really, really fast for not much capital. And that meant that capital providers were less important because their capital was less necessary. And so that again, tipped the scales of negotiation between the entrepreneurs and the capitalists. Out of that grew not only the Google thing of, "We're in control." At first they resisted having any outside CEO, Then they reluctantly accepted Eric Schmidt, but they retained the ability to fire him if they wanted. Going forward, when they went public, they had these super voting shares that allowed them to retain control of Google even if their shareholding fell to a minority size.

Greg Dowling: 31:40

I want to bring the point out that maybe not everybody understands the Google venture story, but there's probably a lot of people out here that are investors in Google's public shares. And if you ever wondered why they have two different shares and why there's a difference, it goes back to this story about having the ability or non-voting rights and voting rights. It all goes back to their founding.

Sebastian Mallaby: 32:01

Exactly. And then that was the model that was copied by lots of other software founders thereafter. So I guess that --just going forward quickly with this history--in 2005, there was this thing I called "the youth revolt," which was kind of picking up on that Google model that, "Hey, the power is with the youth, the entrepreneurs, and we don't have to defer to these old guys, the venture capitalists." And so founder friendliness became a kind of cost of doing business for VCs. They had to repeat this mantra of, "We defer to the founder. We respect the founder. The founder is great." 2005 is when the Founder's Fund was started out by Peter Thiel very much in reaction to his own experience when he had been a founder at PayPal and he felt the VCs had been high-handed in their treatment of him . It was also the year in which Y Combinator got started, and Y Combinator had the idea that brilliant young programmers could start companies with a tiny amount of capital provided by an incubator company like YC. You could go to the series A investors later, but no hurry. And in fact, the series A people, they kind of drowned you in too much capital quite often. And so that was another part of the youth revolt . And that then found expression in what I think is the next big shift in VC models, which is the arrival of growth capital--which is what you were referring to earlier, Greg. There, the inflection point came in 2009, where Facebook was already an established company that'd been around for 5 years or so. It was doing really well. And it wanted to raise growth capital at valuation of about $10 billion. And because of the 2008 Financial Crisis, nobody was investing. Everybody was scared to write a check. The CFO of Facebook went to the Middle East to try to raise money, he was that desperate, and he came back with no money. An investor in Russia called Yuri Milner heard about this through his connections at Goldman Sachs and phoned up the CFO of Facebook in the Bay Area and said, "I know that you need capital . I want to invest. You should let me in." And the CFO from Facebook goes, "Who are you? I've never heard of you. Have you even ever been to Silicon valley?" And this Russian dude says, "No, I've never been to Silicon Valley." And the Facebook guy says, "Well, in that case, goodbye," and he hangs up. Yuri Milner, the Russian dude in question says to his secretary, "Please will you book me a flight to San Francisco." He flies to San Francisco. He calls up, from the airport, the same CFO [ laughs] at Facebook says, "Okay, now I've been to Silicon Valley. I'm in San Francisco, I'm at the airport, now will you see me?" The CFO is so shocked, and in a way impressed and kind of sorry for this guy, [laughs ] that he does a meeting, and it turns out that Yuri Milner is a very smart investor. He started the Facebook clone in Russia called , Mail.RU

Greg Dowling: 34:46

And the index too, later, right? He was involved in the index .

Sebastian Mallaby: 34:49

He, I think, was involved in the index as well. I think it was as an investor rather than an entrepreneur. But he was certainly a central figure in the Russian tech world. He had read Mary Mecca's reports on the internet as a young guy in Russia, and he kind of said , "I want some of that. And he became a pioneer of the digital economy in Russia." He talked his way into Mark Zuckerberg's office, and the way he clinched the deal was to say, "Mark" or Mr. Zuckerberg, maybe, "you created this company, you are clearly brilliant. If you let me invest, I will vote my shares with you, always. I promise. And furthermore, I don't need a board seat ." And so he completely deferred to Zuckerberg's desire for control over the company. Again, it was that founder-friendly thing. And in my view, it worked brilliantly for Milner because he got into the deal and Facebook then proceeded to do great and Milner made a lot of money and his model was then copied. Marc Andreessen says this explicitly, that watching Milner do this was one of the reasons why Andreessen Horowitz, when it became a proper VC fund later in 2009, kind of copied that model and did a lot of growth deals in its first fund. So it was a great investment strategy to defer to the founder, but I'm not sure it was a great thing for corporate governance of unicorn companies. Define unicorn.

Greg Dowling: 36:08

So a unicorn is a private tech company with valuation over $1 billion. And it's called a unicorn because...?

Sebastian Mallaby: 36:14

It's supposedly magical and rare, I guess.

Greg Dowling: 36:16

Yeah. There was never a VC-supported company that ever had a $1 billion valuation until all of them did [laughs ].

Sebastian Mallaby: 36:24

Yeah.

Greg Dowling: 36:24

It was like it was so rare, it was a unicorn. Now there's--all of them are unicorns.

Sebastian Mallaby: 36:27

Now you have to be a deca-unicorn to be anything.

Greg Dowling: 36:29

Right. Exactly.

Sebastian Mallaby: 36:30

And the deca-unicorn thing raises this question about the legacy of that youth revolt where everybody deferred to founders, because you get into a position where in capitalism, there are different models of corporate governance. There's the public markets, where if the managers of the company are being dumb , people can short the stock, the stock will go down, and then somebody will make a takeover bid or something will happen to eject that management that's being done . That kind of works. It's not perfect, but it kind of works. Then you've got the private equity model of governance, where a private investment firm buys the whole company and then completely has skin in the game, controls it, calls the shots. A third model of workable governance is the early stage venture capital model where the series A investors take 25% of the shares, 33% of the shares, and they go on the board, they have a big voice. And if the managers are being dumb, they can probably have enough leverage to force them to change course. The problem comes where you graduate from the VC model I just described, you become a unicorn--a deca-unicorn--and now everybody's deferring to you and saying how founder -friendly they are, and Yuri Milner is saying, "I'll vote my shares with you all the time." And all the other growth investors who copy Yuri Milner are saying the same thing. At this point, you have these, rather pleased with themselves--understandably pleased with themselves--founders who've created this incredible wealth with deca-unicorns. They're not feeling particularly modest at that point in their careers. And precisely when they need somebody looking over their shoulder, warning them of the danger of hubris, nobody is warning them of hubris because there is no real governance.

Greg Dowling: 38:03

That's a great segue into... I wanted to talk a little bit: does that go too far? We have Travis at Uber, we have the whole WeWork story, which were governance issues, Icarus flying too high, too close to the sun. And then you have just an outright fraud in Theranos. But the market just kept going. I was really surprised there wasn't a reckoning in 2016, '15, '17. Wherever that timeframe was, it just kept going. Did it self-correct, or was there so much money that nobody cared?

Sebastian Mallaby: 38:36

I think there was a bit of a peak in 2018 with growth investing and the valuation of unicorns. I think it came down a little bit into 2020, but then you had the Fed responding to coronavirus, the lockdown favoring certain kinds of companies like Peloton and Zoom and all that, and tech just went on a crazy upswing again. So ironically, there's a chart in the back of my book called "The Unicorn Bubble." When I created the chart, it was probably 2020. Then, in 2021, the chart looked dumb. And in 2022 , it looks correct again. [ laughs ] I think it would've corrected in a more normal fashion earlier without the coronavirus monetary policy.

Greg Dowling: 39:19

Interesting. So I want to ask you a few final questions. Maybe one's a comment [laughs ] more than a question. I guess I was blown away by how interconnected some of these founders were . It reminded me of the Gilded Age where JP Morgan would rub shoulders with Vanderbilt and Carnegie, Bezos making an investment into Google. And then there's this whole part of the book on the PayPal Mafia. Is this typical or is this only a Valley type of thing?

Sebastian Mallaby: 39:45

Well, I think it gets to the weird nature of venture investing. I totally agree, it is a very close-knit world. And when I first went to Silicon Valley and I realized that you could interview 75% of the investors on one road Sand Hill Road--

Greg Dowling: 40:00

Sandhill road, yeah.

Sebastian Mallaby: 40:01

--you think, "Wait, this is crazy." I mean, if you wanted to create a machine for bubbles, you would put all the investors on one road, you would ensure that there's only one good restaurant, so they kind of bump into each other the whole time. You would ensure that they have to syndicate into each other's deals. Right? So series A is led by one investment partnership and then series B by a different one. You would say, "You can't go short. No contrarianism is allowed." Which, of course, you can't go short in a private company. And all of that sort of clustering and mental group think is a machine for bubble behavior, and it's kind of weird from the outside. I think that does explain why venture was so late on diversity. I hope it's correcting a bit now, but as late as 2020, the share of women investment partners was woefully low. The share of African Americans was woefully low. So it's a bit of a club. Now the upside of a club is that information travels around the club fast. People can cooperate one day and compete the next day. And you've got social capital in that trust, and that is a productive thing. So there's some upside. I think in a way, with the way that venture is spreading around the world, we're seeing that you can spread the geography and make it a bit less clubby and it still works.

Greg Dowling: 41:17

Interesting. Yeah, it's amazing to me. I remember the first time I was on Sand Hill Road, they're kind of 70s style, low-slung office buildings, and it's a real stark contrast to the glass towers of New York or London. It's sort of unbelievable that there's all this wealth out there on that one road. But it's an interesting concept, that that close system creates a bubble. You chronicle all these great founders, these venture capitalists. We talked about some of them . Did you have a favorite story? Was there one that was like, "Wow, that was my favorite story."

Sebastian Mallaby: 41:50

In a way, I think Uber is a great story because it has this governance failure in the mature phase of Uber, but before that there was sort of the opposite story, where it's a textbook case of how venture worked great. It's a story around Bill Gurley, the benchmark partner who did the investment. But what's so cool about the story is that he got to investing in Uber--the story begins with him reading academic papers on how marketplace businesses work. When you have a marketplace that's more valuable as it grows, there is this sort of positive flywheel, this virtuous circle. Whereas most businesses have diminishing marginal returns as you produce more, in these marketplace, flywheel businesses, you actually have increasing marginal returns. That's a profound insight. So in the 90s, Bill Gurley is thinking about this. In early 2000s he does an investment in the marketplace company called OpenTable, which puts an app on your phone to book restaurant tables, and that works really well. And then he's thinking kind of abstractly, blue sky thinking about what would be the next industry, where if you put perfect information on top, you could create this marketplace that would have positive marginal returns. "Give me some more of that." And so he comes up with this idea that if you did it for connecting drivers with riders, that could work. Because if somebody comes out of an office building and they want a cab, they have to wait on the corner until a cab comes by, and that seems pretty inefficient. You're a New Yorker, there are vicious fights between the different riders .

Greg Dowling: 43:20

Absolutely.

Sebastian Mallaby: 43:21

So surely there was a better way, and of course there was a better way. But he didn't just back the first ride hailing that came across his radar, because he had a very clearly thought out idea of what type of approach was going to work. So he said no to the first couple of opportunities and he waited until the right one came along. And when he got that fat pitch, in the sense that , the right entrepreneur with the right approach in this right business segment that he'd already thought about going back to his readings academically 10 years earlier, then he, you know, it's the fat pitch and he hit it and it was a grand slam. That, to me, is just like the prepared mind working perfectly. And to those who say, "There's no skin in venture capital, it's a Las Vegas casino. Look at these people. Their pattern of returns is: failure, failure, failure, failure, Las Vegas jackpot! Surely that's just luck." It's not luck. If you get under the hood and you understand how these people think and you spend time listening, it's not luck. It's really quite profound skill. And I think Uber really illustrated that as well as then illustrating later on how, if you let the governance slip, success can turn into defeat almost.

Greg Dowling: 44:29

That is a great story. Absolutely great story. So I know this book just came out and it takes you a really long time to write other books. Any fodder for the next book? Anything you're thinking about?

Sebastian Mallaby: 44:41

Well, I'll flag what I've been thinking about in the hopes that your smart listeners will then get in touch on LinkedIn or something and share their ideas. But what I've been thinking about is crypto. Now, not so fashionable, it's just gone down like 70%, but I think that is super exciting to get your mind around. If you're into mind-stretching subjects.

Greg Dowling: 45:01

[ laughs ]

Sebastian Mallaby: 45:02

Things tokenomics and how that creates incentives for users to help to build businesses, is really interesting. I don't know if that's a book yet, but that's what I'm looking at.

Greg Dowling: 45:13

I love it. I would buy that book. I've read other books on crypto, and it's a little bit like entering the matrix. It's...

Sebastian Mallaby: 45:19

[ laughs ]

Greg Dowling: 45:19

You're not sure what's real and what's not. As an author. What are your favorite books? And you cannot choose your own. So give us a couple of your favorite books, either all-time or maybe some that have just come out.

Sebastian Mallaby: 45:31

There's an old classic called The Money Game by Adam Smith describing the go-go markets of the 1960s, which I really, really enjoyed when I read it, and captured that bull market craziness really well. Adam Smith is a course of pseudonym. Another great book, I think Roger Lowenstein's b iography of Warren Buffet is a brilliant k ind of capturing of an i nvestors' mind at work, so I recommend that. I also think that Black Edge, which is the story of Steve Cohen's hedge fund and how it essentially tacitly incentivized insider trading, is a masterful piece of financial journalism by Sheelah Kolhatkar.

Greg Dowling: 46:10

Those are all great books. If you can't wait five or six years to read something from you, you also write articles, you're out there, people can follow you on LinkedIn. Where else can they get some of their Mallaby fix?

Sebastian Mallaby: 46:24

[laughs] Well, if you really promise that you've read all five books, which is quite a big ask ... No, I'm kidding. I write in the Washington Post on the op- ed page two or three times a month, occasionally I contribute to Foreign Affairs, which is the highest journal of the Council on Foreign Relations, where I work. So you can follow me on LinkedIn or Twitter--especially Twitter--and you'll see what I'm up to.

Greg Dowling: 46:47

And you just wrote a nice piece on inflation. That's top of mind for everybody. This has been fantastic. Hopefully this interview was enriching to those who've read the book and still interesting to those who haven't read the book. I really encourage you, if you hadn't read the book and you think this is interesting, buy the book. It's an easy read. It's a great summer read. The stories are just wonderful. You'll learn something and you'll have fun. So thank you so much, Sebastian,

Sebastian Mallaby: 47:10

Greg, it was a pleasure. Thank you.

Greg Dowling: 47:12

If you are interested in more information on FEG, check out our website at www.feg . com, and don't forget to subscribe to our communications so you don't miss the next episode. Please keep in mind that this information is intended to be general education that needs to be framed within the unique risk and return objectives of each client; therefore, nobody should consider these to be FEG recommendations. This podcast was prepared by FEG. Neither the information nor any opinion expressed in this podcast constitutes an offer or an invitation to make an offer to buy or sell any securities. The views and opinions expressed by guest speakers are solely their own and do not necessarily represent the views or opinions of their firm or of FEG.