The Power and Limitations of Venture Capitalists: A Review of Sebastian Mallaby’s The Power Law

By Kyle Scott

Sebastian Mallaby´s book, The Power Law, will give readers a deeper understanding of venture capitalists and venture capitalism while arguing for the peculiar character and skills of venture capitalists as the main reason for Silicon Valley´s success.

There are more stories of successful founders than of successful investors. More people know of Elon Musk and Mark Zuckerberg than of Arthur Rock and Don Valentine. Venture capitalists may be less well known than the founders they backed, but their impact on entrepreneurship through their advancements in finance is one of the key reasons why anyone knows Silicon Valley or has heard of those names that are celebrated in headlines.

In The Power Law, Sebastian Mallaby argues for venture capital as being the primary reason for Silicon Valley’s success. Journalists, academics, and industry veterans have tried to uncover the secret to Silicon Valley’s success. Policymakers and politicians have been informed by these studies as they try to turn other areas into similar success stories. Tel Aviv, Shanghai, Berlin, and Singapore are among the cities that have tried to replicate the success of Silicon Valley. There is not a city of any reasonable size that does not have an innovation hub or investment programme to target local talent with the hopes of nurturing the next unicorn. Nearly every business school has a pitch competition, incubator, or mentor programme designed to spawn successful start-ups. Yet none of these efforts have yielded the success story that is Silicon Valley.

Some of the factors that play into the success of Silicon Valley are well known: proximity to a world-class university, favourable contract laws, density of talent, counterculture mentality, and availability of capital. No single factor can produce a successful ecosystem, but combined, it is assumed, these factors will yield similar results in other locations. To this point, no other city or region has been able to match its success. There is no other location that has produced companies the size of Google, Facebook, Uber, Apple, HP, Yahoo!, Intel, Salesforce, and hundreds of others, within a half-century. Mallaby has written a book that, he believes, explains the phenomenon: venture capitalists. Not just the investment vehicle, but the character and skill of venture capitalists. Mallaby went in search of a silver bullet, and in his telling, he found one.

Mallaby is an accomplished writer who keeps the reader engaged with clear prose and a sharp mind. Given the book’s subject matter, and the fascination the media and public have with start-ups, this book is worthwhile for those who want a deeper understanding of the subject and a solid grounding in the development of Silicon Valley and venture capitalism more generally. For those thinking about new investment structures and business models, this book can be just what they need to understand the possibilities that exist and others that have not yet been explored.

The book begins by contrasting the earliest days of venture capitalism with traditional forms of financing through banks, private investment firms, and government assistance. Mallaby shows the strengths and weaknesses of each approach while showing that only West Coast venture capitalists had the character and investment model to give life to Silicon Valley. While other investors were risk averse and viewed investment as zero-sum, West Coast venture capitalists were hard-charging, open, and treated investing as an opportunity for mutual enrichment. By offering employees meaningful equity in the company, the venture capitalist model incentivised hard work and innovation. The better the company did, the greater the financial rewards for employees. This also meant venture capital attracted others to pursue entrepreneurship rather than staying with a job that offered less upside or pursue other means of finance. The early successes, and the model that has produced enormous wealth, created gravity and momentum that resulted in talent density, ambitious founders, more venture capital investment, and a culture that celebrated contrarian thinking and outsized ambition. This contrasted with East Coast venture capitalists and other investment mechanisms in which the investors would benefit far more than the founders or the workers. West Coast venture capital not only aligned interests, but it allowed many more people to accrue wealth who then had the ability to invest in, or create, their own companies. In the East Coast system wealth was far more concentrated and designed to enrich the investors who were already wealthy.

Arthur Rock, one of the founders of West Coast venture capital, led early investments in companies like Apple and Intel. Rock started his venture capital journey by raising money for what would become Fairchild Semiconductor. When Rock was unable to raise money through traditional means, he turned to the wealthy investor Sherman Fairchild. The experience with Fairchild Semiconductor made Rock look for a new investment strategy in which the interests of management and investors were aligned. While the eight founders of Fairchild Semiconductors made a combined $2.4 million, Sherman Fairchild made 40 times that amount.

The Power Law contrasts Rock with Georges Doriot and his American Research Development. Doriot was based at MIT in Cambridge, Massachusetts, and ran his investment firm more traditionally. This meant founders and employees did not share proportionality in the financial upside the financiers enjoyed. By aligning interests through financial and legal arrangements, Rock created an investment scheme that would be iterated upon by future generations. Successive iterations have sought new ways to unlock innovation and financial rewards. The Power Law traces these iterations through a story of outsiders who saw the current model as one that had to be disrupted so they could achieve their full potential.

Mallaby focusses on two additional characteristics of venture capitalists to explain their impact. First, they have the skillset needed to guide a startup to success. Venture capitalists are business savvy and tough negotiators. They can correct management deficiencies and identify market opportunities better than other investment classes at the start-up phase. In many cases, they do so better than the company’s founders. Second, they create networks in which companies acquire the skills and resources they need. This second point underlies many of the stories included in The Power Law. Venture capitalists encourage collaboration rather than being protectionist. East Coast venture capitalists created closed, secretive environments. Because the investors facilitated network creation, they created an ecosystem of entrepreneurship.

Mallaby writes interesting stories on venture capitalists and well-known start-ups. For the reader new to the subject, this is useful. But no new ground is covered for those already familiar with the stories. Thousands of articles, hundreds of books, and dozens of movies have already covered the most popular companies. The book simply summarises those stories without adding anything new. The reader is left wanting in the chapters that cover the earliest days of venture capital. Less has been written on this era and it would have been valuable to contribute more depth to the people and companies involved.

But this is not an academic book and instead one that tries to tell an interesting story. And if extrapolating a determinant factor is only a secondary objective, then this book succeeds. What is most promising about this book is that it opens the reader’s imagination to the possibilities that still exist within finance. Before West Coast venture capital was invented—and now iterated upon—this type of financing did not exist at scale. So while financiers, students, aspiring founders, and businesses tend to get locked in to considering only the options before them, this book exposes the possibility of other forms of financing that are currently underdeveloped or undeveloped. Getting there requires outsiders willing to think beyond the headlines and current trends; who are willing to take big risks; and who are smart, creative, and ambitious. It is through books such as this, if they get the readership they deserve, that creates the opportunity for exploration.

With the creation of blockchain technology and the rise of inexpensive and accessible investment platforms, the opportunity for a new investment model is available for anyone with the talent and ambition to create.

Kyle Scott, PhD, MBA has previously written for The European Business Review and in outlets such as the Huffington Post, Forbes, and Christian Science Monitor. His sixth book is due out later this year.