FWR regular writer Joe Reilly talks to the author of an influential book on the world of venture capital, its impact on society and economy, and the lessons it has for the future.

Joe Reilly, regulator contributor to this news service, interviews Sebastian Mallaby, author of The Power Law – Venture Capital and the Making of a New Future. They talk about the difference in how Silicon Valley thinks versus Wall Street, as well as the concept of the “prepared mind.”

Sebastian Mallaby is the Paul Volcker Senior Fellow in International Economics at the Council on Foreign Relations as well as the author of More Money Than God: Hedge Funds and the Making of a New Elite.

Joe Reilly:  What drew you to venture capital?     
Sebastian Mallaby: I was drawn to venture simply because it's the most exciting area of current finance and the financing of technology, which increasingly dominates the economy and dominates the creation of value in the stock market. There's also an intellectual mystery. In most areas of finance, you would start by learning how to discount future cash flows so you can figure out the fair value of an asset. In the case of venture capital, you don't have any cash flows when you're doing early stage. You've just got two legged mammals who walk into your office with a dream. Equally, you can't do book to value because the startup doesn't have any book value. 

None of these metrics make any sense. Hedge funds are famous for thinking about normal distributions and excluding the extreme events. Venture capital is the opposite. 

You only care about the tail events. So really extreme outcomes where a company does 20 X your money or 30 X your money. All finance is about allocating capital in the teeth of uncertainty. Venture capital is just the extreme distillation of that challenge. 

Also, more and more of capitalism is not founded upon the kinds of capital that you drop on your foot; it's founded upon software; upon ideas; pharmaceutical patents; and business processes. All of these intangibles are really what drive the modern economy. If you want to invest in those intangibles, you can't just be reading a balance sheet or financial statements. 

Do you think that information circulates differently in Silicon Valley versus Wall Street? 
Niall Ferguson has this phrase to the effect that ideas and information circulate faster in the Valley than elsewhere, because it's got a sort of social capital that’s wired for the fast dissemination of ideas. 

Social capital doesn't arise by accident. There's a certain tribe of people who are specifically incentivized to nurture that social capital and enlarge it, and that tribe of people is the venture capitalists. It's their job to get up in the morning and meet somebody for breakfast and then have fourteen other meetings before they go to bed, because they're always looking for the next company to invest in.

Meeting, making introductions, taking introductions, moving around the ecosystem – that is the job. That is not just part of the job that is the job.  

There's a terrific guy from Sutter Hill who told me explicitly that when he got into the industry his strategy was to think of the smartest people that he knew and go and have lunch with each of them. Then at the end of lunch, ask who are the two smartest people that you know, and would you introduce me?   And then he would go and see them. And then at the end of those lunches, you get two more introductions for lunch. 

And then when you've got this network of a hundred or two hundred people, you systematically stay in touch with them by sending them a new technical article that might be relevant to their work, or just calling them up and saying I just had lunch with so-and-so and he asked after you.  

Hedge funds, it's just a completely different game. I mean, the joke I cite about macro investors is that when Louis Bacon bought a private island, his friends said it made no difference because he was so insular in the first place. 

He was a figure behind a bank of screens thinking about macro trading and he didn't really need to go off and see other people. Of course, he had a team of analysts and researchers and he had people he did talk to, but you can do a lot of this solo and you are pulling the trigger pretty much solo. 

Often you don't want to tell other people what you're up to, or what your trade is, because the trade will become crowded and that would be dangerous.  So I think hedge funds often encourage introverts and do brilliantly that way, whereas venture capital encourages extroverts who like networking and are good at feeling where the consensus is going to be in the network of people that they work with.

Are there similarities or differences between the way VCs network and make decisions and the folks in the policy world? 
That’s a great question. In the policy world I spent eighteen and a half years in Washington, DC, so I did imbibe that culture quite a lot. I think there's a mixture of discussion for sure. People love trading ideas. They love spinning theories. They love gossip about the horse race. 

Not only the election horse race but also the kind of policy horse race of which idea is going to win? Which public intellectual is going to get their view accepted? So there's a lot of communication that goes on. One of the fun things about formally being an economist at the Washington Post and an editorial writer, is that one of the big [dudes] in the network around Senator so-and-so wants to push a bill, and knows that one way of doing that is to pay a visit to the Washington Post to try to get them to write something supportive. What you wrote actually became part of the conversation and your articles would be passed around in meetings and in the highest caucus before a vote on some bill.  

So there's all that “idea showing,” but there's also a desire to protect your own connections because that's your way up the ladder. It's a competitive and backbiting business to climb up to the top of the ladder in Washington. Journalists love chatting about ideas, but they don't like telling each other what their sources are or who their contacts are. So I think it's less collaborative than in Silicon Valley. 

One of my favorite concepts in the book was the idea of the “prepared mind." What can you tell us about that? 
The prepared mind was invented by Accel Partners. There'd been this boom in the early eighties, and new venture partnerships like Accel needed to differentiate themselves at the start, to show that they were putting a spin on the traditional venture model.  

First, they would do an internal management consulting kind of study of some emerging technology. It could be that they think networking technology is going to be revolutionized by ethernet and we're going to figure out prospectively what new companies are likely to arise from this new technology.  

What software will have to be invented to go with that? It could be anything, perhaps it is new kinds of semiconductors that will be needed to pair with these new routers. Now having prepared our minds, we are then going to be able to connect with the entrepreneurs who want to do companies in this space because we'll have our own vision of the future. 

The founders will have a specific idea, but we'll have the map and the territory, and that will be useful to them. We'll make a faster decision on whether to fund them, because we'll have a view before we've even met them as to what's going to work in this space, and we'll even have a view on the profile and the type of person who is likely to succeed.

And they had this revelation that the new breed of social media communications and web applications were being founded by entrepreneurs who might be a bit too weird for others. They thought, next time we see somebody who looks a bit weird, but they've got fast uptake from consumers, you want to invest in that.

And then along came none other than Mark Zuckerberg. This guy's like 20 years old. He won't look you in the eye. His business partner is Sean Parker, who has been fired from his previous two startups for misconduct of various kinds. 

This is the sort of company that a traditional VC would not have touched with a barge pole, but Facebook had extremely fast uptake on college campuses. They were willing to pay up and willing to hold their noses about Zuckerberg’s youthful arrogance, and they did the deal which turned out to be one of the best ever early stage deals in US history.

Adrian Wooldridge did a review of your book and asked “is an economy based on the power law compatible in the long term with the political system based on democracy and equality?” Do you have any thoughts on that?      
I thought that was a really good question that he posed in that Bloomberg article because it's true that the power law is creating inequality. 

You get this skew in outcomes and the people who win, whether they are the entrepreneurs or the early hires in the startup that becomes a unicorn. These people become extremely wealthy, as do the venture capitalists who back them, and then success feeds upon success. Once you've done one successful startup, either as the entrepreneur or as the early hire, or indeed, as the VC, it becomes easier to do the second grand slam company. 

So there's no getting around the fact that this is exacerbating inequality, but I'd say a couple of things about this in mitigation. One, I think you need to distinguish between dynamic inequality and static inequality. Dynamic is way more attractive. 

Static is where you have entrenched power. Somebody is very wealthy or very high income, and they can protect that position and sustain it and maybe even hand it on to their kids. That's not great for dynamism, and it's not fair in terms of equality of opportunity. On the other hand, dynamic inequality is where some people do incredibly well, much better than others, but the winners change at least a bit. 

And so, you're not necessarily creating more inequality of opportunity. You might be actually reducing that inequality and that's way more acceptable. I think startups are clearly in the preferable kind of inequality camp, because what they're doing is disrupting the incumbents. 

If you've got some incumbent big company that is earning the rents that accrue from being a frontrunner, and then all of a sudden they're being disrupted by a startup. Then that startup, if it does well, will create a lot of wealthy people, but it's a different set of wealthy people.    

The other thing is that there is this invention called progressive taxation and it should be used. I think they're the right response to the market-oriented methods that make capitalism efficient. That creates new wealth and new companies and applies technology in a way that gives people more options in their lives.