The year is 1850, and the American whaling industry is booming. Whale hunting is an extremely risky business, but it’s also incredibly lucrative. Each expedition costs a fortune, and one-third of all ships don’t make it home. However, successful trips are returning ten times the upfront investment. As a result, rich people start spreading bets across different whalers to diversify risk.
The plan works out, and lots of investors get rich. Eventually, America stopped using whale oil and switches to petroleum. John D. Rockefeller is the biggest winner during the oil boom and becomes the richest person in history by building the Standard Oil Company. The Rockefeller fortune gets passed down to his family, and in 1946, his descendants are looking for new ways to deploy all this capital. They start funding risky new businesses, but at this point, they’re really just treating these investments like charity and aren’t thinking like venture capitalists yet.
Early Venture capital model:
The first real attempt at making money through early-stage investing comes out of Boston. A group called American Research and Development begins making investments in several military technology companies. It’s a good proof of concept, but startups that took money from ARD were required to give up 70% ownership in order to receive funding. Even worse, the ARD investment fund is set up as a corporation instead of a partnership, leading to all sorts of legal headaches, including a raid by the Securities and Exchange Commission.
On the other side of the country, a few San Francisco stockbrokers are forming a group to invest in technology startups. They need a name, so they call it “the group.” Fortunately for them, they’re better at investing than coming up with brand names. The founder of the group is able to turn fifteen thousand dollars into one million by investing in a company that makes tape recorders. Analog technology would only last for a while, though. Even in the 60s, people could already tell that the future was digital, and everything digital requires semiconductor chips.
Now, at the time, all the best engineers are working for William Shockley. Shockley is running a semiconductor company called Shockley Semiconductor – yet another creative brand name. However, Shockley is a terrible boss, so eight of his brightest employees decide to become traitors and leave the company. Fortunately, there’s a new venture capitalist in town named Arthur Rock, and he says, “Let’s call these guys the traitorous eight.” He then gives the money to start Fairchild Semiconductor.
Government Involvement and Challenges:
This looks really promising. They’re finally making silicon chips in Silicon Valley, and the US government takes notice. It’s the Cold War, and the United States needs cutting-edge technology to win the space race. So, they start subsidizing venture funds known as Small Business Investment Companies. However, this doesn’t work because each fund has to be smaller than four hundred and fifty thousand dollars, and they can’t give more than sixty thousand dollars to a single startup. No one wants to work under these government limitations, so the private sector has to step up to fill the void.
Arthur Rock was really onto something with the traitorous eight, though. He made seven hundred thousand dollars and proved that convincing talented scientists to quit their jobs and start something new could lead to big innovation. So he doubled down. Rock recognized something that no one else did – even though most new ventures would fail, one big grand slam would completely cancel out all the mistakes. Normal distributions are what most people expect when thinking about likely outcomes – the familiar bell curve. But venture capital investing follows a power law with an extremely long tail of huge winners. This tiny shift in mindset would dramatically change the way new businesses got funded.
It’s still only 1968, but Rock’s model is already working. He ends up returning more than 22 times his initial investment, enough to beat out Warren Buffett’s performance at the time. Rock realizes that the power law is extremely powerful. No one is thinking about early-stage investing this way, so he repeats the formula and helps two members of the traitorous eight-start Intel. Rock couldn’t stay on top forever, though. Two new venture capitalists just joined the party, and we’re about to change everything.
Venture Capital in 1970s:
It’s 1972, and two big VC firms launch. Don Valentine founds Sequoia Capital, and Eugene Kleiner starts Kleiner Perkins. Both had worked at Fairchild Semiconductor and seen firsthand how the venture capital model could supercharge new technologies. But there’s one big question at this point: how closely should VCs and startups work together? Traditionally, VCs had mostly just written checks and then turned the engineers loose to go build. Well, Sutter Hill wants to test that theory. So in 1973, they create the Q model, which pairs a talented inventor with a strong outside CEO to help them build the business.
This model seems to be working, so Don Valentine funds Atari, which has some amazing game technology but is basically a complete mess on the business side. Kleiner Perkins also wants to get more hands-on, so they build Tandem Computers in-house and then spin it out into an independent startup. But there’s clearly more to Silicon Valley than just silicon computer chips, and Kleiner Perkins knows this. So they fund Genentech to commercialize recombinant DNA technology. It’s a super risky venture, but by investing slowly one stage at a time, Kleiner winds up building a new model for highly capital-intensive businesses.
It’s 1977 now, and we finally get our first real household name – Apple Computer. Surprisingly, Steve Jobs gets rejected by lots of venture capitalists when he tries to raise money. That doesn’t matter, though, because there’s finally a network of VCs in Silicon Valley. If one says no, you can just go to a different investor. Three years later, both Apple and Genentech go public and yield massive profits for their investors. Everyone in Silicon Valley is pumped and wants to double down on the venture model.
Now, the East Coast isn’t asleep during all of this. New Enterprise Associates starts to build a venture presence on the East Coast, but Silicon Valley is still stronger. Just look at the story of Bob Metcalfe. He invented Ethernet cables and basically made the modern internet possible. But he couldn’t get East Coast VCs to invest at the terms he wanted. So, he wound up building his company in Silicon Valley.
Everything’s going well in California, but now investors have to make a choice. Up until this point, venture capitalists took a very general approach, investing in whatever technology seemed to be on the cutting edge. Arthur Patterson and Jim Schwartz think that there’s a better way, though. So, they start Excel Capital to specialize in particular industries. Instead of looking at a semiconductor company one week and then a biotech company the next. Excel chooses to drill down and focus just on telecom companies.
Focus on technology startups in 1980s:
The ’80s are a boom time for Silicon Valley. Not only are tech companies doing extremely well, but tax laws and financial regulations are changing to supercharge the venture capital model. Capital gains taxes just dropped, and now pension fund managers can allocate money towards venture capital. This leads the total size of VC funds to quadruple to 12 billion dollars in just six years. VCs have more money now and are becoming a lot more powerful. The question of how much control investors should have over the companies they fund pops up again.
It’s 1987, and Sequoia makes an incredible investment in Cisco. But they wind up overhauling the management team in the.
But this would wind up changing the way founders think about maintaining control in future Silicon Valley cycles. Things really start to heat up in the ’90s. John Doerr funds a company called Go with the hopes of basically building an iPad, but it fails. That doesn’t matter, though, because of the power law. VCs have fully embraced the idea of swinging for the fences. After all, venture investments have unlimited upside, and the ’90s are the perfect time to embrace this mindset.
Internet boom in the 90s:
Excel, NEA, and Menlo Ventures team up to fund UUNET, which takes the government-run internet and brings it to the public. The internet is still very primitive at this point, though, so Netscape pulls in funding from Kleiner Perkins to build a new web browser. There’s still a big problem with the internet, though – it’s hard to find stuff. So in 1995, Sequoia invests in Yahoo, and the search engine market starts growing. Everyone in Silicon Valley can see how important search is going to be, and international funds start taking an interest. Masayoshi’s son has a massive war chest and wants a piece of the action, so he goes to Yahoo and offers to write them a 100 million dollar check. The Yahoo team is hesitant; no one’s really ever done a deal like this before. But they don’t like the idea of a competitor having 100 million dollars in the bank, so they take it. Growth investing has finally arrived, and it’s shaking things up.
Amazon also gets going in the ’90s, and again, John Doerr gets Kleiner Perkins in early and makes an absolute killing on the deal. At this point, he’s clearly Silicon Valley’s top internet investor, but plenty of VCs would be coming for his crown soon. The next big ’90s breakout is eBay. The auction site is growing exponentially, and Benchmark’s Bob Kegel makes an incredible early investment. Most venture capitalists are scrambling to raise bigger and bigger funds, but Benchmark is staying lean and focused and winds up generating a 5 billion profit on the eBay investment.
But things are changing for traditional venture capital firms. With so many successful companies in Silicon Valley, individuals can now help startups get off the ground directly. Now, Google isn’t the first company to raise money from angel investors, but when Sergey Brin and Larry Page raise a full 1 million dollars without even talking to VCs, it’s clear that the landscape is shifting.
1999 was, in some ways, the dawn of the fully empowered tech founder. Larry and Sergey were engineers, but they dictated aggressive terms to both Kleiner Perkins and Sequoia when they raised their Series A. These two rival firms wanted the whole round to themselves, but the Google founders knew that they had leverage and they exploited it.
One of the hardest things about building a new business is attracting talent. Small startups don’t have the cash to outbid bigger companies on salary, but stock options provide a solution to this problem. All of a sudden, a talented engineer could essentially be granted a big ownership stake in the business, all with zero upfront tax liability. Stock options were fuel on the innovation fire in Silicon Valley, but the secret about their power was out, and it wasn’t long before Goldman Sachs brought them to China while financing the e-commerce site Alibaba.
Founder influence and changing dynamics:
It’s now the new millennium, and internet companies hit a turning point. People are freaking out about Y2K computer bugs, and the attention on technology is reaching new heights. VC firms now have 104 billion dollars under management, but things are about to get rocky during the dot-com bust. Suddenly, everyone realizes that even though these technologies are amazing, there just aren’t enough people using them. The numbers don’t add up, and the dot-com bubble bursts. The market sell-off doesn’t really matter, though, because the smart investors realize that this new technology will eventually win out.
So, the big players start adjusting. SoftBank winds up making a fortune on Alibaba, which offsets its U.S tech losses, and Tiger Global becomes the first hedge fund to cross over into startup investing. A few years after the dot-com bust, tech is back on track. Google goes public, and interestingly, they use a dual-class share structure, which ensures that the founders will remain in control forever. It’s becoming clear that great founders are capable of thinking in decades and planning for extreme long-term growth.
So, in 2005, Peter Thiel launches Founder’s Fund with the core mission of supporting founders for the long haul. It’s a different approach from traditional venture capital, but he’s not the only one developing new ways to build startups. Paul Graham and Jessica Livingston launch Y Combinator, which essentially creates the startup incubator model. Their plan is simple – back promising founders earlier than any venture capitalist would and focus on highly technical individuals.
New model in 2000s:
Facebook is also starting to change how Silicon Valley operates. By the mid-2000s, Mark Zuckerberg is going around the valley pitching investors in pajama pants and still getting term sheets. He does run into a problem, though. After five years of solid growth, most tech companies would go public. But Yuri Milner offers Zuckerberg an alternative. See, Milner had done extensive research into Facebook’s growth numbers and could tell that the site was going to be massive. Instead of a traditional IPO, why not take a large growth equity round and stay private longer? It was an uncommon path at the time, but it would quickly become immensely popular, with a huge wave of tech companies reaching new heights toward the end of the decade.
Marc Andreessen and Ben Horowitz launch a new venture partnership. The name Andreessen Horowitz is a bit long, so everyone shifts to calling them a16z. Mark and Ben realized that startups are all about talent, so they modeled their firm on the prominent Hollywood talent agency CAA.
Changing dynamics in 2010:
Remember how Sequoia got squeezed out of taking the full Google Series A? Well, in 2010, they invest in the Chinese shopping company Meituan and wind up making more money on that bet than they did on Google. Even though China’s tech industry was delivering incredible returns, America wasn’t slowing down. By 2013, there are so many late-stage tech companies worth more than a billion dollars that we need a special word for them – how about “unicorn”? Those are rare, right? Well, they wouldn’t be for long.
In 2017, Masa launches the nearly 100 billion dollar Vision Fund. All of a sudden, any startup with solid growth numbers can stay private for years and raise hundreds of millions of dollars. Dozens of new unicorns are created overnight, shaking up the industry. Sequoia isn’t happy about it. Mike Moritz is worried that all this cheap capital will distort the market for technology investments. So Sequoia fights back with an 8 billion growth fund.
VCs now have more money than ever before, and this unlocks some unique opportunities. Elon Musk had proven that the right founder could disrupt pretty much any industry, as long as they had enough runway to work on the problem for decades. Founders Fund had witnessed this firsthand when they broke through in defense contracting with Palantir and SpaceX. So they doubled down and backed under founders can now raise billions of dollars in venture capital, all without losing control over their companies. When it works out, everyone gets rich together.
But if there are bumps in the road, things get messy. In 2018, Benchmark goes to war with Travis Kalanick for control of Uber. It’s a big turning point in the extremely founder-friendly environment, and things don’t stop here. Then, WeWork tries to IPO, but ultimately has to pull the offering. There’s a big messy fight for control over the company, and people start thinking that maybe these big startups are staying private too long.
The Power law Book:
And that brings us to today. Two years of lockdowns have fueled even more growth in new technologies, and now 900 billion dollars is sitting in venture capital. All this money is hunting for the next big breakout, but it’s unclear where the industry will go from here. If you want to learn more, you really have to read this book called “The Power Law” by Sebastian Alibi. It’s an incredible read.
“The Power Law” demonstrates the importance of finding a few huge successes early on. With so much money chasing so few opportunities, the typical return targets might need to adapt. The entire goal of venture capital is to outperform the S&P 500. No one wants to pay management fees to a venture capitalist if they could earn a better return by buying an index fund.
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