Sebastian Mallaby is a senior fellow at the Council on Foreign Relations and most recently the author of “The Power Law: Venture Capital and the Making of the New Future,” from which this essay is adapted. He begins a Post column next month.
The defection of 1957 was made possible by a new form of finance, what we call venture capital today. The idea was to back technologists who were too dicey to get a conventional bank loan but who promised the chance of a resounding payoff. The funding of the “Traitorous Eight” and their company, Fairchild Semiconductor, was arguably the first big venture deal in the Valley; and from that moment on, teams possessed of grand ideas and stiff ambition could spin themselves out, start themselves up and generally invent the organizational form that best suited their fancy. Engineers, inventors, hustlers and artistic dreamers could meet, combine, separate, compete and simultaneously collaborate, all courtesy of this new finance. Talent had been liberated. A revolution was afoot.
In its modern incarnation, venture capital involves a series of transactions. When a start-up is formed, “seed” investors might advance $1 million to help it develop its first prototype, receiving shares in exchange. If the start-up makes progress, it will raise a “Series A” round: This time, venture capitalists might advance $10 million so the company can hire salespeople and reel in the first customers. At each stage in the journey, a fresh round of financing depends on the attainment of an agreed milestone, and at each stage, the investors provide capital for shares. Of course, most start-ups fail, with the result that these shares turn out to be worthless — building companies is tough. But the few start-ups that make it often have exponential stock rises, delivering gains to venture capitalists that offset multiple losses.
The invention of this liberating finance explains more than most people still realize. Today, venture capital has morphed from a niche specialty into a global juggernaut, spreading far from the Valley to China, Israel, Europe and beyond. Venture-backed start-ups have changed how people work, socialize, shop and entertain themselves; how they access information, manipulate it and arrive at quiet epiphanies — how they think. But the significance of venture capital goes further. The liberation of the Traitorous Eight, and the countless entrepreneurial liberations since then, explain how Silicon Valley came to dominate innovation. Policymakers the world over have tried to understand the Valley’s secret sauce and bottle it. They must begin by understanding venture capital.
This, to be sure, is not what the standard history teaches. But the rival theories of what established the Valley’s preeminence — that it was home to Stanford University, that it benefited from military contracts, that it was blessed with a certain countercultural irreverence — have never been especially persuasive. After all, Stanford was no more distinguished than the Massachusetts Institute of Technology, which was itself a short drive from Harvard, creating a research cluster more powerful than anything Silicon Valley could muster in its early days. And though Stanford did benefit from military research dollars, the famous military-industrial complex of the 1950s was primarily an East Coast alliance between the Pentagon and Cambridge, Mass. If military ties had determined the location of applied science, Cambridge should have been the center of the universe.
Meanwhile, the cultural explanation for California exceptionalism also falls short. The anti-materialist hacker ethic, championed by communalist nerds who obsessed over code and declined on principle to monetize it, is often cited as the source of California’s peculiarly inventive culture: “We Owe It All to the Hippies,” a Time magazine essay claimed in 1995. But the hacker ethic actually originated at MIT — with the Tech Model Railroad Club, a group of undergrads enthralled by the technology behind model trains before their attention shifted to computers. Similarly, Tim Berners-Lee, the British-born and Geneva-based inventor of the World Wide Web, combined creative imagination with an anti-materialist disdain for business: “If you’re interested in using the code, mail me,” he wrote in a public announcement, refusing to profit from his invention. In Finland, Linus Torvalds created the bare bones of the Linux operating system and gave it away for free. In short, there has been no lack of inventiveness outside Silicon Valley and no lack of countercultural anti-business prejudice outside it, either.
The truth is that the distinguishing genius of the Valley lies not in its capacity for invention, countercultural or otherwise. The first transistor was created in 1947, not in Silicon Valley but at Bell Labs in New Jersey. The first server software was from Minnesota. The first graphical browser was co-developed by Marc Andreessen, the billionaire entrepreneur who was then at the University of Illinois. So, too, early versions of the search engine, Internet-based social networking and smartphone all emerged outside the Valley. No single geography dominates invention. Yet all these breakthroughs have something in common. When it came to turning ideas into blockbuster products, the Valley was the place where the magic happened.
And the magic sprang from venture capital. By freeing talent to convert ideas into products, and by marrying unconventional experiments with hard commercial targets, this distinctive form of finance fostered the business culture that made the Valley so fertile. In an earlier era, J.P. Morgan’s brand of finance fashioned American business into muscular oligopolies; in the 1980s, Michael Milken’s junk bonds fueled a burst of corporate takeovers and slash-and-burn cost cuts. In similar fashion, venture capital stamped its mark on an industrial culture, making Silicon Valley the most durably productive crucible of applied science anywhere, ever. By the 21st century, an astonishing 70 percent of the publicly traded tech companies in the Valley could trace their lineage to Fairchild Semiconductor; and every hoodie-wearing innovator owed something to that crucible moment when it raised venture finance.
By the 21st century, an astonishing 70 percent of the publicly traded tech companies in the Valley could trace their lineage to Fairchild Semiconductor.
The investor behind the Traitorous Eight was a 30-year-old MBA named Arthur Rock. Slight, taciturn, his eyes often clouded behind large glasses, Rock was not an obvious founding father, especially not of a swashbuckling innovation in finance. He had grown up poor in Rochester, N.Y., the child of Yiddish-speaking immigrants, and had worked as a soda jerk in his father’s small grocery store. He had suffered from childhood polio, performed miserably in athletics and been brutally victimized by antisemitic classmates. During a wretched stint as an Army conscript, he had bridled at reporting to superiors whom he considered “not too bright.” Perhaps because of these experiences, Rock was reserved to the point of being prickly. He suffered fools impatiently, and the fools always knew.
The pivotal moment in Rock’s still-early career arrived in the summer of 1957, in a letter mailed to the New York brokerage where he worked. The sender was Eugene Kleiner, one of the Eight and later himself a venture investor. Because venture capital barely existed at this point, Kleiner and his comrades had not thought of starting a new enterprise. Rather, they asked Rock’s firm to identify an alternative employer — “a company which can supply good management.”
Rock understood that the researchers wanted to escape the tyrannical Shockley, the semiconductor inventor whose scientific brilliance was matched only by his prodigious arrogance. Rock also understood that they wanted to keep their team together, believing they could be most inventive as a group. Rather than seeking out a new employer for them, Rock flew to the West Coast and proposed an unexpected alternative.
“The way you do this is you start your own company,” he told them. By striking out on their own, the scientists would capture the rewards of their creative wizardry. A self-made loner from outside the establishment, Rock felt strongly that a certain kind of justice would be served.
Rock’s idea shocked the researchers. “We were blown away,” recalled Jay Last. “Arthur pointed out to us that we could start our own company. It was completely foreign to us.”
Gordon Moore, another of the Eight, who would go on to achieve fame as a founder not only of Fairchild but also subsequently of Intel, characterized his reaction even more directly. “I’m not the sort who can just say, ‘I’m going to start a company,’ ” he told an interviewer later. “The accidental entrepreneur like me has to fall into the opportunity or be pushed into it.” In that summer of 1957, Rock was pushing firmly.
Rock promised the scientists at least $1 million, an ungodly sum of capital at the time. He also stressed that they would each own shares in their start-up.
The scientists duly launched Fairchild, and the results soon proved more raucous, and more glorious, than even Rock had imagined. This was the era of “The Organization Man,” of managers who marked their status with carved paneling, fake fireplaces and dressing rooms. But at Fairchild Semiconductor, the formality and hierarchy of 1950s business culture were tossed out the window. The team worked out of utilitarian cubicles. Company strategy was hashed out at collaborative bull sessions. Sales meetings featured brownies and whiskey. New hires straight out of grad school were empowered to make decisions.
Within a few months of its founding, Fairchild was pushing the frontiers of innovation at a pace that the suffocating Shockley never would have permitted. The scientists were trying out new products: innovative switches, a revolutionary scanner, new combinations of metals in semiconductors (those critical components of most electronic circuits). And the whole effort was self-consciously commercial. At other companies in the 1950s, researchers wore white smocks and were generally confined to the laboratory. But at Fairchild, they were out talking to the customers even before developing their first transistors, determined to discover what kind of device would sell. The goal was to make stuff that the market wanted — stuff that would cause the value of their personal equity to grow.
Sure enough, it did grow. At the formation of the company, Rock had ensured that each of the Eight bought $500 worth of stock. Two years later, Fairchild sold to its main backer, and each founding scientist received $300,000, a bonanza amounting to around 30 years’ salary at the time.
And Rock had a feeling this was only the beginning. More important than the gratifying payout, Fairchild’s success had demonstrated the liberating power of venture capital. It was about unlocking human talent. It was about sharpening incentives. It was about forging a new kind of applied science and a new commercial culture.
At the formation of the company, Rock had ensured that each of the Eight bought $500 worth of stock. Two years later, Fairchild sold to its main backer, and each founding scientist received $300,000.
Over the next decade, Rock took his idea to the next level. He quit his East Coast brokerage, moved to San Francisco and raised a dedicated venture fund. Along the way, he solved one of the most intriguing puzzles in investment history: how to back risky start-ups that normal investors shun.
To begin with, Rock acknowledged the sound reasons why start-ups are so hard to fund. According to the standard rules of finance, allocators of capital should seek collateral. Creditors back companies with physical or financial assets, so if the business hits the skids, they can recoup their loans by selling buildings, stock portfolios or land. Equity investors analyze “book value,” a measure of the capital that can be extracted if the company is wound up. Rock announced cheerfully that he was seeking something different. In backing start-ups, he was betting on “intellectual book value” — the dreams and determination that lay hidden inside the heads of entrepreneurs. If the venture failed, he would not get his money back.
Another standard financial practice, then and now, is to forecast company profits. Investors like to compare the price of a share with projected earnings, combining these numbers into a price-to-earnings ratio. But this reassuring quantitative benchmark was also of no use to Rock: He was backing start-ups whose earnings existed only in an imagined tomorrow. The few props that Rock could grab on to were, again, intangible: the character of the start-up founders, the quality of their ideas. Judging such variables was necessarily subjective. Investment decisions about tech start-ups originated, as Rock put it, “either from ‘the seat of the pants’ or the ‘top of the hat.’ ”
When Rock raised $3.4 million for his first venture fund in 1961, most contemporaries regarded such pronouncements as reckless. But over the next seven years, Rock confounded them. The chief cause of his triumph lay in what venture capitalists came to call “the power law”: the idea that, while most start-ups end up being worth zero, a handful take off exponentially. “Venture capital is not even a home-run business,” Bill Gurley, the venture capitalist behind Uber remarked a few years ago. “It is a grand-slam business.”
Thanks to the power law, Rock’s difficulty in evaluating start-ups was not fatal. The subjective nature of his methods meant he would be wrong much of the time, but a tiny number of winners could make up for the losers. Sure enough, Rock’s first venture fund multiplied his backers’ money an extraordinary 22-fold, largely on the strength of one astonishingly successful bet. Defying the conventional wisdom that taking on IBM, the giant computer incumbent, was bound to be a losing strategy, he backed an upstart challenger, Scientific Data Systems. When SDS became the fastest-growing computer company of the 1960s, Rock’s $257,000 investment generated a jackpot of $60 million.
When word of Rock’s returns spread, the taciturn investor became a business celebrity. In 1968, Forbes posed the question on the minds of many readers, “How do you get to be like Arthur Rock?” After the Forbes article was published, ambitious imitators rushed to copy Rock’s methods. The following year, $171 million flowed into private venture funds, fully 50 times more than Rock had raised in 1961.
The boom set the stage for Silicon Valley’s takeoff, its eclipse of the rival tech cluster around Boston and, ultimately, the Valley’s enduring dominance of innovation over the next half-century. Strangely, Rock’s role in this story is seldom recognized. The prevailing narrative about the Valley lionizes inventors and company founders, neglecting the financiers who liberated them.
Thanks to the power law, Rock’s difficulty in evaluating start-ups was not fatal. The subjective nature of his methods meant he would be wrong much of the time, but a tiny number of winners could make up for the losers.
Today, Rock is a self-effacing nonagenarian active in philanthropy. “I never wanted to be the richest corpse in the cemetery,” he says of his charitable giving. But his business legacy is obvious. His “power law” approach to risk management has freed generations of VCs to back high-risk, high-potential start-ups, knowing they could absorb the cost of failures because the winners would be so profitable. The result is a financial specialty so influential that it demands a new framing of how capitalism works.
The economics profession has long recognized two great institutions of modern capitalism: markets and companies. Markets coordinate activity via price signals and arm’s-length contracts. Companies coordinate by assembling large teams led by top-down managers. But economists have focused less on the middle ground that venture capital inhabits.
Venture capitalists channel capital, advice and talented recruits to promising start-ups; in this way, they replicate the managerial direction and team formation found in corporations. At the same time, venture capitalists have the flexibility of the market. They can get behind a start-up with a fresh business idea; they can shape it, expand it, murmur its name into the right ears. But when a round of funding is exhausted, the market will decide what happens. If there are no enthusiastic buyers for the next tranche of the start-up’s equity, it will be forced to close, avoiding the waste of resources that comes from sticking with doomed speculative ventures. This blend of corporate strategizing and respect for the market represents a third great institution of modern capitalism, to be added to the two that economists traditionally emphasize.
Venture capital challenges economists in another way as well. A huge amount of energy in government and the private sector is spent on economic forecasting; without a clear view of the future, committing resources would seem irresponsible. But extrapolations from past data anticipate the future only when there is not much to anticipate; if tomorrow will be a mere extension of today, why bother with forecasting? The revolutions that will matter — the big disruptions that create extreme wealth for inventors and great anxiety for workers — cannot be foretold because they are so thoroughly disruptive. Rather, they will emerge from the murky soup of tinkerers and hackers and hubristic dreamers, and all you can know is that in 10 years the world will be excitingly different. The future can be discovered by means of iterative, venture-backed experiments. It cannot be predicted.
Of course, venture capital is far from perfect. The very success of the industry has attracted incautious investors who shower money on young companies without overseeing their founders. The result is multibillion-dollar “unicorns” with inadequate governance. In a few celebrated cases — the office-space company WeWork; the ride-hailing giant Uber; the blood-testing sham Theranos — entrepreneurs who thought themselves accountable to nobody cut ethical corners, with investors, employees and customers alike paying the price. The underrepresentation of women and minorities is another failing. Women account for only 16 percent of investing partners at VC firms. Black investors account for only 3 percent. An industry that involves subjective judgments about start-up founders is wide open to bias and should stress diversity all the more. Without progress on this front, people of a certain type will fund people of a similar type. The venture industry is a meritocracy, up to a point. It is also what its critics call a “mirror-tocracy.”
Despite these important reservations, venture capital is a positive force for societies and economies. Only a fraction of 1 percent of firms in the United States receive venture-capital backing, yet this tiny minority accounts for fully 47 percent of the nonfinancial companies that do well enough to go public and 76 percent of the market capitalization of these firms. Venture-backed companies have delivered more progress in applied science than any kind of rival: more than centralized corporate research and development units, more than isolated individuals tinkering in garages and more than government attempts to pick technological winners. Studies repeatedly find that start-ups backed by good VCs are more likely to succeed than others.
Even as the public mood has turned against the tech-industrial complex, this positive case for venture capital needs to remain front and central in policymakers’ minds. As Silicon Valley’s origin story demonstrates, venture capital liberates talented people to be their most effective and creative. The United States needs the innovation that results if it is to compete with China’s rising tech complex — and this competition ranges from civilian technologies (pharmaceuticals, medical robots) to military ones (artificial-intelligence weapons and surveillance systems) and dual-use hybrids (Internet routers, drones). For the past generation, Americans have celebrated entrepreneurs such as Steve Jobs and Elon Musk. But think of Arthur Rock and remember: Without the venture capitalists who helped them get started, Jobs and Musk might have remained unknown.