Elnora H. and William B. Quarton Professor of Business Administration and Economics, Coe College, Iowa
Power Law, 5/23/2022
I read Sebastian Mallaby’s Power Law. Well, actually I listened to the audible version of it. I found audio books more convenient these days. Mallaby is no stranger to me. I read his book More Money Than God before. Both books are well researched with an impeccable flow of storytelling. How do you know you are reading good stories? You get inspired by the characters in the books. You are not being lectured on. You are not reading someone’s indulgence or vendetta. Stories. Just inspiring stories.
In Mallaby’s stories, he took us to a grand tour of the history of Silicon Valley. It was a treat when you read it in full, but I want to only focus on two central points in the book and spare you the other details.
The name of the book is Power Law. It is a statistical description of some natural phenomenon. Many industries, for example, exhibit a Power Law distribution in which the leader’s size, profit, or market share is the combination of the rest of the industry (and the second is the combination of the third and on down and so on and so forth). It is a winner-takes-all phenomenon. The venture business is all about the Power Law as early stage startups might end up as the leaders of a new industry. Venture capitalists must go after these startup winners because the upside payoff is huge. Interestingly, VCs themselves also have a Power Law distribution. Top firms like Kleiner Perkins and Sequoia have more successful cases than the rest of the industry combined.I first learned about Power Law in Peter Thiel’s Zero to One. I think Mallaby’s also inspired by Thiel’s observation.
With years of observing investors and studying investing, I can say that VCs and investors like Warren Buffett are different animals. Their philosophies are different mostly because they are going after different investments.
Buffett is concerned with “the error of commission”. He has a long investment horizon. Both profits and losses compound. He used to talk about his biggest mistake-the SInclair gas station he invested in when he was young. The loss might not be much by today’s standard, but that money could have grown into tens of billions of dollars if he had put it into a better investment. Because of this fear of losing, he chooses investments carefully. I think this mentality should apply to any retail investor. We can have average, or slightly better than average, investments and let time take care of the rest, but we should strive to avoid any losses.
But VCs are quite different. They have to face big return uncertainties. They have a Power Law to look at, but the tail of the distribution is long, meaning they are more lousy startups than good ones. They are more likely to pick a loser than a winner. The right way to venture investing is to avoid “the error of omission”. VCs should cast a wide net. Small and numerous failures are fine, as long as they occasionally hit a jackpot like Facebook or Google. The winnings can easily more than make up for other losses.
On the other hand, VCs don’t have the luxury to wait. They are using other people’s money for a limited amount of time. So they need to act fast and get ready to lose money, but can’t let the Zuckerbergs simply walk away from them.
I always have more respect for VCs than for hedge funds because I think VCs serve a function in society that is uniquely important. American prosperity in the future depends on the continuous risk-taking and job creation done by startups. They are literally the future of America.
The other point I want to focus on has something to do with this American prosperity.
Mallaby’s book tries to explain why venture investing and startups happen in Silicon Valley. I don’t think he is satisfied with his own explanations. That’s why he uses stories of founders and venture investors to illustrate how people, not weather, not the system, not the location, nor the proximity to Stanford, shape Silicon Valley and make it into the world’s premier, and probably the only true, hub of startup ventures.
But I think startups and VCs have this inevitability to happen in the U.S. We have the world’s best political and legal system that protects individuals’ rights and properties. Our system allows free people to exert their endowed abilities. With the system, size of the market, and a vast land, the U.S. is bound to have smart people trying hard to create new businesses and bound to have some other smart people trying to find ways to fund them.
It had to happen in the U.S., but I think ventures clustering in Silicon Valley is just a fluke. It could have been Seattle or Los Angeles. But it got started in the Bay area. That wasn’t by design of genius politicians or dreamt about by some visionaries. It just happened. Once the first few startups got started and showed phenomenal success in Silicon Valley, the place itself became inevitable. Success attracts money. Money attracts talent. Talent creates success. The wheel of fortune, once moving, can’t stop.
With all the problems happening in the People’s Republic of San Francisco, I see San Francisco losing its luster, but I have huge confidence that, even with remote work getting more popular, Silicon Valley will remain the unchallenged leader of startup ecosy
Back to homepage.