The Law of Indexes: Investing in the Raw Diamonds
”The History of Venture Capital” is the new work of financial historian Sebastian Malaby, who was previously known for his “Rich and Enemy”. In “A History of Venture Capital,” Malaby takes us inside the venture capital industry, examines venture capital with the law of the index, explains why venture capitalists’ sole purpose is to win the jackpot, and is critical to the venture capital industry. The biggest strengths and most dangerous blind spots are candidly analyzed.
The index rule is the most common rule of venture capital
The law of exponents is also known as the “80/20 law”: 80% of the wealth is held by 20% of the people, 80% of the people live in 20% of the cities, and 20% of the scientific papers account for 80% of the cited papers. It is called the law of exponentials because winners’ returns grow at an ever-increasing exponential rate, and they explode upwards much faster than a linear progression. Malaby points out that, like Jeff Bezos, once he acquires a huge fortune, his odds of becoming even richer multiply; the more citations a scientific paper gets, the more famous it becomes, The more likely it is to attract more citations. Whenever an exponentially growing outlier is encountered, there is a switch from the realm ruled by the normal distribution to the realm ruled by the skewed distribution—switching from a world where things change smoothly to a world where things change dramatically. Once the dangerous boundary is crossed, it’s best to think differently.
In finance, investors who focus on currency, bond, and stock markets often assume that changes in prices are normally distributed, with values going up and down, but extreme volatility is unusual. Between 1985 and 2015, the S&P 500 moved less than 3% from its opening price on 7,663 of the 7,817 trading days. That said, the market is pretty stable 98% of the time. Because price changes in these widely traded markets are nearly normally distributed, speculators focus on profiting from the non-extreme fluctuations that occur most of the time. Unexpected large price movements are rare and have limited impact. to shake up the average by a wide margin.
That’s not the case with venture capital returns, however. Hollis-Bridge & Co. is an investment firm whose venture capital funds held equity backing 7,000 start-ups between 1985 and 2014. A small fraction of those deals, those that accounted for just 5% of the total asset allocation, generated 60% of Hollis-Bridge’s total returns over that period. Putting it in context, the market capitalization of the top 5% of the sub-sectors in the S&P 500 Index in 2018 accounted for only 9% of the total market capitalization of the index. Other VCs report even more skewed distributions: Startup Incubator (YC), which supports emerging tech companies, calculated that three-quarters of its 2012 earnings came from just two of the 280 companies it bet on. Hence, Peter Thiel writes in “From Zero to One”: “The great secret of venture capital is that the best investments generate returns that equal or exceed the total returns of the rest of the fund’s investments.” Benchmark Capital’s Bill
Gurley once commented: “Venture capital is not even a home run business, it’s a Grand Slam business.” Stocks that doubled in value in 3 years, those stocks that produced “amazing” returns. However, if venture capitalists use this as their investment principle, they will fail in all likelihood, because the number of start-up companies that have doubled their value under the index law is relatively small, or they fail completely, or create dozens of times or even hundreds of times. times the return. Usually, most companies fail, in which case their stock value goes to zero, which is an unimaginable disaster for investors. But there are also a handful of different companies that win the “Grand Slam” every year, and the only thing that matters to venture capitalists is owning a portion of these companies.
When modern venture capitalists choose to back projects like flying cars, space tourism, or the development of artificial intelligence systems to write movie scripts, they follow the law of exponents. Their job is to look into the future and seek high risk and high rewards that most people think are out of reach.
The field favored by venture capitalists lies in breakthrough technologies. After the invention of semiconductors, Ethernet cables that can interconnect personal computers were also invented. With the development of Internet technology, the utilization rate of network equipment gradually increased, and then exploded in an exponential curve. This is the index law of innovation, and with it the index law of financial investments in venture capital portfolios. VCs determined that the Internet would follow a similar pattern, with steady adoption in the first half of the 1990s, and its development curve would become almost perpendicular to the x-axis according to the law of the exponential, implying a spectacular acceleration growing up. And so it is, with companies in this space capturing a huge share of an exploding market by inventing a new generation of bandwidth-boosting hardware and software.
However, venture capitalists often fail to deliver on their judgments. However, in their view, the data analysis that traditional social scientists rely heavily on may be a blindfold rather than a telescope. One can extrapolate the future from past data only if there isn’t much to predict, and why bother predicting if tomorrow is just an extension of today? Major changes that create wealth for inventors, transform the way humans work, upset geopolitical balance, or alter human relationships cannot be extrapolated from past data because they are downright disruptive. A mature and comfortable society should be dominated by people who can analyze every possibility, manage every risk, and should be able to accept the unforeseen tomorrow. The future can be explored through iterative, venture-backed experiments, but it cannot be predicted.
Most people probably think that experts in each field push the frontiers of knowledge forward. However, this view is too idealistic. Experts are perhaps most likely to advance knowledge, but radical new ideas often come from the “layman”. After all, retail innovations didn’t come from Walmart, they came from Amazon; media innovations didn’t come from Time Magazine or CBS, but Uber, Twitter, and Facebook; Musk’s SpaceX; the next generation of cars is not from GM or Volkswagen, but from Musk’s Tesla.
In the book, by reconstructing the growth history of famous companies from Apple, Cisco to WhatsApp, Uber, etc., Malaby reveals how venture capitalists and start-ups come into contact and bring about catalyst-like changes, and why risks Investing is so different compared to other types of investing. For example, most financial institutions allocate scarce capital based on quantitative analysis, but venture capitalists pay more attention to discovering and attracting talent and spend less time studying data in spreadsheets. Most financial institutions value companies by forecasting their cash flows, but venture capitalists often back startups before they have cash flows to analyze. Most financial institutions realize profits through transactions in a short period of time, but venture capitalists will acquire relatively small equity after the company is established and hold it for a long time. Of course, the most fundamental difference is that most financial institutions will infer trends from the past and avoid extreme “tail event” risks, while venture investors want to completely abandon the past and only care about small probability tail events.
Venture capital is necessarily high risk
When financiers buy equity in companies, they prefer to choose safe and mature companies, preferably those with sufficient working capital, so that even if the company goes bankrupt, shareholders can still count on profits. One of the most representative is “Godfather of Wall Street” Benjamin Graham and his students. They are more inclined to find good deals with a huge margin of safety, so high-risk technology companies have become notorious in their eyes.
However, not all investors are overly cautious, and the exceptions are scattered and little known. Georges Doriot, a business school professor known as the “father of venture capital”, declared that the most ambitious but least-obtrusive projects will reap the greatest returns, and investors must wait patiently for long-term returns. The best prospects are advanced technologies, not orange juice or Asian fisheries. Like the later venture capitalists, he not only invests, but also provides management advice to entrepreneurs, helps them recruit talents, and provides assistance in everything from marketing to financing.
Modern portfolio theory, which occupies a mainstream position in finance, emphasizes “diversification”. By holding portfolios exposed to various unrelated risks, investors can reduce the overall volatility of their holdings and increase the risk-reward ratio. Yet venture capitalists often ignore this claim, determined to focus their bets on a dozen companies and insist on investing only in ambitious, high-growth companies—companies whose value will decrease for at least the next 5-7 years. up 10 times. They are well aware that venture capital is necessarily high risk, that most startups fail, and that the winners must win big enough to make the portfolio successful.
In the early 1960s, academia was defining finance as a quantitative science. But in the eyes of venture investors, venture capital is necessarily subjective, and judgments on technology startups will come from “personal experience or intuition”, and quantitative indicators such as price-to-earnings ratios that need to be considered in investment are irrelevant. If you focus too much on metrics like incremental profit, you risk missing the value of entrepreneurial genius. Therefore, they believe that the core principles of venture capital can be summed up in five words: “invest in the right people”.
The venture capital pioneers who created a new model of venture capital are Don Valentine and Tom Perkins, who are the main sponsors of Sequoia Capital and Kleiner Perkins respectively. In 1975, Valentine invested $62,500 in Atari, the world’s earliest video game company, and obtained 62,500 shares. Later, more than $1 million in funding was provided to Atari. By 1980, Valentine’s first fund had returned nearly 60% annually.
Perkins invested in Tianteng Computer. In 1976, he invested $1 million for a 40% stake, Kleiner Perkins’ largest investment in the 1970s. Since then, Perkins has invested an additional $450,000. By 1984, Tianteng Computer had created a return of more than 100 times for the US$1.45 million invested by Kleiner Perkins. That $150 million return eclipsed Kleiner Perkins’ $10 million in total gains on its other top nine investments. Therefore, Tanteng Computer has become a successful representative of the famous “Perkins’ Law”, which reveals the truth that “market risk is proportional to technical risk”, because if you solve a really difficult technical problem, you will face Minimal competition.
The experience of Valentine and Perkins proved the value of the new model of venture capital, and the idea that one bold investment can drive the success of the entire investment portfolio is reasonable. Unprofitable companies should not only be backed by venture capital, but should also be able to go public. Although they didn’t use the term “exponential law” at that time, they obviously noticed another logic of the exponent law: Entrepreneurs with management magic will not fail. They ushered in a new era of investing. Later Apple, Google, Genentech, Cisco, Netscape, eBay, Amazon, Facebook… are all products of the new model of venture capital. This allows growth investing to flourish, and the law of the index is unstoppable.
Venture capital is also evolving
With the success of Masayoshi Son’s investment in Yahoo, “growth investment” has opened a new era. Unlike the new model of venture capital, growth investing, which invests in companies in the mature or growth stages, began with the Yahoo case and underwent a natural transition. “Even if you invest in 19 wrong companies, it doesn’t matter as long as the 20th is Yahoo.” Growth investment has become the mainstream investment model in Silicon Valley since around 2009, and venture capital partnerships have also changed from a hyper-local model to a more global one. Vision business model. Internet company brands are faced with an urgent need for growth, which provides investors with opportunities for growth investment.
Sequoia Capital’s successor, Michael Moritz, was in for reflection as Valentine prematurely sold all of his pre-IPO stake in Apple. Back then, Moritz predicted that the internet would be dominated by brands, with technological features like search engines residing as humble plug-ins on popular sites that relied on consumer loyalty applications. Google is one such company whose main attraction is the technological superiority it possesses. It’s a cognitive leap: if you think existing search technology is already at 90% of peak performance, improving performance at 95% won’t win you users. However, if you think that existing search technology only shows 20% of its capabilities and there is still a lot of room for development, then Google is likely to be 3 to 4 times stronger than its competitors. In this case, the leading edge brought by its superior technology will attract a large number of users. Google’s success marks an important shift.
Peter Thiel was the first venture capitalist to explicitly discuss the “law of indices.” He quoted Wilfredo Pareto, the “father of Pareto’s law”, saying that in the natural and social world, asymmetry and inequality are common. At the beginning of the 20th century when Pareto lived, 20% of the people in Italy owned 80% of the land, and 20% of the pods in Pareto’s garden produced 80% of the total pea production. So it’s not just a coincidence that a single VC bet can dominate an entire portfolio, it’s a law of nature. In fact, this is the iron law that venture capitalists must abide by. A single start-up that forms a monopoly in a valuable niche will capture more value than millions of undifferentiated competitors combined, past, present, and future.
Thiel sees another point in the law of indices, arguing unconventionally that VCs should stop mentoring founders. In Valentine’s era, venture capitalists have always been proud of guiding start-ups, and post-investment management is the foundation of their life. However, according to the “Pareto Law”, the companies that really matter are extremely special. In any given year in Silicon Valley, there are only a handful of companies worth backing, and the founders of these outstanding start-ups must be so capable that little guidance from venture capitalists will hardly change their performance. “The strongest companies in our portfolio are often the ones we have the least exposure to,” a Founders Fund partner put it bluntly.
For Thiel, the art of venture capital is about finding rough diamonds, not polishing them. If, according to the Pareto Law, only a few truly original and revolutionary startups will succeed, then there is no reason or even a fight against the vibrant personality of each startup. Instead, venture capital should embrace founders who are rebellious, idiosyncratic, and as eccentric as possible. It could even be argued that if the founders weren’t eccentric enough, the businesses they created would be mediocre. It’s no accident that the best entrepreneurs are often arrogant, anti-human, or borderline crazy.
In any version of history, the law of exponents ensures that a few winners become superstars, but there is also an element of luck to who is a star. However, due to feedback effects, initial successes can set the stage for later successes. Of course, the first hit or two doesn’t seem to reflect the skill level of the venture capitalist. Instead, success comes from being “in the right place at the right time.” The secret to VC dynamism: If others are intimidated by a problem, the opportunity is there. They would rather try and fail than be afraid to try. Most importantly, the logic of the Law of Exponentials can be stated that the rewards of success will far outweigh the costs of an honorable failure. This heady law has turned venture capital into an enduring pillar of national power.