In “The Power Law: Venture Capital and the Making of the New Future” (2022), Sebastian Mallaby explores how venture capital (VC) has driven innovation and influenced the global economy. The book tells the stories of Silicon Valley’s dominant VC firms and successful venture capitalists like Yuri Milner.
Central to VC is the power law, where a few investments drive most of an investor’s returns. Indeed, the success of a single venture can reshape entire markets. Mallaby’s book sheds light on the power law concept and explores VC’s evolution.
Exponential Returns, Tail Events, and The Power Law
Unlike many other forms of finance, VC embraces uncertainty by focusing on “tail events” — radical departures from the norm. Venture capitalists seek rare, high-risk investments, where only a small number of wins will generate exponential returns.
In “The Power Law,” Mallaby explains that Silicon Valley venture capitalists recognize that their returns from startup investments obey the power law. Also known as the Pareto principle or the 80/20 rule, the power law suggests that a small percentage of causes leads to the majority of effects.
For example, the investment company Horsley Bridge saw 5% of its capital produce 60% of its total returns between 1985 and 2014. Similarly, Y Combinator, a tech startup backer, found that just 2 out of 280 investments made up 75% of its gains in 2012.
Mallaby cites former PayPal CEO Peter Thiel: “The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund.”
According to the power law, “winners advance at an accelerating, exponential rate” and eventually “become outsized stars.” In other words, as venture capitalists achieve success, a feedback loop compounds their positive outcomes, leading a handful of individuals to dominate a sector.
The emergence of these stars depends on a complex interplay of factors like luck, skill, and path dependency (where past events or choices influence future outcomes, making change difficult). But no matter how these winners succeed, their dominance grows rapidly and leaves little room for others to compete.
Mallaby notes that “once Jeff Bezos achieves great riches, his opportunities for further enrichment multiply,” illustrating how the power law acts as “the most pervasive rule in venture capital.”
The Impact of Venture Capital on Our World
Across 14 chapters, “The Power Law” examines the profound impact VC has had on the world, particularly in technology. Companies like Facebook, Apple, and Uber exemplify how a few standout firms can transform our work, social lives, shopping habits, entertainment, access to information, and even our thinking.
Mallaby argues that venture capitalists have achieved such a “disproportionate impact” by backing these transformative companies because VC combines “the strengths of the corporation with the strengths of the market.”
Venture capitalists direct capital, talent, and customers to promising startups, mirroring corporate team structures while maintaining market flexibility. When a round of venture funding concludes, the startup faces a market test: If no buyers emerge, investors cut their losses to avoid wasting resources.
The Venture Capitalist Mindset
Mallaby describes VC not merely as a business but “a mindset, a philosophy, a theory of progress.” He cites Vinod Khlosa as a prime example of this mindset.
Khlosa, an Indian-born venture capitalist, believes that “most social problems can be ameliorated by technological solutions, if only inventors can be goaded to be sufficiently ambitious.” He founded Khosla Ventures in 2004 and made significant inroads into the early internet market by investing in bandwidth technology companies.
Another prominent tech investor who embodies this philosophy is Yuri Milner. His investment company DST Global made a landmark purchase of major shares in Facebook in 2009. Milner also co-founded the Breakthrough Prize, the world’s largest scientific award, and the Breakthrough Initiatives, space science programs advancing humanity’s knowledge of the cosmos.
Meanwhile, Milner’s book “Eureka Manifesto: The Mission for Our Civilization” (2021) advocates for a collective mission that embraces ambitious scientific and technological progress.
These visionary investors support innovative thinkers who offer “the best shot at satisfying human aspiration.” Often, these innovators aren’t experts in the fields they seek to disrupt. Mallaby notes that “radical rethinks” tend to come from outsiders.
After all, retail innovation came from Amazon, not Walmart. Elon Musk’s Tesla introduced next-generation cars, despite Musk not being an “electric car person” before founding the company.
Mark Zuckerberg and Yuri Milner: Shifting the Balance of Power
In Silicon Valley during the early 2000s, these innovative outsiders were increasingly young and rebellious. Chapter nine of “The Power Law” recounts how, in 2004, Mark Zuckerberg and his friend Andrew McCollum arrived “insolently late” to a Sequoia Capital meeting, dressed in pajamas and claiming to have overslept.
Mallaby explains that Zuckerberg’s pajama prank was a pivotal moment for VC. While many young entrepreneurs were playing hard to get with investors, Zuckerberg genuinely didn’t want Sequoia’s backing. He was concerned about relinquishing too much control to investors who might impose their own vision or management style.
This shift in attitude reflected a broader VC trend: Entrepreneurs were becoming more selective about their investors.
Some years later, Milner’s investment in Facebook contributed to a new era of entrepreneur empowerment. By injecting significant capital without demanding a board seat, Milner allowed Zuckerberg to retain more control over Facebook and delay going public.
This approach facilitated the creation of massive private wealth while sidestepping the scrutiny of public markets and traditional governance.
Data-Driven Decisions and Iterative Experiments
Unlike traditional investing, venture capitalists accept that extrapolating from past data cannot predict the major disruptions that create immense wealth, “precisely because such revolutions are so thoroughly disruptive.” Instead, venture capitalists believe we can discover the future through “iterative, venture-backed experiments.”
However, this experimental approach doesn’t discount the power of data to predict trends. Milner’s investment in Facebook, for instance, stemmed from his data-driven strategy.
Mallaby describes how Milner “meticulously compiled the key metrics on the world’s social media firms.” His revenue projections enabled him to offer Zuckerberg a $10 billion valuation, outpacing other investors who made lower offers.
Milner’s predictions proved accurate, as Facebook’s audience and revenues skyrocketed in the following 18 months. This success demonstrated the power law in action: Milner’s strategic investment generated immense returns while others missed out, paving the way for further triumphs with internet giants like Spotify, Alibaba, Airbnb, and Twitter.
The Evolution of Venture Capital
“The Power Law” illustrates how key innovators have reshaped VC through novel investment strategies.
For example, Tiger Global pioneered late-stage tech investing in the early 2000s. Rather than simply focusing on startups, the hedge fund also targeted fast-growing companies ready to scale, capitalizing on mature businesses with proven potential for returns.
Tiger also challenged the “traditionally parochial outlook of Silicon Valley investors.” The firm placed winning bets on Asian tech companies like Sina, Sohu, and NetEase, earning $100 million in less than a year.
In 2009, Andreessen Horowitz (a16z) set out to differentiate itself from competitors by claiming to have developed a new kind of VC model. The Silicon Valley-based VC company drew inspiration from Milner’s tech incubation approach, which involved providing capital to “precocious breakout firms.”
Traditional VCs often replaced technical founders with “real CEOs” — leaders experienced in managing companies. In contrast, a16z assured founders it wouldn’t replace or abandon them.
Instead, the firm “promised to smooth the learning curve for scientists who wanted to be chief executives.” a16z offered tech startups guidance on decision-making and provided valuable industry connections.
The Enduring Impact of the Power Law
Mallaby vividly illustrates how VC drives technological and economic transformation through the power law. This principle reveals that a small number of investments can yield outsized returns, reshaping entire industries and creating substantial wealth.
The book also emphasizes how the evolving VC landscape has empowered a new wave of entrepreneurs, including Zuckerberg and Musk.
Ultimately, “The Power Law” captures the “special way of coming at the world that animates venture capital.” A fearless embrace of uncertainty and a relentless pursuit of breakthrough ideas characterizes the VC approach to investing.
Venture capitalists thrive on tackling daunting problems, driven by the logic of the power law: “the rewards for success will be massively greater than the costs of honorable setbacks.”
Visionary investors like Milner have helped shape the future through bold bets on disruptive technologies. For more insight into Milner’s forward-thinking approach and his vision for humanity’s progress, read his short book “Eureka Manifesto.”
