Power comes in many flavors. For example, relational power differs from structural power. Relational power exists when one player can influence others’ moves in the game. Structural power, by contrast, is the ability to influence the rules of the game itself. Relational power is about individual decisions; structural power is about the agenda, the rules, the exceptions, and the context in which decisions are made.
Relational power helps to obtain goals in stochastic situations; structural power affects who has what goals and what situations are likely to arise in the first place.
In Silicon Valley, the wealth and renown of the biggest VCs obviously give them relational power. They can attract the best graduates and dazzle promising founders.
The more interesting question is how the biggest VCs can influence the outcome before the race has even been announced. What kind of structural power accrues to the biggest Silicon Valley VCs?
Too Big to Fail?
CBInsights’ list of the eight VC firms with the highest-rated partners approximates the industry’s best and biggest. Seven are located in Silicon Valley, so we’ll consider this subset.
All VCs together invested $136.5 billion in US-based companies last year. The seven top VCs in Silicon Valley manage $112 billion, with Sequoia alone managing $38 billion. Losing any of those firms could jeopardize the system that has nurtured the unparalleled US tech sector over the last four decades.
GDP is another telling indicator. Silicon Valley’s $535-billion output accounts for nearly a fifth of California’s $3-trillion economy. Were it a country, California’s GDP would be the world’s fifth largest. Germany is number four, so if one industry accounted for a fifth of Germany’s economy, what would Germany, the EU, and the world do to prop it up?
That’s structural power: before any discussion about regulation or taxation even begins, certain topics are untouchable, certain outcomes are unthinkable, and everybody involved knows it.
Owning the Food Chain
Omnivores, like bears, pigs, and humans, have an advantage: we can find food anywhere on the food chain. From microscopic algae up to big game, it’s all energy to us.
Similarly, the biggest VCs can exploit opportunities at all levels of the startup food chain, each with its own benefits in terms of structural power.
Recently, market-leading VCs have been showering cash upon seed-stage companies. They have the resources to comb the field of startups, detect the most promising, and to disperse cash widely. It’s the carpet-bombing approach to investment. Hit-or-miss funding might seem like the opposite of a strategy, but there is method in their madness:
- Spreading cash among many highly promising early stage companies gives leading VCs an edge in follow-on rounds, crowding out the competition and co-determining the timing and participants of later rounds.
- VCs benefit from the fine-grained information they obtain from board seats, and carpet bombing yields the big VCs information about entire strata of startups that new incoming investors can only — at best — obtain with difficulty later.
The distribution of board seats is stark. The seven top Silicon Valley VCs have 105 board seats on average. By contrast, the seven most active VCs in Silicon Valley founded in the last year, which are naturally much smaller firms, have only three seats between them. Board seats provide information; bigger, older firms have more board seats; ergo, the incumbents own the information.
- Investing is path-dependent. Each decision locks in trajectories and affects future decisions. Therefore, participating early allows investors to influence events for years to come. Each valuation depends on the previous valuation. Each dilution depends on the previous cap table. An early term sheet can affect expectations for several rounds to come.
Pruning weak limbs…
A startling question recently appeared on Reddit. A VC was asking whether to participate in a follow-on round of a languishing startup. Surprisingly, maybe half of the responses suggest reinvesting and losing money … on purpose.
The question is unintelligible without reference to the norms of VC investing. Failing to reinvest in a follow-on round is a faux pas, potentially branding the VC as a fair-weather friend. Losing money on a dud can still be cheaper than losing access to future deals.
The biggest VCs, however, are less sensitive to reputational costs. If Mom&Pop VC make some decisions perceived as selfish, founders might stop taking their calls. By contrast, Peter Thiel could eat pickle and chocolate pizza naked on Instagram live without losing access.
In mid-stage follow-on rounds, most VCs do what they must; the biggest VCs do what they want.
Harvesting the fruit.
Having more capital lets the bigger VCs participate in later rounds, which yields a few advantages:
- As a startup progresses through funding stages, chances of failure decrease and chances of a successful exit increase.
- A 5x return on a billion-dollar investment is 500 times larger than a 10x return on a million-dollar investment.
- Big wins achieved rapidly in later stages score a higher IRR than the same gains spread over many years.
But that’s not structural power. No, the biggest VCs can make unicorns and decacorns by shepherding strong teams through the hurdles of scaling. Making unicorns can change the game.
For example, venture capital has pushed SpaceX from a near-unicorn ten years ago — already an expensive investment — to a valuation of $46 billion, soon to become $100 billion. Such growth has fuelled the impression that space is set to become a trillion-dollar industry.
By taking SpaceX from unicorn to decacorn, big, early investors like Founders Fund have generated not only returns, but an entire sector attracting remarkable buzz and money. This new sector is ripe for further carpet bombing, and strong inflows of capital promise continued growth.
The success of big firms’ investments becomes a self-fulfilling prophecy.
Creating decacorns lets the biggest VCs do more than harvest returns from a growing industry. It allows them to mould expectations about which industry is likely to grow next. They’re not just making plays in the market; they’re shaping the market in which everyone else is playing.