Those interested in investment will find a wealth of knowledge in Sebastian Mallaby’s The Power Law: Venture Capital and the Making of the New Future. This behind-the-scenes examination of Silicon Valley’s most successful venture capital firms reveals the investment strategies of luminaries like Yuri Milner and Chase Coleman.
Mallaby explores how these investors’ strategies have evolved venture capital and the global economy. His insights, especially into the power law, have seen the book garner praise from big names, including The Wall Street Journal.
The Journal describes the book as: “A gripping fly-on-the-wall story of the rise of this unique and important industry based on extensive interviews with some of the most successful venture capitalists.”
Understanding The Power Law
The power law is a concept that many of Silicon Valley’s most successful investors have embraced. When they make 10 investments, 7 or 8 will fail. However, the others will create returns of at least 10 times their investment. Because of this, investors should expect around 80% of their investments to generate 0 returns.
An Industry-Defining Investment: Yuri Milner and Facebook
One of the best examples of the power law in practice is Yuri Milner’s 2009 investment in Facebook. The Eureka Manifesto author knew he wanted to invest in the social media platform. However, this wasn’t easy for an unknown venture capitalist. Facebook’s investors included big names like Microsoft, Peter Thiel, and Accel.
Nonetheless, Milner contacted Facebook’s CFO to tell him he wanted to invest. Although Milner was an unlikely candidate, in the end, the CFO and founder Mark Zuckerberg accepted his offer.
Along with proposing a financial investment outbidding all competition, Milner had:
• Created a spreadsheet of global data on international social media companies. This spreadsheet highlighted revenue opportunities that Facebook was not yet leveraging.
• Decided he didn’t require a board seat. This meant he would allow Zuckerberg to maintain full control over the company, even voting Milner’s shares however he liked.
• Offered to buy employee stock on top of his shares. He proposed that he would pay one price for company-issued stock and another for secondary stock that Facebook employees sold.
Within 18 months of Milner’s investment, Facebook was worth $50 billion, and Milner’s DST Global had profited more than $1.5 billion. Milner went on to apply his successful investment strategy to other companies. This saw him play a major role in the growth of Alibaba, Spotify, X (formerly Twitter), WhatsApp, Snapchat, and JD.
Tiger Global’s Success With Chinese Web Portals
Before Milner’s investment in Facebook, other investors were already paving the way for similar success. For example, in 2001, venture capitalist Chase Coleman launched a small hedge fund called Tiger Global.
He partnered with Blackstone analyst Scott Shleifer, who sought out investment opportunities in semiconductors and hardware. Given the Nasdaq technology bust, this search wasn’t going well.
However, Shleifer’s friend sent him a spreadsheet listing internet infrastructure, dot-com consumer, and online services companies. One part of the spreadsheet listed Chinese web portals that had gone public just before the technology bust — companies like Sohu, Sina, and NetEase.
With funding from venture capitalists like Kathy Xu and Shirley Lin, these companies had seen rapid growth. The venture capitalists had invested based on the founders’ characters and the potential of their markets.
Shleifer took a different approach. Each company had matured to a point where it had customers, revenues, and costs. He calculated the value of each, using a method he had learned at Blackstone that most Silicon Valley investors weren’t familiar with.
Incremental Margins vs Profit Margins
This strategy involved looking at each company’s incremental margins instead of their profit margins. Incremental margins refer to the share of revenue growth that falls to the bottom line as profits, rather than the share of revenues left after costs are deducted.
An investor only considering the profit margins would see that these companies were losing money. However, as an investor considering the incremental margins, Shleifer could see that as revenues increased, costs increased at a much smaller rate. This meant the companies had huge profit potential.
Implementing this strategy allowed Shleifer and Tiger Global to make well-informed choices about investments that would see huge success. As such, the company generated $100 million in under 12 months.
Shortly afterwards, in 2004, Tiger Global invested in Milner’s email service company Mail.Ru Group. The hedge fund inspired Milner to craft the data-driven investment strategy he employed when investing in Facebook.
Industry-Defining Power Law Investments
Thorough data analysis led both Chase Coleman’s Tiger Global and Yuri Milner’s DST Global to make industry-defining power law investments. But these are just two of the companies that have changed the face of Silicon Valley. Read The Power Law to learn about more of the venture capital strategies that have created huge returns.