Is Venture Capital the Secret Sauce of the American Economy? (Ep. 482)
The U.S. is home to seven of the world’s 10 biggest companies. How did that happen? The answer may come down to two little letters: V.C. Is venture capital good for society, or does it just help the rich get richer? Stephen Dubner invests the time to find out.
Listen and follow our podcast on Apple Podcasts, Spotify, Stitcher, or wherever you get your podcasts. Below is a transcript of the episode, edited for readability. For more information on the people and ideas in the episode, see the links at the bottom of this post.
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Vinod KHOSLA: I was 16 in India when I heard about, and in fact read in a two-year-old magazine that I used to rent — once they were old, they came to India, and you could rent them for the weekend — that Andy Grove, a Hungarian immigrant, had come to Silicon Valley and started Intel. So that became a dream for me. If that immigrant can do it, why can’t I?
Stephen DUBNER: But didn’t you start a soy-milk company in Delhi?
KHOSLA: I did try and start a soy-milk company — I never got it started. There was never any funding available. There wasn’t an entrepreneurial culture there. And I still remember vividly, I called the phone company and they said, “Seven years to get a phone line.” I said, “I’m coming to Silicon Valley.”
That’s Vinod Khosla. He did come to Silicon Valley, and in 1982 he co-founded the technology firm Sun Microsystems. Today he runs one of the biggest venture capital firms in the U.S. — and, therefore, one of the biggest V.C. firms in the world. It’s called Khosla Ventures. Since 2004, it has invested in nearly 1,000 startup companies. Khosla often invests in little more than an idea.
KHOSLA: Pat Brown was a professor at Stanford, and he came to us and said, “I want to change animal husbandry on the planet.” That was his entire pitch.
Pat Brown was a very well-regarded biomedical researcher. Now he wanted to do something different. He had come to believe that the production of meat was really bad for the planet. And that’s what Brown would tell the venture capitalists.
Pat BROWN: My pitch to them was very naive from a fund-raising standpoint. I just told these guys, “Look, this is an environmental disaster. No one’s doing anything about it. I’m going to solve it for you.”
KHOSLA: As ridiculous as that sounded, it took us a half-hour to say, “Love the passion, love the mission, love Pat’s credentials.” And we said, “We’ll back you.”
Khosla — and other V.C. firms — did back Pat Brown. After several years and more than a billion dollars in venture money, his company became a sensation. It’s called Impossible Foods, and it makes plant-based substitutes for meat products. It is still privately held, and it’s already thought to be worth around $7 billion. Eventually the venture capitalists will get their money back, and much more. Now, what would have happened to Pat Brown’s idea in a different time, or a different place — I mean, a time and place without venture capital? Access to that kind of money for nothing more than an idea is a decidedly American phenomenon. If you look at the 10 biggest companies in the world as measured by market capitalization, seven are American and six of those raised venture capital: Apple, Microsoft, Amazon, Tesla, Facebook, and Alphabet (the parent of Google). The seventh is Berkshire Hathaway, Warren Buffett’s holding company, which essentially gobbles up existing firms. That is a much safer way to extract billions of dollars. Venture capital is inherently risky, especially at the early stage of a startup. For every Apple or Impossible Foods, there are thousands of failures. So you need a temperament that can handle it. Vinod Khosla has it.
KHOSLA: I don’t mind a 90 percent chance of failure if the consequences of success are consequential, like changing animal husbandry on the planet or making fusion reactors possible. If 10 percent of the time you make a large multiple, then you’re in pretty good shape.
DUBNER: Do you think you were born with that ability, to see that losing one times your money was really not that big a risk if the upside was 50x, or did you learn that?
KHOSLA: I think there was a whole lot of naïveté on my part. Probably a whole bunch of hubris. But naïveté, hubris, trying the impossible is very much Silicon Valley culture. It makes for a great story when Elon Musk builds a Tesla in a way that General Motors can’t.
Today on Freakonomics Radio: the U.S. economy is one of the most dynamic economies in the history of the world. Is venture capital the secret sauce?
Ufuk AKCIGIT: In societies where there’s a larger V.C. capital market, we are going to observe more radical, risk-taking innovations.
How do venture capitalists find a signal in all that startup noise?
Bill JANEWAY: My first law of venture capital is that all entrepreneurs lie. It’s the ones who don’t know they’re lying that really get you into trouble.
And: what’s it like to be on the receiving end?
Jonathan REGEV: When everything’s agreed upon, they submit a deposit to your bank account and then you have a lot more money.
Also: is venture capital good for society, or is it just about making rich people a bit richer? Everything you always wanted to know about venture capital but didn’t know who to ask.
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We’ve been running a series of episodes lately about what makes America so American. We’ve looked at cultural differences, political differences, and given the nature of this show, we’ve looked at a variety of economic differences. But if you were to ask a very basic question about the U.S. economy — something like “Why are so many of the world’s biggest and most innovative companies American companies?” — the answer might well circle back to two little letters: V.C. Venture capital. Imagine you have got what you think is a great business idea, but you just don’t have the money to scale it, to see if it really works. Consider Jonathan Regev.
REGEV: Because we didn’t have any extra capital, we were making the food ourselves. We were delivering the food. We were customer service.
You might think Regev started one of the many meal-kit companies you’ve heard about. But not quite.
REGEV I’m a co-founder of The Farmer’s Dog.
Which is what exactly?
REGEV: The Farmer’s Dog is an online pet-food company that makes it really easy to feed your dog something fresh and healthy, which is entirely different from the typical pet food you’d find in a retail store.
Regev started the company in 2014 with his friend Brett Podolsky. Every month or so, they ship customers a container, packed on dry ice, with the specified amount and flavor of food based on your breed of dog.
REGEV: One of the most significant parts of our journey was that decision to go from, “We’re doing this ourselves, we’re going to take it slow,” to “This needs to be the way that pet food works. This needs to be an industry-changing company, and we should bring on some help.”
Which is how the Farmer’s Dog has come to raise more than $100 million in several rounds of venture capital financing, making it one of the most successful pet-related startups in history. How does all that money make Regev feel?
REGEV: Interesting. It felt nice and vindicating that you had sophisticated investors that saw what we were doing, that understood the opportunity, saw the trajectory, saw the future in the way that we saw it and were willing to go along the ride. So that part was nice. But whenever we raised a round it’s like, “Okay, you just get this increase in seriousness. Now we have a lot to do.”
Now, imagine that Regev and Podolsky had this same idea but didn’t have access to venture capital. Where would The Farmer’s Dog be today?
REGEV: That is a fun question. I think we’d be going in the same direction, just not at the pace and certainly not at the scale that we are today. I don’t think every company needs to go out and raise venture capital. The big difference for us is speed. Our quality is something that we wouldn’t have been able to achieve so quickly.
AKCIGIT: Obviously, there are a lot of anecdotal evidence showing that venture-capital-backed firms are performing very well.
That is Ufuk Akcigit, an economist at the University of Chicago.
AKCIGIT: But the question is: were they also going to perform that well if there were no venture-capital financing?
That is a question that Akcigit tried to answer in a recent paper. Really, the question is this: does venture capital work? Or are venture capitalists just good at backing the companies that were already going to succeed? Akcigit and his co-authors gathered data from a variety of sources that let them compare companies that took venture capital to those that didn’t. The key was to make sure the two sets of companies were really similar, so they sorted them by location, size, industry, and what V.C.’s like to call “year of birth” — the date a company started, as if it were a baby. I know, it’s a little weird. Anyway: Akcigit and his colleagues compared thousands of companies that were similar to each other except for the fact that one batch went the V.C. route and the other didn’t. So, what did their results show?
AKCIGIT: Our results show that, indeed, V.C.-funded firms are performing a lot better than non-V.C.-funded firms.
The firms that got venture capital did better on several dimensions. For instance: job creation.
AKCIGIT: Average employment increases by approximately 475 percent by the end of the 10-year horizon for V.C.-funded firms, whereas growth is much more modest for non-V.C.-funded control group, about 230 percent.
They also looked at how many patents the firms created, especially high-quality patents, as measured by number of citations. Once again, the V.C. firms did better.
AKCIGIT: We find that up to 60 percent of the patent growth after the funding can be attributed to the treatment by venture capitalists.
So this evidence suggests that venture capital essentially works, that it gives young companies a booster shot that helps them thrive. What’s in that booster shot? Money, for starters. Thirty percent of startups fail simply because they run out of cash. Jonathan Regev again:
REGEV: First things first about bringing on an investor is, it’s mainly for capital, right? That’s the main benefit.
But venture capitalists also provide counsel.
REGEV: One of the reasons that we were excited to bring on our investors was the notion that they have been around the block.
Consider the birth of Microsoft, back in the mid-1970s.
AKCIGIT: Bill Gates says when they initially founded the company, they were doing just fine. They didn’t need money, but they didn’t know what to do with their idea, how to bring their company to the next level. They realized that they needed some adult advice. So that’s why they approached a V.C. firm. They never used that money, but they needed the guidance of venture capitalists.
Akcigit found that this guidance also matters. And especially experience. He and his colleagues split the V.C. firms into two groups, based on number of past transactions: a high-quality group and a low-quality group. The researchers then looked at patent creation for the startup firms funded by the high- and low-quality venture capitalists.
AKCIGIT: What we find is that patent stock grows nearly fiftyfold for high-quality group, and only by twentyfold for low-quality group.
So who are these wizards, these experienced investors who can turn an entrepreneur with just an idea into a billion- or even trillion-dollar company? How, exactly, do these venture capitalists get paid? And where do they get the money to invest? Let’s start with that last question — the source of the venture capitalists’ investing funds. The bulk of it comes from big institutions like pension funds, university endowments, charitable foundations, insurance companies, and the like. You might easily characterize this as the rich getting richer. And you wouldn’t be wrong. On the other hand, they are funding ideas that billions of people may benefit from. And there is an inherent risk in funding an idea. Jonathan Regev again, from The Farmer’s Dog.
REGEV: When it comes to venture capitalists, they aren’t looking for small returns. They want to invest in something that can produce extraordinary results and returns for them.
Most V.C. firms cover their operating costs by charging a 2 percent fee to their investors, those pension funds and endowments. But the big money comes, at least potentially, when the startups they’ve invested in are either acquired or go public. After the original investors are paid off, the V.C. firm will typically grab 20 percent of any profits. This can amount to many millions, perhaps even billions of dollars. That’s the happy-ending version of the story. The reality is not always so rosy. Out of 21,000 startups funded by venture capital from 2004 to 2014, 65 percent lost money. Another 25 percent returned less than five times the original investment — which might sound pretty good, but in order to balance out all the losers, V.C.’s need their big winners to return 20 or 30 times the original investment. Only 1 or 2 percent of startups generate this kind of return. And it takes a while. The typical funding cycle is seven to 10 years, which is substantially longer than other sources of private funding. Jonathan Levy is an historian at the University of Chicago.
Jonathan LEVY: The culture of venture capital tends more towards having a long view of potentially disruptive or innovative companies which might not be able to make profits early on. And that provides time for companies to develop their business models, to develop technology, without having to worry about immediate financial pressures.
Levy is the author of a book called Ages of American Capitalism: A History of the United States. It divides American capitalism into four eras. He calls our current era the Age of Chaos. He says it’s been marked by an extreme investor preference for cash and liquidity rather than long-term investment. This can mean — as we’ve seen these past few decades — volatile market trends and the occasional bubble. So how does venture capital fit in? It might help to first think about the size of venture capital in relation to the economy. What would you guess? Considering the massive upside of V.C. investing, you could imagine it would draw trillions and trillions of investing dollars. But considering the risk, and the long time frame, you could also imagine that not many people are willing to invest. So what’s the reality? The best estimates show that U.S. venture-capital firms have about $550 billion under management. The stock markets, meanwhile — the sum total of public equities — are worth an estimated $48 trillion. So venture capital accounts for a bit more than 1 percent of that investment pool, making it rarefied air. It’s also concentrated air: the 50 largest V.C. firms, or about 5 percent of the market, typically raise about half of all venture funding. So venture capital is not very representative of the U.S. economy. But it does play an outsized role — especially when it comes to innovation.
LEVY: Since innovation and also invention take time, long-term investment is a necessary component of an economy that breeds innovation.
What’s an example of this kind of innovation?
LEVY: If you look at big tech, venture capital was willing to take a risk and to give those companies time and space to develop without having to worry about short-term profit criteria, the kind of criteria that stock markets, ever since the 1980s, have prioritized.
Vinod Khosla again:
KHOSLA: In the 40 years since I’ve been in the startup ecosystem, whether on the startup founders’ side or on the venture capital investing side, I have not found one large innovation that came from institutions of any sort. Hyatt isn’t going to invent Airbnb, or Avis is not going to invent Uber, and Lockheed and Boeing aren’t going to invent SpaceX and Rocket Lab. No matter where I looked, there was no large innovation that came from the institutional side of the house. And I point this out because the rest of the world is institutionally driven. And we have this individualism culture in the U.S. You need unreasonable people to first not only believe something else is possible but then to go out and try it and commit their life to it.
And Ufuk Akcigit again.
AKCIGIT: So that’s why, in societies where there’s a larger V.C. capital market, it’s much more likely that we are going to observe more radical, risk-taking innovations.
Akcigit has analyzed how different countries pursue different growth models based on their own technological prowess — and how venture capital plays into that.
AKCIGIT: There are some countries that are at the world technology frontier, like the U.S. or many European countries like Germany, France, and there are some other countries that are very far behind. So a country should decide what kind of growth strategy it will adopt. Will it be an innovation-based growth, or will it be an imitation-based growth? If it’s based on imitation, where you’re trying to import the technologies from frontier countries, maybe bank financing could be sufficient because there is less uncertainty around those technologies. But if a country wants to grow through innovation, by producing path-breaking, radical technologies that are risky, you do need to rely on venture capital.
What if you’ve been an imitator and you want to evolve into an innovator?
AKCIGIT: That’s a very good question. The capital markets have to change. The legal rights, the property rights, have to change. And that switch is not very easy. But do we have any example of a country that closed the gap? The answer is yes. China is a recent example of that. China used to be far behind the frontier. But recently, China managed to close the gap with the frontier. And, at that point, we start to see some new technologies emerging from China.
You also have to consider the role of government in financing these radical technologies. In the U.S., you’ll often hear entrepreneurs — and investors — complain that the federal government isn’t much of a partner, that it’s more fond of regulation than innovation, and therefore the best thing government can do is to get out of the way. The economist Mariana Mazzucato, at University College London, does not see it like that.
Mariana MAZZUCATO: What I say to those who say that we need less state in order to be more innovative, more dynamic, I say, “Well, let’s look at one of the most innovative parts of the U.S. economy, which is Silicon Valley. Did that come from the free market or from an active, visible hand: the state?”
We spoke with Mazzucato a few years ago for an episode called “Is the Government More Entrepreneurial Than You Think?”
MAZZUCATO: My point is actually the state was involved in almost everything in Silicon Valley. Not to exclude the role of the private sector — of course, we all know the very important companies in that area. But the role that public actors played was really across the whole innovation chain.
DUBNER: So you’re talking about agencies like DARPA and NASA and the National Institutes of Health and so on, yes?
MAZZUCATO: Exactly. I’m talking about agencies that do basic research like the National Science Foundation, but also agencies more downstream doing applied research like DARPA and The National Institutes of Health, which continue to spend more than $30 billion a year in the most radical, uncertain, high-risk research. These public institutions have absolutely co-created value.
Mazzucato also argues the government should be getting a bigger share of the return on these investments, especially when you consider the reach of government-funded technologies like the microchip, G.P.S., the Internet. That said, there is nothing new about the U.S. government funding big, risky projects.
JANEWAY: This begins with the canals and railroads of the first Industrial Revolution, extends through the construction of the electricity grids of the second Industrial Revolution, and then, of course, goes on to the Internet and the computer networks that define economic space today — creating a platform for entrepreneurs and venture capitalists to dance on.
That is Bill Janeway. He is a longtime venture capitalist who now teaches at Cambridge University. Like Mazzucato, Janeway points out that startup companies funded by venture capital have the luxury of innovating on top of the platform technologies that were often state-funded. In the 2010s, roughly 30 percent of U.S. patents could be linked to research funded by the federal government. Back in the 1970s, that number was roughly 10 percent. But that trend may be slowing, or even reversing. Government funding of R&D has been falling — from about 1.2 percent of G.D.P. in the 1970s to just 0.8 percent now. If this trend continues, venture capital will become even more important as a driver of innovation. Janeway worries this won’t be sufficient, and that the government needs to show more interest in some key areas.
JANEWAY: I’m talking about the green revolution that we desperately need in time to respond to climate change. Once upon a time, 15 years ago, a few leading venture capitalists — to me the most noteworthy was Vinod Khosla — tried to promote a green bubble, and there was a little surge of venture capital investing in the mid 2000s. It failed. It failed because government was missing in action. There was no state support for the programs, the projects, that would have created the platform, as the Defense Department had done for I.T., as the National Institutes of Health had done for biotech. That’s what we need now.
So it may be that the government doesn’t always focus on the most pressing problems. But the same could be said for venture capitalists. In one recent year, there were over 1,500 V.C. investments in software startups. And how many in renewable-energy startups? Forty-seven. Ufuk Akcigit again:
AKCIGIT: Venture capitalists do contribute, but I should also mention that, while they are contributing to the innovativeness of the startup they are funding, this does not necessarily mean that this is good for the society. It’s highly likely that this is good because they are funding radical technologies, but efficiency is a different question. So this does not mean that venture capitalists are providing the right amount of money into the right sectors.
Venture capitalists are okay with failure, but what’s the difference between failure and fraud? And: how did an obscure change to pension laws help drive the V.C. boom in the first place?
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The notion of venture capital — using investors’ money to fund big, risky ideas — is as old as investing itself. The modern history of venture capital, meanwhile, has two notable birth moments, both of which took place in Massachusetts. The Harvard Business School professor Tom Nicholas, in a recent book on the history of venture capital, traces its origin to the New England whaling industry in the late 1700s. Whaling was a dangerous and difficult endeavor that required a lot of upfront capital. It also carried huge upside: a successful voyage could produce, in today’s dollars, about $3 million in whale oil, sperm oil, and whalebone. To hedge against the risk, individual investors — mostly wealthy doctors and lawyers — would pool their resources and invest in a share of every voyage, relying on the few successful trips to cover the costs of all the failures. Well over a century later, back on land, a Harvard professor named Georges Doriot used a similar risk-sharing model to create a new kind of company. This was 1946, in Boston. The company was called the American Research and Development Corporation, or AR&D. It took in money from institutional investors like endowments and family estates and it funded early-stage companies with the promise that one or two mega-successes would, again, balance out all the failures. This made AR&D the first modern V.C. firm.
JANEWAY: If it hadn’t been for Digital Equipment, nobody would really remember AR&D, because it wasn’t very successful.
That, again, is the longtime venture capitalist Bill Janeway. He’s also the author of a book called Doing Capitalism in the Innovation Economy.
JANEWAY: But it demonstrated the enormous skew in returns because Digital Equipment Corporation, the minicomputer manufacturer, was such a huge success.
But, again, it took a while. In 1957, AR&D gave Digital Equipment $70,000 to start building computers; this gave AR&D nearly 80 percent ownership of the company. It was more than 10 years before Digital went public. That $70,000 share was ultimately worth more than $350 million — that’s 5,000 times the original investment. AR&D had shown that one successful voyage could indeed cover the cost of multiple shipwrecks. But the venture-capital industry was still just a blip.
JANEWAY: When the National Venture Capital Association was founded, you could probably have had everyone around the dining room table. There were only about 25 participants.
That was in 1973. A few years later, things started to change.
JANEWAY: In 1979, intense lobbying from the venture capital industry had led to amendment of the regulations of the Employment Retirement Security Act — ERISA — which allowed fiduciaries to meet their obligations while still putting a portion, a small portion, of their assets into the kind of high-risk investments represented by venture capital.
DUBNER: In other words, it is now legal to take some pensioners’ pension funds and send them to people like you, venture capitalists.
JANEWAY: Exactly, to speculate with them.
Before 1980, pension regulations included a so-called “prudent-man rule.” This required pension-fund managers to act with “skill, prudence, and diligence,” or be held personally liable for losses. As you can imagine, an investment in venture capital at the time wasn’t considered super-prudent. But as Bill Janeway told us, the V.C. industry’s lobbying got the Department of Labor to shift the regulation so that pension managers could invest as much as 10 percent of their money in riskier asset classes. This meant that pension managers could put as much as 10 percent of their fund into venture capital and still comply with federal ERISA regulations. But the relaxation of the “prudent-man rule” was hardly the only factor that amped up interest in venture capital.
LEVY: If you look at the 1980s economy, there’s a boom that brings confidence back into financial markets, and you start to see money and investment moving across asset classes and moving across markets in ways that you hadn’t seen before.
That, again, is Jonathan Levy, the historian of American capitalism.
LEVY: Every day, trillions of dollars are sloshing around the world digitally.
Really, just sloshing? Where do I put out my bucket to grab some?
LEVY: “Slosh” is probably the wrong word.
Oh, okay. Still, all these trillions, looking for somewhere to land. There were a number of factors driving this. In 1978, Congress had steeply cut the taxes paid on investment gains.
JANEWAY: That’s what happened in Washington.
Bill Janeway again.
JANEWAY: What happened in Wall Street was that when the Volcker Shock ended, inflation was defeated. Interest rates came down.
The Volcker Shock was Fed chairman Paul Volcker’s campaign to tame inflation by pushing interest rates to as high as around 20 percent. But now, with interest rates down, investors were looking for other ways to make money. For instance: initial public offerings, or I.P.O.’s — when a company first makes their shares available for sale to the public.
JANEWAY: In 1983, the I.P.O. market opened up. And there was a backlog of really good companies that had been growing quietly. In 1980, there were two I.P.O.s that pointed the way before Volcker smashed the market. One was a company called Apple Computer and the other was a company called Genentech — I.T. and biotech. And there was a hot I.P.O. market in ‘83 and venture capitalists started realizing these profits. Then there was a flow of money, but it’s worth noting that even 10 years later, in the early 1990s, venture capital was a very small segment of the financial system. It was the great tech Internet dotcom bubble of the second half of the ‘90s that turned what was still a pretty marginal activity into an industry. In 2000, $100 billion was invested in venture capital firms.
One year later, the dotcom crash would drive down U.S. venture-capital investment to around $16 billion. But a culture had been established — a culture that began the boom we see today, especially in Silicon Valley. Vinod Khosla:
KHOSLA: Silicon Valley is a culture that gives you permission to try things and says it’s okay if you fail — we’ll fund you again. That culture has been well-established now in creating very large phenomena. It so happened that in Silicon Valley, you not only had the entrepreneurs with crazy ideas — they could scale because investors were comfortable with this paradigm.
These were investors who not only encouraged but practically required a certain level of boldness. Jonathan Levy:
LEVY: You could never tell V.C. guys you’re going to be profitable in three years. I mean, anyone who actually says they’re going to be profitable obviously doesn’t have a bold enough idea. You got to say, “We’re never going to make any money. That’s how radical and crazy our idea is.”
JANEWAY: At the frontier, progress is made by trial and error and error and error.
Bill Janeway again.
JANEWAY: Tolerance of error is essential. An exclusive pursuit of efficiency is the enemy of innovation. That’s often why big companies fail. It’s what happened to IBM. Where we have been very good in the United States, over a long period of time, has been in making space for the entrepreneur, whose characteristics are, first of all, enormous energy, which may or may not be well-directed; a willingness, when reality rejects the vision, of going with the vision, against the reality. That’s why my first law of venture capital is that all entrepreneurs lie. It’s the ones who don’t know they’re lying that really get you into trouble.
DUBNER: Every entrepreneur, you’re saying, has a reality-distortion field similar to Steve Jobs?
JANEWAY: Or attempts to. Some are more successful at projecting it.
Consider Theranos, a health-technology company that raised more than $1 billion in private money, some of it from the biggest names in venture capital. Here’s C.N.B.C.’s Jim Cramer:
Jim CRAMER: For the last few years, Theranos has been viewed as a revolutionary company — the C.E.O. has been heralded as the next Steve Jobs, the company has been valued as much as $9 billion.
That C.E.O., Elizabeth Holmes, promised a new method of blood testing that sounded too good to be true.
Elizabeth HOLMES: We’ve made it possible to run comprehensive laboratory tests from a tiny sample, or a few drops of blood, that could be taken from a finger.
But the Theranos story was in fact too good to be true. Jim Cramer again — this was in 2015:
CRAMER: And just this morning, the Wall Street Journal ran a pretty scathing article about the company — alleging that the company’s proprietary testing devices may be inaccurate, and basically accusing Theranos of deceptive practices.
LEVY: Traditionally in a capitalist economy, we think of the market as disciplining companies that can’t prove the worth of their existence by making profits — that capital markets have a disciplining effect. Part of the story of venture capital to me, which is admirable, which is the willingness to take long-term risks in startup companies that are innovative but can’t necessarily show profits — at what point does access to capital along those lines continue to prop up companies that don’t have a viable business model? If you could wear the turtleneck sweater the right way, talk the talk, walk the walk, you might be able to get access to capital.
Historically, venture capital has been a heavily American pursuit. Twenty years ago, the U.S. accounted for roughly 80 percent of global venture capital, with the vast majority in the San Francisco Bay area, New York, and Boston.
LEVY: So if you’re a startup company that’s appropriately socially networked in Silicon Valley and have some individuals who went to Stanford, there’s abundant access to capital. But you go to the other side of the tracks, not so much.
The field is also very, very male. Start-ups with exclusively female founders took in barely 2 percent of V.C. funding in the U.S. in 2020. This was likely one reason that so many investors were so eager to believe in Theranos and Elizabeth Holmes. It’s somewhat more diverse on the other side of the table: about 12 percent of decision-makers at V.C. firms in the U.S. are women, up from just under 6 percent in 2016. And this change will likely mean more funding for female founders as well, since female investors are much more likely to invest in female founders. An even bigger change is the amount of venture-capital activity now outside the U.S. The 80 percent share from 20 years ago has since dropped to about 50 percent. Here, again, is Vinod Khosla.
KHOSLA: Shanghai’s done a very good job in China.
China now accounts for roughly 25 percent of global venture capital, up from less than 5 percent in the early 2000s.
KHOSLA: Europe hasn’t done well because it is too respectful of institutions. And you need much more disrespect for authority. I find many European start-ups, if they have a big idea, they get turned into a decent idea as opposed to amplifying it and saying, “Go for the moon.”
Khosla himself is definitely the type to go for the moon. Besides backing Impossible Foods, his firm has funded a variety of bleeding-edge technologies in healthcare, online security, and finance. One of his current obsessions is nuclear fusion.
KHOSLA: While there’s a global institutional effort to spend $30 billion over 30 or 40 years, we think we can prove it in five.
His firm is backing a company called Commonwealth Fusion Systems. They recently announced they’ve created the most powerful magnetic field ever recorded on Earth, and magnet technology is seen as one of the biggest hurdles to making fusion energy a reality. The promise of fusion is that it could cleanly produce enough energy to power a small city in a device the size of a shipping container. Commonwealth hopes to build a demonstration device by 2025.
KHOSLA: If I said to you, “Our 15-year goal is to change all animal husbandry on the planet or build a fusion reactor in 10 years instead of 50 with one-fiftieth of the resources—.”
DUBNER: “You’re crazy,” I say. “You’re nuts.”
KHOSLA: Society in general depends on 5 percent of the people doing things at the edges of society where most change happens. So, I do think enabling more of those people to lead society in good directions is a good thing — while increasing the social-safety net at the same time.
DUBNER: So, do you have any advice for someone who’s listening to this and says, “I’m definitely in the 95 percent. I would much rather be in the 5 percent”?
KHOSLA: You have to be inspired by talks like this, by podcasts. Why am I on this podcast? And I said this in the talk I gave at Stanford Business School in 2015. There were 500 M.B.A.s in the audience. And I said, “I’m not speaking to 95 percent of you. The only reason I’m going to waste an hour of my time” — and that could apply to this podcast — “is because I’m going to trigger some people to get enough self-confidence to go try this other world of innovating, making things happen that you believe in, driving society, no matter how hard it is or how difficult it is.” Your goal is to go from impossible to implausible to possible to probable to making it happen. In fact, I’d like to tell your audience, really hard things are the only things worth trying. And they’re the ones that most contribute to society because most things that are easy are either not worth doing or somebody else has already done it.
Khosla’s “really hard thing” was creating Sun Microsystems, which wound up making him a personal fortune.
KHOSLA: In my 40s, I realized I was way more successful and had more resources than I could possibly have imagined even 15, 20 years earlier. And so, what I got was the freedom to indulge myself. Now, I can get a yacht or a place in south of France, but I was always driven by learning. And I said, “Now, cool technology is great. What else would be nice?” And I met Professor Yunus and decided poverty was a pretty interesting problem to take on, mostly because it was hard.
He’s talking about Muhammad Yunus, the Bangladeshi economist and entrepreneur who won a Nobel Peace Prize for bringing microcredit to entrepreneurs too small and poor to get a standard bank loan.
KHOSLA: Hard problems are more interesting than easy problems. So, it’s the exact opposite of getting a yacht. And I remember when we started our firm, I actually knew somebody who’d spent $100 million on their yacht. And I said, “That’s a good yacht for them. For me, 30 $3 million bets is my yacht.” The people I want to play with, learn from, explore ideas, push them to think bigger — and so, poverty was one, and the other thing I started looking at was climate. And so, in some sense, taking on nearly impossible problems made things more challenging, which meant to me more fun. And so, they were both impossibly hard problems. Neither one of them is solved today, but we are making progress on both.
Is venture capital the best vehicle for making progress on hard problems? Vinod Khosla certainly believes so, and it’s hard to doubt his sincerity. Others may hold different views. Others may feel that venture capitalists may talk a virtuous game but that in the end, self-interest will win out, and in the end, it’s just another investment channel that grows the wealth of the already wealthy, that it focuses too much on shiny new products and services at the expense of some of the less-exciting problems our societies need to solve. What do you think?
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Freakonomics Radio is produced by Stitcher and Dubner Productions. This episode was produced by Ryan Kelley. Our staff also includes Alison Craiglow, Greg Rippin, Zack Lapinski, Mary Diduch, Jasmin Klinger, Eleanor Osborne, Emma Tyrrell, Lyric Bowditch, and Jacob Clemente. Our theme song is “Mr. Fortune,” by the Hitchhikers; the rest of the music this week was composed by Luis Guerra. You can follow Freakonomics Radio on Apple Podcasts, Spotify, Stitcher, or wherever you get your podcasts.
Here’s where you can learn more about the people and ideas in this episode:
- Vinod Khosla, co-founder of Sun Microsystems and founder of Khosla Ventures.
- Pat Brown, founder and C.E.O. of Impossible Foods.
- Jonathan Regev, co-founder of The Farmer’s Dog.
- Ufuk Akcigit, professor of economics at the University of Chicago.
- Jonathan Levy, professor of history at the University of Chicago.
- Mariana Mazzucato, professor of economics at University College London.
- Bill Janeway, Special Limited Partner at Warburg Pincus and Member of the Faculty of Economics at Cambridge University.
- Ages of American Capitalism: A History of the United States, by Jonathan Levy (2021).
- NVCA 2021 Yearbook, by the National Venture Capital Association (2021).
- “Value of Venture Capital Investment in the U.S. 1995-2020,” by CB Insights (2021).
- “More Opportunity Than Capital: Venture Dollars Spread Throughout the U.S.,” by Chris Metinko and Gené Teare (Crunchbase News, 2021).
- “The U.S. V.C. Female Founders Dashboard,” (PitchBook, 2021).
- “Venture Capital’s Role in Financing Innovation: What We Know and How Much We Still Need to Learn,” by Josh Lerner and Ramana Nanda (Journal of Economic Perspectives, 2020).
- “More Women Are Top V.C. Decision-Makers, but Parity is a Long Way Off,” by Dan Primack (Axios, 2020).
- “Women V.C.s Invest in Up to 2x More Female Founders,” by Collin West and Gopinath Sundaramurthy (Kauffman Fellows, 2020).
- VC: An American History, by Tom Nicholas (2019).
- “Federally Funded Research Drives Nearly One-Third of U.S. Patents, Report Finds,” by Brittany Flaherty (STAT, 2019).
- “Synergizing Ventures,” by Ufuk Akcigit, Emin Dinlersoz, Jeremy Greenwood, and Veronika Penciakova (NBER Working Papers, 2019).
- “Synergising Ventures: The Impact of Venture Capital-Backed Firms on the Aggregate Economy,” by Ufuk Akcigit, Emin Dinlersoz, Jeremy Greenwood, and Veronika Penciakova (VoxEU, 2019).
- Doing Capitalism in the Innovation Economy, by Bill Janeway (2nd ed., 2018).
- “Tracking Investment by Sector,” (The Wall Street Journal, 2018).
- “U.S. Share of Global Venture Capital Fell More Than 20% in 5 Years,” by Anna Hensel (VentureBeat, 2018).
- “Rise of the Global Startup City,” by Richard Florida and Ian Hathaway (Center for American Entrepreneurship, 2018).
- “The Top 20 Reasons Startups Fail,” by CB Insights (2017).
- “Where Do Venture Capital Dollars Actually Come From? This Visual Explains,” by Lee Hower (NextView, 2014).
- “Venture Capital Funds – How the Math Works,” by Basil Peters (Angel Blog, 2008).
- American Culture series by Freakonomics Radio (2021).
- “The Future of Meat (Ep. 367),” by Freakonomics Radio (2019).
- “Is the Government More Entrepreneurial Than You Think? (Ep. 348),” by Freakonomics Radio (2018).