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Silicon Valley: a cluster of venture capitalists?

What sets the Silicon Valley apart from other clusters? Many other countries have tried to emulate this model, but none have matched California’s ability to host dozens of “unicorns,” not to mention thousands of new startups every year. Why do policies fail to replicate this Californian success? Venture capitalists could very well be the differentiating factor.

21
September 2017
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Executive Summary

The major role played by venture capitalists is unique to the Silicon Valley. It explains entrepreneurial successes, but also how this particular ecosystem works. Two interpretations help analyze their action: the theory of social networks, which describes the embedding of market exchange in social bonds; and the theory of complex networks, derived from mathematics and biology, which explains the complexity of local innovation networks – Silicon Valley being the paradigmatic example.

Silicon Valley is an innovation ecosystem composed of complementary and interdependent economic actors. Many large famous firms are located between San Francisco and San Jose: Apple, Google, Intel, HP, Oracle, Facebook, NVIDIA, etc. There are also other players, notably in the field of research: Xerox Parc, SRI, major universities such as Stanford, Berkeley, or San Francisco for biotech. But external observers often overlook two crucial players.

First of all, lawyers. Intellectual property is at the heart of the economic model of startups. When an entrepreneur meets an investor, the first question they raise is related to the protection of intellectual property. Their economic model depends on this protection. For this very reason, the presence of legal experts is crucial. The law firm Wilson Sonsini is at the heart of Silicon Valley in Palo Alto, with 1,500 lawyers specializing in new technologies. Any researcher from Stanford or Intel with a bright new idea can check whether they can file a patent and get an answer very quickly. This valuable resource partly explains the speed of economic decision-making in the Silicon Valley.

The second players, whose role tends to be underestimated, are venture capitalists.

To understand their importance in the ecosystem of the Silicon Valley, one must consider the complex interplay between its different actors. These are built within social networks of which venture capitalists are an integral part. Three main types can be identified.

Social networks of venture capitalists in the Silicon Valley

The first is related to nationality. It is sometimes difficult to fathom how a small unknown startup from Silicon Valley establishes a partnership with Google or Microsoft. Looking in detail, one finds out that this entrepreneur is Indian, from the same village as that other computer scientist from Microsoft and this simple fact is the origin of their collaboration. Nationality networks emerge very quickly when one looks into partnerships or fundings. The Chinese and Indians account for over 50% of Silicon Valley engineers. Google has many Indians in its workforce, including its CEO. In the database industry, firms like Oracle, there are many Russians. The video games industry, firms such as Electronic Arts, are full of French.

The second type of network is composed of those who have already worked together in a same company, such as HP, Google, Sun or Intel: former colleagues or associates, who know each other and can quickly assess the professional reliability of a potential partner or entrepreneur with whom they have already collaborated. These networks promote the flow of information, access to resources and entrepreneurial collaborations.

Last but not least, networks linked to universities. The social bond is built outside the economic field, but can nevertheless have a strong impact on innovation and entrepreneurship. Networks of Stanford, Berkeley, Harvard and MIT graduates support inter-organizational collaborations and entrepreneurial groups. It is not uncommon to see Stanford students initiate entrepreneurial collaborations during their studies. This was the case of David Filo and Jerry Yang for Yahoo! or of Larry Page and Sergey Brin for Google.

The importance of these three networks in the economic dynamics of Silicon Valley led venture capital firms to recruit from, and embed themselves within these networks in order to access the strategic information and resources necessary for their activities.

Beyond these networks (nationality, former colleagues, alumni), it is worth noting the complexity of the network dynamics that support innovation and entrepreneurship within Silicon Valley. Complex networks are dense networks, marked by a multiplexity of social relations between individuals. The relationship is rarely strictly professional: it relies on the neighborhood, their children’s school, membership of the same association or non-profit organization. The density and multiplexity of complex innovation networks contribute to its strength in the face of external shocks or technological breakthroughs.

The theory of complex networks partly explains the resilience of Silicon Valley. Beyond a simple high-tech cluster, it is also an innovation cluster. Its economic model has been questioned several times, and it could have simply disappeared. Historically, Silicon Valley produced microprocessors. When faced with Asian competition, they stopped manufacturing chips and focused on designing them instead. Then came the era of personal computers, following the same cycle: first they were built locally, then only designed locally, while production was relocated in Asia. And later on, software, digital services, etc. The ecosystem has shown an extraordinary ability to reinvent and reorient itself. Whenever the foundations of Silicon Valley’s economic model were shaken, the ecosystem was able to reconfigure itself based on the knowledge of the previous technological wave, and continued making progress. Facebook, Twitter and Google were created based on previous technological waves.

Capital risk

Venture capitalists play a special role in the multiple networks that form the dynamic and resilient economic fabric of Silicon Valley.

Fifty prestigious firms (Sequoia Capital, Kleiner Perkins Caufield & Byer, Accel Partners, Benchmark Capital, inter alia) co-exist with many small firms and investment companies linked to large companies. There are about 2,000 “Venture Capitalists” in Silicon Valley. Most are gathered on Sandhill Road, just behind Stanford.

The number is important, especially in terms of networks of complementary actors. For example, consider the ratio of venture capitalists and other innovation players, especially researchers, an indicator that reflects the likelihood of meeting a venture capitalist. In Silicon Valley, the ratio is of one venture capital for five researchers. Put in somewhat simplistic terms: what happens on Saturday nights in Silicon Valley? People organize barbecues which serve as places of socialization of the actors of innovation and entrepreneurship. These informal exchanges produce part of the economic exchanges. An entrepreneur has a good chance of meeting a venture capitalist, pitching their project and obtaining an answer such as: “It’s a good idea, see you next Monday, I might be able to invest right away in your startup.” Due to the high number of venture capitalists in Silicon Valley, the likelihood for an entrepreneur to encounter the former is extremely high when compared to any other region in the world.

Another indicator of the importance of venture capitalism is per capita investment. Between 1994 and 2005, in Silicon Valley, an average of $45,000 were invested in venture capital per capita on a population of three million. As a comparison, in France, for example, $270 were invested per capita over the same period. These amounts bear no comparison with what is being invested elsewhere. This is also true between US states: of the 48 billion invested annually in venture capital in the United States, nearly half are invested in Silicon Valley. And yet, venture capital was not invented in California, but in Harvard, although it never reached the scale of Silicon Valley.

Among the major players of venture capitalism, the best known is probably Sequoia Capital. In 2012 alone, they performed nine capital outflows (“exits”) worth over $200 million. They financed Apple as early as 1978, but also Electronic Arts, Yahoo, Google, Youtube, Linkedin, AirBnB, Rumble... For the record, Mark Zuckerberg made his presentation at their headquarters... in pajamas! It should be noted that he had previously found other investors. But Sequoia Capital reversed this mishap in 2014 when Facebook acquired WhatsApp for $19 billion. A quick calculation gives an idea of the profit made by Sequoia Capital: in exchange for 15% of WhatsApp, the fund invested $8 million in 2011 (the company was created in 2009). At the time of resale, these 15% represented $3.5 billion i.e. a capital gain of 43,000% in three years!

The business model of venture capitalism consists in raising capital from institutional investors, investing in startups and then, of reselling their shares once the company has reached a certain size. They play a crucial role in financing innovation because they are often the only players capable of providing capital to finance the development of start-ups. A startup in California never asks for credit to a banker: it asks for capital to venture capitalists. Bankers carry out a statistical evaluation of risks, for example, by measuring the probability for bankruptcy to occur. Venture capitalism is the realm of complete uncertainty: the notion of risk, in the strict sense, disappears. These environments can simply not be measured in probabilistic terms. Everything is uncertain. At the time of the investment request, startups often only have one prototype, a small number of users, few incomes and are sometimes imprecise legal objects. Venture capitalists must make an investment decision, perhaps worth several million dollars, on the basis of all these intangible elements.

Venture capitalists invest very early in the life cycle of startup companies, even at their creation. They often participate in the first round of investment, and frequently via syndication with other venture capitalists.

From a legal standpoint, venture capitalists form small teams, known as partnerships. These may consist of two or three people or, for the larger ones such as Sequoia Capitals or Kleiner Perkins, of approximately fifteen associates. It is an economic model based on cycles of 8 to 10 years, linked to the lifetime of funds. Venture capitalists raise capital from investors, take up equity participation in startup companies, sell their participation and return capital and capital gains to investors. Their remuneration depends on the profitability of the fund: roughly 20 to 30% of realized capital gains. This model has a strong incentive effect, but carries a significant risk: in the event of bankruptcy and absence of profit, they receive... nothing. On average, out of 10 investments, 5 result in bankruptcy; 3 or 4 allow to multiply the investment by 4 or 5; and 1 or 2 by 10. The latter situation ensures the profitability of the investment fund.

Who invests in venture capital funds? Venture capitalists raise funds from insurance companies, mutual funds and university foundations. Harvard, Stanford and Yale have substantial funds that are partly invested in venture capital. There are also individual investors, but their amounts are comparatively lower.

The four issues of venture capital

Four main issues can be identified. The first is to find projects, which implies being closer to the information, either by going for it, or by having a reputation that brings it to you. There is no market to buy startup business plans. It is the quality of embedding in the informal networks of Silicon Valley that determines the flow of business plans (the so-called “deal flow”). An associate of Sequoia Capital receives between 1,000 and 2,000 projects per year on average, when an unknown venture capitalist receives a dozen, of lesser quality.

The second challenge is to assess the quality of the project. How does one decide to invest a million dollars in a start-up? Three questions arise: is it the right technology? Is there a market? And what is the entrepreneur worth? This last point is crucial. Silicon Valley remembers the case of William Shockley. This Nobel Prize for Chemistry in 1958 was a high-level researcher at Stanford and Bell Labs. As creator of the transistor, his work led to the development of microprocessors. He had fully grasped the market opportunity. His company, Shockley Industries, held all technology-related patents. It should have been a resounding success. And yet, no one has ever heard of Shockley Industries. William Shockley was a paranoid entrepreneur who forced all his researchers to take lie detector tests and was particularly rigid in terms of management. This behavior caused his best engineers to flee. The so-called “eight traitors” founded all the great names of Silicon Valley: National Semiconductor, Intel... Knowing what the contractor is worth is therefore crucial to assess risks. One does not risk their funds on someone like Shockley, an introverted personality that is unable to work in team.

The third challenge is to develop the company. VCs play an advisory role, sometimes from the creation phase, but also and especially, during strong growth or pivotal phases. They have unrivaled experience in this area, and can usefully assist entrepreneurs who are in their learning process. They intervene during recruitment, forging strategic alliances with large groups and finding clients or suppliers.

The fourth challenge is that of exit strategy. A venture capitalist only realizes capital gain if the startup successfully achieves an IPO or is bought by a large group. Silicon Valley’s major companies are doing less and less R&D and increasingly moving towards strategies of Acquisition & Development (A&D). Their innovation often originates from startups they acquire. Google did not invent YouTube. Google engineers did not invent Android. In both cases, these technologies were acquired through the purchase of the startups that developed them.

The five roles of venture capital

Venture capitalists play five important roles in Silicon Valley’s high-tech cluster. The first, of course, is to finance startups and, indirectly, their partners (lawyers, consultants, recruitment agencies...). The second is to assess risks for the community as a whole. Not being able to obtain an investment from a prestigious venture capitalist or worse, not obtaining any funding at all, prevents the startup from financing its development and also sends a signal to all the other players in the ecosystem, who will subsequently be reluctant to work with the entrepreneur. Conversely, if a startup secures funding from a prestigious venture capital firm, all the most prestigious service providers (lawyers, consultants...) and large firms will converge towards it. The investor sends a signal on the quality of the risk represented by the startup. There is a sort of division of labor. Being funded or not by a prestigious venture capitalist is a form of qualification for the rest of the ecosystem. For an entrepreneur, the worst-case scenario would be to obtain a first round of investments and not being able to raise a second round. In the first round, an entrepreneur raises $500,000, recruits one or two persons, makes a demo... Six months later, the $500,000 are spent, and the entrepreneur goes back to see the venture capitalist. The latter give them additional funds, in exchange for a larger share in the startup company’s capital. This finances growth until the IPO. But sometimes, a venture capitalist decides not to finance a second round of investment. In this case, if the entrepreneur goes to another investor, the investor will ask him why the first investor stopped financing his project. The first venture capitalist becomes an insider: they have been interacting with the entrepreneur regularly, over six months or more. They have acquired in-depth knowledge of the technology and if they decided to discontinue their support, they probably had strong reasons to do so. This signs the startup’s death sentence because no other investor will take the risk of investing.

The third role: reporting the quality of startups to third parties. Imagine yourself as a reputable lawyer. A startup consults you for a problem concerning intellectual property and offers to pay you in stock options. You can take the risk, but you have to know what the company is worth. Service providers paid in stock options or shares should study which investors finance their clients. If these include firms such as Sequoia Capital or Kleiner Perkins, they are quickly reassured: Sequoia funds four or five projects out of 1,000 received, and boasts a quality portfolio. There is no zero risk but this sends a strong signal of confidence. Let me share an anecdote: I followed three French graduates from the Ecole Polytechnique who subsequently went to Stanford, created a startup and were searching for capital. They devised two strategies: raising funds from venture capitalists of Silicon Valley and activating their network in France. They received two offers: a French institutional investor offered them one million euros in exchange for 10% of their capital, while a reputed Californian venture capital firm offered them $500,000. Following a purely financial logic, they should have accepted the offer of the French investor. But they did not make this mistake. They understood the strength of the signal sent by the investor’s identity in the ecosystem of Silicon Valley. By accepting half this amount from a recognized player of Silicon Valley, they opened up networks that the French institution simply did not offer.

Fourth role: accumulating and sharing knowledge related to entrepreneurship in Silicon Valley. The first venture capital funds were created in the late 1960s, notably by Arthur Rock. Don Valentine, a legendary venture capitalist who was already part of Sequoia Capital in 1970, continues to invest in startups today. He has been working in Silicon Valley for over 45 years and has acquired phenomenal entrepreneurial knowledge that he can share with the startups he finances. A young Stanford graduate, without any entrepreneurial experience, creates a startup but lacks knowledge to develop his company. If Don Valentine, or any other experienced venture capitalist, invests in a startup company, aside from capital, they also brings all their knowledge of the creation and development of startups to young entrepreneurs. Young entrepreneurs may have good technology – they know nothing of how the market works... Valentine, on the other hand, has a detailed view of all these aspects because he followed the development of many startups. This feedback prompted certain observers to claim that Silicon Valley is less of a high-tech cluster than a cluster of venture capitalists who collectively possess a unique entrepreneurial knowledge built over the last 50 years.

The fifth role is to integrate entrepreneurs into socio-economic networks in order to contribute to the development of their company. Investors share their networks with the entrepreneurs they finance. They help find consultants: a good subcontractor in India for invoicing, reliable developers in Estonia… But above all, they participate in the recruitment of engineers and experts in marketing, finance and supply chains, all of which play a crucial role in the development of the company. Venture capitalists also have access to universities, where they make regular presentations. When an associate of Kleiner Perkins or Sequoia Capital presents a startup in Stanford, the lecture hall is packed, and apart from the 400 engineering students attending the presentation, many others follow it through videoconferencing from other rooms. This sends a tremendous signal to potential candidates.

Good use of networks

The theory of networks provides useful insights into the economics of innovation clusters by revealing the embedding strategies of venture capitalists. Classical economic theory does not account for these mechanisms, simply because there is no such market: venture capitalists do not have access to an auction floor for business plans. Networks have a great impact on deal flow, i.e. the ability to access information and startup projects within the ecosystem. Why does an entrepreneur address this investor rather than another? It is the latter’s ability to be embedded in networks that will make the difference in highlighting their offer of service and obtaining information.

Networks also help build information that is incomplete, but valuable, about the value of a technology. Venture capitalists themselves are not experts of the technologies used by the startups they finance. They have a network of experts to assist them – often informally – when assessing a technology. When assessing a business plan, for instance, they have a coffee with a research director from Hewlett Packard or Intel, who will give them their take on the technology. They can also consult their contacts in Amazon and ask them whether they would be interested in using said technology, should they have access to it. A positive response will validate the existence of a market. Here, we are in a situation in which information circulates informally in networks, or where a market value begins to emerge, even if there is no market transaction.

Venture capitalists also perform due diligence by informally calling teachers or employers they know to find out more about entrepreneurs. Again, information flows without any transaction. For a sociologist, this raises the question of the nature of social exchange in these networks: halfway between formal and informal, paid and free. Precisely, this gray zone will support exchanges and eventually, formal transactions that are neither free nor informal.

The flow of information – crucial for the health of this type of ecosystem – is activated by venture capitalists, who not only take advantage from, but also bring unprecedented fluidity to this dual circulation of money and information.

Moreover, it should be noted that these exchanges are subjected to a form of informal regulation, in particular through social coercion exercised by the members of the community. Social networks are structured by a set of specific norms. Of course, these are informal rules, but departing from them incurs real sanctions. A well-known example in Silicon Valley is that of Jim Clark, a former researcher at Stanford, who founded Netscape in 1995. Previously, he had founded another company, Silicon Graphics. On this occasion, he was “swindled” by Glenn Mueller, a venture capitalist from the prestigious firm Mayfield Fund. Nothing illegal, but the venture capitalist broke a social norm in force in Silicon Valley. What norm, exactly? For each round of financing, an entrepreneur assigns a percentage of his company to investors. According to an informal rule, the founder still holds approximately 30% of the shares of the company at the time of the IPO. It is by no means a written law, but most actors are aware of, and respect this informal norm. When the IPO of Silicon Graphics occurred, Jim Clark only held 2% of the company’s shares. At each financing round, the venture capitalist exploited the entrepreneur’s credulity to obtain more shares than provided by the informal standard. When discovered later, this abuse deeply irritated Jim Clark and the latter warned his network in Silicon Valley. He coined the term vulture capital to describe the situation he had been dealing with. There is even more to this story. Everyone in the Silicon Valley ecosystem knew that the venture capitalist had cheated. And this triggered immediate consequence: the deal flow stopped. Entrepreneurs stopped sending him their projects. People did not want to suffer the same fate as Jim Clark and Silicon Graphics. There were even social consequences: no one spoke to him when he went to fetch his children at school, he was no longer invited to weekend barbecues, nor to any other socializing activities. He was gradually excluded from all community networks.

When Netscape was founded, Glenn Mueller’s associates at the Mayfield Fund asked him to contact Jim Clark and suggested he should invest in his startup. Jim Clark refused despite many demands. In August 1994, when Netscape’s first investment round was made public, it was revealed that the investor was Kleiner Perkins and not the Mayfield Fund. On that day, Glenn Mueller committed suicide. He was a multi-millionaire and nothing he had done was illegal. But he had violated an informal standard of Silicon Valley and was expelled from the network of his community.

Embedding strategies

Economic sociology advocates examining how networks explain the organization or terms of contracts. But in the case of venture capitalists, this goes even further: they instrumentalize networks, or even misuse them for economic purposes. In addition, they misuse contracts and economic situations to create social ties and embed themselves within networks.

This happens, for example, via recruitment: venture capitalists recruit Indians or Chinese, Harvard or Apple alumni, to benefit from their networks. They participate in the boards of universities to network within these institutions. Most prestigious venture capitalists are on the board of Stanford or Berkeley. They have also developed “side funds”: venture capital micro-funds in which they invite people who will be useful to their deal flow, for their evaluation capacity and other skills. In addition to raising a $1 billion fund, a venture capital firm will raise a small fund of $50 million, with the same investment strategy as the main fund, with the difference that each key player receives an offer to invest $500,000 each: lawyers, university professors, former entrepreneurs, headhunters... The kind of proposal one cannot turn down when it comes from a venture capitalist such as Sequoia Capital, with an annual profitability rate at a steady 70% for over 40 years. Secondly, if Sequoia Capital’s venture capitalists need information, their side fund investors will give it to them more willingly because they are directly interested in the performance of the fund. This is a clear example of misuse of the purpose of the contract. The legal structure of the side fund is used to create a social network.

Syndications of startup financing are another example of network building. As lead investor, the first venture capitalist has the right to invite other investors into syndications. For example, in anticipation of an IPO, they will invite investment banks in a last-round syndication in order to improve the preparation of the IPO. If they anticipate the sale of the startup to a large group, they will invite Cisco or Google into the syndication, because they are potential buyers. Once again, syndication is less a matter of finding funds than creating networks with players that venture capitalists will need and benefit from.

When the most reputable firms raise funds, investor demand often exceeds supply. For example, a $500 million fundraising organized by Sequoia Capital was oversubscribed twelve times in one week. Investors offered $6 billion to Sequoia Capital. Venture capitalists chose to conduct interviews with investors and select them based on their potential contributions to startups in which Sequoia Capital would invest. For example, an insurance company was asked if they would agree to be the client of a startup funded by Sequoia and how quickly they would respond to a demand from venture capitalists.

These embedding strategies define the strength and uniqueness of Silicon Valley, and contribute to making it not only a high-tech cluster but also an innovation cluster. The flow of information – crucial for the health of this type of ecosystem – is activated by venture capitalists, who not only take advantage from, but also bring unprecedented fluidity to this dual circulation of money and information.

An important theoretical implication for innovation clusters can be drawn from this model: the robustness and efficiency of networks are not only related to the density of links; the nature and complementarity of economic actors are also paramount. What sets Silicon Valley apart from other high-tech clusters around the world is the important presence of venture capital companies for over fifty years. Without its Californian VCs, Silicon Valley would no longer be Silicon Valley.

Practical involvement is also required. When thinking about industrial policy and the development of innovation clusters, we must not only question the links between actors, but also ask ourselves, precisely, who are the actors necessary for the dynamics of innovation. It is not only a matter of focusing on the interactions between large companies and universities, as was the case with technopoles and later, with competitiveness clusters. The permanent presence of other actors of entrepreneurship, namely, legal experts and venture capitalists, must also be guaranteed.

This article is a transcription of a presentation in Monique Dagnaud and Olivier Alexandre’s EHESS seminar, The Californian Model.

Michel Ferrary
Professor of Management, University of Geneva, Graduate School of Economics and Management, Affiliate Scholar at Skema Business School