The Overt And Covert Power Of The Biggest Silicon Valley VCs

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 obtain goals in stochastic situations; structural power affects who has what goals and what situations are likely to arise in the first place.

Too Big To Fail

In Silicon Valley, the wealth and renown of the biggest venture capitals (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?

CB Insights’ list of the 100 VC firms with the highest-rated partners approximates the industry’s best and biggest. Seven of the top eight are located in Silicon Valley, so we’ll consider this subset. All VCs together invested $136.5 billion in U.S.-based companies last year. Losing any of those firms could jeopardize the system that has nurtured the unparalleled U.S. tech sector over the past four decades.

GDP is another telling indicator. Silicon Valley’s $535-billion output accounts for nearly a fifth of California’s $2.9-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?

Owning The Food Chain

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.

Sowing Seeds

Like hardy omnivores, 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 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 a method to their madness:

1. 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.

2. 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 — at best — obtain with difficulty later. The distribution of board seats is stark. According to my research with Pitchbook, 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 past 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.

Pruning Weak Limbs

3. 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.

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 suggested 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.

Harvesting The Fruit

The biggest VCs, however, are less sensitive to reputational costs. If a mom-and-pop VC makes some decisions perceived as selfish, founders might stop taking their calls. By contrast, Peter Thiel probably won’t lose access no matter what he does. In mid-stage follow-on rounds, most VCs do what they must; the biggest VCs do what they want.

Having more capital lets the bigger VCs participate in later rounds, which yields a few advantages:

1. As a startup progresses through funding stages, chances of failure decrease and chances of a successful exit increase.

2. A five-time return on a billion-dollar investment is 500 times larger than a 10-time return on a million-dollar investment.

3. Investing larger amounts in later stages can yield larger absolute returns, and big wins achieved rapidly 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, VC has pushed SpaceX from a near-unicorn 10 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 could become a trillion-dollar industry. By taking SpaceX from unicorn to decacorn, big, early investors have generated not only returns but also 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 mold 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.

Originally published at https://www.forbes.com.