The Power Law (Part Four): The First Venture Deal

They were the best and brightest young engineers American could produce. But they had one problem: their boss was a tyrant.

Shockley Semiconductor Laboratory founder William Shockley shouted at his talented engineers, recorded all phone calls, and even demanded they take lie detector tests. All refused.

Instead, they did something few engineers in the 1950’s had ever done: struck out on their own. But how could these men of modest means start a semiconductor company?

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Enter Arthur Rock, perhaps the first venture capitalist. Rock invested and also brought in entrepreneur Sherman Fairchild, who put in a cool $1.5 million.

The “traitorous eight” engineers were off to the races. The company called itself Fairchild Semiconductor.

This was the first modern-style venture capital deal. This fascinating history is recounted in Sebastian Mallaby’s new book, The Power Law: Venture Capital and the Making of the New Future.

Like today, the Fairchild deal involved equity investment. What’s more, the founders and employees continued to own much of the company.

That employee ownership was a critical advantage.

Its engineers interviewed customers about what they needed before building anything. This made sure the new company’s products were useful.

The engineers had a strong incentive to make sure they built products that sold well. Big sales meant their stock went up!

Fairchild prospered, making huge advances in semiconductors and racking up millions in sales. Rock’s investment proved to be a home run.

His first fund went from $3.4 million to $77 million in just 7 years. This 23-fold return would be absolutely off the charts, even today.

What’s striking about the story of Fairchild is how unlikely it was.

The culture of the 1950’s was all about big institutions, from major corporations to the army. Finance was highly conservative, more concerned with avoiding loss than reaching for enormous gains.

Without this new form of investing, the Fairchild engineers would’ve kept laboring miserably for Shockley. Or perhaps they’d have moved to some lumbering bureaucracy with little interest in their ideas.

Either way, they probably wouldn’t have been able to make the huge technical advances they did at Fairchild.

The impact of what some call “liberation capital” has only grown with time.

Just a fraction of 1% of US firms raise venture capital. But that tiny group of companies accounts for 76% of the market value of IPO’s and 89% of R&D spending in America.

The most valuable assets are increasingly intangible. They are not smoke belching factories but lines of code.

This is why the venture industry will only become more important with time. It’s the only one that’s good at financing these intangible assets.

Most other investors are conservative and want collateral young firms don’t have.

When I meet with an ambitious founder today, I sometimes wonder where they’d be without venture capital. Perhaps they’d be toiling away miserably in some large bureaucracy indifferent to their talents.

And I want to free them.

More on tech:

The Power Law (Part Three): Angels and VC’s

The Power Law (Part Two)

The Power Law (Part One)

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Photo: The “traitorous eight” at the Fairchild Semiconductor offices


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