We Precious Few

The vanity of venture capitalists, and some theories about it.

The first thing that strikes you about Kathryn Gould is that she isn’t a man. Her long brown hair falls girlishly to the middle of her back, and jewels the size of small door knockers decorate her ears and hands and wrists. “I’m a total sucker for jewelry,” she says, almost before she says her name. “You show me a big stone, and I shout, ‘Buy it!’ ” There is really no need for her to shout–she has made tens of millions of dollars for herself and a billion or so for investors in her eight years as a venture capitalist. She can afford her jewelry, as well as her private plane, her house on the beach, and a small collection of old violins that reminds her of her abandoned ambition to become a musician. “She is the most successful female venture capitalist in the Valley,” says an equally successful male venture capitalist. “She may be the only female venture capitalist in the Valley.”

The second thing that you notice about Kathryn Gould is that except for her long brown hair and her jewels and the other superficial differences, she is indistinguishable from the boys in her business. She has that air of financial delight peculiar to her breed. “One of the things about the Valley,” she says, “is that people are happy to talk about their money. Money is not something to be ashamed of. We like money! Maybe it’s because we’re not afraid to talk about it that we have so much of it.” She has the same air as the men of being a member of an exclusive club (“I get 400 business proposals a year, and I throw them all away–I start businesses with people I know”); the same relentless schedule (“This is the only free time I have between now and the end of the year”); and the same odd enthusiasm for obscure technologies. Nothing Gould bankrolls would be even faintly familiar to an ordinary person. The businesses she funds make technology for other businesses. “Business customers respond to logic and economics,” she says, approvingly. “Not taste.”

Above all, Kathryn Gould shares the male VC’s belief that it takes an unusual person to succeed as a venture capitalist. Venture capitalists, like investment bankers, are middlemen. They take money from people who want to invest in new companies and hand it over to the new companies. The VC’s putative talent is for picking the winners and avoiding the losers. A typical venture-capital firm starts with a pile of money–say, $30 million. That pile will fund perhaps 10 start-up companies. Out of those 10 companies, five will typically fail altogether, four will succeed modestly by Silicon Valley standards (i.e., triple their money), and one will be an honest-to-God-I’m-ordering-the-Testarossa-now hit. A venture capitalist who has never multiplied other people’s money by 30 is like a novelist who has never published a book. He is considered a venture capitalist by no one but himself.

At this moment in history, there is nothing in our financial world that it’s better to be than a venture capitalist. There are perhaps a thousand VCs in the world and tens of thousands of VC wannabes. These days VCs condescend to mere Wall Street investment bankers. Investment bankers, they say, don’t understand business. The condescension sticks mainly because venture capitalists make more money than Wall Streeters. A lot more.

This raises an obvious question: Why, if VCs make so much money and everyone wants to become one, don’t more people actually do it? Why don’t VCs’ paychecks get driven down to ordinary Wall Street sizes by the very free market that most VCs claim to venerate?

To this obvious question there are at least three answers. The first–favored by just about every VC in Silicon Valley–is that precious few people have what it takes to be a successful VC. These precious few are worth the tens of millions they make investing in other people’s companies, because no one else could do what they do.

A second explanation–favored by entrepreneurs who raise money from VCs and who occasionally refer to them as “idiots” and “scum bags”–is that the venture business in the Valley is actually a cartel: You must be tapped by one of the established VC firms. This is nearly impossible for a Valley outsider to do. Gould’s break, for instance, came only after she had spent years in the Valley. She came to Palo Alto with a degree in physics and took a job with the newest, least developed company she could find. It promptly failed. In 1981, at age 31, she became the 10th employee at Oracle. That lasted a bit more than two years. She then spent six years as a headhunter until finally, through connections, she broke in with an established VC firm.

Like every other prominent VC, Gould sees hundreds of résumés a year from fancy MBAs and Wall Street types, none of which she thinks twice about. Her firm might hire one or perhaps two more people over the next few years, and they will be people who have already made their fortune starting high-tech companies. In other words, to get rich the easy way, you first must have become rich the hard way.

Just getting hired is not enough. To join the 1990s equivalent of Tom Wolfe’s 1980s “Masters of the Universe” (investment bankers in those days), you must get yourself into the exalted position where the Stanford University endowment or the General Motors pension fund hands you $10 million to invest. And to do that, you must have a hit. Gould has had half a dozen or so of these, among them Grand Junction Networks, Applied Digital Access, Documentum, and Rapid City Communications. As a result she is offered hundreds of millions more than she could possibly use by institutional investors.

The third possible explanation for why Gould is paid tens of millions of dollars to do a job that lots of smart people would do for half as much is the most interesting. It explains equally well (or poorly) the outrageous salaries paid to CEOs and the vast bonuses earned by Wall Street bond traders. It grows out of work done over the past 15 years by a pair of professors at Stanford who live in the shadow of the venture capitalists. Their names are Edward Lazear and Sherwin Rosen. Their theory is called the “tournament theory.”

Put aside the usual question of whether someone is being paid what she is worth. The tournament theory holds that it is sometimes efficient, and in some sense right, to pay people far more than they are worth.

Start with the example of the professional tennis tournament. Players are paid not for their absolute value but for their relative value. If Pete Sampras plays better than Andre Agassi he wins, no matter whether both of them were playing well or playing poorly. So how do you use money to motivate a tennis player? The answer is obvious: Pay the winner more than the loser. The greater the difference between the loser’s paycheck and the winner’s paycheck, the harder the players will try. The only limit is that the loser’s paycheck must be big enough to guarantee that they both show up in the first place.

T his seems trivial: People respond to financial incentives. Where the tournament theory becomes interesting is when you introduce luck into the equation. Say that the tennis match is to be played in the dark. This will reduce the importance of effort: The player who tries less hard may well luck his way to victory. The effect is to make the prize money less efficient: Each dollar elicits less effort from the players. To restore the optimal level of intensity, you must widen the gap.

Sometimes in economics it is hard to say where explanation stops and rationalization begins. It is perhaps a little too neat that we have a theory just now that justifies seemingly exorbitant paychecks. But before venture capitalists take too much comfort from the tournament theory, they should notice two things about it. First, it assumes that success and failure in their game are due in large part to luck and not skill. Second, it assumes that even successful players are being paid far more than they deserve.

Kathryn Gould might well work just as hard, and be just as efficient, for half the pay–years of psychological conditioning have left her with the inability to do anything but work hard. But the theory says: Never mind! Her $10 million a year–or whatever–serves as a kind of mechanical rabbit for the young dogs at Stanford business school just taking to the track. She is being paid, in a sense, so that all those people who will never get into her firm will bust their asses for far less.

For the market to be efficient, according to the tournament theory, it must often be unjust. The tournament theory is thus radically different from the meritocratic argument you usually hear from venture capitalists. It’s not you and your unique qualities that caused your $50-million windfall gain. You are no more than a cog, a device, used by this intricately designed system to persuade others like you to throw their lives away in this luck-ridden game. Oh, you’ll get your money all right–but don’t you believe for a moment that you are worth it.