SYLVIE DOUGLIS, BYLINE: NPR.
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DARIAN WOODS, HOST:
Today's story starts in 1957, with seven scientists working in the semiconductor industry in Northern California.
SEBASTIAN MALLABY: The seven scientists were working at a company called Shockley Semiconductor.
WOODS: Sebastian Mallaby told the story of the scientists in his book "The Power Law."
MALLABY: William Shockley, the founder, was a brilliant Nobel Prize-winning scientist, but an absolute jerk to work for.
WOODS: One of the seven had the idea to send a letter to an investment firm in New York, where he had a personal connection. And they weren't asking for money. Rather, this was a desperate attempt to network.
MALLABY: They figured that they're going to be more likely to invent something of consequence if they stick together as a team.
WOODS: They were working with semiconductor chips, which, as we know, are fundamental to electronic devices we use today. But it was early days then, and these scientists were collaborating on what materials should even be used.
MALLABY: And so their idea is maybe we can find another company that would hire us as a squad and keep us together.
WOODS: And so this letter ends up in the hands of a guy called Arthur Rock at the investment firm. But Arthur doesn't have a job lined up for them, does he?
MALLABY: No, but he has a better idea. And that is, don't go work for somebody else's company - start your own company.
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WOODS: This is THE INDICATOR FROM PLANET MONEY. I'm Darian Woods. Today on the show, the experiment that kick-started modern venture capital and much of the technology we use today.
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WOODS: All right. So Sebastian, let me set the scene here. The investment banker Arthur Rock has flown to San Francisco, and he's meeting with this group of disgruntled scientists at a restaurant. And he's proposing that they start their own company. And so how do they respond?
MALLABY: The first reaction is shock - what do you mean our own company? - partly because the concept was sort of a novel one in the 1950s. The culture was you join one company; you work there loyally until you retire at 60 with a gold watch. And they say, well, that would take a lot of money. We would need at least $750,000, they say, thinking that's an impossible number. And Rock calmly, but somewhat dishonestly, counters, don't worry. We'll raise you 1 million, no problem.
WOODS: And so why was Arthur Rock so confident?
MALLABY: Firstly, he knew that these engineers were working on a technology of enormous commercial promise. The second thing that Rock knew was that, hey, William Shockley is pretty much the god of the semiconductor business. Therefore, these several engineers who are threatening to walk out, they must be really, really good.
WOODS: So this is the Traitorous Eight, as they've become known, once they add another engineer to the group.
MALLABY: Yeah. And this all comes to a head at the grand, art deco Redwood Room at the Clift Hotel in downtown San Francisco, where Arthur Rock and his partner Bud Coyle are waiting for the now eight traitors to join them. And Bud Coyle pulls out 10 crisp dollar bills and invites everybody to sign each of these dollar bills. And they keep them - one each - so that they have a sort of contract with each other.
WOODS: OK. So Arthur Rock and his business partner need to find a million dollars. And at this stage, venture capital is still pretty fringe. So how does he find the money?
MALLABY: It wasn't so easy. What he did is he went back and made a list of 35 potential backers, and he reached out to all of them. And they all turned him down.
WOODS: I mean, it's good to just kind of think about - back in this time, there was no such thing as a personal computer. We didn't know what these things could be used for. So this was actually an extremely risky bet, right?
MALLABY: Yeah. And finance at the time was just not keen on any kind of risk. So finally, Rock and his partner had the idea of pitching somebody called Sherman Fairchild, who was a playboy with an inherited fortune and who was crucially a science enthusiast. And the idea was basically that this guy, Sherman Fairchild, might do the investment partly for fun. He was just excited by the science. And that turned out to work.
WOODS: All right. So we've got the million dollars ready. And so tell me about the structure of this deal.
MALLABY: Well, Fairchild and Arthur Rock cooked up a slightly complex structure, which had the appearance of giving the eight engineers a lot of ownership. So they got almost one-tenth of the company each. But the Fairchild loan came bundled with an option to buy all of the company's shares for $3 million.
WOODS: OK. So if the company went up in value to $3 billion or more, then Fairchild's parent company could buy out the engineers. And so there was a cap on how much the engineers could make.
MALLABY: Exactly.
WOODS: However, even giving some equity, that wasn't necessarily very common at the time.
MALLABY: Absolutely. In fact, it was radical. You know, in a culture where engineers were expected to work all their lives at one big organization, you could kind of just assume employee loyalty, so why would you pay for it?
WOODS: So the Traitorous Eight - these eight engineers - have the money, but now they need to build this company. So what do these early days look like?
MALLABY: Well, amazingly, some of that sort of zany informality that we've come to associate with Silicon Valley startups was immediately apparent at Fairchild Semiconductor. You know, for the first couple of months, the eight scientists worked out of a garage. You couldn't make that up.
WOODS: Classic Silicon Valley...
MALLABY: Yep.
WOODS: ...Origin story.
MALLABY: Absolutely. And then, they moved out of that, and they moved into a half-constructed building that didn't even have electricity. But because they were engineers, they figured out a way around that. They climbed up a nearby electricity pylon and rigged up some wires. When they had company meetings, there were brownies and whiskey, and the junior guys could speak up. There was not much hierarchy.
And it was also template because of that determination to actually make a lot of money. The scientists who might have been sequestered in the lab were actually out, first of all, talking to potential customers because they were determined that whatever they made would actually be sold. And that, again, is the template for later Silicon Valley success stories. If you think about the internet, you know, the basic science was done in government-backed labs. But when it came to actually turning the basic internet into something that every household used, it took venture capital to kind of turn that into a mass product.
WOODS: So how did this deal go in the end?
MALLABY: Pretty soon, Fairchild Semiconductor had its first order, which was for 100 transistors to be sold to IBM at $150 apiece. And a couple years later, in 1959, Fairchild Semiconductor was taking in orders worth around $6.5 million. And everything was going so well that, of course, the parent company exercised that option and paid $3 million to buy all of the stock outright. Probably, the company was worth a hundred million at that point. So that was a cool 97 million profit.
WOODS: OK. So this, as you describe him, playboy, inheritor guy that's kind of just interested in science just made a killing.
MALLABY: Absolute killing. Now, the Traitorous Eight, the engineers, each made $300,000. And I worked out that that was around 30 years of salary. So that's a lot of money.
WOODS: Yeah. Yeah, nothing to sniff at. But it's all relative, right? You think, OK, I made much more than any other engineer around me is going to be making. But this guy just went off with $97 million.
MALLABY: Exactly.
WOODS: So why is this deal so important to Silicon Valley?
MALLABY: Well, by liberating those eight engineers from a tyrannical boss, he had really shown that you could collapse that distinction between a scientist and a profit-motivated business guy and therefore forge a new kind of applied science and a new commercial culture.
WOODS: I mean, it is incredible how influential this deal has been. Like, in your book, you talk about how 70% of companies that are public in Silicon Valley were traced back to Fairchild. And that kind of raises the question, why did Arthur Rock succeed when there were other venture capital deals going on at the same time?
MALLABY: Yes. I mean, he was the father of modern venture capital because he came up with a formula and made the formula work.
WOODS: Well, Sebastian Mallaby, thanks so much for talking about venture capital, the Traitorous Eight and Arthur Rock. It's been a fascinating origin story.
MALLABY: Thank you for having me, Darian. It's been great.
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WOODS: This episode was produced by Audrey Dilling. It was engineered by Brian Jarboe. Sierra Juarez is our fact-checker. Viet Le is our senior producer, and Kate Concannon edits the show. THE INDICATOR is a production of NPR.
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