Essay | Mario Gabriele | Arthur Rock: Silicon Valley's Unmoved Mover | The Generalist

Created

Jan 31, 2023 5:00 PM

The Traitorous Eight

No one at Hayden, Stone & Company (HSC) was sure what to do with the letter.

It had arrived on the desk of one of the bank's managers, written by a client's son. Over a few pages, Eugene Kleiner, a scientist at Shockley Semiconductor, asked for help from his father's financiers. He made an unorthodox request:

This prospectus is to introduce a group of senior scientists and engineers that have been working together at Shockley Semiconductor Laboratory...A group feeling arose that rather than leave one by one, we believe we are much more valuable to an employer as a group.

Kleiner hoped that with HSC's help, he might secure a new place of employment for himself and his six colleagues.

Shockley Labs was a prestigious place to work in 1957, even if it was in the comparative research backwater of Palo Alto. A year earlier, Dr. Shockley had been awarded the Nobel Prize in Physics for his work on transistors. But while Shockley was widely regarded as a genius, he was far from an ideal boss, prone to erratic outbursts and fits of paranoia. Once, in a cloud of suspicion, the Nobel laureate tried to convince the entire office to undergo a lie detector test. Eugene Kleiner and his peers had had enough; one way or another, they were going to leave Shockley. Either HSC would find an employer to take them aboard, or they would go their separate ways.

Born in Rochester, New York, Arthur Rock had arrived at HSC after studying at Syracuse and Harvard Business School. As a young man, he'd worked in his parents' candy store upstate and sold magazines door-to-door. That salesmanship still hadn't made him much of a talker, though: with sharp, narrow features and a pointed style of speech, Rock cut an unusually stern figure, especially for someone just thirty years old.

He'd developed a reputation at HSC as an astute picker of technology stocks. In particular, he'd worked on General Transistor, a manufacturer of equipment used in hearing aids. Whereas other investors worried about the limitations of the technology, Rock saw enormous potential.

It was obvious to me that these things were going to be used for a lot more than hearing aids...They weren't used in computers at the time, but it was perfectly evident to anyone who studied the subject that it wouldn't be long before they would.

Though he was just a junior banker, that experience meant it was only a matter of time before Kleiner's letter landed on Arthur Rock's desk. Where others saw an inconvenience, Rock smelled opportunity.

He reviewed the details of the seven men, scanning the names.

Gordon Moore C. Sheldon Roberts Eugene Kleiner Victor Grinich Julius Blank Jean Hoerni Jay Last

Each was highly educated and experienced, having worked at SRI International, Dow Chemical, the Naval Research Lab, Western Electric, and the California Institute of Technology.

"These were, by their resumés, very superior people," Rock later recalled. "And I thought, 'Oh gee, maybe there's something here, something more valuable than just being an employee.'"

Maybe, Rock thought, he could encourage the men to start a company.

He flew out to the West Coast a few days later. Along with his senior colleague Bud Coyle, described as a "ruddy-faced Irishman," Rock met the seven Shockley deserters for breakfast in the august "Redwood Room." Rock might have been surprised when doling out handshakes to discover an eighth man had joined the cause; at the eleventh hour, Eugene Kleiner and his colleagues had persuaded their coworker Robert Noyce to join them.

Handsome with dark, thick hair and a penetrating gaze, Rock must have noticed the gravity Noyce carried, even among peers. It can only have encouraged Rock's belief in his idea.

At the end of the meal, Rock shared his proposition: the scientists should forget about finding a new job — it was time to build something of their own. It was a bold idea at the time, but all eight agreed. They would be able to do much more exciting work and run things the way they wanted to. Rock and Coyle suggested each researcher receive 10% of the new entity, with HSC taking 20%.

Fifty years later, Arthur Rock laughed about that moment.

"That's where the famous 80-20 began," he said, referring to venture capital's traditional carry. "For all you venture capitalists, if there are any in the room, you can thank me for your 20 percent."

Coyle pulled out ten 1-dollar bills to seal the commitment, suggesting each man signed all of them. With the ersatz contracts signed, Arthur Rock got to work.

Starting a tech company in those days was a tricky proposition. There was no formal risk capital asset class, with most venture-style funding conducted by the Rockefellers and other wealthy families on the East Coast. That meant that Rock was going to have to rely on the interest of corporations to forge the new laboratory.

Rock outlined a list of over 35 enterprises he thought might be willing to finance the venture in exchange for benefitting from the work of the cutting-edge researchers.

He scrawled the names on a sheet of yellow legal paper:

Ford General Mills Western Union Motorola General Dynamics

The list went on and on. Surely one of these companies would jump at the chance to bring the "California group," as they referred to themselves, under their auspices?

In an early example of portfolio support, Rock reached out to every single business. And each time, he was rebuffed. Yes, these were "superior people," but they were on the West Coast and wanted to stay there — that was little good to the majority of electronics companies out East. Even for those able to countenance the Eight's preference to remain in California, how should a deal be structured? Giving stock options to employees just didn't make sense, let alone to an unproven joint-venture. As Rock later told it:

All were interested, but no one knew how to incorporate the group without offending the existing employees in the company. No one was offering stock options at the time, except at the executive level and they didn't see how they could do it for some employees and not for others.

It must have been tempting to quit at this point and let Kleiner, Noyce, Moore, and Co. drift apart, each to their siloed laboratories. But Rock kept going, and finally, he found someone willing to talk to the men: Sherman Fairchild.

The son of a wealthy Republican congressman (Fairchild senior had financed the creation of IBM), Fairchild utilized his father's connections to win government contracts for his aerial photography equipment, leading to the creation of Fairchild Aerial Camera Corporation in 1920. In the years that followed, Fairchild built a technical empire, expanding into lunar photography — used by NASA on Apollo 15, 16, and 17 — airplane manufacturing and recording equipment.

By the summer of 1957, Fairchild was 61 years old and in the twilight of his career. But he still possessed a fascination with new technology and a willingness to take risks. He agreed to take a meeting.

Noyce handled the presentation. He explained the group's belief that silicon, not germanium, was the key to making commercially viable semiconductors. Fairchild would later admit that Noyce's passion and force proved the decisive factor.

A deal was struck: Fairchild would loan the group $1.38 million to start their laboratory, structured as a subsidiary of the existing business. In exchange, the parent company could buy the division outright for $3 million within eight years.

It didn't take nearly that long. With Noyce, Moore, Hoerni, Kleiner, and the rest of the group installed at Fairchild, progress was rapid. Within six months, Fairchild Semiconductor turned a profit, and within just two years, the parent company exercised its right to purchase the unit for $3 million. In 1959, led by Noyce, the group created the first commercially viable integrated circuit embedded in a silicon chip.

It's hard to overstate how influential Fairchild Semiconductor proved to be. Not only did it put the "silicon" in "Silicon Valley," but it served as the breeding ground for a crop of generational technologists and entrepreneurs. The "Traitorous Eight," as Shockley branded them, proved prolific, founding companies like Intel, Xicor, and Intersil.

That represented the start of a larger movement. As of 2014, an estimated 92 companies trace their roots back to Fairchild Semiconductor founders and employees (some suggest the number is closer to 400), with $2 trillion in value created. That includes Apple, Advanced Micro Devices, and Applied Materials, as well as venture firms like KPCB and Sequoia.

It may never have happened were it not for Arthur Rock's intervention and stroke of inspiration: talented engineers should be incentivized to build.

Davis & Rock

Despite his success orchestrating Fairchild Semiconductor's formation, Rock didn't relocate to the West Coast until 1961. In New York, he further burnished his reputation at HSC as a shrewd stock-picker, advocating for a basket of science and technology companies that rose 457% between 1958 and 1961. That included companies like Hewlett-Packard and Teledyne. The latter company would play a significant role in Rock's future.

Rock's success was, in part, down to his exceptional understanding of the right vectors upon which to analyze these businesses. Reflecting on that skill, Rock highlighted the kind of thinking that would come to dominate the venture capital industry with its focus on the future rather than the present state:

Most fellows were approaching electronics stocks the wrong way. They wanted to know a company's revenues and earnings this year. That's crazy. The industry is in its infancy. Knowing where past earnings or present ones are coming from is no help.

Perhaps realizing that he was one of the few financiers on the East Coast that thought about businesses in this way, Rock decided to cross the country in 1961. He'd noticed, increasingly, that the best scientists were coalescing around Stanford University, where Fred Terman, head of the engineering school, had fanned the flames of technical entrepreneurship:

Fred Terman did two things. He allowed doctoral students and professors to start companies while they were still at Stanford, and he convinced Stanford to lease some of its land to individuals to start companies.

Rock wanted to be near those kinds of people — the kind of men he'd gotten to know as part of the Fairchild deal. He packed up his life in New York City and, with acquaintance Thomas Davis, founded a West Coast investment firm focused on funding new companies.

Davis & Rock raised $5 million, with Rock putting in $175K of his own money. The rest primarily came from Rock's East Coast network, including Harvard Business School classmate Fayez Sarofim (the second-largest shareholder in Kinder Morgan) and Teledyne founder Henry Singleton. It didn't take the new entity long to invest in one of its LPs:

I raised the initial money for Teledyne a few months before I moved to California. And then when Davis and Rock was formed, we made a follow-on investment. In fact, I knew I was going to do that when I set the thing up, and I was on their board for 34 years.

That marked the beginning of a remarkable run. Over the following seven years, Davis & Rock would invest just $3 million of the $5 million raised into only 15 companies. It returned $100 million to investors.

Portfolio companies included:

Scientific Data Systems, a maker of scientific computers. 300-380x.
Teledyne, a conglomerate of scientific businesses. That included Amelco, founded by members of the Traitorous Eight. 233x.
Astrodata, an Epsco spin-off focused on "data processing equipment." 7.4x.
Anadex Instruments, a manufacturer of electronics. +2x.
SAGIMO, a real estate company focused on the French market. +2x.
General Capacitor. Bankrupt.
International Holding Corp, an insurance fund started by Davis & Rock, that subsequently acquired General Corp. Unknown.
Benrus, a watch manufacturer. Unknown.
Intersil, a manufacturer of integrated circuits for watches developed by Traitorous Eight member, Jean Hoerni. Unknown.

As illustrated, the bulk of the 33x fund return came from Teledyne and Scientific Data Systems (SDS).

The latter company was founded by Max Pavelsky, a Packard Bell engineer with a management style that made an impression on Arthur Rock.

I was convinced Palevsky was going to make money. Very few people turn me on the way he did...Max was and is a very interesting man... He was a very, very good manager. But his style was different than most people's style. His was an easy going, slap you on the back, put your feet up on the table [type of person]. I think he was the first executive I ever came across who didn't wear a tie.

In Pavelsky, Rock saw a reaffirmation of the lesson he'd taken from the Fairchild transaction — remarkable people, not ideas, were the secret to great investments. According to Rock, Davis & Rock invested $257,000 into Pavelsky's venture, a decision that would return as much as 380x.

In addition to delivering absurd returns, together, Davis & Rock's partners solidified a style of venture investing and talent spotting that has influenced every successor to some degree or another. Davis best articulated this approach in a 1966 speech to the Western Electronic Manufacturers Association. During his address, he noted a focus on six founder characteristics.

Integrity. "The guts to take responsibility, admit mistakes, face the facts."
Motivation. "This is the key criterion...The motivation of the man I want to back is to build a large, important company. To him, the products and product fields are not objects of affection or evidences of his brilliance, but merely the means to achieve his goal as a builder/manager. And he intends to keep sweating and sweating and sweating to attain this goal."
Market-oriented (the desire to sell). "The man I like to back...has interest only in things that people are going to buy, buy soon and buy in quantity...He knows that everything has to be sold. He's quite different from many engineers I have seen whose reaction to every slump in sales is to run back into the laboratory to invent something they hope will sell itself."
Skills and experience. "The man to back in starting a company must have the technical capability to create in his chosen fields...he should have had experience in actually managing operations of substantial size.
Accounting ability (understanding of financial levers). "A real manager has a deep appreciation of the role inspired accounting can play in his company. Without accurate information on costs, the really astute manager knows he cannot price his product appropriately, or bid on contracts with any assurance. And he cannot tell where to place his efforts in cost reduction."
Leadership. "I won't try to describe this quality."

He also identified the attributes the pair looked for in businesses.

Manufacturing over services. "I like manufacturing because you sell your design repetitively, and the more you sell, the more profitably you can produce, either by breaking the production down into less and less skilled activities or through employment of machines."
Sophisticated products. "It is a lot easier to prove superiority in such products than in, for instance, alphabet soup, cigarettes, light bulbs, and printed circuit boards."
Existing, growing markets. "I like to back a man who wants to operate in fields which already have markets of around $100 million and which are still growing rapidly... say, 15 percent to 20 percent or more a year."

The polar opposite of Davis personality-wise, Rock usually opted for fewer words. When asked about his approach, Rock noted:

Well, it's all about the people...Good ideas and good products are a dime a dozen….good people are rare.

Rock exercised that ethos for the rest of his career.

45,000x

In 1968, Davis & Rock's partnership expired. While there was no bad blood between the two men, they decided to go their separate ways, in part because of byzantine securities laws that would have required Rock to step down from SDS's board.

Arguably, the best was yet to come for both. Tommy Davis went on to found Mayfield, a celebrated fund in its own right. Meanwhile, Arthur Rock was about to play a pivotal role in the founding of another historic business.

Passed over for promotion, Bobby Noyce decided it was time to leave Fairchild Semiconductor. The Traitorous Eight had created game-changing technology, but there was little incentive to stay now the unit was wholly owned by Fairchild. By 1968, only Noyce and Gordon Moore remained. And once they had an idea for a new business — focused on using silicon for computer memory — they knew who to call.