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Venture Capital Builds The Modern World

November 2020

The American method of high-risk, potentially high-reward investments has fueled innovation from New England whaling ventures to Silicon Valley start-ups such as Apple, Intel, Cisco, and Google.

Venture capital (VC) is largely an American invention. It is a “hits” business where exceptional payoffs from a few investments in a large portfolio of startup companies compensate for the vast majority that yield mediocre returns or simply fail. This “long tail” distribution of pay-offs has been embraced with more impact in the United States than anywhere else in the world.  Today, Silicon Valley stands as the world’s most important center of VC-based entrepreneurship, despite challenges to its leadership position. 

High risk, high return investments in whaling ships, such as these in New Bedford, Massachusetts, in the late 1800s, provided a model for modern venture capital. Courtesy New Bedford Whaling Museum.
High risk, high return investments in whaling ships, such as these in New Bedford, Massachusetts, provided a model for modern venture capital. Courtesy New Bedford Whaling Museum.

Conventionally, the origins of the venture capital industry in America are traced back to the founding of the Boston-based American Research and Development Corporation (ARD) in 1946. ARD was among the first investment firms to attempt to systematize long-tail investing in startups in a way that is analogous to the modern venture capital industry. Yet, many of the characteristics defining modern venture finance can be clearly seen in much earlier historical contexts, such as New England whaling ventures and the early financing of industrialization provided by elites.

History shows how some key financial institutions and precedents were developed early on and offers valuable perspective on the industry’s future. It also helps to reveal why venture capital is so prominently American.

Venture Capital Book Cover
Adapted from VC: An American History by Tom Nicholas (Harvard University Press, 2019)

Venture capital is concerned with the provision of finance to startup companies and it is heavily oriented toward the high-tech sector, where capital efficiency is at its highest and the potential upside is greatest.

Modern VC involves intermediation by general partners in VC firms, who channel risk capital into entrepreneurial ventures on behalf of limited partners — typically, pension funds, university endowments, and insurance companies which characteristically do not act as direct investors in startups. For their intermediation, VC firms receive remuneration in the forms of annual management fees (typically 2 percent of the capital committed by limited partners) and “carried interest” as a share of the profits generated by an investment fund (typically 20 percent). VC funds tend to last about seven to ten years, and the firms behind them often manage multiple funds simultaneously.

It is well known that the VC model of financing is characterized by a distinct approach to payoffs. Venture capital returns do not follow a normal, “bell-shaped” distribution like stock market returns, but rather tend to be highly skewed. A few exceptional investments in the long right-sided tail, such as Genentech or Google, generate the bulk of the aggregate return. Although not mutually exclusive, the attraction of these low-probability but high-payoff outcomes and the pursuit of them are distinct from the periodic behavior associated with manias and speculative bubbles, and the persistent behavior associated with long-shot betting events, such as lotteries, where expected value can be negative. 

In the venture capital context, long-tail investing denotes a systematic approach to the deployment of risk capital into entrepreneurial ventures by intermediaries who attempt to use their domain expertise to generate large returns. In a world of perfect information and efficient markets, economic theory suggests, intermediaries should be absent. The fact that venture capitalists do exist is arguably because they are able to maintain informational advantages in the selection and governance of startup investments. Another interpretation is that they function merely as capital conduits and organizers, but do not particularly add value in terms of startup outcomes.

VCs have helped create hundreds of high-tech firms such as Apple, formed by Steve Jobs and Steve Wozniak in 1976 with an investment from venture capitalist Arthur Rock.
VCs have helped create hundreds of high-tech firms such as Apple, formed by Steve Jobs and Steve Wozniak in 1976 with an investment from venture capitalist Arthur Rock.

Long-tail returns have always been difficult to generate, and the VC industry has sometimes been chaotic and subject to the destructive ebbs and flows of investment cycles. History shows, however, that the social benefits of venture capital have been immense. By facilitating the financing of radical new technologies, US venture capitalists have supported a large range of high-tech firms whose products, from semiconductors to recombinant insulin, telecommunications inventions, and search engines, have revolutionized the way we work, live, and produce. While technological change can often disrupt labor markets and increase wage in equality, in the long run, innovation is essential to productivity gains and economic growth. The venture capital industry has been a powerful driver of innovation, helping to sustain economic development and US competitiveness.

The United States is not the first to deploy venture capital-style models. The need to divide financial payoffs from joint pursuits led mankind to establish rules and norms akin to those used in the modern venture capital industry. Some of the classical civilizations of the Mediterranean were characterized by stable, highly profitable, and well-developed systems of commercial enterprise. While markets were frequently rudimentary in both scale and scope, transactions could extend beyond familial ties to arm’s-length exchanges between investors and traveling merchants. Medieval Venice was strikingly modern in terms of its contracting traditions, and it could be argued that the Venetians acted very much like venture capitalists in their operation of risky trading voyages. A milieu of institutions and cultural norms facilitated the expansion of enterprise through commercial ventures.

It was in the United States, however, that structure and contracting became embedded into capitalism through the provision of finance for entrepreneurship. There are four main stages in the history of venture capital from the nineteenth century up to the early twenty-first century. These chronological stages are not always cleanly distinct from one another and the allure of long-tail investing is the theme that runs through them all. The stages reflect the development of some of the most important financial institutions and practices which were then carried forward. Over time, the VC function of providing capital to startups evolved from being conducted by collections of wealthy individuals to being the work of specialized firms. Enabled by the changing cultural and regulatory environment in the United States, the VC industry expanded to large scale and became increasingly impactful in the sphere of entrepreneurial finance.

The first stage saw early investors deploying risk capital into high-risk and potentially high- reward activities in ways that established historic precedents for VC-style investing. The risk capital deployment in the New England whaling industry in particular has especially striking parallels with modern VC in terms of organization, payoffs, and more. Whaling was one of the largest and most important industries in America during the early nineteenth century. In it, New England whaling agents looked a lot like modern venture capitalists. 

There  were wealthy individuals able to supply finance and there were captains and crew willing to initiate and manage voyages, and whaling agents intermediated between the two groups in much the same way that today’s venture capitalists intermediate between entities like pension funds that supply risk capital and entrepreneurs capable of applying that capital to profit-making opportunities. 

Bill Gates and Paul Allen
Microsoft Founders Bill Gates (left) and Paul Allen. Photo Courtesy of Museum of History & Industry

Like venture capitalists, whaling agents charged fees and received a share of the profits in return for intermediation; they engaged in repeat business with the best captains; they sometimes syndicated to spread risk; and the most capable of them, along with the most capable captains, enjoyed returns that  were persistent over time. Flexible partnership structures worked because of strong compensation incentives. And the reasoning behind profit splits on whaling voyages still persists today in the conventions regarding how equity should be allocated to the various roles in entrepreneurial startups. 

The deployment of risk capital in this first stage in the history of venture capital, is evident in the financing of leading-edge cotton textiles innovation in Lowell, Massachusetts — essentially the first Silicon Valley-type cluster in America. As New England financing elites redirected capital from merchant trading to industrial production, their need to access high-tech know-how compelled them to develop new heuristics to guide their contracting. Examining the structure of contracting, it is clear that tradeoffs between cash flow and control rights were being made in ways similar to the contracting strategies venture capitalists use today as they interact with entrepreneurs. 

The intersection of entrepreneurship, technology, and finance was powerful. In 1820, Lowell had a population of only two hundred citizens. There was not much in that location but land and fast-moving water on the Merrimack River as a source of power. By 1836, however, Lowell’s population had exploded to 17,633, and by 1845 it had topped 30,000. The financing of new innovation hot spots further west gave rise to additional Silicon Valley–style clusters. Most notably, Cleveland and Pittsburgh became high-tech hubs between 1870 and 1914 in such areas as electric lighting, chemicals, oil, and steel. The industrialist and politician Andrew Mellon became a pivotal venture capitalist as he devised ways to finance local enterprise in this region relying on syndicated lending, governance, and equity participation.

During the late nineteenth and early twentieth centuries, the kinds of affluent individuals who would today be called “angel” or “super angel” investors, and more formal (albeit small-scale) private capital entities, provided finance for new ventures. Investors captured upside in returns using convertible securities transferable into common stock later in the firm’s life cycle, while simultaneously mitigating downside risk due to the seniority of these securities. Financing was often tied to board representation, managerial assistance, and other governance mechanisms. Looking at this first stage in the history of VC, the direct lineage from some early entities based on family wealth to various modern VC firms can also be traced. For example, Laurance Rockefeller, the grand child of the oil baron John D. Rockefeller, was a prolific venture capitalist. Venrock Associates, founded in 1969, is an extension of his investing activities. 

Another well-known venture firm today, Bessemer Venture Partners, was founded in 1981 as a spinoff from a family office created by Henry Phipps, who had partnered with the famous steel magnate Andrew Carnegie. In 1946, John H. Whitney, the son of a wealthy industrialist, founded J.  H. Whitney & Company, which also endures to this day. During the 1940s and 1950s, Whitney recognized the challenges associated with constructing a portfolio of early-stage investments to generate long-tail returns, as opposed to building a portfolio of more mature firms. This helps to explain why the firm shifted away from early-stage investing over time and became increasingly oriented toward later-stage private equity.

The second stage in the history of venture capital roughly spans the 1940s to the 1960s. It involved the implementation by specialized firms of the VC model focusing on right-skewed returns, and the gradual shift toward adoption of the limited partnership structure. ARD was founded in Boston after the Second World War by local elites who felt a sense of civic duty to fund enterprise and regional growth in New England. From a modern-day perspective, ARD was unusual in that it was organized as a closed-end fund and did not employ the limited partnership structure that is the leading organizational form used in the venture capital industry today. Its highly successful 1957 investment in the computer startup Digital Equipment Corporation illustrated that the venture capital hits model could work. ARD was able to build a portfolio of investments in which the return from one big hit could offset many middling or loss-making investments. Furthermore, ARD was founded at a time when America was largely devoid of institutions to provide risk capital to startups, a problem that had prevailed since the Great Depression. 

Government efforts to close the “funding gap” culminated in the 1958 Small Business Investment Company program, which created private-sector investment companies to provide capital to small businesses. Given the sense that the gap was an instance of market failure, debate centered on the extent to which the government should intervene in the allocation of venture capital. ARD powerfully illustrated the potential effectiveness of a market-based approach to the intermediation of risk capital.

During this second stage, the venture capital industry came to be dominated by limited partnerships, an organizational form with a long history. This structure made sense because it allowed venture capitalists to exploit tax advantages and avoid laws mandating the public disclosure of sensitive information regarding compensation and fund-level performance returns. It is no accident that the first limited partnerships emerged during the tax-shelter era from the mid-1950s to the mid-1970s. The choice of organizational form, however, also involved disadvantages. The limited partnership with a finite lifetime (typically less than a decade) worked against a more long-term investment focus. The first venture capital limited partnership in Silicon Valley, Draper, Gaither & Anderson, founded in 1959 in Palo Alto, California, generated poor returns, underscoring the difficulty of realizing payoffs from a portfolio of early-stage investments within the timeline of a limited partnership. 

East coast–based Greylock Partners, founded in 1965 by William Elfers after a long career at ARD, and Venrock Associates — did much better, however, providing impetus to expansion in the industry. Crucially, this stage also saw government policy play a key role, with large, industrywide effects. In the late 1970s, the clarification of rules relating to the Employee Retirement Income Security Act of 1974 created a supply-side boost to venture capital and the limited-partnership model because it gave pension funds much more leeway to invest in risky asset classes. Venture capitalists had helped to shape this aspect of the market framework through the National Venture Capital Association, founded in 1973, which lobbied heavily for legislative change. That trade group also expended considerable effort lobbying for the changes to capital gains tax policy that venture capitalists at the time considered necessary for the industry to flourish.

The third stage in the history of venture capital in America played out from the late 1960s through the 1980s, as the long-tail model of VC investing was repeatedly verified and the wider ecosystem to support early-stage investing developed. Various factors came together to create Silicon Valley including: Human capital development facilitated by local educational institutions; government investment in military-based technologies; focal high-tech firms; and high-skilled immigrants. The combination of these meant that, by the mid-twentieth century, the area that became known as Silicon Valley was well poised to displace the east coast as a center of entrepreneurship and high-tech innovation. 

Three key figures in the history of venture capital— Arthur Rock (cofounder of Davis and Rock in 1961), Tom Perkins (cofounder of Kleiner Perkins in 1972), and Don Valentine (founder of Sequoia Capital in 1972)— responded to and helped compound that regional advantage. All were born and educated on the east coast but migrated to the opportunity-rich west coast. Rock, Perkins, and Valentine were responsible for some of the most import ant investments of the twentieth century, in companies such as Intel, Genentech, and Cisco Systems. Continually proving the VC model based on hits and long-t ail investments, they generated staggering fund-level returns. They also personified the three oft-cited investment styles in the VC industry, since Rock tended to identify opportunities based on investing in people, Perkins emphasized investments in technology, and Valentine stressed the idea of investing in markets.

The 1980s was a crucial time in the history of venture capital. For the first time, the industry experienced a pronounced high-tech boom-and-bust cycle, from about the time of Apple Computer’s 1980 initial public offering (IPO) through 1984. The industry grew in scale as a result of both the supply-side effects of the government policy changes and the repeated verification of the VC hits model. Scale created challenges associated with managing larger funds, and the de cade was associated with more general industry-structure changes. The best venture capital firms were distinguished by their performance records, giving rise to the notion of a “top-tier” venture firm. The industry sorted itself into different varieties of venture capital formation, and segments formed according to firm size, geographic focus, and sector (that is, private venture capital, corporate venture capital, or government initiative). Mezzanine finance, specialized IPO intermediation, and venture debt all became instrumental to the industry’s evolution. 
Leadership transitions in the marquee firms gave rise to a new generation of exceptional investors.  Women’s representation in venture capital became a discussion point, flagging issues that have yet to be resolved.

The fourth stage in the history of venture capital in America is defined by the widespread implementation of its investing model, culminating in the late 1990s stock market run-up and subsequent crash. The 1990s and early 2000s were the most volatile period in US venture capital history. The high-tech revolution of the early 1990s witnessed a new era of hardware, software, and telecommunications innovations, mostly in response to the commercialization of the internet. 17 Importantly, this period witnessed a flurry of investments in software and online ser vices, setting precedents for a trend in VC investing that continues to the present. 

Online retailing became a particularly “hot” area of investment because consumer buying was expected to shift rapidly from brick-and-mortar stores to online sellers. As the IPO market became more active, opportunities for liquidity increased and expected payoffs rose steeply. Capital commitments in the venture capital industry peaked in 2000 at over one hundred billion dollars. In the immediate aftermath of the high-tech, dot-com and telecommunications crash in 2001 to 2002— when trillions of dollars of stock market value were wiped out— attention focused on the destructive side of the venture industry and how its dynamics had created unproductive incentives. Yet, although venture capitalists were criticized for performance defects and a legitimacy crisis ensued, from today’s vantage point this era looks considerably more productive than it did at the time. In retrospect, it can be seen as one of the most profoundly important epochs in the history of American business.

There are five recurrent themes here. First, history shows that exceptional VC-style payoffs have been sporadic and infrequent, concentrated in specific firms and time periods. Indeed, the industry as a whole has reflected more of a cultural habituation to risk and a behavioral bias toward long-tail investing than an evolution toward any more systematic realization of outsized returns.

Second, if one asks how exactly VCs do what they do, it is not clear that the answer today is much different from half a century ago. The dominant form of organization is still the limited partnership with an ephemeral fund life, even though this places constraints on the time scale of investment returns. Although there have been some organizational structure and strategy innovations, these have been paradoxically rare in an industry that finances radical change.
Third, while it is often argued that Silicon Valley’s special advantages can be challenged by competitive emulation, within America or globally, this misses the fact that the region’s development as a center of VC-fueled entrepreneurship has been deeply historically contingent. It is largely because the US venture capital industry emerged in a specific cultural and regulatory context that replication efforts elsewhere have been largely unsuccessful. At the same time, the threat remains real as China and other countries seek their own pathways.

Fourth, and relatedly, it is important to note the often-ignored fact that the venture capital industry became institutionalized partly as a consequence of government policy. Lawmakers shaped the enabling environment — kick-starting regional growth in what would become Silicon Valley — by crafting policies that allowed institutional investors to increase their risk tolerance in making investment choices, changed the taxation of investment gains, and promoted more high-skilled immigration. In many ways, the US government acted as America’s VC writ large by funding the basic university research that would break open the development pathways to entrepreneurial businesses. Clearly, the future of the VC industry in the United States will depend on maintaining key aspects of that amenable, enabling environment.

Fifth, from a cultural standpoint, it is inescapable that the history of VC centers on the activities and achievements of white males. This mirrors the composition of the American business and financial elite more generally. Reversing the venture capital industry’s poor record on diversity will be vital to its future, in terms of talent management, competitiveness, performance returns, and how the industry is publicly perceived.

Through the lens of the history of the venture capital industry, the essence of American-style free markets is revealed, including the forcefulness of incessant competition in startup finance and the incentives that condition the inexorable pursuit of capital gain. The venture capital industry emerged in a cultural context where entrepreneurial risk, wealth accumulation, and financial payoffs were embraced in ways that have not been as palatable in other countries. The allure of the long tail can be seen as a manifestation of much deeper economic and cultural uniqueness, highlighting how capitalism in general has evolved and been embraced in the United States.

 

Excerpt adapted from VC: An American History by Tom Nicholas (Harvard University Press, 2019). Copyright © 2019 by the President and Fellows of Harvard College. Used by permission. All rights reserved.

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