Excerpts from the book

A History of Silicon Valley

Table of Contents | Silicon Valley History pages | Purchase | Correspondence
(Copyright © 2010 Piero Scaruffi)

 

7. Early Funders:  The Early History of Venture Capital (1900-59)

by Arun Rao

THESE ARE EXCERPTS FROM THE BOOK A History of Silicon Valley

 

Background on the Venture Capital Industry

Venture capital is private money to fund early-stage, high-potential/high-risk, growth companies.  The provider of the money generally wants an equity stake and a return of capital within five to ten years through:

i)           An initial public offering (IPO) of the company, or

ii)          A sale of the company to a strategic investor, usually a large and well-established technology company.

Long-term harvesting through dividends and share buybacks are generally not used by venture capital firms, for reasons discussed below.

Most venture capital is invested in high technology industries such as software, computer hardware, biotechnology, clean energy, and so forth. Yet some venture capital firms invest in scalable low-tech business ideas like consumer products and retail. Venture capital is directed toward new companies with a limited operating history, which are too small to raise capital in the public markets, secure a bank loan, or complete a debt offering. In exchange for the high risk that venture capital firms assume by investing in smaller and less mature companies, they get significant control over a company’s decisions (through board seats), plus a large portion of the company’s equity (so large that founders sometimes call them “vulture capitalists”).

The startup game goes like this:  An aspiring entrepreneur starts with a team, an idea, and some artificial currency (stock). Her goal is simple:  to increase the value of the business and so the stock, so she and her team can cash out. The trick is to swap portions of the stock for resources that make the business more valuable:  people, more and better ideas, and money. The initial people want stock and they bring their ideas, or intellectual property (designs, patents, contacts, trade secrets, etc.). The venture capital firms give cash in stages for the team to hit milestones to prove the business. Yet at any point, the team can pull the plug, or the business can die if the milestones aren’t met and the venture capitalists don’t give more capital. Game over. Alternatively, the company can make a promising product and so sell itself to a corporate acquirer or to the public markets in an IPO. The entrepreneur and her team can cash in and leave. Or they can double down and try to be corporate managers. Success.

Venture capital firms are typically comprised of small teams with technology backgrounds (scientists, researchers), with business training from investment banks or consulting firms, or with deep industry experience. Venture capitalists bring managerial, governance, and technical expertise, as well as capital, to their investments. [Note: Confusingly, both a venture capital firm and a partner/associate of a venture firm, a “venture capitalist,” are both referred to as a “VC”]  Venture capitalists pool together funds for their investments from institutional investors (pension funds, foundations, endowments) and high net worth individuals, through creating a partnership (most commonly a limited partnership, where the venture firm is the general partner, or “GP,” and the outside investor is the limited partner, or “LP”).

Venture capital and startup generation are often associated with job creation, the knowledge economy, and business or technological innovation. One stunning fact comes from Robert Litan, who directs research at the Kauffman Foundation, which specializes in promoting entrepreneurship and innovation in America: “Between 1980 and 2005, virtually all net new jobs created in the U.S. were created by firms that were 5 years old or less . . . That is about 40 million jobs. That means the established firms created no new net jobs during that period.”[12]  The National Venture Capital Association estimates there were 12.1 million jobs at venture-backed companies in the US as of 2009, and those companies accounted for 21% of US GDP.

Some of the themes from the history of venture capital include:

  • Origins with family offices of very wealthy families such as the Phipps, Rockefellers, and Whitneys;
  • The influence of one man, George Doriot, in single-handedly creating much of the modern venture capital industry;
  • Early informal partnerships in Silicon Valley due to a confluence of factors, most importantly the high-tech semiconductor industry and offshoots of Fairchild Semiconductor;
  • Great venture firms like KPCB, Sequoia, and NEA refining the partnership-based model of investing with institutional capital;
  • The loosening of ERISA rules and the boom and busts of the 1980s and 1990s, in which success mixed with excess;
  • An industry somewhat lost in the 2000s and searching for a viable model again.

One of the most insightful sayings about the Valley has been repeated by Don Valentine and John Doerr, two of the most successful venture capitalists:  “Silicon Valley is a state of mind.”

 

Origins of Modern Venture Capital, 1900-1945

Benno Schmidt of J.H. Whitney claimed he and his partners put together “risk capital” and “our business is the adventure” to first describe the industry as “private venture capital” in 1946. Schmidt claimed they shortened “adventure capital” to “venture capital.”  However, the first documented use of the words “venture capital” can be traced to 1920, when the Industrial Securities Committee submitted a report on it:  “The enlistment of venture capital is necessary for the development and growth of the country, as well as for the safety of all investment securities.”[13]  These investors saw venture capital as part of a traditional portfolio for large investors, as an investment in “business in the experimental stages.” 

Prior to 1920, a few wealthy families, such as the Phipps, the Rockefellers, and Whitneys, informally invested in new ventures. They were amateurs. Yet as the stock market took off in the 1920s, these individuals switched their investment allocations to the public markets, and venture funds declined. When the markets crashed from 1929-1931, wealthy individuals shunned all risky investments and delegated more to institutions.

A number of other factors led to a paucity of venture investing from 1931 to 1946. First, as tax rates rose through the 1930s and 1940s, especially due to higher tax brackets for the rich and interpretations of rules by the IRS, wealthy families shunned venture investing. Second, as power shifted from individuals to institutions, the new “institutional investors” found that state fiduciary rules limited their investing to only securities on approved lists, usually the safest bonds and preferred stock. This combined with the natural risk aversion of institutional investors, leading to the decline of venture funding. Third, the public’s distrust of investment bankers, the difficulty of getting transitional funding for a growing venture due to the new securities laws of 1933 and 1934, and bankers’ reluctance to take risk impeded the growth of venture capital. Fourth, the excess profits tax that Congress raised in 1933 penalized young companies more than established ones, since their rates of return were highly variable and the tax would hit them in their peak years. Fifth, inventors and entrepreneurs had little bargaining power with holders of capital after the depression, and so many chose to bootstrap their own companies or join larger corporations.

During those lean years, most venture funding was being done by large corporations and the US government. Corporations could expense their venture creation as “R&D costs,” and could raise the large amounts of capital that some new ventures needed. Generally, the US government avoided venture funding, and New Deal programs funneled capital to large projects like the TVA. Government banking agencies like the Reconstruction Finance Corporation (RFC) could not finance risk ventures (though the RFC made loans to some small businesses). Rather, most government venture capital came during World War II, as government, industry, and universities formed a research network, and subcontracting programs for federal procurement encouraged technology transfer to small firms. One example is the development of synthetic rubber production from scratch, where $700 million was invested in 51 plants over two years. Most importantly, many state governments started giving institutional investors more leeway to finance risky investments, often dropping approved investment lists for a “prudent man rule,” a discretionary standard. Also, a tax code change in 1942 gave capital gains a more favorable treatment. Finally, the GI Bill after WWII put millions of Americans in college, educating a generation of technologists and entrepreneurs, while increasing funding for research in pure science many times over.

 

The Venture Pioneers of 1946

Five important venture organizations were started after World War II, around 1946, as businessmen and government officials realized the importance of venture funding. The organizations were J.H. Whitney and Company, Rockefeller Brothers and Company (later Venrock), the American Research and Development Corporation (ARD), and two in Silicon Valley, Industrial Capital Corp. and Pacific Coast Enterprises. These were daring experiments, as conventional wisdom was that the US would fall back into a depression after WWII ended. This is why US government bond yields were so low around 1945, and most investors clung to government bonds yielding a little above 2%. Venture capital investors, however, were bolder and willing to take more risk for a potential higher return.

J.H. Whitney & Company was founded by John Hay “Jock” Whitney and his partner Benno Schmidt in February 1946, after Whitney wrote a $5 million check to capitalize the firm. Whitney had been investing since the 1930s, founding Pioneer Pictures in 1933 and acquiring a 15% interest in Technicolor Corporation with his cousin Cornelius Vanderbilt Whitney. Benno Schmidt was working at the State Department in 1946 when one day he got a call from Whitney, one of the wealthiest men in the country. Whitney wanted to stake a new firm with $5 million to finance young companies in new industries. Schmidt told Whitney that he had no business experience whatsoever. Whitney replied: “I’m not looking for somebody who has a lot of business experience. I’m looking for someone who has had a lot of experience with life.” Schmidt signed on and became a partner for 52 years, until 1992.

Schmidt and Whitney did good deals. An early deal of the new firm was buying Spencer Chemicals after World War II and converting its munitions plant into a fertilizer facility (the $250,000 of initial equity was eventually worth over $10 million). Whitney’s most famous investment was in Florida Foods Corporation. The company developed an innovative method for delivering nutrition to American soldiers, which later came to be known as Minute Maid orange juice and was sold to The Coca-Cola Company in 1960. Eventually, J.H. Whitney & Company left the venture capital space to become a buyout firm.

Rockefeller Brothers Co. had its roots in the 1930s, when Laurence S. Rockefeller (1910-2004) pioneered early-stage financing by investing in the entrepreneurs of Eastern Airlines and McDonnell Aircraft. Over the years, the family’s investment interests included the fields of aviation, aerospace, electronics, high temperature physics, composite materials, optics, lasers, data processing, thermionics and nuclear power.   Beginning in August 1969, the VC firm Venrock was founded to continue the family’s heritage of investment and building entrepreneur-backed companies, beginning with its investment in Intel, based on the advice of Arthur Rock. Venrock still existed in 2010, having invested $2.5 billion in 442 companies resulting in 125 IPOs and 128 M&A exits over its 41 year life.

These early family venture funds share a few goals: achieving high returns on an initial investment to get favorable capital gains tax treatment (versus the higher-tax burden from dividends and interest from established companies); creating a more effective way to finance new ventures from their entrepreneurial friends and associates; and pushing an ideological view of free market capitalism over state-sponsored socialism. All three goals came together with a sense of noblesse oblige, as the rich felt they needed to lead the way back for a prosperous economy and free enterprise system. The most important firm founded in 1946, however, was not a family venture capital firm.

 

The Father of Venture Capital: Georges Doriot of ARD

Non-family venture models essentially began with the American Research and Development Corp. (ARD), founded by Georges Doriot, who many believe was the “Father of Venture Capital.”  Before WWII, Doriot was a banker at Kuhn, Loeb & Company, the premier investment bank of its time (along with JP Morgan & Co.). Doriot then became a Harvard Business School professor, where he formed close bonds with many students and taught an eccentric business philosophy (rather than mutable facts or fancy theories) in his Manufacturing Class.  Note that Doriot was also an uber-capitalist and elitist, as shown by a speech he gave in 1934 where he denounced FDR’s popular and socialist New Deal programs as “one thing that has done more harm to the morals of the nation” and that “those who pay the taxes have more right to govern than those who don’t.”

During WWII, Doriot partnered with Ralph Flanders, Merrill Griswold, and Karl Compton (a former President of MIT) to encourage private sector investments in new products for the war effort. He even joined a private company, Enterprise Associates, which raised $300,000 from twenty stockholders to finance the final stages of promising research projects and looking for entrepreneurs and ideas to finance. Doriot was pulled even further into the war when he became the head of the Military Planning Division in the Office of the Quartermaster General of the US Army, where his role was putting together teams to develop technologies and get ideas made into products and weapons for the battlefield (one example is the food ration bars for soldiers on the line, packages containing meat, biscuits, a powder-made drink, a sweet, gum, and cigarettes).

After WWII, members of previous committees that Doriot sat on formed the American Research and Development Corporation (ARD) on June 6, 1946, as a Massachusetts corporation. ARD raised $3.5 million through a public equity offering (a mistake, as we shall see), of which $1.8 million came from nine institutional investors like MIT, Penn, and the Rice Institute. ARD’s significance lay in that it was the first institutional venture capital firm that raised capital from sources other than wealthy families although it had several notable investment successes as well. One of the incorporators, Ralph Flanders, gave a speech in 1945 to the National Association of Security Commissioners explaining the need for “new methods of applying development capital” and that the nation could not “depend safely for an indefinite time on the expansion of our big industries alone.”  Hence ARD sought to bring together cash-poor entrepreneurs with great ideas and an institutional investor community that had become too risk averse.

ARD’s investment record was typical of the economics of many venture firms. A few failed (Island Packers, tuna fish packing), a few made modest amounts of money (Tracer Labs), and one investment made the fund (Digital Equipment, a chip manufacturer). ARD’s criteria was “taking calculated risks in select [growth] companies”, with guidelines such as projects having passed the test tube stage, with patent or IP protection, and an “attractive opportunity for eventual profits.”  Doriot also thought entrepreneurs were more important than ideas and joked in the 1949 annual report that “An average idea in the hands of an able man is worth much more than an outstanding idea in the possession of person with only average ability.”  ARD raised $4 million more in 1949, and Doriot found that selecting companies was the easy part and that the “hardest task [was] to help a company through its growth pains.” 

Doriot had an interesting business philosophy. He felt the study of a company was not the study of a dead body, but rather of things and relationships which were alive and constantly changing. For him, business was “the study of men and men’s work, of their hopes and aspirations… a study of determination of successive goals and of victorious competitive drive towards them.”  Doriot also fostered an entrepreneur’s paranoia that   “someone somewhere is making a product that will make your product obsolete.”  He pushed managers to delegate down, grow slowly, and examine small decisions which could lead to vital errors. In the end, he felt work was a part of living, that work was not just an activity necessary for existence but also a worthwhile part of existence.[14]

ARD and Doriot went through hard times, as by 1953 venture investing was not fashionable again. By 1954 the number of proposals fell and the company made no investments. Also, the SEC created problems by examining and questioning the valuation of the underlying portfolio companies (a speculative endeavor). The stock price slumped below the net asset value that the accountants had valued the company’s assets per share.

ARD’s greatest investment was Digital Equipment (DEC) in 1958, its sole investment of that year, where it put in $70,000 in equity and $30,000 as a loan. 70% of the equity went to ARD, 20% to founders Ken Olsen and Harlan Anderson, and 10% was set aside for a more seasoned management team (a spot which went unfilled, so everyone’s share increased pro rata). ARD invested $30,000 more in 1958. Olsen and Anderson went on to build a powerhouse, based on their new technology (their first product was a module to test computer memory devices), and their natural frugality and penchant for hiring MIT engineers. In 1959, the PDP-1 was an interactive computer DEC sold at a fraction of the cost of an IBM mainframe. While DEC prospered, Doriot invested $190,000 in a Texas oil rig manufacturer named the Zapata Off-Shore company, run by a young war hero named George H. W. Bush (later President of the US).

ARD was prospering by the spring of 1961, when Doriot gave a talk he titled “Creative Capital.”  Of the $11 million invested in 66 ventures, ARD’s portfolio was now worth $30.3 million. Doriot’s thoughts on venture investing were that:

  • The best returns were from the riskiest companies, which were started from scratch.
  • The best companies were built over time with steady progress and solid management, and were not overnight successes.
  • Specialized technical areas were the best places to invest, as patents and know-how gave small companies the ability to compete with larger ones.
  • The hardest thing to do was to convince entrepreneurs to seek and accept outside help, whether it was for generating sales, getting a bank credit line, or hiring the right team.

Doriot was busy on the side of ARD too. He helped start the pre-eminent French business school, INSEAD, along with international venture capital companies, Technical Development Capital Ltd. (a British VC firm started in 1962 with $2 million in capital) and the European Enterprise Development Company (a French-Euro venture capital firm started in 1963 with $2.5 million in capital).

The first real trouble ARD and Doriot got into with the government was in 1963, when the SEC contacted Doriot. The SEC objected to ARD’s officers, Doriot’s young men who screened ideas and sat on portfolio companies, from holding stock options in ARD affiliates. Doriot complained that this was the best way to motivate people, but the SEC saw a conflict of interest in a public company doing this. This problem was one strong factor pushing the entire industry into private partnerships, where contracting was not inhibited and parties could do anything they wanted without government interference.

A second, more important problem was losing key people. Doriot relied on his associates to find and screen deals, and Bill Elfers was his right hand man who made many decisions. When Doriot refused to retire or set a retirement date in 1965 (after leading ARD for nearly 20 years), Elfers left. Elfers (along with Arthur Rock) used the limited partnership (LP) entity form seen in the oil wildcatting business (used by Texas millionaires since 1900). The advantages were numerous, as discussed in a later section, with the key one being attracting good venture capitalist partners and compensating them properly with the right incentives (something Doriot couldn’t do at ARD, a public corporation). Elfers started Greylock Capital in 1965, raising $5 million from J.H. Whitney & Company along with 5 other wealthy families (the Watsons of IBM, Warren Corning of Corning Glass, Sherman Fairchild of Fairchild Semiconductor, etc.). Another Doriot associate, Charles P. Waite griped that when one portfolio company, Optical Scanning, went public, the CEO made $10 million but Waite just got a $2,000 raise. He left for Greylock. Later associates of Doriot founded Morgan, Holland Ventures, the predecessor of Flagship Ventures (founded in 1982 by James Morgan), Fidelity Ventures (started by Henry Hoagland in 1969), and other firms.

But 1963 also brought good news. DEC went public, selling $8 million of stock at $22 per share, and ARD’s 65% stake was valued at $38.5 million. When ARD eventually liquidated the stake, it was worth $400 million, a 70,000% return. This made tensions worse in the ARD office, as only four ARD employees had DEC options, making them millionaires, while the rest, who also worked on the deal, got peanuts.

By 1968, Doriot realized ARD was not competitive anymore. The SEC was still hounding the firm. Talent was leaving for other venture partnerships or corporate venture arms. Doriot wanted to merge ARD with an industrial firm, and eventually he merged it with Bill Miller’s Textron Corp in 1972. Doriot reached out to three executives to succeed him, and all rejected the offer. The most important of the three was Thomas J. Perkins, a student of Doriot, who would go on to work with Bill and Dave at HP and start the most famous venture firm in the West Coast, if not the US. More on Perkins later, but one main reason he didn’t join ARD was the compensation structure and the limited upside. Many say ARD failed for another reason other than compensation:  Doriot just couldn’t leave and empower a successor, and the ARD board stood behind him, the intellectual and moneymaker, instead of pushing him out for younger talent (Elfers worked magic at Greylock). Textron didn’t solve any of the compensation issues, and ARD faded away within it.

Doriot lived by his principle that “you will get nowhere if you do not inspire people.”  He was fond of telling a story about three men breaking stones on a medieval road. They were asked what they were doing:  One said, “I earn a living.” One said, “I break stones.”  One said, “I help build cathedrals.”  Doriot wished his students and associates to build cathedrals together.

 

Economics and Legal Structure of Venture Capital Firms

The paradox of venture capital investing is that most investments will fail, but on the whole, a venture capitalist should make a 2x to 4x multiple on the invested capital. Because no one can know ex ante (before an investment) what will succeed and what will fail, venture firms must invest in large groups of companies (at least ten, and as many as a few dozen). For a sample of any ten investments, three to five will be written off to zero (complete failures), three to four will break even or eke out a small return (moderate failures at 1.5x to 2x multiples), and the remaining one to two will generate an outsized return (5-10x or more). The winning investments are tail events or positive “black swans,” that is, improbable events that are hard to predict ex ante but which carry out-sized benefits or returns (and which seem obvious in hindsight, ex post). Hence while some diversification is prudent for most asset classes, it is central to the venture capital model. To some extent, this is a calculated shotgun approach, especially for the earlier stages (such as the “seed” stage), and the composition and balance in a pool of investments matters more than any single investment. This economic logic leads to the ideal incentive and legal structure.

Venture capital funds are typically structured as limited partnerships, with the limited partners (LPs) being institutional investors and the general partner (GP) being the venture firm, which serves as an investment advisor and has complete control over the fund. As noted above, when institutions started displacing wealthy individuals, they became the biggest LPs in venture funds (though even today, technology company CEOs and select centi-millionaires form an old-boys network that can invest directly in venture funds). Most venture capital funds have a fixed life of 10 years, with one year extensions allowed for sales and IPOs in dry exit markets.

Venture capitalists are compensated through a combination of management fees and carried interest (often referred to as a “two and twenty” arrangement):

  • Management fee: An annual payment made by LPs to the fund’s GP to pay for the GP’s expenses. In a typical venture capital fund, the general partners receive an annual management fee equal to up to 2% of the committed capital during the investment period, and a smaller amount (as low as 0.5%) for the harvest period.
  • Carried interest or performance fee: A share of the profits of the fund (typically 20%), paid to the GP as a performance incentive. The remaining 80% of the profits are paid to the LPs. 

 

Why partnerships and not a corporate structure?  As Doriot‘s experience at ARD showed, the following reasons were important:

  • Partnerships could fund daily operations (salaries, offices, etc.) with the management fee and so didn’t need to raise money through more equity offerings or company sales, giving them flexibility;
  • Partnerships could compensate the general partners with carried interest, but corporations had a hard time creating similar incentives (Doriot and the equity investors got the lion’s share of returns from ARD‘s investments, while his junior team was salaried and received almost no upside);
  • Partnerships could take a long view by marking asset values sensibly, unlike corporations such as ARD, which was harassed by the SEC on its reporting of asset values for many years;
  • A limited fund life, per the partnership structure, forces the GP to return investors money in a timely way, which fits most LPs expectations of a return of capital in 7-12 years.
  • Partnerships avoided the problem of raising additional funds and compensating junior members that corporations had. Doriot had to constantly haggle with companies to pay interest/dividends or with equity investors to put in new capital (and about the valuation level of the current portfolio), where GPs only have to launch a new limited partnership and so can start from scratch. Multiple funds also allow younger partners to take higher carry stakes and also simplified performance measurement for LPs.
  • Partnerships could avoid the problem of a dominant founder who doesn’t age well and understand new technology trends. Or as Dick Kramlich stated it:  “One of the purposes of a partner is to save another partner from himself.”

 

It can take anywhere from six months to several years for venture capitalists to raise money from institutional investors. At the time when all of a fund’s money has been raised, the fund is said to be “closed” and the 10 year lifetime begins. A fund’s “vintage year” generally refers to the year in which the fund was closed; this helps institutional investors stratify venture funds and compare their performance.

The investing cycle, or “commitment period,” for most funds is generally three to five years, after which the venture capitalist focuses on managing and making follow-on investments in an existing portfolio. This means LPs have a fixed commitment to the fund that is initially unfunded and subsequently “called down” by the venture capital fund over time as the fund makes its investments. The remaining years are a “harvest period” where companies are expanded and then sold. This limited life structure can occasionally create a conflict between venture capitalists and entrepreneurs, as investors prefer to cash out early whereas entrepreneurs want to hold on.

One example of founder versus venture capitalist strife was the sale of Zappos to Amazon in 2009. Some reports suggested the venture capitalist, Mike Moritz, pressured the founder, Tony Hsieh, to sell early despite Hsieh’s wish to wait for an IPO and maintain control of the company to nurture its unique customer-oriented culture. Hsieh was emotional and wanted to stay independent.  Moritz was cold and rational, as Zappos relied on a revolving line of credit of $100 million to buy inventory; it had to hit projected revenue and profitability targets each month, or the banks could walk away from the loans during the 2009 credit crunch and create a possible cash-flow crisis that could bankrupt Zappos. Other problems with asset-backed inventory also existed. Moritz concluded Amazon would be a safe place for Zappos to borrow money, and Moritz’s investment would be safe from these non-trivial risks.

Because a fund may run out of capital prior to the end of its life, larger venture capital firms usually have several overlapping funds at the same time; this lets the larger firm keep specialists in all stages of the development of firms almost constantly engaged. Smaller firms tend to thrive or fail with their initial industry contacts; by the time the fund cashes out, an entirely-new generation of technologies and people is ascending, whom the general partners may not know well, and so it is prudent to reassess and shift industries or personnel rather than attempt to simply invest more in the industry or people the partners already know.

Finally, most venture investments are structured as convertible preferred stock. If a startup fails, the venture fund, as a preferred stock owner, gets priority in a sale or liquidation to earn its money back (generally to break even or minimize losses). If a startup succeeds, the venture fund can convert the preferred stock into common stock and share in the startup’s upside. This type of financing was seen early in the industry’s history, with ARD using convertible debt (with interest at twice the government rate) or convertible preferred stock.



Table of Contents | Silicon Valley History pages | Purchase | Correspondence
(Copyright © 2010 Piero Scaruffi)