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These are excerpts from Arun Rao's book
3. The Greybeard Funders: Venture Capital in its Clubby Days (1955-78)by Arun Rao
Early Venture Capital in Silicon Valley
Venture capital action followed government action. One of the first steps toward a professionally-managed venture capital industry was the passage of the Small Business Investment Act of 1958. The launch of the Soviet Sputnik satellite scared the US Congress enough to pass the law, which officially allowed the U.S. Small Business Administration (SBA) to license private “Small Business Investment Companies” (SBICs) to help the financing and management of the small entrepreneurial businesses in the United States. SBICs had problems. They could borrow four dollars for every one to invest, and many did. But this is unsuitable for risky venture investing. Government guarantees for the debt usually meant taxpayers subsidized dumb deals, when bankers came to collect.
Despite these problems, many venture capital pioneers think the SBIC program did little to advance the art and practice of venture investing. The booming IPO market proved the model of investing in new companies, as some SBICs cash out at attractive levels. SBICs did give a boost to early venture firms, and some like Franklin “Pitch” Johnson, profiled below, thought the new law made the US “see that there was a problem and that [venture investing] was a way to do something… it formed the seed of the idea and a cadre of people like us.” Bill Draper, the first West Coast venture capitalist, has been more blunt: “[Without it] I never would have gotten into venture capital. . . it made the difference between not being able to do it, not having the money.” Many believe SBICs filled a void from 1958 to the early 1970s, by which point the partnership-based venture firms took off. The US government, however, lost most of the $2 billion it put into SBIC firms.
So why did Silicon Valley take over the leadership of the venture capital industry? Geography and history were part of the answer. Before WWII, the northeast dominated because the technical skill was in Boston (MIT) and the capital was there too (Boston and New York City). The West Coast took over because of the sunny weather and the federal funds that boosted the engineering departments at Stanford and Berkeley (along with shrewd institution building by Fred Terman, described in another chapter in this book). Additionally, the West Coast was much more a meritocracy, where young engineers could lead companies and young bankers could fund them. Fairchild itself was the nucleus of many semiconductor startups in the 1960s. So with its world-class engineering departments, strong commercial track record (HP, Fairchird, Varian, etc.), and a seasoned group of entrepreneurs, smart venture capitalists started moving West. (See the second introduction for more details).
Four Venture Capital Firms Set the Tone
Four venture capital firms formed in the 1960s are worth noting. Most of these greybeards, interestingly, had financial backgrounds and not strong technical backgrounds.
The first notable firm of the 1960s was Davis and Rock, founded by Arthur Rock and Tommy Davis in 1961 with $5 million. Rock initially began more as an agent than as a principal in an investment company, doing deals on the side. Rock was a banker at Hayden, Stone & Co. in New York, who had been flying to California to do technology deals. One early deal in 1957 was getting some scientists who left Shockley Labs a new home at Fairchild Semiconductor, after Sherman Fairchild (an inventor and the largest owner of IBM stock) decided to back them for $1.5 million. After 4 years on red-eye flight, Rock moved to California (because of the scientific energy around Stanford, created by Terman), founded his own firm, and played a key role in launching Teledyne, Intel, Apple, and many other high-tech companies.
One early white swan for Rock was Scientific Data Systems, funded for $280,000 in 1962 and sold for $990 million in 1969. Rock’s biggest deal was funding Intel in 1968, after Noyce called him to say “Gee, I think maybe Gordon [Moore] and I do want to leave Fairchild Semiconductor and go into business for ourselves.” This was because Fairchild had died, and the bureaucratic new CEO in New Jersey didn’t want to pay the scientists options or give them management control of the division (a big mistake!). Rock raised $2.5 million for Gordon and Noyce‘s team (no venture firm was large enough to fund that amount as a single commitment) and Rock even wrote their business plan. Rock always attributed Intel‘s success to the scientific talent and the great manager-engineer CEOs (Noyce first, then Moore, then Grove).
Between 1961 and 1968, Davis & Rock invested $3 million (after raising $5 million) and returned $100 million to their investors. Yet Davis and Rock dissolved in 1968, despite a stellar run. Rock was a difficult man to work with.
A second notable early West Coast venture capital company was Draper, Gaither & Anderson (officially the first venture firm in the West Coast in 1959). It was later re-formed as the Draper and Johnson Investment Company in 1962, by William Henry Draper III (a student of Doriot‘s) and Franklin P. (“Pitch”) Johnson, Jr. Bill Draper‘s father was responsible for the economic reconstruction of Germany and Japan under the Marshall Plan, and put Bill in touch with an associate, Fred Anderson, to start a venture firm in 1959. In 1962, Draper and Johnson started their firm with $150,000 of their family money and $300,000 of SBIC money. In 1965, they merged their ship with Sutter Hill Ventures (discussed below) and acquired the talent of Paul Wythes. Sutter Hill set the early tone of the Valley, partnering with other venture firms to syndicate investments (i.e. split them into pieces to co-invest in). While in the venture capital business, Bill Draper was a founding investor in Apollo Computer Dionex, Integrated Genetics, Quantum, Activision, Measurex, Hybritech, and LSI Logic.
Draper’s earthy philosophy was about people. He believed that if you back the right person, “he’ll get you out of a bum business, a bum product idea, a bum service idea, and move you into a better one.” But the wrong person with a great idea would never get anywhere and instead just bumble and fumble.
Bill’s son, Tim Draper, left Alex Brown & Sons in 1985 to become the third generation of venture capitalists in his family with the formation of Draper Fisher Jurvetson. Tim restructured a family-owned Small Business Investment Company (SBIC) that had been set up by his father in 1979. Tim then created an early-stage venture capital fund, which invested in successes like Hotmail, Skype (where a $2.5 million investment turned into $2.5 billion), Baidu, and so on. Pitch Johnson went on to form Asset Management Company, in 1965, and over his career he made over 250 venture investments, including legendary ones like Amgen, IDEC Pharmaceuticals, Octel, Sierra Semiconductor, Tandem Computer, Teradyne and Verity.
The third notable firm was Sutter Hill Ventures, founded by Bill Draper and Paul Wythes in 1964. Wythes had held technical marketing and sales positions at Beckman Instruments and Honeywell. He went on to be a Founding Director of the National Venture Capital Association, the main industry association, and served on over 27 boards and led Sutter Hill investments in Tellabs, Xidex, Linear Technology and AmeriGroup. Sutter Hill pioneered a few techniques: the warehousing of people, today called entrepreneurs-in-residence, basically talented entrepreneurs nurtured for a while to come up with a venture; simple terms of straight preferred stock and a handshake (no complicated term sheets); backing people from a diversity of backgrounds, including immigrants and women (e.g. Andy Gabor of Diablo Corp. or Donna Dubinsky of Palm Corp.). Wythes philosophy on his work is pithy: “Venture capitalists don’t create successful companies, entrepreneurs do… we are in the business of building businesses. We’re not trying to do financial transactions.”
The fourth notable firm was the Mayfield Fund, started by Rock’s partner Tommy Davis, who moved to CA from the East Coast to join a land development company so he could ride horses in his spare time. Davis worked in the Central Valley (farm country), but started making investments in Silicon Valley, and when his employer wanted him to focus on buildings and oil wells, he joined Rock in 1963. After one partnership cycle, he left to start the Mayfield Fund in 1969 with Wally Davis, with about $3 million raised. Davis formed a close relationship with Stanford University and its technical professors, something all the venture firms do today. Mayfield focused on early-stage hi-tech companies, and its impressive roster of investments included 3Com, Amgen, Atari, Compaq, Genentech, Sandisk, and more.
In 1969, the entire venture capital community could meet at the Mark Hopkins hotel in San Francisco for lunch, and it was about 20 people. Many people had intimate connections with Arthur Rock, who partnered with and mentored others. These venture firms were the beginning of the institutionalized venture capital business where funds were dedicated specifically to starting companies. They had small numbers of money and a limited number of practitioners. But they set the stage for the great venture firms of the 1970s, of which three have set the standard.
Fred Terman and the Venture Capital Industry
Terman‘s involvement with venture capital started when Stanford President Wally Sterling met George Montgomery of the Kern County Land and Development Company (KCLD) in February 1957. KCLD was a Southern California-based financial company primarily involved in the agriculture, land, and oil businesses. Montgomery told Sterling that he and his associate, Tommy Davis, wanted to invest in the electronics industry. Sterling had Terman to contact Montgomery.
Montgomery and Davis were developing ideas about how to invest in the electronics business. Initially, Terman brushed them off and suggested KCLD contract with professors Joe Pettit and Edward Ginzton to advise them on small companies to purchase. Montgomery and Davis, though, decided they were not interested in owning shares of stock in a bigger company like HP or Lockheed. They were more interested in growth and wanted to be directly involved in the creative construction of a young technology and to interact directly with management.
Davis wrote Terman a letter in 1957 explaining that he wanted to combine KCLD’s capital with the technical skills and creative ability of engineers to build up young companies. Enginerrs would benefit financially through their equity stake in the company and emotionally through having control over their own venture and surroundings. They could also rely on KCLD to build up the operations element with legal, accounting, personnel, and other functions done for them. Davis wanted to “offer a vehicle for young creative talents that few companies could or would be willing to provide, especially the large electrical, electronic and aircraft companies.” Both the engineers and KCLD would keep a large portion of ownership and hence be responsible for the venture’s success.
The letters between Tommy Davis and Fred Terman showed their ideas about what a venture capital firm should be. Davis wanted a connection to Stanford through an advisory board to his new venture capital firm. He wanted Stanford engineering school faculty who were close to new ideas that could potentially form the basis of a startup company. Davis recruited Stanford engineering professors such as Bill Miller, John Linvill, Bob, and Michel Boudart as advisors for the first Mayfield Fund. These advisors were special limited partners in the fund. They received a part of the carried interest of the fund and were touted as a “Brain Trust” to raise money.
Terman viewed consulting and startup companies as recruitment and retention issues. Terman’s own goal was to get premier faculty to join Stanford. The prospect of being able to launch a company growing out of their research was an attraction in Terman’s view and frequently was an incentive to come to Stanford, but not the reason for recruiting faculty in the first place. Similarly, in order to retain high quality faculty it was important that the University not create obstacles to entrepreneurial activity. Terman’s policy was not to push people into entrepreneurial activity, but not to stand in their way if they wanted to pursue it.
Later Stanford did have a formal plan for venture capital investment. Rod Adams wrote a memo in 1978 called “Venture Capital: A Policy Paper for Stanford University.” He argued that Stanford should benefit not just from the licenses on intellectual property at Stanford’s Office of Technology and Licensing, but also from a flow of ideas, tacit knowledge, and techniques that would not necessarily get patented or lead to the formation successful companies in the area. Stanford could, however, benefit by investing in venture capital funds whose purpose was to shape these sorts of resources into viable high-tech firms. Adams’s idea was for a staff of trained specialists within the Stanford Management Company (SMC) to use their local contacts within the financial industry invest as limited partners in the best funds. These investments started in 1981 at 1% of the endowment and later increased to approximately 6% of the endowment by 2002.
Kleiner Perkins, Sequoia Capital, and NEA Multiply Money
The growth of the venture capital industry was fueled by a number of venture firms on Sand Hill Road. The three most important ones historically were Kleiner, Perkins, Caufield & Byers (Kleiner Perkins or KPCB) and Sequoia Capital, both founded in 1972, and New Enterprise Associates (NEA), founded in 1978.
KPCB was in 1972 the world’s largest venture capital partnership when it raised $8 million (50% of the fund came from the secretive Pittsburgh billionaire Henry Hillman). Gene Kleiner was an alumnus of Fairchild Semiconductor and Tom Perkins was a protégé of David Packard at HP (not to mention a favored student of Doriot‘s at Harvard). Both were deeply plugged into the Silicon Valley network, and neither wanted to meet the other when the SF investment banker Sandy Robertson put them in touch. KPCB’s model would be different because they practiced hands-on management, organized portfolio companies in an informal keiretsu (a group of companies with interlocking business relationships), and formalized the business by distributing audited quarterly and annual reports to investors. They also had investor friendly terms like: an 8-year fund life limit; and a clause saying all capital must be returned in full to limited partners before the GP received any compensation; no profits could be re-invested; the GPs could not invest in deals outside the partnership, for their personal benefit.
After a few early failures (a semiconductor deal, a tennis shoe resoling company, and a snowmobile-to-motorcycle conversion kit company), Kleiner and Perkins decided to focus on their strengths: computers. Also, deal flow and connections to engineering professors and entrepreneurs was critical (the phones didn’t ring at all in those early years). Or as Kleiner stated: “We just didn’t wait around for deals to come to us. You had to create the deals to be really successful.” For example, Perkins teamed up with an old colleague at HP, Jimmy Treybig, to create a company making fault tolerant computers that could operate on a reduced level when one part failed (banks were an ideal customer). In 1974 they founded Tandem Computers, with Perkins as the Chairman and Treybig as the CEO. The company went public in 1977 and had $2.3 billion in sales by 1996.
One of Perkin’s great innovations was his keiretsu method of investing. It comes from the Japanese word “keiretsu,” which describes a set of interlocking relationships among Japanese suppliers and manufacturers (which in turn came from the zaibatsu of pre-WW II). Basically KPCB encouraged its companies to help each other by forming buy-sell, licensing, or endorsement arrangements, and it provided companies with regular updates on the strategies and plans of their peer group, along with organizing half a dozen formal gatherings of portfolio company CEOs and other key executives each year. Perkins’ protégé, John Doerr, stated it thus: “Keiretsu are rooted in the principle that it is really hard to get an important company going and that the fastest and surest way to build an important new company is to work with partners.”
One example was Destineer, which KPCB incubated with Mobile Telecommunications Technologies in 1990 to develop a one-way and two-way nationwide messaging service. Since Wireless Access, another Kleiner Perkins company, was developing advanced pager technology, a Kleiner Perkins partner suggested that the two companies work together. The two companies, along with Motorola and Destineer, co-developed protocol, networking, and chip technologies, all of which have been fused into SkyTel, Mobile’s paging network.
After the dot.com bust, when the word keiretsu become disfavored, Brook Byers stated “It’s not keiretsu, it’s relationship capital.” It could more broadly be seen as a network, a Rolodex, or just outside business help with domain knowledge or potential sales leads.
Tom Perkins further elaborated on his investment philosophy in his memoir, where he wrote that “money is the least differentiated of all commodities. With water, you’ve got Calistoga, Perrier, and San Pellegrino, all noticeably different. With sugar there’s the cane and beet variety; some can tell the difference. But with money it’s all the same.” Perkins felt a venture capitalist was in the business of selling money to entrepreneurs and so needed to add value to differentiate oneself.” He attributed his success to not just waiting for “fully fleshed-out business plans, and full teams” coming in through the mail or the front door. Instead, he incubated ventures that he brainstormed with entrepreneurs, and he actively built high-tech teams.
Kleiner himself had some interesting apothegms. Two of them were: “When the money is available – take it” and “The more difficult the decision, the less it matters what you choose.”
Another big 1970s win for Kleiner and Perkins was born from failure. KPCB had hired Bob Swanson to handle deals, but nothing worked out, so they politely asked him to leave. Swanson started learning about the emerging field of biotechnology and started trading ideas with Herb Boyer, a biochemistry professor at UCSF. Boyer had developed a technique to make drugs by splicing DNA from one organism directly into the genes of another, and thought it would take 10 years to commercialize. Tom Perkins used KPCB’s funds to do a proof-of-concept trial, then bought a 25% stake for $100,000 in 1976. The company would be Genentech and it was the first commercial venture to synthesize insulin in 1978, to help millions of diabetics worldwide. Genentech’s 1980 IPO raised $35 million.
Sequoia Capital was started by Don Valentine in 1972. He had come to California due to the military, and then worked at a string of technology companies, ending as a salesman at Fairchild Semiconductor. He left for National Semiconductor. At both companies he evaluated technology and markets while head of sales and marketing, and the problem was the same. Engineers could do amazing things, but capital for projects was scarce, so he had a system regarding where corporate capital was to be invested.
Valentine felt his interest at Fairchild and National was in investing in companies that addressed very large markets and solved a specific kind of problem. At National, with its limited engineering resources to make custom circuits, he had to help the company to decide what business to accept and what to decline. Over a period of four or five years Valentine created “a more intuitive investment selection process based on huge markets and solutions that made a significant short-term commercial sense.” The market came first, technology second.
Valentine was approached by The Capital Group, a large Los Angeles-based mutual fund company. It was launching a business in the creation of a trust company, and their clients wanted some exposure to the venture capital business. Valentine was invited to join that start-up and create a venture capital company which would be part of The Capital Group that’s how Sequoia was started (Valentine took it independent in 1975 from Capital). One early big success was Nolan Bushnell’s Atari, which was 3 years old in 1976 (with a $3 million profit on $40 million in sales in 1975), and Atari needed money to grow. Valentine put in Sequoia money and raised funds from the Mayfield Fund, Time Inc., and Fidelity Ventures. Within that same year, Bushnell realized Atari needed more money and the entire company was sold to Warner Communications for $28 million, netting the venture capital investors a quick profit.
Valentine’s greatest deal was funding Apple Computer. Bushnell had suggested that Steve Jobs and Steve Wozniak visit Valentine. Valentine got them to focus on marketing and “think big,” and he teamed them with Mike Markkula, a thirty year old marketing manager so they could launch Apple in 1977. The company raised $517,500 in January 1978 from Venrock ($288,000), Sequoia ($150,000), and Arthur Rock, with a promise to keep the shares for 5 years. Valentine, in a dumb move, sold his stock in the summer of 1979 for tax reasons and to make distributions to investors. It was a big mistake, as Rock’s $57,000 stake was worth nearly $22 million by 1980 (and would be worth over a billion dollars by 2010). Other notable successes were funding Cisco in 1987 and Yahoo in 1997.
Valentine developed an “aircraft carrier” method of investing, where a big ship/company would sail with a fleet of other ships/companies for servicing and defense purposes. So a large strong portfolio company would be supported by smaller ones (this is a center-periphery version model compared to Kleiner’s distributed network model of portfolio investments). So Apple was the carrier, and 13 other companies were the smaller ones to serve it (e.g. Tandon Corp. to make disk drives for Apple’s computers). Valentine was also uncomfortable just relying on the quality of people: he wanted to know the potential market size, momentum toward there, and the exact product/application.
One interesting point Valentine raised: semiconductors were the core. Valentine estimated in 2004 that Sequoia have financed probably six hundred different companies, with about forty of those companies being semiconductor companies, as that industry was a fundamental business to the digital revolution. By the early 1970s, there were many semiconductor companies based in the Santa Clara Valley as well as early computer firms using their devices and programming and service companies.
In 1973, with the number of new venture capital firms increasing, leading venture capitalists formed the National Venture Capital Association (NVCA). The NVCA was to serve as the industry trade group for the venture capital industry. Venture capital firms suffered a temporary downturn in 1974, when the stock market crashed and investors were naturally wary of this new kind of investment fund.
Dick Kramlich started NEA in 1978 with Chuck Newhall and Frank Bonsal with $17 million. Kramlich had previously joined Arthur Rock in 1969 to do some investments, and that partnership had turned $6 million into $40 million. NEA changed the venture model in two ways: it raised the first billion dollar fund, and it tried to go national, having offices in both Silicon Valley, the Boston Route 128 corridor, and in other key cities. Chuck and Frank stayed on the East Coast and Dick operated from the Valley, and they communicated daily by telephone, making early investments in Apple and 3Com. By NEA-3 in 1984 (the third partnership fund), they had raised $125 million, but so much money was chasing deals that prices was high and NEA made bad deals. But by 2000, NEA had about 130 IPOs, nearly 130 companies acquired, and $4.3 billion distributed, including Immunex, Juniper (a $3 million investment for NEA that turned into $1.5 billion), Silicon Graphics, 3Com, PowerPoint, and Healtheon.
Other investors were active in the venture world, at least in the growth stage and on the East Coast. The famous investment banker Andre Meyer at Lazard Freres involved his partners’ capital in various growth venture investments such as Avis (car rentals) and Allied Concord (specialty finance). One of his younger partners, John Vogelstein, was tasked to a failing deal and eventually left. He joined Warburg Pincus, which traces its roots to E.M. Warburg & Co., an investment banking and private investment counseling firm founded in 1939 by the German-Jewish banker Eric M. Warburg. In 1966, Warburg’s firm joined with Lionel I. Pincus & Co., a venture capital and financial consulting firm. Lionel Pincus and John Vogelstein, who joined in January 1967, brought a “professionalized approach” to venture capital. Warburg Pincus and the National Venture Capital Association, which Mr. Pincus helped found, played a central role in negotiating with the Labor Department to revise ERISA regulations which had restricted investments in those asset classes. Finally, Charles Waite at Greylock and Richard Burnes at Charles River Associates were doing interesting work in Boston.
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