VC: An American History

The American venture capital model is rooted in this country’s early business climate, and has been exported around the world.

For example, New England whalers came to dominate their 19th-century industry through their innovation of pooling capital and syndicating their risk across many expeditions. This established the concept of long-tail, led to the basic funding model that later developed in modern venture capital and other small innovations.

That’s a central theme of the 2019 book by Tom Nicholas called VC: An American History. The book is a thorough review of the journey that led to the venture capital and private equity of today. I enjoyed it enough to recommend it to anyone interested in business, economics and the history of financial systems.

Below I share my notes from the book for future review.

Here are my notes:

• ARD in 1946 is commonly cited as the beginning of long tail VC investing;
• “In a world of perfect information and efficient markets, economic theory suggests intermediaries should be absent”: the fact that VC exists means they hold information advantages, or are pure capital conduits but do not add direct value;
• Three big early personifications of modern VC:
  • Rock (invest in people);
  • Perkins (Kleiner Perkins) invest in technology and
  • Valentine (Sequoia) invest in markets
• “The investment models behind whaling expeditions and venture capital funds can be thought of as interchangeable.” (11)
• Whaling agents and VCs both intermediate between wealthy investors and crew;
• Icelandic started early whaling industry in 1500s , then Dutch led by the 1770s, then British before United States; in 1850, 75 % of 900 global whaling ships were American registered (in 1850s average American whaling expedition took 3.6 years);
• Whaling lay system is akin to equity today;
• The capital was syndicated (wealthy investors would rarely if ever fund a single expedition and instead spread their funds across assets);
• Charles W Morgan, a Quaker Philadelphian who became prominent in New Bedford whaling (ownership stakes in at least 42 voyages between Dec 1832-sept 1856)
• ”In 1853, The New York Times confidently asserted that New Bedford was “probably the wealthiest place“ in America,” due to whaling and its associated support systems. At that point it’s average taxable income was at $1m in todays dollars and that cash reinvested in more whaling;
• Millwood example of a ship that amassed a historic return in six months. With that massive return, their agent earned 59.2% profit; the median was just 4.9;
• Whaling agents would take. 2.5 fee for outfitting and 15 commission at least of the value of the products sold, very similar to VC’s 2 and 20 model;
• All told whaling and VC match in three buckets :
  • lucrative low-probability events;
  • agent-centered organizational structure (matching money with growth) and
  • equity or partnership based method for aligning incentives to reduce moral hazard (39)
• After whaling, cotton played a role in economic growth, coming to United States from Britain, where in 1850, it produced half of the world’s cotton textiles despite being just 1.8% population. Why? Scholars say high labor costs (for skill), cheap energy and low capital costs fueled it;
• John Nicholson was an example of an American attempting to import British style cotton manufacturing though British laws combated the practice. Nicholson was swindled and bankrupted and died in a Philadelphian debtor’s prison in 1800;
• Slater as a technical cofounder in a mill in Rhode Island proved highly successful as a partnership before the Boston Manufacturing Company (1813) was founded as a corporation with limited partners that served as the next stage of speculative capital. Not debt but equity, which made this venture capital in the purest sense;
• In 1781, Robert Morris chartered the Bank of North America, the first commercial bank in country (More here); It showed how colonies creatively financed  projects; by 1790, NYC, Boston and Baltimore also had banks including Alex Brown & Sons, the first investment bank (57);
• New England kept its equity based financing from textiles while Philadelpia pioneered the bond market for railroad construction and other massive industrial projects — especially through national banks, with the second bank’s closure in 1836, Boston led in the 1840s but was eclipsed by NYC;
• Westinghouse and Brush in Pittsburgh and Cleveland respectively were electric pioneers whose work exemplified these early innovation hit spots before decline;
• A long-standing debate in VC literature: do they drive greater returns “with the selection of good investments ex-ante or the governance ventures during their life cycles”;
• Mellon took investments with Carnegie and became a kind of VC, including phasing out Acheson as the technical founder of his firm;
• Early entrepreneurs often had wealthy backers: George Eastman funded by Henry Strong; Henry Ford first funded by William Murphy before leaving and later starting again after several failed attempts with funding from Alexander Malcomson (and Edison had NYC backers) (81)
• Crocker called Silicon Valley’s first venture capitalist for his backing of a tube company that later did business with Philco, the radio company that wanted to diversify into TV in the 1930s;
• Carnegie and Phipps have opposite views of wealth: Carnegie in The Gospel of Wealth outlined philanthropy where Phipps developed an investment trust (Bessemer) and transferred wealth to his kids;
• Laurence Rockefeller represents another step in VC but he didn’t actually beat the market, though he did shape the style;
• The East and west divide was there right from the post War start, and likely tied to the idea that VC had heavy governance oversight and bicoastal travel was difficult (11 hours by plane in the 1940s.) (98);
• JH Whitney is noted for using the phrase “venture capital” but it was already in use. In a 1938 Wall Street journal article, EI DuPont was said to be using it as “investment without definite assurance,”; used repeatedly in a 1940  congressional report “Investment Trust and investment  Companies”; 1945 book The Market for Risk Capital (100);
• Whitney like Laurence Rockefeller (and others like New Enterprises) were already rich who tried to make venture capital long tails work;
• ARD in Boston in 1946 is widely credited as breaking through to modern VC: It was an intermediary for institutional funds and proved out the long tail theory of a few big wins make up for lots of losses (Digital Equipment Company); though it was a closed-end fund with tradeable shares, it showed its limitations and helped inform the Limited partnership models of today (108) It was the start of an era commercializing  scientific breakthroughs over previous decades especially during the war effort
• SBIC in 1958 was government backed loans after debate about how involved government could be in small business; this was another funding model to VC, not great returns but did change market and developed investments like focused law firms;
• Polaroid in 1950: 429 employees at $6.5m net sales ($64.8m today or $150k per employee)
• ARD founded by New England Council (itself founded in 1925), which was worried about state of small business in the post war era
• Doriot associated with ARD leadership though he is known for a strong gender bias (he wouldn’t let women into his Harvard manufacturing class, and later said it was something he was “damn proud of” (113)
• 1930s Roosevelt tax policies are said to have limited investment in new technologies (see below)

• A predecessor to ARD was the New England Industrial Development Corporation, which charged ventures for due diligence, a practice that is frowned upon today (115);
• ARD’s Doriot goal was “to find men and to find ideas” (123) People and Governance identified as key
• ARD invested largely in Boston
• “As a general rule, the use of debt tends to decrease with asset intangibility” because it can’t be easily liquidated. So R&D even in the ARD days was either inside firms or began to be by equity financing;
• By mid 1950s, a buoyant stock market deflated interest in venture capital with ARD, which had underperformed. In mid 1950s Doriot says “venture capital is not fashionable anymore”;
• ARD was flailing, then their Digital Computer Corporation investment took off (127); $70k in 1957 for 78% stake that they estimated was worth $52m in March 1967 (in November 1967, Dunn’s review estimated it to be worth $230.2m)
• William Congletom who left ARD to found Greylock & Company as a partnership was one of many who did that to earn more than the basic bonuses that the closed end fund ARD represented;
• In 1953 the SBA was founded as a compromise after previous SBIC program underperformed. Democrats pushed for more intervention via SBIC and Republicans pared back, resulting in SBA;
• In 1958, Eisenhower signed the National Defense Education Act, pushing technical and scientific education facing Soviet investments (which also fueled business investment);
• But Barron’s and Chicago economists were critical of SBA from the start, wanting free market only;
• In 1960, Greater Washington Industrial Investments Inc was the first SBIC, invested in $900k C E I R and within 9 months was worth $7m. Many followers, 29 SBIC in 1961 (138)
• Intel got SBIC money in 1969; Draper said he wouldn’t have made it in VC without SBIC funding;
• SBIC did not outperform VC, but it did market make and establish rules and regulatory environment;
• In the 1970s, rates in capital gains declined (see below) and pension fund reforms accelerated VC investment  (146)

• The limited partnership (that Draper and Greylock adopted and modern VC uses) started in 1822 in New York State following French Societe en Commandite. That was the first time in the United States someone followed something other than English law. Connecticut introduced it in 1824 and Pennsylvania in 1836. The partnership model developed general partners with unlimited liability and LPs with limited liability
• 1916 uniform limited partnership act
• Draper Gaither also underperformed financially even after new energy and money came in by the way of Don Lucas and others. They all got rich but limited partners didn’t always, though partly it was about timing. Intel was founded in 1968 the year DGA closed and it went public in 1971 (159)
• Greylock succeeded financially, first fund was 1965-1977; attracted university money (Harvard. Duke, MIT, Yale) (166)
• Venrock vehicle for Laurence Rockefeller; its 1978 investment in Apple was its long tail win;
• The “prudent man” rule from 1974 was influenced by 1830 Massachusetts common law that kept pension funds from investing into VC, if it could look speculative. But finance is a portfolio of assets not single assets.
• James Poterba’s research showed lower capital gains tax rates in the 1970s didn’t clearly have an impact as the rise in VC funding was more from pension funds and others who already had tax advantages, than those who stood to benefit from declining capital gains rates (181)
• Research shows for superstar inventors being impacted by tax rates who then others follow
• In a 1977 congressional hearing on pension fund investing modifications, Morganthalee argued investment opportunities “occur largely around university and research centers,” so we  “are always concerned when our states fail to keep up in the research and development activities, or especially fail to get their share of federal funds for research and development.” (183);
• Frederick Terman, a classic Stanford ecosystem broker between research and commercializing (184) thot allowed early Boston to lose its 1950s grip on hub of commercialization (MIT professors were not allowed to run companies like Stanford encouraged it);
• Californias diverse historical culture, options based pay, restrictions on non-compete and great weather were all factors into a culture that attracted new thinkers who felt the east coast was stuffy
• Rock and Fairchild
• Scientific Data Systems and then Intel were among the first major VC deals with outsized returns
• Kleiner Perkins prospectus outlined its three principles: exposure to a range (deal flow); judgment in making bets and ability to develop those bets they make (governance) (231);
• That still shapes much of VC; they were an early Sand Hill Road staple. Once again a few big wins defined (Genentech and Tandem from first fund far outdid other companies they invested in, like one that sold equipment to retrofit a motorcycle into a snowmobile or another to retread tennis shoes; This shaped their focus on software);
• Sequoia Capital and their pushing out of Cisco founders, was an early legend; Larry Ellison was also very critical of VC. (Relevant to Mazzucato, who should get the biggest value, VC or founder?)
• H&Q (Hambrecht was a DuPont west coast corporate guy) was one of the four horsemen who did pre IPO underwriting i the 1980: ((Alex Brown was another). H&Q did Adobe and Genentech IPOs, and joined Morgan Stanley for the Apple Computers mega IPO;
• Silicon Valley Bank joins the mix in 1983;
• In the 1960s, a quarter of Fortune 500 companies started VC arms, booming in the 1980s. General Electric and Exxon early examples (244) but they operated it as another department with similar compensation packages as opposed to VC type comp. 3M was a standout. In a survey in 1991, 3M was most admired by others;
• In 1982 the Small Business Innovation Research (SBIR) program launched and was informed by VC models
• “We finance change”. NEA outlined dockent when founded by Bonsal (T Rowe and then Alex Brown) and another Baltimore guy and someone else. They grew what became the largest VC fund
• 1983 Human Rights Comission report entitled “Women and Minorities in High Technology”: in Silicon Valley about 86% of the managers and 83% of the professionals working in HiTech businesses were male, whereas 88% and 84% respectively were white.” (That report is here)
• “It helps if you were in the network and the network is mostly male,” but it’s not a barrier to entry. The VCs just aren’t doing anything about it. Ann Winblad said in an interview a year after her 1983 sale of Open Systems (263)
• 6-9% of women VC from 1990-2015, little change over that time;
• “In 1980 women made up 42% of the workforce, which is 14% of employment in STEM fields.” (266)
• Why fewer women? In addition to women leading families, as VC picked up and hiring practices focused on tech and executive backgrounds, which had mostly men. The author points to one other third reason why women were so disproportionately undercounted in VC: Harvard University educated many of the leading venture capitalists of the 1980s who were educated by Professor Georges Doriot who has previously epitomized the school’s institutional sexism — including literally barring women from taking some of his classes;
• Speaking to the National Venture Capital Association in 1987 Pete Bancroft issued a warning: “Today I see our industry is over financed and under disciplined”;
• “Matrix partners V, a 1998 vintage year [VC] fund, generated a net IRR for its limited partners of 514.3%” … Its VI fund from 2000, as the tech bubble burst, brought a return of 2.5%
• At end of 1999, just six tech firms — Microsoft, Intel, IBM, Cisco, Lucent and Dell — had a combined market value of $1.79 trillion, equivalent to almost 20% of US GDP. By 2002, their total had fallen to $678.9 billion, an 89% collapse.
• “Nuclear winter” of VC: from 2000 to 2003, a 62% decline in VC commitments to $11.4B
• The flow of modern VC to today: From “real” tech of semiconductors, computers and biotech products to software and online services;
• After CERN develops WWW with NSF, they privatize it;
• The average annual rate of return for a VC fund from 1997 was a 62.5%. That’s the AVERAGE! Top quartile performing funds that year averaged 171.6%. By 2000, the average was 1.1% ARR;
• In 1997 John Doer of Kleiner Perkins explain that “Silicon Valley isn’t about silicon anymore… It’s about networking”;
• David Cowan from Bessemer Ventures didn’t even meet with Google Sergei and Larry because he didn’t see the value in another search engine;
• At time of IPO, Amazon owned 43% of Pets.com; in its frenzied battle against Perstore.com, both lost;
• John Doeer on 90s era VC innovation: “the largest legal creation of wealth in the history of the planet.” Then it collapsed;
• In 1999, Yang famous asked: what risk?
• Barron’s at dot com bubble peak: 74% of online companies were cash flow negative
• “In a world of disruptive Internet technologies, how do you know if your business model is crazy or brilliant?” Petsstore.com founder Newman after the collapse
• Bill Janeway: “ it took the wastage of a bubble to fund the exploration that would yield Amazon and eBay and Google”
• By 2013, 170 accelerators , a new kind of early stage venture financing model tied to governance; Andersson Horowitz popularized the model of offering backend services to companies;
• Agglomeration effects are often called “Marshallian“, after Alfred Marshals 1890 book Principles of Economics which identified the tendency of innovation to cluster together due to labor and idea exchanges