Wednesday, February 2, 2011

The Early History of Venture Capital and Silicon Valley - Alpha

I'm getting set to publish a book titled: "A History of Silicon Valley (1900-2010)" with Piero Scaruffi. Below is an excerpt from the book on the early history of venture capital. For more information about the book, plus some great resources about Silicon Valley, see:

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.” 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.

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 . . .

See for more!

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