The Rise Of Venture Capital
Venture Capital is so familiar in the startup world that we tend to forget how it emerged. Its thriving success in the technology industry is all over most startup blogs. Company X has raised $10M to invest in growth; fund Y raised $1B to invest in healthcare and company Z did an IPO. On the other hand, venture capital history is unknown, and its roots are quite surprising.
For most of the capitalism’s history, startup ventures raised money through debt rather than equity since it was almost impossible to keep track of the company’s revenues accurately. Through debt financing, investors knew they could retrieve their capital and interests at a certain date, and don’t have to take into account companies’ key metrics. Maritime expeditions were the only cases of equity investment. Venture capital was born when ship owners financed navigators to go on expeditions. At the time, the greatest entrepreneurs were the bravest adventurers like Magellan or Colombus. That’s how the concept of carried interest emerged, an essential part in the VC model.
The term originated from the practice of ship owners and ship captains getting a 20 percent commission on the things they carried. If you were going to operate a ship and drive it from, say, the New World back to Europe with some valuable cargo, you and the captain of the ship would keep an interest of 20 percent for whatever you carried. So it’s called the carried interest. (explained Morris Peal)
Fast-forward in time, after the establishment of limited liability and reliable information systems, the American Research & Development Corporation (ARD) laid the ground for venture capital in 1946. Aiming to build the American economy to create jobs for veterans, the public company based on the East Coast raised $3.5M from institutional investors, including prestigious universities. After investing in multiple ventures, the VC firm ceased to exist because of its conflicting goals and the lack of incentives for managers to make returns. The VC industry fully emerged in 1958 thanks to the passage of the Small Business Investment Act (along with the creation of NASA and DARPA) to facilitate investments in startups. In 4 years, more $205M was committed in private companies, fueling the first tech’ giants like Xerox or Intel.
At the same time, Silicon Valley was born thanks to Frederick Terman, provost of Stanford University. He turned Stanford into a leading university in sciences by attracting military budgets into its research labs. The university quickly became the preferred contractor for prototypes, attracting the best students, engineers, and investors in the Bay Area. Silicon Valley became « a magnet for venture capitalists .» (check out the intriguing post made by Steve Blank on the subject)
But the VC industry had hard times making money and being successful because of the lack of incentives in getting a significant return on investment. The establishment of the legal form, limited partnership, and the implementation of carried interests in the VC model solved the problem and gave enough incentives for managing partners to invest the right way. The largest and most established venture capital firms were founded in the 70’s like Kleiner Perkins Caufield & Byers and Sequoia Capital leading to the massive growth of internet companies. By this time, « only » $3 billion has been raised in capital, but it’s during the late 1990s that the industry skyrocketed. Venture capital plays now an essential role in boosting the economy and support startup ecosystems all around the globe.
Reflecting on venture capital is critical. But the problem is this model has not changed for the past 40 years while the context in which startups are growing is different. Is a new model of venture capital like investing based on data analysis (Correlation Ventures) would pave the way for more sustainable growth for startups ? Are the interests between limited partners and venture capitalists still aligned? I am betting on the fact that the current VC job will be disrupted, but how?
References
- https://www.financialpoise.com/a-brief-history-of-venture-capital/
- http://www.corporatelivewire.com/top-story.html?id=the-history-of-private-equity-venture-capital
- https://www.feld.com/archives/2015/08/venture-capital-history-perspective-jack-tankersley.html
- https://www.preqin.com/docs/press/VC-Deals-2016.pdf
4 comments on “The Rise Of Venture Capital”
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Great post Loic, and really interesting to learn that the VC industry has its roots in equity investments in maritime expeditions. Like you, I find it interesting that an industry focused on driving disruption has not changed for the past 40 years. There’s definitely a need for innovative financing instruments, especially to encourage startups to contribute to solving some of the biggest global challenges in a more holistic way. However, I got a really interesting new perspective on this from an article I read earlier this week by Ferrary and Granovetter (2009, p. 326-37) that argues: “What is distinctive about Silicon Valley is its
complete and robust complex system of innovation supported by social networks of
interdependent economic agents in which the VC firms have a specific function.” In essence they use social network theory to claim that the success of Silicon Valley can be attributed to the VC industry, as the investors are the most connected nodes in the system ensuring learning and system wide knowledge sharing. I wonder if this would have been the case if the VC industry would not have remained so stable and unchanged in terms of how it operates. “The role of venture capital firms in Silicon Valley’s complex innovation network” is a really great paper, if you haven’t read it I warmly recommend it!
Great article Loic! A possible explanation for the migration of debt to equity VC investments can be the changing industry demographics of start-ups. Historically you would assume that new companies tended to deal with more physical products and machinery, hence allowing collateralisation of loans making them relatively less risky. In the case of bankruptcy creditors can take these assets and sell them to recoup the investment. In modern times, software companies do not have real-value in assets if they go bust, meaning this strategy is no longer viabke. Instead investors will prefer equity so they can gamble on the potential upsides of the business. Let me know if tend to agree or disagree! 🙂
Great article! I am very interested in your last point about the potential for disruption in the VC sector. However, I find it difficult to see where this could come from. You mentioned the possibility of data analysis, and thus implying a degree of automation in the process. However, it is my understanding that a large part of venture capitalism involves a good VC – client relationship. Failure is an inevitability in the startup world, but does that mean excuse someone’s first company failed that their next one would too? Hence, it is my view that there will always be a need for strong human relationships in the industry.
Thanks for the post Loic! It’s evident from your post how VC’s contributed to the growth and innovation of Silicon Valley. It is also interesting to see the big role the government played in the process to support the growth of the VC industry.
I think many countries in the world fail in setting up efficient VC’s for emerging entrepreneurs. There are various factors contributing to this but government support is definitely one of them. In South Africa the current prime interest rate is 10.5%. This results in an extremely high opportunity cost for any company to make capital available towards investments in risky startups.
I agree that the VC industry needs renewal, I just hope that developing countries catch up quickly enough.