In the first half of the 20th century (1900-1950)– with very few exceptions– venture capital investments were made by very wealthy families like the Rockefellers (Standard Oil), the Vanderbilt family (shipping lines and railroads), and the Warburg family (financial dynasty including banking, and the US Federal Reserve). Among the many businesses these families funded one must include both Eastern Airlines and Douglas Aircraft.
Venture capital is not a new business arrangement, but has been in practice for centuries. For example, when Magellan convinced the King and Queen of Spain to fund his voyage in searching for the Spice Islands, the King and Queen dictated a deal to Magellan whereby they took over 75 percent of the profits from his ’round the world, three year adventure. In an era when a large handful of spices could be sold for enough money to buy a house and care for a person for many years, Magellan did not see the fruits of his daring adventure but instead was killed on the voyage. (There is a lesson in that.)
Origins of Modern Private Equity
Prior to 1940, development capital was known as “money orders.”
After World War II (Post-1945) the true private equity investments emerged as the first two venture capital companies (American Research and Development Corporation -ARDC- and J.H. Whitney & Company) in the United States.
ARDC was founded by Georges Deroit, Ralf Flanders, and Karl Compton. (Deroit was the former Dean of Harvard Business School. Compton was the former president of MIT.) Their goal was to encourage private investors to invest in businesses developed by former American soldiers after they returned from World War II.
ARDC is important in the venture capital world because this firm was the first to raise money from sources other than wealthy families like the Rockefellers and Warburgs. ARDC impressed the investing world when the company’s 1957 investment of $ 70,000 grew to be worth over $ 350 million when the company went public in 1968. This huge economic return for ARDC caused a huge growth in the industry as investors sought to duplicate those returns.
Early Venture Capital and the Growth of Silicon Valley
In 1958 the Small Business Investment Act was passed by the Small Business Administration (SBA) which allowed Small Business Investment Companies (SBICs) to provide financing, including locating private investors, to aid in the financing of small businesses in the United States. (Source: Small Business Administration Investment Division (SBIC).
In the 1960s and 1970s venture capital firms invested in high growth companies in the electronic, medical, or data-processing areas. As time progressed most uneducated investors saw VC funding as only technology business funding because VC firms seemed to only invest in them. Although technology funding is still a strong suit among VC firms, venture capital can now cover multiple areas of development.
During the 1960’s, creative investors have developed the primary legal structure to aid in financing the growth and development. “General and Limited Partnership” legal structures are the perfect opportunity for investment in private equity. This type of structure, with some variation, has been used in a wide range of investments ranging from real estate syndication through private equity business investments.
The legal structure places the general partner (GP) in an unlimited liability position if an investment fails but limits the risk of the limited partner (LP) (hence the name) to the amount invested, if the business fails.
This form of partnership often carries with it an annual management fee of less than 2.5 percent as well as 20 plus percent of the profit proceeds to the GP. The risk reward ratio is high enough that General Partners are more than satisfied to accept the risk, and the Limited Partners see the exponential growth development into multiple returns against the capital they have contributed.
In the 1970s, VC firms grew fast in Silicone Valley on Sand Hill Road almost next door to emerging technology firms like Hewlett Packard, Intel, and Apple. As these firms became more successful and VC investments paid-off, more and more individuals left these successful companies to start their own firms and sought additional VC funding.
It became an upward spiral–an American success story, that has had bumps in the road, but still successfully continues today.
Interestingly during this same period, with the passage of the Employee Retirement income Security Act (ERISA) in 1974, corporate pension plans could place money in this type investment, creating a new source of revenue.
At the start of the 1980s there were very few VC firms in Silicone Valley, but by the end of the decade, the number of VC firms in the same area had increased to over 650 with enormous amounts of money chasing too small a number of truly good business opportunities.
In the mid-1980s, returns began to decline and after the stock market crash of 1987 only the Japanese and Koreans seemed to be injecting money into start-up businesses. Instead, the business VC firms shifted from investing in start-up businesses to seeking leveraged buy-outs and hostile takeovers (as was portrayed in movie “Wall Street”).
Bibliography
Joseph W. Bartlett, “What Is Venture Capital?”. VCexperts.com.
“Venture Impact: The Economic Importance of Venture Backed Companies to the U.S. Economy”. Nvca.org. Retrieved 2012-05-18.
Ante, Spencer E. (2008). Creative Capital: Georges Doriot and the Birth of Venture Capital. Cambridge, MA: Harvard Business School Press. ISBN 1-4221-0122-3.
Article: The New Argonauts, Global Search and Local Institution Building. Author: Saxeninan and Sabel.
1971, a series of articles entitled “Silicon Valley USA” were published in the Electronic News, a weekly trade publication, giving rise to the use of the term Silicon Valley.
Kirsner, Scott. “Venture Capital’s Grandfather.” The Boston Globe, April 6, 2008.
Small Business Administration Investment Division (SBIC)
The New Kings of Capitalism, Survey on the Private Equity industry The Economist, November 25, 2004
The Future of Securities Regulation speech by Brian G. Cartwright, General Counsel U.S. Securities and Exchange Commission. University of Pennsylvania Law School Institute for Law and Economics Philadelphia, Pennsylvania. October 24, 2007.
Venture Impact (5ed.). IHS Global Insight. 2009. p. 2. ISBN 0-9785015-7-8.
WGBH Public Broadcasting Service, “Who made America?” – Georges Doriot”
Wilson, John. The New Ventures, Inside the High Stakes World of Venture Capital.