CandidCapital

The remarkable story of the US venture capital industry starts with the foundation of the first venture firm by an eccentric emigre French academic with the right to style himself 'General' after services rendered to Uncle Sam in WW2.
Although risk capital had often been provided before (for instance to build railways in Britain during the 1840s), it was not until 1946 and the creation of the American Research and Development Corporation (ARDC) in Boston that a formal venture capital fund first came into existence. In the interwar years, ‘family offices’ had undertaken one-off high-risk investments (Laurence S Rockefeller co-founded Eastern Airlines in the 1930s, for example). Though some of the most powerful family offices did undertake investment management for other families, this was a largely informal activity, and did not provide opportunities for pension funds or smaller individual investors to become involved in ‘venture funding’.

ARDC was ground-breaking in several ways. It could probably only be launched because of an unusual combination of circumstances:
• its promoters—especially MIT President Karl Compton and Harvard Business School Professor General Georges Doriot—were convinced that much of the scientific research undertaken during the war remained to be exploited
• the calibre of the individuals and the academic institutions they represented gave ARDC a head start in pioneering a new concept
• the financial sector in Boston was reasonably sophisticated and some investors were prepared to invest as much pro bono publico as for a commercial return

ARDC initially only raised $3m of a target $5m. It nevertheless set a precedent (J H Whitney & Co was set up immediately afterwards, one of whose successful investments would be Minute Maid). It was now possible for relatively small investors, by investing in a pooled fund, to have access to higher risk and potentially higher reward deals previously only open to high net worth investors; the ARDC fund structure enabled risk to be sufficiently spread to comply with SEC regulations. ARDC employed an experienced staff to structure deals, give business advice and organise investees; it also maintained a technical advisory board to provide leads and give assessments. Early Investments included the High Voltage Engineering Corporation and Digital Equipment Corporation, both MIT-related.(1)

The context in which venture capital developed in the US is essential for an understanding of the subsequent differences between the US and UK industries. The take-off of venture capital in the US did not occur in an economic or policy vacuum. During the Cold War, the Federal Government invested heavily in military R&D; it also invested indirectly in the health sector. In 1958, the Small Business Administration licensed and helped fund the first Small Business Investment Companies (which have since backed such household names as Intel, Apple Computer, Callaway Golf, JetBlue Airways, Whole Foods Market and Palm Computing), the model behind the recently-announced Enterprise Capital Funds in the UK:

“SBICs are private equity funds that invest in U.S. small businesses that meet size and operational criteria set by the federal government. SBICs are licensed and regulated by the U.S. Small Business Administration (SBA), but privately managed by private sector management teams whose qualifications and business plans are approved in advance in rigorous licensing process. Minimum capital required to form an SBIC—$5.0 million—must come from qualified private investors. Additional capital—as much as three times the private capital—is then potentially available to each SBIC through SBA by sale of SBA-guaranteed securities on an "as needed" basis to support fund investments and expenses. The private capital is at risk in its entirety before any taxpayer money is at risk and SBA examines SBICs regularly to ensure their financial soundness and regulatory compliance.” (2)

Other policy measures - working with the grain of the market - included:

• Reducing capital gains tax from 49% to 28% (1979) then 20% (1981)
• Amending Incentive Stock Option Act tax so that charges are only incurred when options are sold, not when they are exercised (1980s)
• Amending the Employment Retirement Income Security Act 1974 to allow pension trustees to invest in venture capital within the ‘prudent man’ and ‘safe harbor’ rules (1979, 1980)
• Establishing Small Business Innovation Research programmes from 1982: Federal Agencies with external R&D budgets in excess of $100m were to allocate a percentage of their budgets to small firms
• The Bayh-Dole Act 1980, transferring ownership of intellectual property to universities undertaking government-funded research

And more recently, in the National Innovation Act legislation has been initiated in the US Senate, in response to the National Innovation Initiative Report published by the Council on Competitiveness, to establish the President’s Council on Innovation. The bill identifies “three primary areas of importance to maintaining and improving United States’ innovation in the 21st Century: (a) research investment, (b) increasing science and technology talent, and (c) developing an innovation infrastructure.” (3)

From the 1960s, what was to become eventually a much larger venture industry developed along Sand Hill Road in Northern California, around Stanford University, from the engineering department of which Hewlett-Packard had originated in 1939 to exploit a resistance-tuned oscillator. HP was the original ‘garage venture’ and was mentored by Fed Terman, originator of the ‘steeples of excellence’ policy at Stanford and a key founder of Silicon Valley, which until the 1970s consisted largely of fruit groves in Santa Clara County. The transformation of the region accelerated following the decision in 1955 of the co-inventor of the transistor, William Shockley, to move from Bell Labs on the East Coast to Palo Alto. In 1958, eight senior engineers left Shockley to form Fairchild Semiconductors; by 1971, 21 of 23 semiconductor firms in Valley were ‘Fairchildren’ offshoots, including Intel, founded by Gordon Moore.

Venture capital emerged alongside the industries it supported. When in 1964 Sutter Hill Ventures was formed in Palo Alto, its only existing competition was Davis & Rock (Arthur Rock had been an early supporter of Sherman Fairchild) and George Quist (4), who ran the Bank of America SBIC in San Francisco. But in 1971, another ex-Fairchild employee, Don Valentine joined Sequoia Capital (5) ; in 1972 family offices offered to invest $4m in Gene Kleiner if he could raise another $4m, which he did following and an introduction to Tom Perkins (6) of HP by Sandy Robertson (7). The size of funds raised gradually increased, such that in 1974 Reid Dennis started Institutional Venture Partners(8)with $19m. Much of the landscape of the modern Menlo Park industry was recognisable. The oil crisis of the mid-1970s was a break on progress, though this was partly offset through benign policy moves discussed earlier such as tax cuts and the SBIRs in the early 1980s.(9)

(1) Henry Etzkowitz: MIT and the Rise of Entrepreneurial Science (2002) Chapter 8
(2) http://www.nasbic.org/about/sbic_history_highlights.cfm
(3) http://lieberman.senate.gov/documents/bills/051215niasummary.doc
(4) Founder of Hambrecht & Quist in 1968 (acquired by Chase Manhattan 1999)
(5) www.sequoiacap.com
(6) www.kpcb.com
(7) Founder of Robertson Stephens in 1978 (bought by Bancamerica in 1997; closed by FleetBoston 2002)
(8) www.ivp.com
(9) Udayan Gupta: Done Deals (2000)

Trackback URL for this post: