A Brief History of Venture Capital
Definition of Venture Capital
Investopedia defines Venture Capital as “a form of private equity and a type of financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential.”
When privately held companies require significant capital to support rapid growth, they seek Venture Capital as a means of financing. Venture Capital is high risk because often the companies in which VCs invest are early stage and lack a substantial track record.
Typically, for every 10 companies a Venture Capitalist invests in, 8 of them will result in break-even or losses, one will yield a moderately successful return and the other one will yield an outsized return of 10-20x.
Venture Capital funds operate based on the Power Law, in which one huge win offsets dozens of losses, and returns the entire fund (in terms of dollars) and then some.
Overview of Venture Capital’s Role in the Economy
For decades, venture capital has played a crucial role in the advancement of technology. Apple, Amazon, Facebook, Netflix, AirBnB, Uber, Dropbox, Slack and so many other incredible companies only came to life through the power of venture capital. In fact, 8 of the top 10 largest companies in the world are backed by venture capital.
We’re talking about trillions of dollars in economic impact, hundreds of thousands of jobs, and most medical and technological breakthroughs… nearly all funded by Venture Capital.
According to Forbes, over the last 40 years, nearly 40% of all IPOs were venture-backed companies. Furthermore, despite only making up 20% of the public market, VC-backed companies account for 44% of all R&D spend. R&D (research and development) is the business activity dedicated to exploring new, untested ideas. These breakthroughs typically spill over into the wider market, benefiting the general public.
Despite its current limitations, and obvious areas in need of improvement, it’s safe to say that Venture Capital has a net positive impact on the world. To use the words of US economist and Nobel Prize Winner, Kenneth Arrow (1995), “Venture capital has done much more, I think, to improve efficiency than anything.”
The First Venture Capital Deal
The notion of risk capital as a means to fund, and profit from, innovative endeavors is not a novel concept. In fact, entrepreneurs have been pitching their high-risk, high-reward concepts to investors for centuries.
The earliest documented venture capital “deal” occurs in a notary contract recorded in Genoa on April 26, 1156. The contract was between a shipping captain and an investor, and the terms state that upon successful completion of the trip, the captain would get 25% of the profits and the investor would receive the resicum payout of 75% of the profits.
The latin word resicum is the distant ancestor of the english word ‘risk’, and was adopted as a mechanism to allow investors to capitalize on the risky business of merchant shipping across the mediterranean. Resicum was instrumental in supporting the growth of the trade business, which was inherently risky. Previously the entire risk (and reward) was held by the ship’s captain, and those who were unable to sail had no way of profiting.
Shipping across the Mediterranean in the 12th century was especially risky due the prevalence of pirates at sea, and the uncertainty about what would be waiting at the destination’s port. It was not uncommon for merchants to arrive and find that plague or conflict had completely wiped out the trade in an area – the resulting outcome being that the ship returned to port with no goods and thus no profit.
Resicum evolved as a way to allow captains and investors to share in the risk and potential reward of the Mediterranean trade business, and was quickly and widely adopted across various industries.
From its origins in Genoa notary contracts, throughout history, entrepreneurs and investors have been sharing the risk and reward of speculative business endeavors.
Later in the 1800s, Nikola Tesla, secured investment from American entrepreneur, George Westinghouse to fund his company which developed the alternating electrical current, which became the standard for power systems.
Expansion of Venture Capital in the 20th Century
While the ancestors of venture capital date back to the 12th century, most business historians agree that the formal origins of the Venture Capital industry trace back to 1946 when Harvard Business School professor Georges Doriot led the formation of the American Research and Development Corporation to fund new ventures founded during WWII.
Doriot laid out and practiced the terms of Venture Investing that are still the guideposts used today. These included: scrutinous review and frequent rejection of business plans (deal-flow & due diligence), the staged financings of investments (rounds), and the ultimate return of capital and profits to investors (exits).
ARDC’s first big hit came from a $70k investment into Digital Equipment Corporation in 1957, when they received several multiples in return on investment after their DEC’s initial public offering in 1966. ARDC invested in over 150 companies and its employees spun out to form prominent venture capital firms such as Greylock Partners and the predecessor to Flagship Ventures.
Later, in the 1970’s, some of today's most distinguished Venture Capital firms were founded to invest in the semiconductor and computer industries. These firms, such as Sequoia Capital, Kleiner Perkins and New Enterprise Associates represent the foundation of the modern venture capital industry.
A critical legislation change in the 1980’s opened the metaphorical floodgates of capital flowing through VC firms. Up until this time, an obscure law in the Employment Retirement Income Security Act stated that private pension managers had to invest in very low-risk assets. This changed in 1979 when that law was clarified to account for portfolio diversification, meaning pension fund managers could allocate a portion of their managed funds to Venture Capital.
Although pension funds were only allowed to allocate a small portion of their funds to VC, a small portion of an enormous amount of money, this still represented a huge influx of capital into VC funds. This amount grew as US Pension funds also began investing in US VC firms, and private and sovereign funds followed.
In the 40+ years that followed, VC has become the preferred method for financing early-stage, high-risk, high-reward companies and technologies.