Taking Stock of Venture Capital
If the owl of Minerva flies at dusk, then venture capital as we know it is probably past its peak. In recent years, a growing body of scholarship (such as the work of Mariana Mazzucato and Robyn Klingler-Vidra) has demythologized Silicon Valley venture finance at precisely the moment when its network-effect-driven megacorporations have come to dominate the U.S. economy—and when the political, social, and economic effects of their ascendance have come under increasing criticism.
Tom Nicholas’s VC: An American History is another important contribution, not only an insightful study of an asset class but a fascinating history which touches on fundamental questions of political economy.
VC is distinctive mainly because it offers such a long view of venture capital’s evolution. Nicholas begins his account not after World War II, the starting point for most scholars, but traces the development of American venture capital all the way back to the whaling industry of the early 19th century. The book largely reads as a series of case studies—unsurprising given that its author is a Harvard Business School professor—and, for better or worse, Nicholas mostly prefers to document events without integrating larger theoretical narratives. Yet his prose is engaging, and his meticulous history offers many lessons for attentive readers, explaining not only the present features of the venture landscape but also how we might address some of the widely recognized problems facing the U.S. economy today.
Nicholas’s history of venture capital is a chronicle of American economic dynamism, from whaling and textiles in New England, to steel in the Rust Belt, to autos in Detroit, to computer manufacturing and later software and Internet services in Silicon Valley, with a few other stops along the way. The parallels across eras and geographies have been catalogued elsewhere, but they are nevertheless striking. As Nicholas demonstrates through a series of charts, the risk and return profiles, compensation schemes, and certain organizational forms have changed surprisingly little since New Bedford, Massachusetts, arose as a hub of whaling industry captains and financiers. Likewise, a high tolerance for failure and illiquidity, a clustering of activity in specific cities or regions, and a small number of individuals and firms driving most of the profits seem to be enduring features of venture capital-funded growth.
The persistence of these characteristics often inspires a “Whiggish” interpretation of venture investing’s history: venture capital has evolved in the way that it has as investors and entrepreneurs have simply refined what works, culminating in the successes of recent decades. But Nicholas’s long history invites a contrarian conclusion: in critical respects, venture capital represents more of a rearguard than a vanguard. It is a vestige of an earlier form of capitalism—as are the entrepreneur-controlled businesses that venture capitalists fund—and one that often underperforms the rest of the economy. Silicon Valley-style venture capital was not an inevitable outcome of market economics, nor is it necessarily the model of the future. Rather, successful venture funding of entrepreneurs and innovation is an achievement that must be constantly and consciously pursued, frequently for non-economic reasons.
The uniqueness of venture-funded entrepreneurialism is usually celebrated with little thought given to the structural developments that have made it seem unique—namely, the rise of the “managerial economy,” as famously analyzed by Adolf Berle and Gardiner Means, James Burnham, Alfred Chandler, and others. (Nicholas, incidentally, currently teaches a Harvard course once taught by Chandler.) America’s largest corporations mostly transitioned away from entrepreneurial ownership and control to managerial direction in the late 19th and early 20th centuries, with the professional asset management industry originating as a more or less concomitant development. During this time, entrepreneurial control became an outlier at the commanding heights of the U.S. economy, and the principles of systematic portfolio management discouraged the funding of risky small enterprises. Tellingly perhaps, old-line families such as the Rockefellers and Whitneys dominated venture investing until deep into the 20th century.
The phrase “venture capital” itself was scarcely used before the 1940s. Prior to that, there was little need to identify it as a unique asset class, as it was effectively the funding model for broad and diverse swaths of the American economy. But when institutional venture capital was being born, the sources of high-risk, long-tail small business investment seemed to be disappearing. By the late 1930s, a “funding gap” for startups had become apparent. As one banker stated in a 1939 congressional hearing, “I think the difficulties today, for a variety of causes, are greater in getting proprietary risk capital for small and moderate-size businesses than was the case in former years.” “The crux of the matter,” writes Nicholas, “was that entrepreneurs could not systematically obtain startup capital or long-term financing because of the high-risk nature of the activity and the likelihood of poor returns.”
Entrepreneurial, small business ventures seemed to be on the way out as professional financial and corporate management took hold. Ralph Flanders, a cofounder of ARDC, one of the first institutional venture capital vehicles founded in 1946, as well as a former Federal Reserve president and eventual U.S. senator, diagnosed the problem as follows: “As president of the Federal Reserve Bank of Boston, I became seriously concerned with the increasing degree to which the liquid wealth of the Nation is tending to concentrate in fiduciary hands. This in itself is a natural process, but it does make it more and more difficult as time goes on to finance new undertakings.”
If anything, postwar venture capital arose as a social and political project, rather than an attempt to maximize risk-adjusted returns. ARDC, for example, was the brainchild of university presidents, professors, and politicians who recognized that New England’s traditional industries were in decline and who sought to leverage the technological capabilities of the region’s universities to reenergize small businesses. ARDC’s legendary president, Harvard Business School professor Georges Doriot, said that the aim was to be “creative,” not “remunerative.” Another venture capital pioneer and technology enthusiast, Laurance Rockefeller, described his project thusly: “what we want to do is the opposite of the old system of holding back capital until a field or an idea is proved completely safe. We are undertaking pioneering projects that with proper backing will encourage sound scientific and economic progress in new fields…that hold the promise of tremendous future development.”
It is in fact fortunate that these early venture capitalists were not motivated mainly by financial returns—because, despite funding some successful and transformational companies, they did not outperform at the portfolio level. ARDC underperformed major public indices for its first 10 years, as did Rockefeller during the same period. One J. H. Whitney & Co. (also founded in 1946) partner stated, “We have not batted much better than we would have if we had put the capital in listed securities, with far less trouble and far less risk.” The firm’s early-stage venture portfolio fared even worse, with returns estimated to be “something less than 2 percent a year.”
In the 1950s, while private venture capital struggled, the federal government began taking concrete steps to address the small business funding gap, beginning with the formation of the Small Business Administration and the authorization of Small Business Investment Corporations (SBICs). SBICs provided multiple forms of debt finance and favorable tax treatment to encourage small business venture investing. At one point, over 700 SBICs were operating, some of which helped fund breakthrough companies like Intel. In addition, the proliferation of SBICs helped to develop critical capacities in adjacent areas, like venture-oriented law firms. A number of individuals who would go on to become leading venture investors in subsequent decades gained their first experiences in this space through SBICs. Nevertheless, SBIC returns did not outperform the S&P index, and they faced a host of governance problems. Around 20 years after they were first created, SBICs gradually fell out of favor.
As the SBICs declined, other policy reforms were undertaken to boost small business investment. A 1979 amendment to the Employee Retirement Income Security Act altered the “prudent man rule,” which made it easier for fiduciary institutions like pension funds to invest in risky venture capital. That same year, capital gains tax rates were lowered. According to Nicholas’s summary of the research, capital gains rates have little impact on investor portfolio allocation to venture capital, but they may exert some influence on career selection, making entrepreneurship more attractive.
What made venture capital the financially attractive field it is today was the advent of personal computing, software, and Internet technologies. On the one hand, venture capital funding played a major role in building these industries. At the same time, however, the unique economics of these technologies built venture capital as an asset class. Venture firms had funded successful, innovative companies in the past without outperforming on a portfolio level. It was only after venture investment became concentrated in software and Internet sectors that it began to significantly outperform other asset classes, at least for a time. These sectors, focused on intellectual property (one might also include biotech), are unique in that they are characterized by low capital intensity and a high potential for rapid scaling due to low marginal production costs and network effects. Not only can world-class businesses be built with relatively little capital investment in these sectors, but rapid scaling allows early investors to exit comparatively quickly, further boosting returns.
The success of the venture capital model in building Internet and software companies need not be revisited here. But less discussed are the costs of this success. Venture capital itself began to be “disrupted” as it attracted new participants who were not particularly interested in innovation or entrepreneurialism but motivated simply by the quest for returns. Inverting Doriot’s axiom, their goals were remunerative, not creative, and there is a strong argument to be made that the massive influx of institutional capital changed venture investing for the worse. Some of the most successful venture capitalists saw this early on. Nicholas quotes former Greylock chairman Daniel Gregory’s criticism of institutional investors’ short-term outlook; he observed that “the quest of the institutions for rates of return is very counterproductive for achieving the long-term results that we are supposed to be after.” Such counterproductive behavior was epitomized by the Pets.com wars of the late 1990s bubble and the flood of capital-chasing copycat companies instead of taking risks on real innovation. Likewise, it is probably not particularly encouraging that some of the most prominent “tech” IPOs of recent years have been food delivery companies, photo-sharing apps, coupon services, and taxi businesses whose distinguishing feature is labor and regulatory arbitrage.
According to Victoria Ivashina and Josh Lerner’s Patient Capital: The Challenges and Promises of Long-Term Investing, also to be published this year, venture capital significantly outperformed the S&P 500 index from about 1992 to 1998 (with another period of modest outperformance from 2010 to 2013). Yet the exceptional returns of the 1990s have largely obscured the real, more challenging history of venture investing. In the imagination of large segments of the American elite, venture capital is a magical force that unites socially beneficial innovation with financial outperformance. Hence the chorus continually calling for more venture capital to solve persistent economic problems—despite the fact that these problems have often worsened while venture capital commitments have soared.
Instead of dwelling on the 1990s, perhaps the lessons that need to be recalled at present are those from the 1950s. Today, the “funding gap” for small business has returned, even though venture capital fundraising is at record highs. Business dynamism is in decline, while incumbent markups are higher. Bank lending to small businesses is also weak. Indeed, venture capital probably generates so much interest today because the possibility of high-risk growth investment and transformational innovation seems foreclosed everywhere else.
One problem is that the current venture model is basically suited to fund only capital-light, intellectual property businesses. There is probably too much capital chasing too few ideas in these areas, but they are the only sectors that can generate sufficient returns within the current paradigm. If venture capital is going to once again play a broad, socially positive role in the U.S. economy, then the incentives for such activity will have to be intentionally created, as they were in the past.
Addressing the present funding gap may require direct government intervention. Updated versions of the SBIC and SBIR initiatives targeting underinvested sectors of the U.S. economy could be highly beneficial, even if they only achieved a fraction of what the original programs accomplished. History also suggests some other options, such as altering the regulations governing pension fund allocations. One item Nicholas highlights that rarely receives attention is the dominance of the limited partnership structure among American venture capital firms (and private equity and hedge funds). Limited partnerships became the norm among private capital pools mainly because they allow for higher compensation to fund managers and because of reporting and tax advantages, but they are not necessarily the best structures for long-term investment. ARDC, for example, was organized as a closed-end fund, and according to Nicholas, “Had [ARDC] been organized as a limited partnership…it probably would have failed.”
If there is a blind spot in Nicholas’s history, it is that it generally overlooks the distinction between fundamental innovation and the commercialization of technology. Venture-funded startups tend to be very good at the latter but can rarely pursue the former, which is inherently capital intensive and often has no visible commercial rationale. Large organizations, however, often fail to commercialize their innovations, either because breakthroughs get lost in massive bureaucracies or because the innovation threatens legacy business lines. Thus many of the fundamental innovations upon which successful startups have been built were originally developed by established corporations or the government.
In the middle of the 20th century, America funded a lot of “big science” research but lacked the small business ecosystem to commercialize it. Today, the opposite is arguably the case. Venture firms are flush with capital, but large corporate research centers like Bell Labs have been largely eliminated as Wall Street has come to prefer “capital discipline” and share buybacks over investment and R&D—at least in any corporation not granted the dubious halo of “tech company.” Government spending on basic research has also declined significantly. In this respect, today’s biggest challenge may not be a lack of venture capital but a lack of funding devoted to large-scale fundamental research.
At bottom, modern venture capital is an attempt to combine old-fashioned entrepreneurial risk-taking with systematic portfolio management. But, as Nicholas’s history shows, these objectives are fundamentally in tension with each other, whether applied to large or small businesses. The massive risks that successful innovation and entrepreneurialism entail ultimately elude systematic portfolio optimization. Those hoping that venture capital will advance certain political and social goals too often forget this reality, as do many venture capital investors.
Today, both advocates and critics of what is called capitalism tend to base their positions on perceptions of the market’s uncompromising efficiency and rationality. But the history of venture capital recalls another school of thought, going back at least to Max Weber, which recognizes that capitalism is fundamentally irrational and that entrepreneurialism relies on much more than the desire for profit maximization. As Reuven Brenner has argued, the long-tail risks required for entrepreneurialism and innovation are seldom motivated by narrowly rational portfolio optimization concerns, but rather by the existential fear of being leapfrogged by a rival and totally bankrupted, whether at the level of the individual, firm, or even nation. From this perspective, it is not surprising that the U.S. Defense Department played such an important role in venture investing during the Cold War. Likewise, other countries that have promoted venture and innovation clusters most successfully—such as Israel, Taiwan, and more recently China, which in 2018 raised and deployed more venture funding than the United States—are those that see themselves as engaged in geopolitical rivalry.
If there is going to be another great American venture capital story, one which is truly creative rather than merely remunerative, then the U.S. private and public sectors will have to recover their appetite for this sort of seemingly irrational risk-taking. Like the postwar pioneers of venture capital, American investors and entrepreneurs will have to find a willingness to pursue sectors and investment models that at present hardly look like the opportunities of the future. They might start by taking some lessons from Nicholas’s thoughtful survey of the past.
Julius Krein is the editor of American Affairs.