Finding Genius Read online

  The History of Venture Capital

  Now the dominant source of financing for companies within the global economy, venture capital was initially designed to accelerate the process of building and scaling a high-risk venture and stress test a business model over five to seven years. The simple truth is that most businesses that receive venture funding will fail and entrepreneurs who deploy this form of capital are okay with that fact. While most investors strive for balanced portfolios, these investments are speculative: venture capitalists use a minimal amount of available data to make a series of investments in companies with the conviction that one or two of those, across a portfolio of several companies, will be a runaway success.

  Traditionally, and for several reasons why financiers preferred this method, entrepreneurial endeavors were often financed through credit instead of equity. Banks provided loans to American entrepreneurs but were less vested in the growth of the company. They were conservative and myopically concerned with cash balances. This often led to a conflict for entrepreneurs who sought to invest in company growth but were instead now servicing interest payments and managing debt. Phil Knight, the founder of Nike, captured the essence of what it was like to grow a business on credit with banks in his memoir, Shoe Dog. Most banks turned down the opportunity to finance the vision for Nike, and the one that hesitatingly took the risk urged Knight to take a more conservative approach to growth. Knight recounts how the bank was focused on cash balances, not on extraordinary growth; the push-and-pull with bankers often cost him the business in the earliest days of Nike’s history. This conflict became the bane of Knight’s existence as he scaled Nike at a time when the venture capital industry was non-existent.

  While classic American companies such as Ford or General Electric found their startup capital through traditional means as Nike did, the U.S. venture capital industry sprung into existence through a regulatory change called the Prudent Man Rule, which allowed pension funds to invest in venture capital. Simultaneously, the 1978 Revenue Act decreased capital gains tax from 49.5% to 28%, making these sorts of investments more attractive. As this unfolded from the 1950s through the 1980s, venture capital funds in the U.S. exploded with capital ready to be deployed to entrepreneurs. Pension funds were also a factor, as they controlled over $3 trillion by the end of the 1980s and were searching for higher returns during the poor performance of stocks and bonds in the decade prior. Venture capitalists were willing to oblige. While the Prudent Man Rule, favorable tax structures, and an increased appetite for this risky asset class were the catalysts behind the rise of venture capital, the industry began with a sense of humility that it now so often lacks.

  The venture capital industry begins with the story of Georges Doriot. In his book Creative Capital: Georges Doriot and the Birth of Venture Capital, author Spencer E. Ante captures the founding principles of venture capital as the catalyst to jump start American innovation after World War II. Antes profiles Georges Doriot, a World War II veteran and innovator, who “came to believe in a future of financing entrepreneurs in an organized way.” Doriot, born in Paris to the son of an entrepreneur in the automobile industry, went on to turn down a job as the head of the post-World War II U.S. Department of Research and Development, returning instead to his post as a celebrated professor at Harvard Business School. Boston — a hub of intellectual and scientific talent drawn to MIT and Harvard University — became the ideal backdrop for entrepreneurship and venture capital to begin its launch.

  As Ante puts it, Doriot recognized the importance of creativity, innovation, and technology in the business world, and at the behest of the New England elite, ran one of Boston’s first venture funds: the American Research and Development Corporation (ARD) in the early 1940s. ARD was the first professional venture capital fund that raised capital outside of non-family resources, but instead through insurance companies, educational institutions, and investment trusts. Concepted by the president of MIT, ARD was designed to ‘solve a major imperfection of modern U.S. capitalism’ and address the plight of a growing class of American entrepreneurs. Ante describes how the U.S. had dreamers, brilliant minds, innovators, and hard-working men and women who had been re-invigorated to take risks but lacked access to capital and mentorship:

  “New companies were starved for money and professional management… ARD promised to break down the walls of an elitist, insular world, reviewing ideas from thousands of companies across the country… In his personal life, Doriot was cautious to a fault at times. But in his professional life, Doriot realized venture capital was all about taking huge but calculated risks.”

  One of the founding members of ARD spoke publicly in 1945, cautioning that the country should not rest on its laurels and expect existing U.S. industries to continue to remain competitive. He wanted to disrupt traditional American industry, saying:

  “We cannot depend safely for an indefinite time on the expansion of our old big industries alone. We need new strength, energy and ability from below. We need to marry some small part of our enormous fiduciary resources to new ideas which are seeking support.”

  Venture capital would become the bridge between these groups of people. It would “marry money with people and their crazy, new ideas and the result would be a stronger country with a growing supply of well-paying jobs.” Venture capital was born to increase competition, disrupt the status quo, and support American innovation.

  ARD began humbly with a $3.4 million fund and went on to seed the inception of over a hundred American companies. Doriot referred to his companies as ‘children,’ worked with them for over a decade, and maintained a patient investment philosophy to build companies for the long haul. He viewed ‘returns as the by-product of hard labor, not a goal.’ One such company within Doriot’s portfolio, Digital Equipment Corporation, established itself on a $70,000 investment from ARD in exchange for 70% of the company. When ARD liquidated its stake in Digital, the company was worth more than $400 million, yielding a return of more than 70,000%! While regulation, public perception, and investor appetite for venture capital would continue to evolve over the next decade, Ante places the inception of venture capital and its role in American entrepreneurship squarely on the shoulders of Georges Doriot. He writes:

  “Doriot’s influence persisted through the work of his disciples, as various ARD alumni founded and ran the second generation of successful VC firms, including Greylock and Fidelity Ventures… Doriot was the prophet of this new “Start-up Nation,” the leader of a social and economic crusade that democratized the clubby world of finance. More than any other person, Doriot — through his teaching, writing and leadership in the military, academic, and financial worlds — pioneered the transition to an economy built on entrepreneurship and innovation.”

  Booms & Busts

  What began as a ‘cottage industry,’ with a $3.4 million fund in 1946, has since exploded with an abundance of capital chasing those 70,000% returns. In a similar problem that still plagues investors in 2018, the sudden surplus of capital perversely affected investment decisions and portfolio theory through the late 1900s. As more cash was available to be deployed, certain industries came into favor and investors flocked towards them with herd mentality, driving up valuations for which venture investors paid far too much.

  This cyclical nature of the industry is something which has had ‘experts’ claiming, every few decades, that the venture capital model is dead. And yet, over time, it’s clear that high-growth business models have become more attractive for financing for two reasons: the decreasing cost of starting and operating companies and the ebb and flow in phases of technology. The MIT Technology Review reflected that in the 1990s, ‘venture capitalists seemed like genuine alchemists, able to turn even startup dross into purest gold.’ Just prior to this boom, Paul Gompers, a professor of business administration at the University of Chicago, published a study of the industry titled “The Rise and Fall of Venture Capital.” His pessimism was followed by a decade that saw public offerin
gs of venture-backed companies such as ‘Juniper Networks, foundational to the Internet organizations such as Netscape, and others that would generate solid returns for their investors, but did not perform well in the public markets such as Pets.Com.’ Years followed by extreme exuberance in entrepreneurs is often followed by a bust, in which technology companies that were well-funded were not worth their lofty valuations.

  Josh Lerner, an economist with Harvard Business School, wrote that “time and again groups raised huge amounts of capital that they invested foolishly, either funding entrepreneurs who never should have raised capital in the first place, or else giving far too much money to promising entrepreneurs.” As this phase of the startup bubble burst and public offerings slowed down, many would proclaim that the end had once again come for venture capital as an asset class. In the 2000s, the industry progressed slowly. MIT Technology Review captured that sentiment:

  “The word crisis has become ubiquitous. Matrix Capital founder Paul Ferri told the Wall Street Journal in 2006 that the industry does not now have ‘an economically viable business model.’ In the June 2005 issue of this magazine, Yankee Group founder Howard Anderson bid ‘goodbye to venture capital.’ And when the executive search firm Polachi and Co. asked a thousand VCs last summer ‘Is the venture capital business broken?’ more than half said it was. When you consider the key role that venture capital has played in funding American innovation over the last 50 years, that conclusion seems ominous.”

  Describing a slowdown in venture capital in the early 90s, many at the time believed that the role of a venture capitalist was to invest in risky projects, which led to issues within the industry. Yet again, with the entrepreneurial fabric that ran through American society in the early 2000s, venture capital too made a resurgence.

  Some of these booms and busts have happened with each phase of the Internet, and the introduction of new applications built on top of the Internet — including mobile, virtual reality (VR), artificial intelligence, blockchain — or even across new business models. The herd mentality of venture capital often begins with a unique ‘thesis’ about an industry that drives up valuations with an expectation of large exits in the future. More recently a venture investment boom existed in the VR and augmented reality (AR) sector as investors expected strong consumer adoption in the short term. Over $3 billion in venture funding was poured into AR/VR in 2017, but by 2018 that euphoria had waned as valuation write-downs and product disappointments weighed on the market. Investors remained hopeful but held off from further investments, dampening the expectations of entrepreneurs in the space.

  This valuation shift happens to promising entrepreneurs behind game-changing movements more frequently than one would hope. Given that the venture capital model is based on seeking higher valuations, founders and venture capitalists alike can fall victim to chasing the hype of a vision over true progress of a company. The valuation of a company is often not based on a mathematical or logical exercise but instead based on the prospect of how attractive a business might be in the future. Sustaining these over-inflated valuations becomes more difficult as investors and public investors begin to seek real results.

  Christopher Altchek, the co-founder and CEO of Mic, a fast-growing media company for Millennials, raised over $100 million as investors poured money into ‘future of media’ companies such as BuzzFeed, Circa, Flipboard, Vice Media, and others that sought to capitalize on media and content consumption behaviors. In late 2018, Mic was sold for close to $5 million, Circa shut its operations, and BuzzFeed and Vice Media both reported growth and valuation concerns. As these shifts occur, former darlings of the venture capital industry go out of favor, which reduces the likelihood of similar business models from being funded in the future.

  Still, the venture model is built to withstand these booms and busts because there are often experiments and risks in which winners in each of these nascent categories emerge. In the end, the goal of venture financing is to sort through the ‘losers’ to find the diamond in the rough and have the foresight to identify those winners while the industry is still seemingly crowded with dozens of competitors. In the years that followed the early 2000 crash, the world would again see companies such as Facebook, Twitter, Tesla, and Google IPO. Google, which offered shares publicly for the first time in the summer of 2004, received $12.5 million in venture capital from Kleiner Perkins and Sequoia in 1999. At the time of the public offering, this $12.5 million stake was worth well over $2 billion. The Facebook IPO returning capital to its investors, a booming technology scene out of China, and exuberance around valuations of private companies such as Uber, Airbnb, Paytm, Lyft, Stripe, WeWork, and more had venture investors once again pouring capital into startup ventures hoping for similar returns. In 2017, over $72 billion in venture capital was invested into startups in the U.S. and $165 billion was invested globally, and there were no signs of slowing down. In 2018, some funds raised in excess of $3 billion for the first time in the history of venture capital. From 2011-2018, over 250 new micro-venture funds, or funds that would deploy $100,000 to $250,000 in a few companies, sprouted up. In 2019, the exuberance for venture capital is high and in line with Lerner’s thoughts on capital deployed, where some founders are raising excess capital, just because they can.

  In 2019, venture capitalists are backing geniuses to the tune of billions of dollars and as history has shown time and again, this cycle too will come to an end. But until then, venture capitalists continue to search for entrepreneurial geniuses to accompany on this journey. As in the examples of media, VR/AR, artificial intelligence, and other sectors that have produced more losers than winners, this is a fundamental truth of venture capital. Venture capitalists, spread across hundreds of funds, will invest heavily in spaces or industries where they see potential and often times, only few winners will emerge. These winners, however, can return 500-700 times an initial investment. Venture capital is built on a winner take all mentality and these investors are racing to find those winners. As was the case at the time of Georges Doriot, this asset class is meant to be the startup capital to allow individuals to take outsized risks in the name of innovation.

  In the short history of venture capital, there have been many fits and starts with even more ‘pundits’ claiming that the market for venture capital is dead. While there have been disruptive forces from within the industry that have forced it to evolve, venture capital is now synonymous with global innovation. Through the history of venture capital, one thing has remained true: profit incentives drive all investor decisions.

  Commitment to Outsized Returns

  “I’ve seen Venture Capitalists make wild decisions under the guise of being founder friendly. If some of the Limited Partners were around that table, they would have been shocked. A venture capitalist’s most important responsibility is to the Limited Partners — to drive investor capital wisely, to get the best, but fair deal and to do this with a long-term view of the relationship with that company, not just a loyalty to the CEO.”

  Rick Heitzmann, FirstMark Capital

  Venture capitalists choose the entrepreneurs they back through differentiated channels, but they are all driven by a single performance metric: generating outsized returns for their investors, with an emphasis on the word ‘outsized.’ Given that the return on investment is the common qualifying denominator amongst all investors, it automatically excludes a meaningful group of promising entrepreneurs: those men and women who aspire to create brilliant businesses but will plateau at sub-$100 million valuations because of execution, market opportunity, state of technology, or competitive landscape. Matthew Hartman of Betaworks, a startup incubator and venture fund based in New York City, discusses incentives:

  “What entrepreneurs need to understand is that by going with venture capital, everyone is agreeing to take a bet that they’re going to try to build something very fast and there may or may not be a company there. If demand is scaling quickly, we’ll pour more money to see it through. Everyone has t
o be on the same page on what the goals are. With venture capital, investors have said they’ll return five times the investment to their Limited Partners within five years. They need to now find investments that will return 100 times the money invested and have to find crazy bets to do so. Everything is possible as long as the objectives are explicit and the same. The reality is that when someone is waving a check in front of you for financing, it becomes hard to see past that.”

  Venture capitalists pursue risky investments that have the potential to reach the unicorn stage of a $1 billion valuation or more. They search for the highest return on their capital within the shortest period of time. It is often said that investors treat each investment as if it can return the value of an entire fund. For example, if a venture capitalist raises a $250 million fund, a venture capitalist’s goal should be to find one single investment out of that fund to create returns that would match the entire fund size. In an era where fund sizes have ballooned, so too has the demand for higher returns from startups. This requires a certain breed of founders who can withstand the pressure cooker of a venture-backed startup while remaining ethical and focused while commandeering a ship through a storm.

  The primary investors in a venture fund and the ones who the entrepreneurs most commonly interface with are known as General Partners (GPs). These individuals raise capital from Limited Partners (LP) and agree to share a percentage of the profits of the investments they make. While GPs are most often former entrepreneurs or operators or have risen up through the ranks in a career in venture capital, LPs can be high net worth individuals, pension funds, sovereign wealth funds, corporate balance sheets, university endowments, and/or other sources of capital. While the LPs operate in the shadows to most of these venture funds, the GPs are the ones entrepreneurs liaise with. At a structural level, the LP and GP relationship is opaque to most entrepreneurs. How do the investors, or limited partners, that a venture fund chooses determine the investments they will make? What time horizons do the LPs want to see a return on the capital they invested? Can these LPs be strategically aligned, or misaligned, with the startup company within a portfolio and how will that impact the founder, for better or worse? Brett Martin, a serial entrepreneur turned venture investor, reveals a common and exaggerated misnomer some founders still have about venture investors: