Discussions About The Risk Capital Industry In The United States
Frank Knight, a professor of economics at Chicago in 1928, wrote in Uncertainty and Profits, “The only risk which leads to a profit is a unique uncertainty. Profits arise out of the inherent, absolute unpredictability of things.” Alfred R. Berkeley III, vice chairman of NASDAQ, told us that “capital is like oil; it’s stored energy. It’s the fruits of someone else’s labor ready to be put into play in businesses.”
For nearly every entrepreneur, access to private equity capital, or risk capital, is a key ingredient to successful business growth. In the broadest understanding of the stratification of capital, risk capital is money for investment in innovative enterprises or research in which both the risk of loss and the potential for profit may be considerable.
We use the terms risk capital and private equity to refer to the universe of that asset class—which includes angel investments, venture capital, leveraged buyout, and mezzanine financing—that make direct capital investments in high-growth potential ventures. The one element that binds this diverse group of investors is that they receive some type of equity or stock vehicle when they put money into a venture.
Conceived in France
Contrary to most media reports, the venture capital industry did not start in 1996, nor did it die in 2000. Many claim to be the “first venture capitalist,” but the practice dates back as long as humans were exploring, inventing, producing, and selling. Although Britain already had developed a capital market late in the eighteenth century to fund the industrial revolution, it was the Parisian brothers Jacob and Isaac Pereire who leveraged the studies of the French economists who established Credit Mobilier as the first true entrepreneurial bank in 1852. Their work in France became “a philosophical system around the creative role of capital” and the prototype for the entire banking system in Europe, and it ushered in what we can call finance capitalism.
Born in New York
The model for modern banking crossed the Atlantic after the turmoil of the Civil War. Its beachhead was established in New York by Jay Cooke and the American Credit Mobilier, which helped to finance the transcontinental railroad. Later, J.P. Morgan, who had been exposed to banking in London, established his bank in New York in 1865 as the “conduit for European investment capital in American industry.” He is recognized as the founder of the “most successful entrepreneurial bank of the nineteenth century,” and it still operates today. One of the first major deals in American history was in 1877 when Thomas Alva Edison formed the Edison Electric Light Company. In 1889, working with the investment bank Drexel, Morgan & Company, Edison established his electrical manufacturing firm, which today is known as General Electric.
Nurtured in Boston
The industry was still immature until the end of World War II. Three people stand out among those who put risk capital on a more permanent institutional base: John H. Whitney, a wealthy polo player and angel investor; Georges F. Doriot, a Harvard Business School professor of entrepreneurship; and Ralph E. Flanders, president of the Federal Reserve Bank of Boston. In 1946 Flanders helped Doriot form the American Research and Development Corporation (ARD) in Boston. It used a small pool of risk capital from individuals and institutions to make active investments in selected emerging businesses. Whitney was first to coin the phrase venture capital. On February 10, 1946, J.H. Whitney & Co. opened their doors with $10 million of Whitney’s own money committed to invest in new business ventures.
Matured in Silicon Valley
Venture capital, which was born in New York and nurtured in Boston, did not really come of age until it moved to California. There it “joined forces with the brash young technologists who were using bits of silicon to create an information revolution as profound as the industrial revolution a century earlier” in Santa Clara County.
With only some 600,000 acres, about the size of Rhode Island, it is hard for some to believe that Santa Clara was seen as the seed farm to the world. But millions have visited Santa Clara, much like the nineteenth-century politicians, journalists, technologists, and revolutionaries, who made obligatory pilgrimages to Manchester, England, to pay homage to the steam revolution and to meditate on the new economy that was then being created. Silicon Valley’s investment banking community was firmly established in the late 1960s and early 1970s. It turned entrepreneurs’ dreams into mountains of cash on the fertile soils first tilled by innovators like Bill Draper.
After he helped run the Marshall Plan in Europe for President Eisenhower, General William H. Draper founded Draper, Gaither & Anderson in 1958, together with Rowan Gaither (founder of the Rand Corporation in Santa Monica, CA) and Frederick L. Anderson (a retired Air Force general). After working three years at his father’s firm, William Draper, General Draper’s son, founded Draper & Johnson Investments with Pitch Johnson. The Drapers along with Arthur Rock are known as the few who “made Silicon Valley happen.”
Educated in the SBIC Program
In 1958 Lyndon Johnson was seeking small-business support for his run as the Democratic presidential nomination, and he pushed the Small Business Investment Company Act of 1958 through the U.S. Senate. The SBIC program gave tax breaks to private investment companies that targeted small businesses and let them leverage their resources with low-interest loans from the U.S. Small Business Administration (SBA). During the late 1960s the program helped fuel the creation of today’s formal venture capital industry by creating hundreds of venture capitalists overnight. These early firms were formed as limited partnerships, with the venture capital company acting as the general partner. The general partners received a management fee and a percentage of the profits earned on a deal. The limited partners, who supplied the funding, were institutional investors such as insurance companies, endowment funds, bank trust departments, pension funds, and wealthy individuals and families.
This pattern has pretty much been the same since 1978–1979, when pension funds began investing in venture capital funds after the Labor Department liberalized rules under the Employee Retirement Income Security Act (ERISA). One of the key milestones of the venture capital industry in the United States, the act changed not only the composition of investors in risk capital funds but also increased the total flow of funds into the venture capital industry. Before 1978 new commitments to VC funds had never exceeded $500 million (in 1993 dollars). In 1979, new commitments exceeded $1 billion for the first time and averaged over $4 billion in new commitments per year throughout the 1980s.
Perfected in the Reagan Era
Things changed with President Ronald Reagan’s election in 1980, when the business environment shifted from President Carter’s “Days of Malaise” as the Republicans produced political leaders committed to entrepreneurial capitalism. Their thrust took shape under “supply-side economics,” which was first envisioned by economic adviser Dr. Arthur Laffer. His winning thesis was simply this: Lower the marginal tax rates. He believed that individuals should keep more of their hard-earned money, which would encourage them to make more.
On August 15, 1981, less than seven months after being sworn in, President Reagan signed the Kemp-Roth bill into law. It was the cornerstone of what would become the most successful economic policy for new business venturing in U.S. history. The bill’s treatment of capital gains, a lowering of the top capital gains tax rate from 28 percent to 20 percent, made high risk investments even more attractive, causing a twofold increase in commitments to venture capital funds in 1981. Entrepreneurs then launched a boom that would last, except for a brief eight months following the Gulf War in 1991, until the end of the twentieth century. It was the longest period of economic expansion in the nation’s history. Between 1983 and 2003, the Dow Jones Industrial average provided an annual return of 11 percent. For comparison, between 1965 and 1983 its annual return was 1 percent.
According to the U.S. Department of Labor Non-Farm Employment Data, the American economy generated over 27 million new jobs between 1980 and 1995. Over 24 million of these new jobs were created by small- and medium-size entrepreneurs operating high-growth ventures. As Dr. Laffer predicted, even Washington, D.C., prospered well, with the U.S. Treasury revenues increasing 28 percent to more than $1 trillion in 1990.
At the closing of the last century, MIT economist Lester Thurow had this to say: “In what will come to be seen as the third industrial revolution, new technological opportunities are creating fortunes faster than ever before. The United States has created more billionaires in the past fifteen years than in its previous history—even correcting for inflation and changes in average per capita gross domestic product.”
Understanding the Economic Impact of Venture Capital on the U.S. Economy
Entrepreneurship, combined with support from venture capital, is a major force driving economic growth in the United States. Thomas McConnell of New Enterprise Associates said, “Venture capital investment is a national phenomenon that helps set the U.S. economy apart from others in the world.” Venture capital financed groundbreaking research and untold improvements in infrastructure and technology. The average venture-backed company employs nearly 100 workers within five years and creates almost twice as many jobs as their nonventure-backed competitors.
In his 2002 presentation before the U.S. Senate Committee on Small Business and Entrepreneurship, Mark Heesen stated it clearly. He said, “Investments by venture capitalists over the past thirty years have built companies that are responsible for nearly 11 percent of the U.S. gross domestic product, have created 12.5 million jobs, and have generated $1.1 trillion in revenue in the year 2000 alone.”
John Taylor from the NVCA provides more details. A NVCA-supported study found that for every dollar invested in 1970–1999 there was $6.50 in U.S. revenue during 2000. And for every $13,775 of venture capital investment between 1970–1999, there was one job in the year 2000. In 2000, U.S. venture-backed firms paid $58.8 billion in federal taxes, $7.8 billion in state and local taxes, had net income of $13.8 billion, exported $21.7 billion, and invested $157.3 billion in R&D.
There is no doubt that venture capital will continue to play an increasingly vital role during difficult economic times like we experienced after the Perfect Storm. It is one of the few sources of risk capital available to innovative businesses. In fact, as Heesen adds, “Some of today’s most successful companies were founded in difficult economic environments.”