Part I: A Beta was born, the genesis of modern day venture capital
Thanks to Michael Ramos-Lynch for co-writing this series with me.
My friend Michael and I recently had a long conversation about where venture capital was going as an industry. Realizing we lacked some historical context to back up our hypotheses, we decided to do some research.
We collected and analyzed data through online resources like PitchBook, the NVCA, CB Insights, and others. We also interviewed several significant figures in the VC and tech industry who generously shared their insights, typically from decades of experience.
Realizing how much info we had, we decided to organize and share it for three reasons: (1) to provide a convenient means for anyone else to quickly gain a broad understanding of the evolution of the industry, (2) to contribute context to conversations regarding the future of tech/VC, and (3) to spark a thoughtful dialogue about the industry. We firmly believe that you need to know where you’ve been to know where you’re going.
In this 5-part series, we’ll review the birth and maturation of the industry, and with that context consider where it might be headed. This first post will focuses on the formalization of VC from the 1950s through the dotcom bubble.
The Birth of Venture Capital
In its most basic form, venture capital refers to capital that has been invested in a private company, typically a company that is very young, unproven and therefore very risky. With this risk should come the potential for extraordinary financial return, especially based on the application of new technologies or creation of new markets.
Venture capital is fairly well known, rising in the dotcom bubble and the subsequent association with household names like Facebook, Twitter, and Snapchat. Everyone is interested in VC and startups these days. From “Shark Tank” and HBO hit show “Silicon Valley” to even companies like Kellogg’s, the excitement for tech and venture is higher than ever before. How did we get here?
At the beginning of the 20th century, venture investments were reserved for the wealthiest, including royalty and families like Vanderbilts and Rockefellers. The first two companies to resemble the venture capital firms of today opened in the 40s: American Research And Development Corporation (ARDC) and J.H. Witney & Company.
Georges Doriot, considered by many to be the “father of venture capitalism,” founded ARDC as a way to help facilitate investment in private businesses started by soldiers returning from WWII. In 1957, ARDC invested $70,000 for 70% ownership of a startup called Digital Equipment Corporation. This investment may be the first modern VC “home run”, being worth $355 million at IPO just 11 years later.
While ARDC experienced great returns, it was the passage of the Small Business Investment Act of 1958 that significantly furthered the rise of venture capital. The Act enabled the Small Business Administration (SBA) to grant licenses to Small Business Investment Companies (SBIC’s) to invest in and manage small businesses. Thru the SBA, the federal government subsidized private investment from SBICs in the form of loans. These loans were usually ten years in length, setting the standard length for venture funds as ten years.
An influx of dollars from federal loans directly coincided with the exponential rate of technological development in several industries such as advertising, automobiles, consumer goods, and telecommunications. Feeding off one another, several independent investment firms and tech companies launched in the early 1970s, including modern day powerhouses like Kleiner Perkins and Sequoia Capital.
Many of these firms were founded by students of Georges Doriot. The list of this second generation includes foundational figures in the industry like Arthur Rock (supported the “Traitorous Eight” in creating Fairchild Semiconductor, early investor in Intel and Apple), Tom Perkins (founded Kleiner Perkins, invested in Genentech, Tandem Computers, and Applied Materials), and Don Valentine (founder of Sequoia Capital, investor in Atari, Apple, Cisco, and EA).
The passage of the 1974 Employee Retirement Income Security Act (ERISA) initially restricted the growth of venture capital, since the Act prevented corporate pension funds from investing in risky privately held companies. But after the easing of those restrictions in 1978, the industry saw its first banner fundraising year, with firms collectively raising roughly $750 million. This is despite rapidly rising interest rates in the late 70s and early 80s.
The overwhelming funding from pension funds ultimately powered several major victories in the late 70s and 80s, including Intel, Apple, and Genentech. These tremendous, public successes drove significant returns for investors which in turn drove investment growth. In 1980, there were roughly 30 venture firms managing approximately $3 billion dollars. By 1990, there were 650 venture firms managing approximately $31 billion dollars.
The increased competition through in the 80s led to reduced returns for venture capital overall, which would not see an industry-wide rebound for almost a decade. While investment continued to climb almost 3x by 1995, there was a plateau in the number of firms over the same time period as non-performant funds flamed out.
While US-based venture firms were competing with one another, Korean and Japanese companies were also making significant investments in early-stage companies in the US. The increasingly competitive landscape, along with the floundering market for IPO’s in the mid and late 1980’s, is likely what considerably slowed- growth in the number of firms.
The Dotcom Era
After the major consolidation and retraction in the late 80s and early 90s, venture returns became increasingly attractive again. In another direct correlation with technological advancement, venture capital experienced a major boom beginning in 1995 as massive interest mounted in new companies focusing on the Internet.
The Boom/Bust of the Nasdaq
Companies like Apple and Microsoft rapidly grew the base of personal computers. The Internet was more widely available thanks to internet service providers like AOL and Netcom and more usable thanks to companies like Netscape and Yahoo. There was fervor around the shift to a new economy and new opportunity. Tax cuts in 1997 reduced the tax on capital gains below the tax on dividends, driving even more money into highly speculative investments in young companies.
A perfect storm was brewing for a public market mania. We spoke to angel investor Jerry Neumann who summarized it as follows:
Ten Internet IPOs in 1995 turned into 18 in 1996, 15 in 1997, and 40 in 1998.In 1999 there were 272. Even in 2000 there were 148, despite the stock market crash of March of that year.In 2001 reality finally sank in and there were only 6 Internet IPOs.
US Tech IPO Funding and Number of IPOS
Vox and A16Z, data from Jay Ritter, University of Florida
In early 1998, valuations for public tech companies were about 40% above the rest of the market.
By early 2000, they were 165% above the rest of the market.
According to Satya Patel, general partner at Homebrew, “Nobody thought it was ever going to end.” But, of course, it eventually did. The Nasdaq began to crash in March of 2000 as a result of inflated valuations and a lack of new investors.
By November of 2000, the 280 companies in the Bloomberg US Internet Index had lost almost $2 trillion in market value from their respective 52-week highs.
Some very famous and successful startups today have some significant resemblance to failed startup ghosts of the past. Digital currency company flooz.com has been reborn with crypto and grocery delivery disaster Webvan.com has come around again as Instacart and its incumbent competitors.
While there are several anecdotes to draw from major dotcom failures, some stand out simply for the size and speed of their rise and subsequent crash. Pets.com is easily one of the most famous.
Beginning in August in 1998 and closing its doors only two years later in November of 2000, it was nearly over before it started. The company’s branding of a sock puppet dog was so ubiquitous that it appeared in major events like the Macy’s Day Parade and the Super Bowl.
Despite their outstanding marketing efforts, the company miserably failed at nearly every other basic principle of business. Its products reportedly sold below cost, so the more they sold, the more money they lost.
In its first year, the company spent $11.8 million on marketing and earned $618,000 in revenue. Revenue eventually skyrocketed but funding dried up before the company could get to breakeven. By the time the liquidation was announced on November 6, 2000, the share price was only $0.19, down from its initial offering price of $11 per share just nine months earlier. This is considered emblematic foolishness in hindsight, but with funding what it was in 1999, it was maybe more fairly just an aggressive winner-take-all approach.
Flooz.com is another cautionary dotcom tale. One of several pre-bitcoin digital currencies, Flooz raised over $35 million in venture financing and enabled its customers to earn and buy “Flooz credits” which could be spent or shared online. User adoption was initially strong, but the platform was vulnerable to fraud and money laundering.
The FBI contacted Flooz in 2001 to inform them that a Russian crime syndicate had made fraudulent transactions on the platform to launder money. By mid-2001, Flooz founder Robert Levitan reported that 19% of all user transactions were fraudulent. However, Flooz had to make good on those transactions with its partners. This contributed to the company declaring bankruptcy soon after in August 2001. Users who had purchased Flooz credits were not reimbursed and had to pursue reimbursement through bankruptcy court. That didn’t work out well.
The Crash
At some point, there were no new buyers left to bid up company valuations and stock prices, and the resulting implosion was swift. Many investors had managed to realize significant returns on the tech boom, even after taking into account their losses. It was John Q. Public who left holding the bag as public markets crashed from a glut of low-quality tech IPOs (not unlike the current crypto/ICO market).
Institutional investors began defaulting on fund and IPO commitments, escaping further losses. VCs began failing and not making committed investments.
While the reckoning meant disaster for most, it didn’t mean disaster for all. From an anecdote Satya shared:
“Companies that were already well-capitalized and reacted to changes in the market, really benefited. One of the seed companies we funded was OpenTable.OpenTable raised a bunch of money and when the bubble burst, they exited a bunch of businesses, built a focused business in a rational way. They were willing to make some tough decisions.”
Still, many companies didn’t have enough of a business model to survive. The time was marked by the rapid and continuous demise of many companies. Jeff Clavier of early stage fund Uncork Capital recalls:
“We were hearing of people being over-leveraged who couldn’t make commitments. Hundreds and thousands of people being laid off. People would be checking fuckedcompany.com to see who had most recently gone under.”
The fear, uncertainty, and doubt took time to subside. It wasn’t until 2003 that the market finally bottomed out. But by that point, a new mania was set to begin. More on that in Part II.
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Neil Devani is an early stage investor based in San Francisco, California working with companies that create positive externalities, with a focus on healthcare, financial services, and education as well as certain frontier technologies. He is also a licensed attorney in the state of California.
Michael Ramos-Lynch previously worked for a venture firm in Palo Alto, California and is currently an entrepreneur and practicing attorney in Austin, Texas.
None of the above post is intended as investment or legal advice.