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Venture Capital

A Brief History of Venture Capital

Editor’s Note: This is an updated version of an article first published on July 22nd, 2013.

What is “Venture Capital?”

The term “venture capital” (VC) is typically associated with high-risk, high-growth potential start-ups that may sink or soar depending on a number of external factors.  Any investment in a start-up, however, can be called a venture capital investment, though a common hallmark of venture capital investors is that with their investment they obtain some level of influence over the company in which they invest.

Some commentators consider VC a subset of private equity (PE) but we think it makes more sense to think of the two investment classes as separate and distinct.

[Editor’s Note: For more on the difference between Private Equity and Venture Capital, please see Private Equity, Venture Capital and Angel Investing – How Are They Different?.]

Venture Capital Inside of Large Companies, 1929 and the GI Bill

Innovative technologies historically took form inside large corporations or looked to wealthy families. The stock market crash of 1929, the ensuing Great Depression, and World War II resulted in an environment that was decidedly not entrepreneur-friendly. Though it is a sweeping generalization, start-ups were few and far between during these periods

After the end of World War II, with former soldiers graduating college under the GI Bill, a newly educated generation of potential entrepreneurs began to emerge just as the U.S. economy was beginning a prolonged post-war boom. This, in part, laid the foundation for a renaissance for entrepreneurs.

The Modern Venture Capital Industry

The present-day VC industry traces back to the creation of the VC/PE firm American Research and Development Corporation (1946) by Georges Doriot. ARD raised $3.5 million, of which $1.8 million came from nine institutional investors, including MIT, Penn, and the Rice Institute.

The Small Business Investment Act

The industry picked up real steam in 1958, when “Venture Capital was in its infancy,” according to Mark Heesen, former president of the National Venture Capital Association. Heesen also explained, “[a] significant boost was given to the industry with the passage of the Small Business Investment Act.”

The passage of the Small Business Investment Act gave tax breaks to private investment companies, leading to the creation of professionally-managed VC firms by licensing private, small business investment companies (SBICs) to help entrepreneurs finance and manage their startups.

Evolution of the Prudent Man Rule

Around the same time, another pertinent legal development occurred: the Prudent Man Rule, underwent a change that also helped lead to an increase in venture investments. Succinctly stated, the Prudent Man Rule is the standard by which fiduciaries are judged.

Prior to 1959, the general rule was to judge each investment a fiduciary made on a stand-alone basis, based on state laws that limited a fiduciary’s ability to invest in only securities on approved lists, such as bonds and preferred stock.

Succinctly stated, the Prudent Man Rule is the standard by which fiduciaries are judged. Click To Tweet

In 1959, influential legal scholars and commentators recognized that a fiduciary ’s ability may go beyond the assessment of each asset individually (which may have been considered too risky or “imprudent” on its own) and instead, look to the entire portfolio. Thus, the law began to give more protection to fiduciaries who built diversified portfolios even where certain components of those portfolios could be viewed, in their own right, as risky.

The 1960s and 1970s

From 1960 to 1962, according to Heesen, 585 SBIC licenses were approved, representing $205 million committed in private money. “The experience with SBICs demonstrated a key point – government policy has an extremely important effect on the venture capital ecosystem.”

Some examples of companies funded through early venture capital include Xerox, Intel, and American Microsystems. In fact, throughout the 1960s and ’70s, computers, electronics, and data processing were exploding with growth and development, and venture capital firms were there to provide financing for these highly risky endeavors. So much so, that the investment vehicle soon became thought of as the primary method by which to finance tech startups.

More Changes to the Prudent Man Rule

Changes to the Employee Retirement Income Security Act in 1979 further clarified the Prudent Man rule and opened a wide pathway for investing in venture capital. According to a major industry study conducted by Paul Gompers in 1995:

Prior to 1979, pension funds were severely limited by ERISA in the amount of money they could allocate to high-risk assets, including venture capital. The 1979 change explicitly allowed fund managers to invest up to 10% of their capital in venture funds. Pension fund commitments to venture capital rose dramatically, increasing annual new contributions to venture capital funds from $100-200 million during the 1970s, to in excess of $4 billion by the end of the 1980s.

[Editor’s Note: Gompers’ study, Optimal Investment, Monitoring, and the Staging of Venture Capital, can be found in the Journal of Finance, Vol. 50, No. 5, (Dec., 1995).]

Startups funded during this time include Compaq, Intel, McAfee, Hotmail, Skype and American Online which ushered in a massive time of growth of the internet age.

The “Dot Com” Era

In the 1990s, the “dot com” era was a boon to venture capital, providing numerous opportunities for new firms to emerge and go public and for existing firms to put financing into the seemingly endless array of internet startups, but the bubble eventually burst, causing heavy losses across the board.

[Editor’s Note: for more on the history of venture capital, please see The History of Private Equity and Venture Capital. You may also like this one hour podcast by BusinessWeek editor and author Spencer E. Ante on ARD and history of VC. Learn more about the fantastic history of VC in Silicon Valley]

The history of venture capital is fascinating. From its humble roots, the industry continues to grow and change. Stay tuned to see where venture capital goes in the future.

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About Judy Radler Cohen

Judy Radler Cohen is a financial editor and investigative reporter. Since 2007, she has worked with business publications and websites, including Global Finance magazine, eFinancialCareers.com and Wantedtech.com. Judy spent over a decade as editor of Mergers & Acquisitions Report where she managed weekly production, generated story ideas about all facets of capital markets and investigated/wrote…

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