Individuals and companies have provided funding to fledgling businesses for centuries. The original 13 U.S. colonies were founded and developed through venture capital–funded expeditions. In more recent times, The Ford Motor Company was partially financed by Alexander Malcolmson (a coal dealer who was an acquaintance of Henry Ford), Pan American Airways was in part funded by the wealthy Vanderbilt family, and Eastern Airlines was partially funded by Laurance Rockefeller.
Venture capital as a structured, formalized investment strategy began in 1946 when Georges Doriot (whom many consider the “father of venture capital”) and others started American Research and Development Corporation (ARDC), the first publicly owned VC firm. Many consider its best investment to be the $70,000 it spent in 1957 to help fund Digital Equipment Corporation. Eleven years later, that investment was valued at more than $355 million after the company’s initial public offering. [Digital Equipment Corporation was bought by Compaq in 1998, which subsequently was snapped up by Hewlett-Packard (now HP, Inc.) in 2002]. Also in 1946, three wealthy families established professional VC operations (Rockefeller Brothers Inc., J. H. Whitney, and Payson & Trask) in New York City. From 1946 through 1957, ARDC and the three family entities engaged in VC investing, but no other VC firms were founded.
From the late 1950s onward, a series of technological, political, financial, and regulatory events stimulated growth in the VC industry. These events included:
- the October 1957 USSR Sputnik satellite launch that fueled the Space Race between the USSR and the United States
- the passage of the Small Business Investment Act in 1958, which provided federal funding to investment firms that were licensed by the U.S. Small Business Administration as Small Business Investment Companies (SBICs)
- advances in electronics—especially computers, components, and software—that allowed for breakthroughs in processing power, magnetic data storage, and later, data communications systems
- an increasing emphasis on the research and development of weapons and surveillance systems as a result of the Cold War
- a strong bull market from 1959 to 1962 spurred on by speculation regarding the stocks of electronics manufacturers
A New Type of Partnership
In 1959, Draper, Gaither, and Anderson (DGA)—the first VC limited partnership for investing non-familial money—was organized in Palo Alto, California. Prior to the founding of DGA, venture capital was largely concentrated on the East Coast. By 1960, DGA had invested in 23 firms. It was liquidated in 1967. Davis & Rock, another limited partnership, was formed in 1961. Before its liquidation in 1970, it disbursed $94.5 million to its investors for an estimated 60 percent compound annual rate of return.
The success of Davis & Rock prompted several other groups of investors to start VC funds in the San Francisco area and nationally (especially in the Boston area). Major VC firms founded during this era include Sutter Hill Ventures (1962), Greylock Partners (1965), the Heizer Corporation (1969), and New Court Private Equity Fund (1970). The latter two funds are considered the first mega-funds because they raised previously unheard of levels of investment capital. According to “How Venture Capital Became a Component of the U.S. National System of Innovation” (Industrial and Corporate Change, Volume 20, Number 6, pp. 1677–1723), by Martin Kenney: “These two funds pioneered a significant innovation. In contrast to the pioneer limited partnerships that raised capital from individuals and families, and the SBICs dependent upon the federal government, the mega-funds attracted conservative institutional investors having longer time horizons and searching for improved returns.” The emergence and success of the Heizer Corporation, New Court Private Equity Fund, and other mega-funds encouraged other investors to launch VC firms.
Venture capital firms suffered a temporary downturn in 1974, when the stock market crashed and investors were naturally wary of the new kind of investment fund. In 1975, only one venture capital fund raised money, but that was the same year Tandem Computer received a generous (at the time) $3 million from several VC firms. Returns were tremendous for the few firms in the business in the late 1970s.
The federal government lent a helping hand in the form of legislation through this period. In 1978, the government changed the pension plan rules under ERISA (the Employee Retirement Income Security Act), making it possible for pension funds to invest in alternative (and potentially higher-risk) asset classes such as venture capital funds. Pension funds represented billions of dollars in capital, so an allocation of even 1 percent of funds represented an enormous increase in the pool of money available to venture capitalists. The industry raised $750 million in 1978.
In 1979, capital gains taxes were reduced from 49 percent to 28 percent, so anyone making profits from investing in venture capital funds, or any venture capital firms making profits from investing in private companies, had to pay less taxes. In 1981, the capital gains tax was further reduced from 28 percent to 20 percent.
Then came 1983—the year of excess. The stock market peaked and there were more than 100 initial public offerings (IPOs) for the first time in U.S. history. Major IPOs included Amgen, Biogen, Compaq, and Paychex. That year venture capital investments jumped to a total of $4 billion. Some of 1983’s funding went to newly founded companies that are some of today’s largest and most prominent firms including Apple and Intel.
Due to the excess of IPOs and the inexperience of many venture capital fund managers, VC returns were very low through the 1980s. In 1984, although 45 new venture capital firms were formed, a long decline in returns and capital raised began. The number of new VCs declined every year through 1991, when the industry actually saw 17 more VC firms go out of business than were formed. As the public markets began to falter, opportunities dried up for private investors to liquidate their portfolios. A handful of VC firms then lead the way in trimming their funds to smooth out returns by easing the burden placed on partners to allocate large dollar amounts over fewer deals. In 1991, disbursements from VC firms to their investors hit a 10-year low. VC firms retrenched, working hard to make their portfolio companies successful. The work paid off, and returns began climbing again.
Booming Into the ’90s
Venture capitalists couldn’t take full credit for the turnaround. Macroeconomic forces helped. In the mid-to-late 1980s, interest rates were relatively high, and the price/earnings (P/Es) ratios in the public markets were low. Ten years later, interest rates were low, and P/Es were very high (by historical averages). Pension funds grew dramatically. In 1987, U.S. pension funds held approximately $2.5 trillion. By 1997, that number reached $7 trillion.
The booming economy made pension fund managers more comfortable allocating up to 4 percent of their capital into alternative assets. The U.S. stock market had one of its greatest run-ups in history between 1991 and early 2000. Mutual fund assets grew from $1 trillion in 1990 to more than $6 trillion in 1999.
The Rise of Technology
By the late 1990s, VC funds were in full swing—taking advantage of new technology upstarts hungry for seed money. The rate of merger and acquisition activity increased dramatically, and that created more opportunities for small, venture-backed companies to exit at high prices. VC firms cashed out in droves, putting their spoils aside with hopes to funnel into a new crop of fledgling ideas. In general, 1999 and 2000 were boom years for IPOs, and venture-backed firms were particularly prominent. In 2000, nearly two-thirds of newly public companies were backed by venture capitalists, according to the National Venture Capital Association. The industry also netted approximately 245 new firms that year.
It was the period that founded some of the world’s biggest technology powerhouses, chief among them being Google. The company was formed in a garage in 1998, and raised a total initial investment of almost $1.1 million—including $100,000 given by Sun Microsystems Inc. cofounder Andy Bechtolsheim. Others like online music file sharing service Napster secured $15 million of financing from Hummer Winblad Venture Partners, and electronic payment provider PayPal raised more than $210 million during this period.
However, the good times didn’t last. By 2000, the glut of technology IPOs hitting the NASDAQ and a severe correction in the stock market sent venture-backed investments into a tailspin. By 2003, venture capitalists pledged a mere $19.7 billion—half of the amount in the glory days of 2000.
The year 2004 marked yet another turning point. The Dow Jones industrials began to fight its way up, rising almost 29 percent to its peak in July 2007. And, with more money in pocket, so did the profit-seeking VC firms. They funded 3,072 deals in 2004 worth $22.9 billion, and then pumped $30 billion into nearly 4,000 deals alone the next year. Big IPOs began to make a comeback, with the most prominent being Google’s flotation for $85 per share in 2004. The company’s dominance in the search industry eclipsed that of both Microsoft and Yahoo. As of 2020, Google had a market valuation of about $1 trillion—much larger than some of the nation’s biggest blue-chip companies, such as J.P. Morgan Chase & Co. ($309.4 billion), Intel ($230.3 billion), and IBM ($112.2 billion). The Google IPO marked the beginning of a