Prior to World War II, venture capital was primarily the domain of wealthy investors and families. In 1958, the government passed the Small Business Investment Act of 1958 which allowed the Small Business Administration to license private small business investment companies (SBICs) to spur entrepreneurial activity.
Government officials felt there was a gap in capital markets for funding growth-oriented small businesses. In addition, the government wanted to stimulate technological advances to compete against progress in the Soviet Union. The Act enabled small investment firms to access federal funds which could be leveraged up to 4:1 against privately raised funds.
In 1946, Georges Doriot, a former dean of Harvard Business School, founded the American Research and Development Corporation (ARDC) with Ralph Flanders and Karl Compton (former president of MIT). Its goal was to encourage private sector investments in businesses run by soldiers who were returning from World War II. ARDC was significant because it was the first institutional private equity investment firm that raised capital from sources other than wealthy families. Among its early success stories was a $70,000 investment in Digital Equipment Corporation (DEC) which would be valued at over $355 million after the company’s initial public offering in 1968. Former employees of ARDC went on to found other prominent venture capital firms.
The DEC investment was a precursor to the explosive growth of venture capital in Silicon Valley, California, in the 1960s and onward. Venture capital firms based in Menlo Park, California, such as Kleiner, Perkins, Caufield & Byers and Sequoia Capital, focused their attention on breakthrough technologies in electronics, medical technology and data-processing. Venture capital came to be almost synonymous with high tech. It served to launch many familiar brand names, including Apple, Cisco, Compaq, Electronic Arts, Federal Express, Genentech and others.
The highly public success of the venture capital industry in California in the 1970s spawned a proliferation of other firms. By the end of the 1980s, there were more than 650 venture capital firms managing over $31 billion in capital. However, by the end of the decade, venture capital returns started to drop, due to increased competition for hot startups, too many IPOs, and foreign competition. Through the first half of the 1990s, firms focused on improving operations in their portfolio companies.
We are all familiar with what happened next. Venture capital exploded in the late 1990s as investors showed a huge surge of interest in rising Internet businesses and other computer companies. IPOs for dot-com companies with little more than a website and a business plan reaped huge sums of money for venture capitalists and early investors. Among the high profile start-ups making the headlines were Amazon.com, e-Bay, Intuit, Netscape, Sun Microsystems and Yahoo! Some of the biggest dot-com ventures to crash and burn included pets.com, eToys and Webvan, a company proposing to deliver groceries via online ordering.
When the Nasdaq bubble that had been supporting many of these companies finally burst in 2000, it took the venture capital industry down with it. Many VC firms had to write off huge chunks of their investments. Many others closed their doors. By mid-2003, the venture capital industry had shrunk to roughly half its 2001 capacity.
The success of some Internet based businesses such as Google.com and Salesforce.com have helped revive the industry, though it remains a small portion of the overall private equity market and has not come close to matching its mid-1990s levels of investment. In 2008, the industry was managing roughly $28 billion in capital, according to the National Venture Capital Association.
The financial crises that began in 2007 has put a further damper on VC activity, drying up new sources of capital and all but slamming the door on the market for initial public offerings, a popular exit strategy for VCs. Many portfolio companies have had to put their IPO plans on hold, or to rely on sales to strategic buyers for an exit from their investment.
The increasingly international nature of start-ups has put further pressure on VC firms. Whereas in the early years, the competition was between Silicon Valley and perhaps Boston’s Route 128 region, today it’s just as likely to be in Shanghai or Bangalore. Venture capital today requires a global strategy.
References:
Forbes.com
Harvard Business School www.hbs.edu
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