The Development of the Venture Capital Industry in the United States

Beginnings

The venture capital industry has developed in the United States over the last few decades, and U.S. funds now manage more than $100 billion. While private and corporate investors have financed ventures in the United States for many years, the first U.S. venture capital fund (ARD American Research and Development) was founded only in 1946 after World War II by Professor Carl Comton, President of the celebrated Massachusetts Institute of Technology (MIT) and Professor Doriot of Harvard University. With the help of several local financiers, ARD started financing ventures which were based, among other things, on inventions developed for the U.S. Army during the Second World War, particularly developments made at MIT. The investments of this venture capital fund fit what had subsequently become the norm among venture capital funds: a small portion of the investment portfolio yielded the lion's share of the fund's return during its lifetime. The fund's investment in Digital, for instance, in the amount of $70,000, yielded approximately one half of the fund's return (the value of the investment rose to more than $350 million).

When the fund was first founded, institutional investors shied away from it, and it was traded on the stock exchange as a closed-end mutual fund. Its main shareholders were private investors. More venture capital funds were founded in the 1950s, but they too raised money mainly from the public, and were traded as closed mutual funds. The first known fund which was organized as a limited partnership for venture capital investments, was the Draper, Gaither and Anderson fund, which was established only in 1958, and signaled the beginning of a phenomenon which became more prevalent in the 1960s and 1970s. Nevertheless, most of the funds in these decades were still closed mutual funds traded on the stock exchange, or small business investment companies which received loans guaranteed by the U.S. government to encourage investments in small businesses.

At first, most of the funds were founded in the Boston and New York areas. A little later, starting in the late 1950s, similar funds started appearing in California. In the 1960s, funds became organized as limited partnerships, but these funds constituted a small percentage of funds until the 1970s. Although now it may seem puzzling, the investments in those decades were only on the scale of hundreds of millions of dollars per year. It was not until the late 1970s and 1980s that the venture capital industry started raising large amounts of money. The turning point in the volume of money raised may be attributed to the 1979 amendment of the regulations governing the investments of pension funds in the United States. Until then, restrictions were imposed on the amount of money pension funds were allowed to allocate to high-risk investments. The amendment enabled such funds to invest in high-risk capital, known today as "alternative investments," which also include investments in the venture capital fund industry. From that point on, a constant increase has been visible in the resources directed by pension funds to venture capital investments. Thus, the share of pension funds in the venture capital money invested in the industry grew from approximately 15% in the late 1970s to more than 50% at the turn of the 21st century.

The 1980s

One of the most important phenomena in the venture capital industry, which began in the early 1980s, was the investment which large venture capital funds made in companies in earlier stages than was customary until then. That resulted in the investment requiring more resources in each company. In addition, although the funds preferred to dedicate their managerial attention to a relatively small number of companies, the amounts of money which they started managing were larger than before. This substantial transformation created more flexibility for funds to specialize in investments in early-stage companies, as well as private investors.

At the same time, many advisors started assisting pension funds and other institutional investors in screening and selecting investments in venture capital funds. These consultants (known as "gate keepers") helped pension funds and institutional investors to create a portfolio which was spread across several venture capital funds. Pension funds were thus able to achieve the diversification they sought and reduce their exposure. In the late 1990s, more than one-third of the money which pension funds undertook to invest in venture capital funds was managed by such gate keepers, who usually manage "funds of funds" for institutional and other investors.

The share of pension funds in the resources of venture capital funds rose to approximately 50% of the funds' money. Other large investors who invest in venture capital funds are corporate investors, whose investments account for approximately 30% of the money invested in venture capital; high net-worth individuals, whose investments account for approximately 10% of the investments; and not-for-profit organizations, such as university funds which receive many endowments, whose investments also constitute approximately 10% of the money raised by funds.

In the 1980s, due to the multitude of venture capital funds established and the vast amounts of money they raised, the returns on their investments declined. The surplus money raised the investment prices, which in turn reduced the IRR. This phenomenon slowed the pace of investments funneled to venture capital funds and reduced their volumes. The returns achieved by venture capital funds declined dramatically, not necessarily because of a decline in the returns on the stock exchange, but rather due to the excessive amount of investments made in limited areas of the high tech world (for instance, an absurd investment in an unprecedented number of companies manufacturing computer hard disks) and due to the establishment of new funds led by managers who had no relevant experience in the field and hence were bidding up the prices of private firms, causing returns to decline. For instance, the average annual return by funds rose in 1982 to 32% and declined in the following decade to a low of approximately 8%.

The 1990s until the 2000 Crisis

As a result of the deceleration in the pace of investments in the late 1980s, together with the eruption of the communications and Internet revolution, the returns started rising again, and funds were once again raising ever-increasing amounts of money. The huge prosperity of the stock market in the 1990s also contributed to an unprecedented infusion of money into private investments in startups. In the first three quarters during the year 2001 alone, venture capital funds raised more than $50 billion, a process which came to a near standstill in the fourth quarter of 2001 (see the section on the venture capital industry at the dawn of the third millennium for a discussion of the venture capital industry today).

The venture capital industry of the 1990s was characterized by changing trends which reflected changes in the expected returns in various fields. For instance, B2C (Business to Consumers) companies, which flourished in 1999 and in early 2000, receive almost no financing at all from venture capital funds following a significant decline in returns expectations in the area. On the other hand, investments in biotechnology became more fashionable from 2000.

Additional characteristics of the venture capital industry in the late 1990s were:

• The immense volume of money which is managed by venture capital funds approximately $100 billion in the year 2000.

• The establishment of mega-funds, including some funds commanding more than $1 billion.

• The unprecedented returns on investments. According to the trade journal Venture Economics, the average return of U.S. VC funds in 1999 was approximately 160% (for a further discussion of venture capital fund returns, see an earlier section in this chapter).

• The entry of many entities into venture capital investments, including private equity funds which had previously invested in other fields, as well as operating companies.

• The increase in the compensation of fund managers. As a result of the remarkable performance demonstrated by funds, some fund managers started charging up to one-third of the profit after reimbursement of the investment ("carried interest") far above the 20% which had once been the industry standard (see the section on distribution of profits and compensation of fund managers for a discussion of fund managers compensation).

• The global basis of fund investments, as well as the establishment of separate funds for investments in different continents (see the section on the characteristics of the venture capital industry today for a discussion of globalization).

The crisis which befell the capital markets in the fall of the year 2000 has many implications on the industry. These implications are discussed below.