What Is the Venture Capital Secret Sauce?
Because no other country besides Israel has created a venture capital sector as vibrant as that of the United States, a historical exploration of VC would seem to be an eminently good idea. Unfortunately, VC: An American History by Tom Nicholas provides little insight into what enabled the Americans to dominate in this difficult-to-develop realm of activity. Strangely, the main text, which wraps up with a final chapter about the Big Bubble, ends in the year 2000, even though the book was published (with an Epilogue that does not bring it up to date) this summer.
The history that Nicholas does offer sheds scant light on the venture capital sector in the last few decades. The William J. Abernathy Professor of Business Administration at the Harvard Business School begins with the 19th century American whaling industry, then discusses the 19th century cotton industry. There is no original research or insight in either chapter, with both summarizing, in the typical cookie-cutter style of business-school case studies, a large number of insightful, original books on these topics. The main reason to pick these industries is that they displayed the well-known pattern characterizing venture capital efforts later (and stock market investments too, not mentioned in the book), that pattern being the domination of a few extraordinary successes as far as return on investment was concerned. (These days that domination is expressed in the acronym FAANG: Facebook, Amazon, Apple, Netflix, Google.)
Chapter 5 explores the subject of limited partnership in the 19th century, which is unnecessary, too, as it does not shed light on what was different about the United States. Such partnerships had existed in Western European countries for centuries before. Why these summaries are in the book, and not a word about the angel groups and venture capitalists who financed Broadway productions, movies, the recording industry, and concert tours, creating an entertainment sector that dominated the world’s entertainment offerings as much as Silicon Valley dominates IT today—I do not know.
If this isn’t a history of VC in America, what is the book about?
Chapter One starts with a few introductory sentences about the Dutch having been dominant in the whaling industry in the 18th century. Nicholas fails to note that Italy’s city states, and ports like Marseilles a few centuries earlier, organized the shipping industry in ways replicated later by the Dutch and the Anglo-Americans.
Jean Favier, a French historian, writing about the rise of commerce during medieval times, emphasized the weather- and pirate-related dangers that vessels faced. Entrepreneurs, financiers, and governments found solutions to these problems that do not differ much from measures taken today against pirates in the Indian Ocean. In Venice, for example, the merchants could either sail under the protection of the city-state’s official vessels for a fee, or opt out and find a variety of private ways to insure themselves. To be sure, such an exposition as Favier’s tells us about similarities with today’s organizations, not about the eventual uniqueness of the American or Israeli VC sectors.
What features and patterns of the venture capital industry does Nicholas cover?
It is well known that the following are the drivers of angel and venture capital investments everywhere and at all times: 1) ease of financing and permanence of access to capital, attracting entrepreneurs and shaping skilled teams around them; 2) expertise in deal-making and leading an organization, managing relationships between boards and management in particular, so as to hold all parties accountable; and 3) last, but not least, the business environment as shaped by government’s regulatory and fiscal policies, with the Israeli military playing a central role, though different from the (also crucial) role played by the military in the United States.
Nicholas details who were the founders, whether for whaling, cotton, or later technology-related businesses, be it within venture capital funds or within corporations’ internal venture capital; who were the captains and entrepreneurs; how the latter, in collaboration with funders, selected the teams; and what was the nature of contractual agreements. However, he does not always follow up his summaries of investment philosophies found in prospectuses or other documents with a close look at whether or not the verbiage was followed up by actions, and what were the returns.
For example, in Chapter One about the whaling industry, he writes:
Given the distributional characteristics of payoffs from voyages some downside protection also became part of the financing structure. Venture capitalists use, among other things, financial instruments for this purpose. For example, preference shares financially subordinate entrepreneurs if a startup is liquidated by sale, merger or acquisition.
But the text jumps to describing standard insurances the whaling industry used, having nothing to do with preferred shares. Later, he writes:
With respect to cognition, it is well known that herding behaviour arises to the extent that uncertainty exists about outcomes and signals about the future are imperfect. First movers provide information that affects the decisions of later movers, leading to copycat behaviour as economic actors advance in lockstep, even when private information specific to late movers should encourage decisions in the opposite direction.
This speculative paragraph of mindsets in the 1850s comes on the heels of an uncritical precis of one article saying that the whaling industry would have been better off if its practitioners had explored other parts of oceans than they actually did. Nicholas does not ask whether the technology or the institutions of the times would have allowed such explorations. Besides, what does the statement “to the extent that uncertainty exists” mean?
Nicholas emphasizes the “long tail” feature of the venture capital industry, meaning that it is a “hit” business where a few wildly successful investments compensate for the vast majority of mediocre returns and bankruptcies. After summarizing various cases that show to what extent unusually high returns are due not only to expertise, drive, or insight but also to being in the right place at the right time, Nicholas concludes (in the book’s Epilogue) that “The most obvious of these modern challenges is the extent to which outsized financial returns can be achieved systematically.”
What does this sentence mean? Perhaps the author speculates that achieving what is out of the ordinary could be done on a regular basis. But then the extraordinary would become ordinary, no? Or perhaps Nicholas is trying to say that all venture capital firms could achieve returns significantly higher than, say, the NASDAQ or S&P indexes. If so, in that case more capital would immediately be allocated to venture capital, more smart people would join funds and finance people would quit employment to start businesses, and the returns on various classes of assets would become comparable—American capital markets being uniquely liquid allowing for such transitions. If he meant the latter, the book should have linked the development of venture capital to what makes American VC almost unique: America’s deep capital markets.
Women and Venture Capital
Before getting to other important omissions that could have helped account for U.S. success at venture capital investing, let me give an example of where a historian’s perspective would have been most helpful. Nicholas notes the crucial role that Georges Doriot played in the shaping of the venture capital sector, but is severely critical of Doriot’s 1960s view dismissing women in this sector. Later, in a section titled “Diversity,” Nicholas asks, “Can the VC industry reverse its abysmal record on diversity?”, noting that in 52 percent of top venture capital firms, women do not occupy senior positions. The question itself reveals the extent to which Nicholas did not fully grasp the significance of the features he just emphasized about founders, entrepreneurs, and forming quickly competent teams in the technical sectors.
Why is it a surprise that, in the 1960s—and even now—women do not play far greater roles in this sector (never mind 19th century whaling)?
Most women working outside the home well into the 1960s were teachers or nurses. True, society constrained women to these sectors—that is a fact. Venture capitalists could not have done much about this. Even today, less than 25 percent of women enrolled in universities are studying science and engineering, and it is not clear what this higher number means for the venture capital sector. Since success in venture capital investment depends on gathering good teams quickly, and gaining rapid access to scientific and technical information and information about people’s behavior under intense stress, venture capital firms’ not hiring women for decades is hardly surprising. Women did not have the required backgrounds even if they had PhDs in math.
When I earned my Bachelor of Science in math at the beginning of the 1970s, there were two programs one could enter: a “regular” math program with 150 (mostly female) students enrolled, or an “advanced path” with 70 students, where there were five women. Those going for the regular math degree wanted to become math teachers. True, some went on to complete PhDs in the pedagogy of math and science. But the venture capital sector has little interest in such PhDs.
A historical perspective could have revealed that the main obstacle for women in venture capital has been that health and education—sectors where they could have broken “glass ceilings” by leveraging their vast and detailed experience into VC positions whether as funders, chief executive officers, or chief financial officers—were heavily regulated. For decades, there was little if any upside for venture capital investors to get into in these unionized, bureaucratically managed, and politicized sectors.
Policies Can Set the Stage for Venture Capital (or Not)
The chapter entitled, “Market versus the Government” could have, with a serious rewrite, illuminated the history of U.S. venture capital. A section titled “The Funding Gap for Startups” is about “the difficulties of financing new ventures. Chester Carlson, inventor of the photocopier, struggled to raise capital between 1938 and 1946 to turn his xerography machine prototype into commercial reality.” Instead of a detailed examination of these times, including the U.S. recovery from the Great Depression and entry into the second World War, the text lapses mainly into fact-free jargon.
Yet snippets of information in this chapter could have led to a good understanding of government’s role, and a grasp of the almost-uniqueness of the American VC experience. It would also give us insight into today’s debate in Washington on taxation, and taught us a cautionary tale about assigning greater roles to politicians and bureaucrats with zero experience in technology and finance to be in charge of allocating funds to projects involving just about every technological area.
Nicholas writes: “Whereas during the 1920s, Secretary of the Treasury Andrew Mellon lowered taxes for the rich, the 1930s brought more progressive taxation. It was frequently argued that this diminished the supply of entrepreneurial finance.” Plausible as this is, he neither offers evidence that this was the case nor connects it with the U.S. failure to get out of the Great Depression more quickly. He also notes that “it was argued that the specific operation of the tax code acted as a strong disincentive to formal organization of venture capital. Capital gains accrued under an investment company structure were taxed more heavily than gains from individual investing . . . At the same time, entrepreneurs faced large tax hurdles when their ventures expanded, because tax withdrawals put a dent in working capital.”
He does not follow up on this theme. If he did, he might have concluded that these were gravely mistaken policies that not only hindered start-ups and the growth of smaller firms, but also increased inequality in American society. The next chapters could have offered an arc to the story and shown how tax and regulatory changes during the 1930s and then the war led to people having less discretionary income to put into start-ups, which hindered the creation of venture capital firms. This would have allowed him to put in the proper perspective governmental policies since then, setting up a discussion of the almost-uniqueness of the U.S. venture capital sector.
After all, no matter what country we consider, or in what period of history, people access capital only from family and friends, or the financial sector, or the government. The latter is a “financial intermediary,” too, transferring to constituents money raised through taxes and borrowing. If, say, because of wars or ideology, governments tax at high rates that prevent people from accumulating sufficient savings to invest in start-ups, then only the rich—be it from inheritance (as Nicholas shows) or from the funds of a “vital few” who make it—can play this game.
In the extreme case of policies crippling the financial sector altogether, government becomes by default the sole “financial intermediary,” and bureaucrats become the sole matchmakers. Now we get to the crux of the matter: This happened in most countries, but not in the United States. When Nicholas praises the role the government played in the emergence of a vibrant VC sector, he fails to show that (except when military considerations dominated) interventions were needed to correct for past regulatory, fiscal, and monetary mistakes. The impression he leaves is that a viable venture capital sector could not have come into being without federal funding.
The SEC’s Important Action
Yet what happened after the Second World War was that funders and entrepreneurs, noticing the lack of funding for start-ups, initiated discussions with U.S. government agencies. They ended up convincing the Securities and Exchange Commission to make precedent-setting decisions to approve funds entering the void under a “public interest” exemption. As a result, small funds were created, though these remained of marginal importance well into the late 1950s.
The big change in the venture capital sector came in the late 1950s, and for accidental reasons. The first VC limited partnership in America (Draper, Gaither, and Anderson) was formed in 1958. That same year, the U.S. government set up the Small Business Investment Companies, a federally guaranteed risk-capital pool, establishing the conditions for a competitive angel and venture capital sector. Also in 1958, the government passed the National Defense Education Act, allocating a large amount of taxpayer dollars to expanding enrollment in universities’ science and engineering programs to catch up with a Soviet Union that had just made a successful launch of its Sputnik satellite. Thus did a panic serendipitously beget—or at least, speed up—a groundbreaking new area of finance.
The United States had clusters of universities, but it was in what became Silicon Valley that the interaction between universities, venture capital firms, the military, and the tech sector became the most successful, also attracting extremely qualified and ambitious immigrants from around the world. The American venture capital sector was on its way—and it had nothing to do with the 19th century.
The interactions created a culture that the political economy scholar Anna Lee Saxenian (cited by Nicholas) has described as different from the rest of the United States: “the region’s culture encouraged risk and accepted failure,” and “there were no boundaries of age, status, or social stratum that precluded the possibility of new beginning.” It is a pity that, when summarizing the evolution of Silicon Valley, Nicholas does not delve into how such cultures are created. He wants more of them, as do we all. In this review I’ve called the U.S. experience almost unique, not totally, because such a culture was created in one other place.
Israel, Start-Up Nation
Below is a brief detour into Israel’s transformation from a socialist, centralized country with no venture capital sector into a “start-up nation” in a relatively short period of time. A culture similar to Saxenian’s description came into being in Israel, and putting the two examples side by side shows what it would take to replicate these two countries’ success. In fact, it would be quite difficult.
The first Israeli venture capital firm, Athena Venture Partners, was founded in 1985 by a team including a former chief of staff of the Israeli air force. In 1993, the Israeli government offered tax incentives to foreign venture-capital investments, among others, by matching any investment with government funds. As in the United States, which became a more centralized society after the Great Depression and during the Second World War, this policy was required as Israel was beginning to transition out of the socialist model it had adopted at its founding in 1948. The policies assured investors that the government was committed to the changes over the long term.
Between 1991 and 2000, Israel’s annual VC outlays rose from $58 million to $3.3 billion; the number of companies launched went from 100 to 800; and revenues of the new technology sector rose from $1.6 billion to $12.5 billion. Migration played an important role. Among the one million Russian immigrants in the early 1990s (a 20 percent increase in the nation’s population), more than 55 percent had post-secondary education; 15 percent were engineers and architects; 7 percent were physicians; 18 percent were technicians and other professionals. By 1998, Israel had 140 scientists and engineers per 10,000 in its labor force, becoming the world leader in these terms, followed by the United States with 80, and Germany with 55.
Israel’s culture was, furthermore, like that of Silicon Valley due to virtues and habits associated with military service, which is compulsory in the country. It added crucial components of “education”—namely, discipline and loyalty. A characteristic feature of many (perhaps most) of the successful Israeli companies is that their founders served together in the Israeli army. A unit within the Intelligence Corps, responsible for collecting signal intelligence decrypting codes, is one example. The founders of Nice, Comverse, Stylit, and Outbrain all emerged from this unit.
A 2016 book, Israel’s Edge, by Jason Gewirtz describes another unit, Talpiot, created about 30 years ago as a collaboration among the Israeli air force, a weapons and technology arm of the Israeli Defense Forces, and the Hebrew University. Soldiers sign up for 10 years, and their long preparation for top positions combines the study of advanced sciences and math with training with the members of every branch of the IDF. Gewirtz documents the success of graduates of this program in creating companies around the world. The mandatory three-years’ army experience, followed up by annual service in the reserves, is reminiscent of both the esprit and the relatively hierarchy-free culture that emerged in California’s Silicon Valley.
The big problem for start-ups and funders of venture capital firms is finding the team that can bring ideas to life. Team members must trust one another. They must know how the skills of each complement those of the rest. Who has leadership skills? Who is the techie “nerd”? Who has managerial, negotiating skills? Who is good at dealing with stress? Who is the better listener? In Israel, the military happens to be the best training ground to answer these questions. Also, soldiers higher in the military hierarchy have been subordinates outside it, and, when serving in the reserves, higher-ranked employees were under the command of lower-ranked ones in the business. The result is a casual fluidity in communication within teams that helps an enterprise succeed.
Bureaucrats and politicians like to brag about whose economy is the most “dynamic,” usually drawing on aggregate statistics but seldom raising this question: Why are the entrepreneurs and top people with technical skills voting with their feet to come to the United States? What institutions were needed to enable such dynamism in America but (almost) nowhere else? If you would like an answer, unfortunately, reading this book will not help.