A Strategy of Progress

For nearly seventy-five years, venture capital has been a force of change relying on capital and chance to bulldoze and reshape the American business landscape. The business had a small beginning with a few wealthy and notable American families investing their spare cash in what in the day were considered high risk investments-frozen orange juice and fly-by-night new airlines. Some of these early venture capital buccaneers actually made money, and a new American financial industry was born. Over time a new breed of financial capitalist evolved, first sometimes known as an adventure capitalist, then later as venture capitalists.

The small industry almost went under in the 1970’s until the Labor Department in 1974 relaxed institutional investments rules with “the prudent man” provisions of the ERISA Act, which allowed pension funds and other institutional money managers to invest in venture capital. This government action ushered in the modern venture capital industry, with eventually very large pools of mostly institutional capital from university endowments, public and private pension funds, insurance companies, corporations, and other institutional investors making up the bulk of the venture capital funds available for high risk investment. Funds were generally organized as limited partnerships, with an entrepreneurial venture capitalist raising the capital, taking the “2 and 20” management fees and participation in investment gains as compensation.

The early funds were small, with the first ones raising only about $10 million, and investing in eight to ten companies. Most deals failed, and with them most funds too, but some survived even through the returns were often not that high; less than 10% annually. Those that did the best went on to raise ever larger funds, with many of the largest now investing and managing well over a billion dollars, with a few over ten billion.

Many of the early venture capitalists were successful entrepreneurs who were motivated both by making money and by the satisfaction of encouraging and supporting new entrepreneurial talent. Those early to the party saw a number of good deals that had not yet been picked over, and they understood, based on their own entrepreneurial experience, how to start and build a successful company. Since much of the bet in venture capital is on the entrepreneur rather than just on the product or industry, this “it takes one to know one” approach to investing not surprisingly made significant money and launched venture capital as a true meaningful investment asset class.

Like many new developments that enjoy a degree of success over time, the growing venture capital industry, which had a dramatic impact on job and wealth creation, grew tired and began to lose its way and its magic. The early-experienced entrepreneurial breed of investor was often sidelined; too much money was now in the hands of “financial engineers” and their gatekeepers, whose investment practices were guided by a cloud of fat caution rather than the initial venture capital investment intuition of swinging for the fences. Investment by checklist became the norm and the jazz and pizazz went out the door along with strong returns. The Internet bubble propped things up for a time, but when the bubble burst in 2000, the industry suffered through hard times once again, earning negative 1.9% annual returns for almost a decade. It was increasingly unclear whether the industry could scale with the old entrepreneurial magic gone, the same old, often failed investment formulas being deployed, and a lot of the newbies not having a clue.

An investment category that was generating negative returns for almost a decade then ran into the wall of near financial collapse in 2008. The number of active venture capital firms dropped into the abyss, with a few of the best and the brightest, or at least the ones with steel nerves, hanging onto the side of the rapidly caving cliff. As the broader financial market began to recover, the rising stock market and the IPO market put the steam back into venture capital returns. Those venture capital firms that didn’t lose too much money in the long drought and had a few winners were back in active business.

Mutual funds and other major investment pools then re-entered the fray, having learned nothing from the previous downturns and repeating many of their historical errors. Major write-downs have now become common for these firms, which have too often thrown good money after bad. Even hedge fund investors, who knew very little about venture capital but still should have known better, have deployed large amounts of their capital into high priced venture capital investments, and have often taken a major bath. It has seemed at times like a return of the same old boom-and-bust cycle, with capital infusions into the industry beginning to drop once again in 2016. This, together with a slowing IPO market, have resulted in tougher times for raising capital for entrepreneurs and investors alike, amid falling valuations.

It seems like over its 75-year life, the venture capital industry has been riding on a roller coaster, lacking a Strategy of Progress, bounding from one bubble to another, with many of the same old venture capital firms doing things in the same old way, never imagining a different future or deploying a differentiating process. An industry based on innovation has broadly failed to innovate itself and was in danger of stalling at best, or flaming out at worst.

But there have been some changes that appear to represent hope for the industry. A fresh perspective has emerged and things have begun to change. A segment of the business has gone back to its roots and became entrepreneurial once again. Just like in 1974 with its “prudent man” provisions within ERISA, it has been the government, spurred on by venture capital entrepreneurs, which has initiated change enabling progress. The Obama administration, in a rare occasion succeeding at pulling together bipartisan support, enacted into law the JOBS Act in 2012. In late 2013, the SEC began implementing associated regulations that gave tangible legal form and support to the movement toward online venture capital investment by individuals, first those more affluent individuals categorized by the SEC as accredited investors. Subsequent SEC regulations implemented in May 2016 now permit almost anyone who wanted to take a chance on a high-risk flyer, though investment dollars permitted from those not categorized as accredited investors are very limited.

The online funding of high-risk venture capital investments is bringing back the spirit of entrepreneurialism that reigned years ago. Luminaries such as Steve Case, the co-founder of AOL and Chairman of the venture capital firm Revolution, have gotten behind the movement and promoted both the JOBS Act and “the Rise of the Rest” – entrepreneurialism and venture capital investments in communities where the foundational infrastructure was not readily available before. Numerous online venture capital investment portals have been set up, some run by professional venture capitalists and some by newcomers, many with different strategies for progress. In China alone, by early 2017 over $200 billion had been invested, mostly online, by Chinese investors eager for the next big venture capital win. Spring is once again in the air, as new sources of capital with a new and a more democratic, inclusive perspective entered the investment arena.

The critics of the new wave approach have been quick to point out that once again it could be “too much money chasing too few deals,” and that individual investors would “get burned.” While this may be true, the old ways are quickly falling by the wayside, and once again, venture capital is returning to its entrepreneurial roots, taking a new approach and a new risk, again seeking the high returns associated uniquely with venture capital.