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The Very Small World of VC

The people who bet big on disruptive technologies have a lot in common.

Spencer Platt / Getty Images

In the nineteenth century, there was a lot of money to be made tracking down sperm whales off the coast of Massachusetts—harpooning them, melting down the fat into oil, and bringing the bones ashore. A single voyage could bring in $100,000, the equivalent of over $3 million today. But it wasn’t easy. In 1858, around two thirds of whaling ships that pushed off from New Bedford and Fairhaven returned without making a profit. It turns out whales are hard to find, and even harder to kill. The average whaling boat spent over three years at sea. This created a dilemma for the rich families of Massachusetts: How to kill the whale, sell the fat and bones, but not lose money paying crews and hiring out extra boats for long, failed voyages? 

Harvard University Press, 400 pp., $35.00

In 2012, Harvard Business School devoted a case study to this conundrum: Whaling Ventures used the nineteenth century whaling industry to teach about American venture capital. These cases are basically adult versions of the Encyclopedia Brown mysteries, to which the solution is always: Make more money. Whaling agents devised a number of clever techniques to make the investments profitable. They studied which captains had the best records, helped rich families spread their money between multiple whaling ships, hoarded knowledge about whale hunting grounds, and drew up profit-sharing agreements to incentivize crews to stay out at sea.

These agents, students learn, created the model for contemporary Silicon Valley venture capital firms. Just imagine the crew of each whaling ship as a pod of quirky engineers, who may be developing an app we can’t live without—or may be working on Juicero, the high-tech juicer company which raised $120 million in VC investment before imploding.

Harvard Business School Professor Tom Nicholas co-wrote Whaling Ventures in 2012, and has now expanded it into a new book VC: An American History. He argues that although not the only society to encourage risky investments, the United States did pioneer special firms for that very purpose, a move that may have been crucial to America’s role as a technological powerhouse, and most certainly linked technological innovation and the investor class in the American imagination. A detailed, fact-filled account of America’s most celebrated moneymen, the book ably presents the logic of VC financing: It’s common sense that most technological innovations start out as long-shot ideas, with a low probability of success. If a society only invested in those ideas which had already proven to work, then new technology would never get off the ground, and new ideas would die on the vine.

Nicholas shows less interest in the ways VC shapes society and in the inequalities it perpetuates. Who wins—and who loses—in a society that adopts the American approach to financing revolutionary changes? What are the consequences when the financial engines of innovation are so far insulated from democratic forces? And what kinds of alternatives may be possible? Someone has to specialize in making these kinds of calls. But the way that we currently pick winners and losers is woefully oligarchic: In 2018, U.S. Venture Capital fund commitment hit an all-time high at $130.9 billion dollars. Many of the most world’s most transformative tech firms—Uber, Airbnb, WhatsApp to name just a few—were backed by major VC investments; even aspects of Trump’s immigration policy involve VC-backed tech. These decisions were made behind closed doors by groups of mostly white men. And while Nicholas’s book may not offer much criticism of those men, it provides a valuable look into their world. 

From its earliest days, venture capital mirrored, and amplified, the core structural dynamics in the American economy: What often counts most is who you know, and who your parents are. Take one of the early pioneers of venture finance, Laurance Rockefeller, whose grandfather John D. Rockefeller’s wealth was estimated at 1.5 percent of GDP. In the 1940s, Rockefeller hired a staff of experts to pick winning technology companies—especially aviation firms. He would fly his personal plane between California and New York to check in on his investments, an incredibly rare move in the 1940s when casual continental air travel was almost unheard of. Even with his massive advantages, between 1938 and 1969, Rockefeller failed to outperform the stock market, bringing in just 86 percent of what a normal investor who skipped the plane—and just bought an index fundwould have seen in returns.

In later years, Rockefeller did better; the firm he founded in 1969, Venrock Associates, became an early investor in Apple, but largely because one of Venrock’s partners and Apple’s founders already knew each other. Even Nicholas, who’s quite taken with Rockefeller, calls the Apple investment “close to accidental.” Later in life, Rockefeller would turn his family wealth toward the twin goals of environmental conservation and convincing Bill Clinton to tell the truth about UFOs.

Although there are some self-made modern VCs, the industry seems to move in sync with the consequence-free world of inherited wealth and family connections. For instance, in recounting the origins of Greylock, a leading contemporary VC firm, Nicholas describes a “a series of limited partnerships, composed of a select group of wealthy U.S. families (and their investment agents) and, later, university endowments.” All the partners were Harvard Business School alums. A few years after its founding, surprise surprise, Greylock started managing a portion of Harvard’s endowment. Other elite universities followed, and before long, university money accounted for more than half the capital in each of the firm’s partnerships. It’s not that all VCs succeed because they start out as plutocrats. John Doerr, a partner at the leading VC firm Kleiner Perkins Caufield & Byers, was able to get in early on the pioneering browser Netscape, because one of its founders, the pathbreaking computer engineer Jim Clark, respected his technical expertise. Over two years, the firm turned a $5 million investment into a $361 million return. 

The prospect of such outsized rewards, though, can often lead to risky behavior. And given how embedded VC has become in the unaccountable American plutocracy, those risks aren’t always shouldered by the VCs themselves: Take the VC-backed medical device company Theranos. In 2015, the Wall Street Journal reported that its claims and testing methods were faulty and could endanger lives. Before that, Theranos received major VC-backing from Tim Draper, a third-generation VC who happened to be a neighbor and family friend of Theranos founder Elizabeth Holmes. The year after the Theranos fraud came out, Draper raised another 190 million for a new venture fund, and has recently said he would back Holmes again, if given the opportunity.

VC was never exactly intended as an egalitarian enterprise: The man responsible for devising the modern venture capital formula was a French immigrant and Harvard Business School professor named Georges Doriot. He’s often hailed as the “father of U.S. venture capital,” for his early involvement in the American Research and Development Corporation (ARD), founded in 1946. The firm drew heavily upon the networks of returning soldiers from World War II, and, significantly, sought investment outside of wealthy families. After Doriot turned a $70,000 investment in Digital Computer Corporation into a $52 million return, Nicholas writes, he “validated the long-tail investment approach,” that undergirds modern VC financing—the idea that making a lot of long-shot investments in early-stage companies will pay off eventually, if one firm makes it big.

Doriot barred women from his classes at Harvard, even after the university admitted them. Nicholas writes that Doriot “seeded a narrow mindedness on gender issues that the industry still grapples with.” Although he spends some time in the book bemoaning the lack of gender diversity in VC, cultural critique is not Nicholas’s strong suit. He does not like to stray from market analysis, and favors banal formulations like, “lines of continuity or change can often be traced from the past to the present.” 

It’s not that Nicholas is unaware of the social and distributional dynamics at play. In Whaling Ventures, he gestures at the “substantial environmental cost” the culling of whales imposed. (Though it doesn’t mention that nearly 30 percent of the world’s sperm whales were killed between 1800 and 1880, or that they are still on the endangered species list). In a section titled “Risk Management,” he explains that workers aboard these ships were regularly flogged, leading to risk of mutiny and desertion that could, from an investor’s perspective, “endanger the success of a voyage.” Towards the end of the book, Nicholas turns to what he considers the “much darker side” of VC—the fact that VC firms can get rich taking a company public, sell quickly, and then watch as everyday investors, pension funds, and retirees, buy in late, and then lose money when the stock goes down.  

But Nicholas just does not pay that much attention to the ways that VCs’ hunt for outsized returns may have encouraged broader exploitation over the centuries. Agents in the whaling industry, for example, structured insurance payments so that the ship workers would shoulder some of the costs of premiums—but, if the ship were lost at sea, only the owners and investors would recoup the insurance benefit. It’s a devious scheme that foreshadows how gig economy companies approach workers. But Nicholas doesn’t get into how this burden-shifting arrangement resembles how VC-backed Uber and Lyft forces drivers to pay for their own insurance.     

Nicholas is at his best when he is charting just how reliant venture capital has been on the government—and just how far the industry has gone to try and shape government policy in its favor. The very structure of VC firms—the limited liability partnership—was created by state governments in the nineteenth century, as a “conduit for wealthy investors.” When government policy got in the way of VC interests, investors lobbied. In the 1940s, the U.S. Securities and Exchange Commission allowed Doriot’s firm ARD to be labeled as in the “public interest,” to sidestep around investment restrictions, and get access to new capital. When ARD wanted to tap funds from the heavily regulated life insurance industry, it lobbied government officials to change laws that got in its way.

Over and over again, venture capitalists won favorable regulatory change. In the 1970s, they were able to win an amendment to the “prudent man” rule, which was designed to limit how much pension funds can risk members’ retirements on long-shot investments. And in the most recent Trump tax cut package, VCs
joined with other interest groups to preserve a special tax break, known as the “carried interest loophole,” which allows the funds to pay much lower tax rates than everyday wage earners.

Even as it worked to constrict tax revenues, VC has also benefited from taxpayer largesse, especially from military contracting after World War II. The ripple effects of these government contracts are still being felt today. After World War II, VC firms began seeing major returns by investing in technology developed by Fairchild Semiconductor, a firm that perfected the integrated circuit for missiles. Fairchild was propped up by major government contracts. And it used that government money to incubate much of the technical talent and financial acumen that made modern Silicon Valley. For example: two Fairchild men, Robert Noyce and Gordon Moore, went on to found Intel. Intel’s success, Nicholas proposes, and the money it made its VC investors, was a watershed moment for modern VC, a proof of concept for the investment form, that “attracted other entrepreneurs and venture capitalists to Silicon Valley to seek out wealth-making opportunities.”

Perhaps the most dominant contemporary VC firm, Sequoia Capital, was founded by Don Valentine, a salesman at Fairchild. Sequoia is now investing in Chinese facial recognition tech. But, that’s not to say that modern VC is moving away from the U.S. defense industry. As Jamie Martin points out in a review of Nicholas’s book in Bookforum, VC-backed tech firms are increasingly competing with old school defense contractors for U.S. military cash. Celebrity VC Peter Thiel’s company Palantir recently beat Raytheon for an $876 million contract, and Elon Musk’s SpaceX, backed by over $2 billion in VC money, is competing with Lockheed and Boeing’s joint venture, United Launch Alliance, for lucrative satellite contracts.

The love is flowing both ways: After leaving office in 2016, Barack Obama
mused that he may look for work in a Silicon Valley VC firm. Obama said that he found his conversations with VCs and Silicon Valley “really satisfying, and that the fields combined his interests in science and organization.” But perhaps he also sensed that power in society is shifting from the institutions he oversaw, to those that distribute private capital—it wouldn’t be the wrong read, even if it’s an unsettling one.