CHAPTER 2

A LOOK BACKWARDS

Before exploring how governments can help entrepreneurs, it is important to understand if they can be effective at all. In the next three chapters, we will explore the major justifications for public intervention to promote entrepreneurship and venture capital. We’ll begin by posing questions that doubtless will be in the back of many readers’ minds: most pressingly, how can we reasonably expect government officials to help freewheeling entrepreneurs and venture investors?

In this chapter, we’ll seek to answer this question by exploring a few episodes from the history of entrepreneurship. By examining the history of pioneering entrepreneurial regions and venture funds, we’ll see that they are not just creations of “capitalist cowboys” chasing profits. In each case, there were many parents, including government agencies and public-spirited citizens with a broad set of goals. Together, these stories suggest that a skeptical doubt that government has any role in promoting entrepreneurship is too simple.

A SKEPTIC’S QUERIES

The skeptic might well wonder why there is a need for government encouragement for entrepreneurship and venture capital. During the past three decades, there has been a tremendous boom in the economic role of high-growth entrepreneurial firms and the venture capitalists who fund them.

This growth is seen most dramatically among venture funds, since they are tracked more carefully than entrepreneurial ventures. The pool of U.S. venture capital funds grew from about $1 billion in 1980 to about $100 billion in 2008. Venture capital’s growth over that period has outstripped that of almost every class of financial product (one exception is its close cousin, buyout funds, which have grown even faster). This is captured in figure 2.1, which shows the growth of venture activity worldwide.¹

Figure 2.1. Venture capital investment worldwide, 1992 to 2007

Moreover, where such funds are located is also becoming more diverse and global. Venture capital was originally concentrated almost exclusively in a few small corners of the developed world, such as Silicon Valley, the western suburbs of Boston, and around Cambridge University in England. The venture industry in 1996, as figure 2.2 illustrates, was very much dominated by activity in the United States.² The same was true of most years before and since. In recent years, however, venturing activity has become far more global. While the United States still captured the lion’s share of funding, by 2007 the share of funding heading to Asia—especially China and India—and other markets from Toronto to Tel Aviv was growing rapidly.

Figure 2.2. Geographic distribution of venture capital, 1996 and 2007

These data reflect the increasingly global focus of entrepreneurial activity. Through the 1990s, many venture capital funds—particularly those in Silicon Valley—had an extremely parochial view, wishing only to invest in firms within a few miles of their office. Attitudes have changed dramatically in recent years, as groups have taken increasingly global perspectives. Steps taken include increasing the share of investments outside their native countries or regions, creating overseas funds in addition to their domestic ones, and forming strategic partnerships with non-U.S. groups.

Moreover, scientists and engineers, who in the 1990s saw in the United States their only opportunity to pursue a cutting-edge start-up, are increasingly involved in ventures in their native lands as financiers, advisors, or on-the-ground entrepreneurs. Expatriates are important sources of new ideas and capital for ventures: for instance, a surge of Indian-born entrepreneurs doing research in semiconductors in the United States is likely to lead to a boom a few years later in similar ventures in India.³

A more subtle reason for being skeptical of the need for public intervention lies in the variations in figure 2.1. The sector has been characterized by a pattern of boom and bust: the rapid increases in fund-raising in the mid-1980s and late 1990s were followed by precipitous declines in, respectively, the early 1990s and early 2000s. Indeed, if our data took us back that far, we’d probably see the same patterns on a smaller scale in the 1950s and 1960s! In many cases, groups raised huge amounts of capital that they invested foolishly, either funding entrepreneurs who never should have raised capital in the first place, or else giving far too much money to promising entrepreneurs.

This instability has been part and parcel of the funding of new ventures. For instance, during the 1980s venture capitalists backed many of the most successful high-technology companies, including Cisco Systems, Genentech, Microsoft, and Sun Microsystems. But the industry did not present a picture of smooth growth: commitments to the venture capital industry during this decade were very uneven. The annual flow of money into venture capital funds increased by a factor of ten during the first half of the 1980s, but steadily declined from 1987 through 1991 as investors grew disappointed with the sector.

Figure 2.3. U.S. venture capital returns, 1974 to 2007

Much of this pattern of excitement and disillusionment was driven by the changing fortunes of venture capital investments. Returns on venture capital funds declined sharply in the mid-1980s after being exceedingly attractive in the 1970s. (See figure 2.3 for returns from U.S. venture funds over these years.)⁴ This fall was apparently triggered by overinvestment in a few industries, such as computer hardware, and the entry of many inexperienced venture capitalists. The same cycle was seen among the pioneering funds geared toward European and Japanese entrepreneurs over the same period.

The 1990s saw these patterns repeated on an unprecedented scale. Much of the decade saw dramatic growth and excellent returns in almost every part of the venture capital industry. This recovery was triggered by several factors. The exit of many inexperienced investors at the beginning of the decade meant that the remaining groups faced less competition for transactions. The healthy market for the initial public offerings during much of the decade meant that it was easier for all investors to exit venture capital transactions. Meanwhile, the extent of technological innovation—particularly in industries related to information technology—created extraordinary opportunities for venture capitalists. New capital commitments to venture funds rose in response to these changing circumstances, increasing to record levels by the year 2000.

But as had often happened before, venture activity increased at a pace that was unsustainable. Institutional and individual investors—attracted by the tremendous returns enjoyed by venture funds—poured money into the industry at unprecedented rates. In many cases, groups staggered under the weight of capital. In other cases, groups that should have not raised capital garnered considerable funds.

Too rapid growth led to overstretched partners, inadequate due diligence, and, in many cases, poor investment decisions. Thus, we saw such scenes as venture capitalists driving around Silicon Valley, handing out checks after printing up deal documents in their car trunks. The behavior of entrepreneurs was even less restrained: think of Internet entrepreneurs in the late 1990s throwing Christmas parties with Cristal champagne, buying impossible-to-understand advertisements on the Super Bowl for many millions of dollars, and moving into extravagant marble-clad offices.⁵

While the pattern seen in figure 2.1 was largely driven by activity in the United States and western Europe, the dramatic boom and bust of investment is certainly not unique to the developed world. Figure 2.4 shows the level of venture capital and growth equity investment in China and Hong Kong.⁶ Here again, we see the same ebb and flow (similar patterns could be seen in many other markets, from Latin America to eastern Europe).

And this brings us back to the public sector. In an ideal world, we might think, public investors would even out these variations, encouraging investments at times when there are few, and stepping back when the market overheats. But given the tendency of some politicians to jump on the bandwagon at exactly the moment it careens off the road, can we trust them here? We can reasonably worry that government officials will only worsen this boom-and-bust pattern, by throwing money at these ventures at precisely the wrong times.

Figure 2.4. China and Hong Kong private equity activity, 1992 to 2007

Consider some past examples, such as the Chinese venture market.⁷ The boom in the late 1990s and early 2000s was largely fueled by investors in the United States and western Europe, who were attracted to the tremendous growth potential of the Chinese market despite the immaturity of the sector and lack of experienced venture professionals. As the money flowed in, the market came under many strains, including rising valuations. Many of the groups that had raised overseas money were unable to maintain a disciplined focus: for instance, Chengwei Ventures made ten investments in its first year of operation, often in very young Internet companies, despite having marketed itself to investors as undertaking extensive due diligence and having a hands-on approach to investing.⁸

Given this period’s tremendous increase in activity—and the associated growing pains—one might expect the public sector to see little need to stimulate investment. But a wide variety of state-related entities, from provincial and municipal governments to state-owned enterprises, launched venture initiatives around this time. While a few groups backed with public funds, such as New Margin (funded by the Shanghai municipal government), proved to be enduring successes, the vast majority were unsuccessful. Public funds simply poured fuel on the fire, overheating this rapidly growing market. Again, the role of the public sector in stimulating venture activity raises troubling questions.

THE (UNCENSORED) STORY OF SILICON VALLEY

However compelling the skeptical questions delineated above may appear, they are too simple. In this chapter, we will consider the historical record and what it tells us about the role of government in stimulating venture activity.

The limitations of the skeptic’s view can perhaps best be illustrated through the story of Silicon Valley. This example may seem surprising, as it might be thought that the role of the public sector was minimal here—that it was the rugged individualism of entrepreneurs and venture capitalists that established the region.

Certainly, this is the story that many Silicon Valley luminaries love to tell. T. J. Rodgers, the colorful founder of Cyprus Semiconductor, has stated, “Silicon Valley is an island of freedom and free markets, more in line with 1776 America and its laissez faire government than with America [today] and its interventionist government.… I do not want more government in Silicon Valley. Government can do only two things here: take our money, limiting our economic resources; or pass laws, limiting our other freedoms.”⁹ But the reality is a bit more complex, as a brief history of Silicon Valley reveals.¹⁰

Many narratives of the history of Silicon Valley begin with 1955, when William Shockley founded Shockley Transistor in Palo Alto, which would soon in turn spawn Fairchild Semiconductor and much of the modern semiconductor industry. Other accounts extend back to 1938, when Frederick Terman, dean of Stanford’s Engineering School, encouraged (and indeed, directly assisted in financing) his students William Hewlett and David Packard to found Hewlett-Packard. The powerful culture that drove Silicon Valley during its growth over the past few decades—with close ties between local universities and start-up firms, the absence of legal or social barriers to job-switching, an active venture community to finance new entities, and a willingness to work with young firms—has also been rightly celebrated by Annalee Saxenien and other authors.

At the same time, it is important to note that the story of Silicon Valley’s creation is more complex than many of these accounts, which often rest upon what Timothy Sturgeon calls “the myth of ‘instant industrialization.’”¹¹ In particular, a review of the histories of Silicon Valley suggests two facts that are little appreciated. First, the culture of, and approach to, doing business in Silicon Valley was profoundly shaped by the pioneering firms in the early decades of the twentieth century. Second, the public sector, especially the U.S. Department of Defense, played a crucial role in accelerating the early growth of the region.

The first point can be illustrated by the early history of Silicon Valley. As documented by Sturgeon, the first three decades of the twentieth century saw a series of pioneering technology firms in the Bay Area. These included Federal Telegraph Company, Magnavox, Fisher Research, Litton Engineering Research, and Heintz & Kaufman. While the level of activity was modest relative to contemporary ventures in the eastern United States, these entities established the template that other groups would follow in decades to come. Among the elements that would be commonplace in subsequent years were the following:

•  The active involvement of Stanford University as a source of technology and funding. Cyril Elwell, a Stanford graduate, raised initial financing for Federal Telegraph in 1909 with the help of Stanford’s president and the head of its civil engineering department, and later made extensive use of the Stanford High Voltage Laboratory.¹² In the 1930s, Frederick Terman would play a key role in nurturing Hewlett-Packard and Litton Engineering.¹³

•  The proliferation of spin-offs. Federal Telegraph produced a number of new firms, when employees left to pursue seemingly tangential technologies or explore new markets. As early as the formation of Magnavox’s speaker business in 1910, this form of company creation, which would become part and parcel of the Silicon Valley way of doing business,¹⁴ was established. Metal detector manufacturer Fisher Research and Litton Engineering Laboratories (which began as a vacuum tube manufacturer before evolving into Litton Industries) were two other Federal Telegraph spin-offs during the interwar years.¹⁵

•  The reliance on local financiers for capital. While the formal venture industry was several decades away from forming in California, wealthy angel investors such as William Crocker and Henry Mc-Micking played an important role in financing firms.¹⁶

The second point is that, especially during these early years, the government played a critical role in shaping Silicon Valley. Many of these pioneering firms relied on military contracts to get established and grow. Examples of firms and activities that benefited materially include Federal Telegraph and Magnavox during World War I and the years thereafter; Ralph Heinze’s pioneering work on airplane-based power systems between the world wars; Dalmo-Victor, Hewlett-Packard, and Litton Engineering during World War II; and Varian Associates during the Korean War.

The success that Silicon Valley firms experienced during wartimes reflected several factors. First, in light of the dominant patent portfolios that incumbent firms (especially RCA) had assembled in civilian technologies (such as radio), Silicon Valley firms tended to focus instead on military electronics and advanced electronic instruments. Second, geographical circumstance was an important factor, especially during the critical years of World War II. Santa Clara County (the epicenter of what would become Silicon Valley) was convenient to major defense facilities and manufacturers in Oakland, Richmond, and San Francisco; and, of course, its proximity to the Pacific Ocean was helpful in light of the focus on fighting the Japanese.¹⁷

It should be acknowledged that this federal funding was a mixed blessing. Typically, funding for research and orders would grow rapidly during wartime, only to be abruptly cut upon the end of hostilities: hardly ideal for managing a growing firm. The more successful firms in the region were able to reinvent themselves during the times of these cutbacks; others languished or were sold.

Despite these limitations, Terman continued to focus on military markets in the years after World War II. In particular, he argued that the share of federal contracts going to Stanford and Bay Area businesses was unfairly low, given the level of technical sophistication and the production of engineering Ph.D.s. Stanford helped address this deficiency by establishing the Stanford Research Institute, whose goal was to conduct defense-related research and assist local businesses to break into these markets. Indeed, many of the pioneering firms of the “modern” Silicon Valley, such as Fairchild Semiconductor, relied on government contracts for much of their initial growth.¹⁸

These comments are not meant to minimize other creative endeavors that Terman and his contemporaries pursued and that helped put Silicon Valley on the map. The attraction to the Stanford campus of select teams of scientists pursuing highly visible, cutting-edge technologies, the creation of an industrial park nearby the university, and the encouragement of cooperative programs where students could work with cutting-edge local firms all boosted the region and its stature.

Despite these examples of private initiatives, it is important to note that the world Rodgers describes is unrealistically simplistic. The public sector did play a key role in shaping the evolution of Silicon Valley, particularly in its earlier years. The impact of public funding, to be sure, was considerably less during the years of spectacular growth, the late 1970s and the 1980s. But in many senses, federal money played a crucial role when it mattered most: during the period when the foundation for that spectacular growth was being built and key aspects of the Silicon Valley business culture were being developed and refined.

THE BIRTH OF VENTURE CAPITAL

Not only was the formation of the entrepreneurial cluster of Silicon Valley driven in key respects by public sector intervention, but so too was the venture capital industry itself.

Of course, fast-growing firms were able to raise financing before the creation of the venture industry. Banks provided debt in the form of loans, and for more long-run, riskier investments, wealthy individuals provided equity. By the last decades of the nineteenth century and the first decades of the twentieth century, wealthy families had established offices to manage their investments. Families such as the Phippes, Rockefellers, Vanderbilts, and Whitneys invested in and advised a variety of business enterprises, including the predecessor entities to AT&T, Eastern Airlines, and McDonnell Douglas.

But by the time of the Great Depression of the 1930s, there was a widespread perception that the existing ways of financing fast-growing young firms were inadequate.¹⁹ Not only were many promising companies going unfunded, but investors with high net worth frequently did not have the time or skills to work with young firms to address glaring management deficiencies. Nor were the alternatives set up by the Roosevelt administration during the New Deal—such as the Reconstruction Finance Corporation—seen as satisfactory. The rigidity of the loan evaluation criteria, the extensive red-tape associated with the award process, and the fears of political interference and regulations all suggested a need for an alternative.

The first formal venture capital firm was thus established with a broader set of goals in mind than just making money.²⁰ American Research and Development (ARD) grew out of the concerns that the United States, having been pushed out of the depression by the stimulus of wartime spending by the federal government, would soon revert to economic lethargy when the war ended. In October 1945, Ralph Flanders, then head of the Federal Reserve Bank of Boston, argued that if this danger was to be addressed, a new enterprise was needed, with the goal of financing new businesses. He argued that the enterprise would not only need to be far more systematic in “selecting the most attractive possibilities and spreading the risk” than most individual investors had been, but would need to tap into the nation’s “great accumulation of fiduciary funds” (i.e., pension funds and other institutional capital) if it was to be successful in the long term.²¹

ARD was formed a year later to try to realize this vision. Flanders recruited a number of civic and business leaders to join in the effort, including MIT president Karl Compton. But the day-to-day management of the fund fell on the shoulders of Harvard Business School professor Georges F. Doriot. ARD in its communications emphasized that its goal was to fund and aid new companies in order to generate “an increased standard of living for the American people.” While profitability was a goal of the effort, in the words of Pat Liles, financial returns “were not the overriding purpose of the firms. Instead, they were depicted as a necessary part of the process.”²²

This tension between the broader social goals and financial returns ran through ARD’s first two decades. In part, these dual goals reflected the tensions inherent in being a public company. Despite Flanders’s emphasis on institutional capital, because of limited interest ARD had been able to raise its initial $5 million only by completing a public offering. (The first venture capital limited partnership, Draper, Gaither, and Anderson, was not formed until 1958.) Many of the investors—perhaps having been persuaded by overzealous brokers to buy the shares—had not appreciated the extended time period that it would take to realize capital gains or other profits from the early-stage companies that dominated ARD’s portfolio. Doriot, as a result, spent much of the 1950s and 1960s defending the longer-run objectives of the fund. In Fortune’s rather unsympathetic portrait of ARD in 1967, Doriot was quoted: “Your sophisticated shareholders make five points and then sell out. But we have our hearts in our companies, we are really doctors of childhood diseases here. When bankers or brokers tell me I should sell an ailing company, I ask them, ‘Would you sell a child running a temperature of 104?’”²³

The same tension underlay the next great experiment to promote venture activity, the Small Business Investment Companies (SBICs). These federally guaranteed risk-capital pools proliferated during the 1960s, and accounted for the bulk of all venture capital raised during these years.²⁴

The rationale for these entities was similar to that invoked by Doriot: numerous promising entrepreneurs were unable to garner the capital needed to commercialize their ideas. But in one important respect the SBICs were unlike the pioneering efforts of the 1930s: legislators realized that government bureaucrats—no matter how well intentioned—were probably not the right people to make the tricky decisions about which businesses to fund. Instead, this responsibility would be put in the hands of the private sector.

As enacted in 1958, the SBICs received two powerful mandates: they could borrow up to half their capital from the federal government and would also receive a variety of favorable tax incentives. In return, the SBICs had to confine themselves to investing in small businesses. More onerously, the investments were limited to those structured in certain ways: for instance, the SBICs could not hold equity in firms (though the debt could be convertible to equity), and their control over these firms was also restricted. Moreover, steps that seem like second nature to venture capitalists—such as offering stock options to employees of the firms—were sharply restricted.

These features of the SBIC program were criticized by knowledgeable observers even before the legislation enabling the funds was enacted. The criticism of the program intensified in the early 1960s, when a large number of SBICs were financed, often with minimal review. The entities receiving charters and loans from the government included some run by inexperienced financiers who undertook lines of business very different from those originally intended by Congress—such as real estate development—and corrupt funds determined to make “sweetheart” financings to dubious businesses run by friends, relatives, and, in a few cases, organized crime. Nine out of ten SBICs violated federal regulations in some way.²⁵ The SBIC program consequently drew extensive congressional criticism for low financial returns and for fraud and waste. Despite some wavering, the officials responsible for the program (and the executive branch more generally) remained committed to it and resisted calls to dismantle it.

Viewed with the benefit of hindsight, however, the legacy of the program from the 1950s and 1960s looks quite different. Though few of today’s significant funds began as a part of the SBIC program, it did stimulate the proliferation of many venture-minded institutions in Silicon Valley and Route 128, the nation’s two major nurseries of entrepreneurs. These institutions included law firms and accounting groups geared specifically to the needs of entrepreneurial firms. For example, Venture Economics, which originated as the SBIC Reporting Service in 1961, gradually expanded its scope to become the major source of returns data on the entire venture industry. Moreover, some of the United States’ most dynamic technology companies—including Apple Computer, Compaq (now part of Hewlett-Packard), and Intel—received support from the SBIC program before they went public. Similar lessons could be drawn from programs modeled after the SBIC program in other nations such as China and Singapore.

This applause for the catalytic role of the SBIC program, however, is not meant to suggest that it remains a useful program.²⁶ Like far too many public entrepreneurship and venture capital programs, it has proven virtually impossible to “kill off.” It continues despite the fantastic growth of venture capital in recent decades and ample evidence that the bureaucratic rules associated with the program have scared off most talented venture capitalists. (For instance, arcane rules govern the type of securities that can be used by the venture funds participating in the program, the extent to which they can give follow-on financings to firms in their portfolios, and their holding periods.) Moreover, the consequences of the program remain remarkably unexamined, despite the considerable amount of funds that have gone into the effort over the years. The Specialized SBIC program, which is geared toward minority businesses, proved almost impossible even to modify, notwithstanding the extremely high failure rate of funds in that program’s first three decades.²⁷ In chapter 7, we’ll talk about how this failure to seriously review the program runs counter to best practices.

Even the dramatic growth of the venture industry in the late 1970s and early 1980s can be attributed in large part to the public sector. Much of the shift was owing to the U.S. Department of Labor’s clarification of the Employee Retirement Income Security Act’s “prudent man” rule in 1979. Prior to that year, legislation restrained pension funds from investing substantial amounts of money in venture capital or other high-risk asset classes. The Department of Labor’s clarification of the rule explicitly allowed pension managers to invest in high-risk assets, including venture capital. Numerous specialized funds—concentrating in such areas as leveraged buyouts and mezzanine transactions and such hybrids as venture leasing—sprang up during these years.

The same pattern, where government intervention played a crucial role, was repeated in many other nations, from Germany to India. Consider, for instance, 3i Group plc, one of the oldest private equity groups in Europe.²⁸ Its most direct predecessor, the Industrial and Commercial Finance Corporation (ICFC), was founded in 1945 by political and financial leaders to provide long-term capital for small and medium-sized firms, to help domestic industry recover from the ravages of World War II and the Great Depression that had preceded it. The Bank of England and the five major clearing banks at the time funded the effort with £10 million in equity ownership, in effect establishing a future competitor.

ICFC initially used both debt and equity to fulfill its mandate. This was a tricky proposition, as assessing the long-term prospects of small private businesses was not a widely held skill. Operating among small to medium-sized businesses that were often family-owned and had little history of external funding, the new organization had to invent not just itself, but also an entire skill set.

Under Lord William Piercy, its first chairman, ICFC became somewhat of a financial maverick and an innovator, working across much of the economy and injecting a new measure of competition into London’s financial circles. For instance, in the early 1950s, ICFC significantly undercut the prevailing fees charged to underwrite stock issues for medium-sized companies. Despite the controversy this pricing generated, the organization developed a substantial underwriting business during that decade, even as the market rate for such services dropped by half. By the mid-1990s, having largely transformed the investment banking market, 3i had essentially ceased underwriting.

ICFC helped create a greater awareness of the power and usefulness of equity for small companies, especially those that were family-owned. Starting in 1950, ICFC saw the chance to drive growth by expanding into regions outside London, moving first into Birmingham and then, by 1953, into Manchester and Edinburgh. The local offices were encouraged to make independent investment decisions, but also bore responsibility for them. This expanding branch network (twenty-nine offices by 1972) and devolved decision-making contrasted with the clearing banks’ strategy of centralized decision-making and reduced attention to small regional businesses.

Over the years, the firm (renamed 3i) expanded the classes of investments it made—for instance, moving into buyouts and early-stage venture capital. It backed a number of companies that became significant successes, including Bond Helicopters, Caledonian Airways (later British Caledonian), and Oxford Instruments, the pioneer of magnetic resonance imaging (MRI).

Over the years, 3i’s dominant position as the primary provider of equity capital to private British businesses eroded. Additional venture capital and private equity groups entered the market, in a number of cases (for instance, Apax and Permira) experiencing growth that far outstripped that of 3i. Meanwhile, 3i transformed itself, in some ways increasingly resembling other venture groups (i.e., dropping some of the far-flung product lines, like consulting and ship financing) and in other ways, becoming more peculiar (going public on the London Stock Exchange). But it remains an enduring financier of private firms of different degrees of development. The bottom line is clear: not only did public intervention establish a viable investor in 3i, but it established a template that many other firms, operating without the benefits of public financing, were able to follow.

WRAPPING UP

I began this chapter by giving voice to a skeptic, who wondered about the likelihood that government intervention could make a difference. But the historical episodes reviewed here suggested a more complex picture.

In particular, we saw that Silicon Valley was far from a creation of unfettered capitalism. Rather, public subsidies—particularly during the two world wars—catalyzed its growth and shaped its critical features. Similarly, the pioneering firms in the venture industry were initially shaped largely by government interventions and public-spirited citizens. While government invention wasn’t the entire story, it provided an important spur.

Moreover, these experiences are the rule rather than the exception. As noted in the introduction, virtually every hub of cutting-edge entrepreneurial activity in the world today had its origins in proactive government intervention. Similarly, the venture capital industry in many nations has been profoundly shaped by government intervention.

In the next two chapters, we’ll look at systematic arguments explaining why government has an important role to play in the development of entrepreneurship. As we’ll see, there’s a considerable rationale for public intervention. But important cautions must also be raised.