New Business Ideas: Venture Capital in America

In most circumstances, free market economies allocate capital through the mechanism of supply and demand. But how does capital get attracted to new ideas, that is, to the development and distribution of products and services that don't yet exist and for which there is, consequently, no demand, no supply, and hence no price? This is a critical question for an economy that wishes to be more than static, and it is the central question for an economy that wishes to lead the world in innovation, efficiency, growth, and power.

When Bill Gates and his team began to mess around with something called Windows, for example, few of us owned computers or could imagine why we might want to. And those few of us who did own them were using DOS and were perfectly happy with it.²⁰ Gates figured that computers were the future, and that if massive numbers of people were going to use computers, something far simpler than DOS had to be developed. He turned out to be right, but he could easily have been wrong. Where did he get his early capital for this odd idea?

The answer is the venture capital industry—in its broadest sense—which has a much longer history in America than is generally supposed. When we think back to the period between about 1870 and 1930, we tend to think of the great Captains of Industry (or, depending on our point of view, the Robber Barons): Carnegie, Morgan, Ford, Rockefeller, and so on. These men accumulated vast fortunes putting together the industrial enterprises that were required to meet the huge appetites of a rapidly industrializing United States. But, in retrospect, we can see that such figures could exist only during a brief period of time, a mere speck in the great sweep of history. Very quickly, the requirements for capital to build railroads, highways, steel mills, oil refineries, iron ore and coal mines, and other industries far outstripped the financial capacity of any one family. Only firms that could gain access to the public equity and debt markets could hope to continue to compete effectively. The Captains of Industry were, in effect, spectacular dinosaurs.

But something else was going on at about the same time that would persist far longer, namely, the support for new ideas and enterprises provided by wealthy individuals in the form of what we now think of as venture capital. The best known of these early venture capitalists was Andrew W. Mellon, then and now perhaps the greatest venture capitalist who ever lived. Mellon was one of the great industrial titans of the day (he controlled the Pennsylvania Railroad, for example), but he made his lasting impact on history through his support for a wide variety of new, start-up enterprises. Operating from the platform of the family bank (then known as T. Mellon & Sons, now Bank of New York Mellon), Mellon listened to many entrepreneurs pitch their ideas, and when he found one he liked, he backed the venture. Because these new enterprises were far too risky to justify a simple loan, Mellon took stock in the ventures as additional compensation.

Many of the new businesses failed, of course, but others grew into industrial behemoths that changed the landscape of American industry. Mellon's major venture capital successes included Gulf Oil Corporation, which rivaled Rockefeller's Standard Oil Company for control of the world oil markets; Alcoa, founded by Charles M. Hall, the inventor of the process to convert alumina to aluminum, and for many decades the world's largest producer of aluminum;²¹ Carborundum Company, founded by Edward Goodrich Acheson, the first manufacturer of synthetic abrasives, which were and are critical in the mining and extraction industries; and H. Koppers Company, founded by coke oven inventor Heinrich Kopper, which created an entire industry by transforming industrial waste into usable products such as gas, tar, and sulfur.

Beyond these spectacular and enduring venture capital successes, Mellon was also instrumental in the organization or growth of many other young enterprises, such as Standard Steel Car Company, McClintic-Marshall Company, Pittsburgh Coal Company, Pittsburgh Plate Glass (now PPG Industries), Crucible Steel Corporation, and so on. Mellon also founded the Union Trust Company and, of course, dominated Mellon Bank. Other companies controlled by Mellon, or in which he exercised substantial influence, included Eastern Gas and Fuel Associates, Brooklyn Union and Brooklyn Borough Gas, Duke-Price Company, Pullman, Incorporated (into which Mellon merged Standard Steel Car), Bethlehem Steel, United States Electric Power Corporation, United Light & Power, United Light & Railways, American Light and Traction, Westinghouse Electric Corporation, Niagara Hudson Corporation, the Pennsylvania Railroad, the American Rolling Mill Company, and the Philadelphia Company, which controlled Pittsburgh's public utilities.

Andrew Mellon's eye-popping success in his venture capital activities, and the lasting impact of his investments on the American economy, did not go unnoticed, and the venture capital industry as we know it today gradually evolved as other wealthy investors attempted to emulate Mellon's triumphs. As the industry matured, the players in the industry began to specialize, with some being responsible for identifying and nurturing new ventures (the general partners of venture capital, or VC, partnerships), while others were responsible for providing the capital (the limited partners). For decades, these limited partners were virtually all wealthy families. As the industry continued to mature, however, institutional investors got into the action.

Today, however, the well-known VC partnerships are not really in the business of backing true start-ups, which are far too risky for most of the institutional limited partners. In addition, start-ups don't require enough capital to attract the attention of major VC partnerships, which these days command hundreds of millions or even billions of dollars of capital. Instead, business start-ups in America²² continue to be underwritten almost exclusively by creative private capital. Entrepreneurs seek the earliest, smallest amounts of capital from the proverbial “friends and family” equity round: Money is raised by maxing out the entrepreneurs' credit cards and by tapping the capital of wealthier friends, neighbors, and family members. If all goes well, the fledgling business will seek out “angel” investors, wealthy individuals who enjoy backing and working with new businesses and with young (and not so young!) entrepreneurs. The next step may be to send a business plan to one of the many regional venture capital funds that almost every sizeable city boasts. Only when the business has passed all these hurdles is it likely to find favor with one of the larger VC partnerships.

Thus it is that from the founding of the venture capital business to the support for new business ideas being developed today, the only source of capital is the creative private capital that is made available only by wealthy investors. But notice one very odd aspect of the use of creative capital: It almost never provides a satisfactory return on investment in the usual sense of the word. This is obvious in the case of private philanthropy—however happy we might be with our “investment” in a nonprofit organization, we will never receive a return on our investment in the traditional sense. Our “returns” will come to us in other, nonfinancial ways.

And the same is generally true of the use of creative capital in the sense of backing for new business enterprises. At the most mature level of the VC industry, it turns out that only a tiny fraction of the hundreds of VC partnerships—the so-called top-tier funds—will ever produce an investment return that truly compensates investors for the risks they are assuming. And few investors will ever have the opportunity to invest with these top-tier firms. As we go down the VC ladder toward the regional venture capital partnerships, to the activities of angel investors, to the hapless “friends and family” who are the reluctant backers of most true start-ups, we find that almost no one receives even a positive return, much less a return that could begin to compensate for the risks. Indeed, many VC angels can spend a lifetime backing start-ups and never hit a double, much less a home run. For every local angel who backs a Google or a Cisco,²³ there are tens of thousands whose returns come, if at all, only in nonfinancial terms.

But, in both the case of private philanthropy and private venture capital, there is all the difference in the world between the return to the providers of the capital and the returns to society at large. The great good that accrues to society as the result of private charity and as the result of successful venture capital investments is obvious. But the same outcome results from the use of creative capital to back new business ventures that don't necessarily succeed in financial terms: The collective losses experienced by the providers of the capital are vastly, vastly outweighed by the enormous good that redounds to society from these activities.