“Organizing Venture Capital: The Rise and Demise of American Research and Development Corporation, 1946-1973,” D. Hsu & M. Kenney (2005)

Venture capital financing of innovative firms feels like a new phenomenon, and is clearly of great importance to high tech companies as well as cities that hope to attract these companies. The basic principle involves relatively small numbers of wealthy individuals providing long-term financing to a group of managers who seek out early-stage, unprofitable firms, make an investment (generally equity), and occasionally help actively manage the company.

There are many other ways firms can fund themselves: issuance of equity, investment from friends or family, investment from an existing firm in a spinoff, investment from the saved funds of an individual, or debt loans from a bank, among others. Two questions, then, are immediate: why does anyone fund with VC in the first place, and how did this institutional form come about? VC is strange at first glance: in a stage in which entrepreneur effort is particularly important, why would I write a financing contract which takes away some of the upside of working hard on the part of the entrepreneur by diluting her ownership share? Two things are worth noting. VC rather than debt finance is particularly common when returns are highly skewed – a bank loan can only be repaid with interest, hence will have trouble capturing that upside. Second, early-stage equity finance and active managerial assistance appear to come bundled, hence some finance folks have argued that the moral hazard problem lies both with the entrepreneur, who must be incentivized to work hard, and with the VC firm and their employees, who need the same incentive.

Let’s set aside the question of entrepreneurial finance, and look into history. Though something like venture capital appeared to be important in the Second Industrial Revolution (see, e.g., Lamoreaux et al (2006) on that hub of high-tech, Cleveland!), and it may have existed in a proto-form as early as the 1700s with the English country banks (though I am not totally convinced of that equivalence), the earliest modern VC firm was Boston’s American Research and Development Corporation. The decline of textiles hit New England hard in the 1920s and 1930s. A group of prominent blue bloods, including the President of MIT and the future founder of INSEAD, had discussed the social need for an organization that would fund firms which could potentially lead to new industries, and they believed that despite this social goal, the organization ought be a profit-making concern if it were to be successful in the long run.

After a few false starts, the ARD formed in 1946, a time of widespread belief in the power of R&D following World War II and Vannevar Bush’s famous “Science: the Endless Frontier”. ARD was organized as a closed-end investment trust, which permitted institutional investors to contribute. Investments tended to be solicited, were very likely to be made to New England firms, and were, especially in the first few years, concentrated in R&D intensive companies; local, solicited, R&D heavy investment is even today the most common type of VC. Management was often active, and there are reports of entire management teams being replaced by ARD if they felt the firm was not growing quickly enough.

So why have you never of ARD, then? Two reasons: returns, and organizational structure. ARD’s returns over the 50s and 60s were barely higher, even before fees, than the S&P 500 as a whole. And this overstates things: an investment in Digital Equipment, the pioneering minicomputer company, was responsible for the vast majority of profits. No surprise, then, that even early VCs had highly skewed returns. More problematic was competition. A 1958 law permitted Small Business Investment Corporations (SBICs) to make VC-style investments at favorable tax rates, and the organizational form of limited partnership VC was less constrained by the SEC than a closed-end investment fund. In particular, the partnerships “2 and 20” structure meant that top investment managers could earn much more money at that type of firm than at ARD. One investment manager at ARD put a huge amount of effort into developing a company called Optical Scanning, whose IPO made the founder $10 million. The ARD employee, partially because of SEC regulations, earned a $2000 bonus. By 1973, ARD had been absorbed into another company, and was for all practical purposes defunct.

It’s particularly interesting, though, that the Boston Brahmins were right: VC has been critical in two straight resurgences in the New England economy, the minicomputer cluster of the 1960s, and the more recent Route 128 biotech cluster, both of which were the world’s largest. New England, despite the collapse of textiles, has not gone the way of the rust belt – were it a country, it would be wealthier per capita than all but a couple of microstates. And yet, ARD as a profitmaking enterprise went kaput rather quickly. Yet more evidence of the danger of being a market leader – not only can other firms avoid your mistakes, but they can also take advantage of more advantageous organizational forms and laws that are permitted or created in response to your early success!

Final published version, in Industrial and Corporate Change 2005 (RePEc IDEAS).

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