Venture capital

Based on Wikipedia: Venture capital

In 1957, a company called American Research and Development Corporation made a bet on a tiny startup called Digital Equipment Corporation. They invested what seemed like a reasonable sum at the time. Eleven years later, when Digital Equipment went public, that investment had multiplied by more than 1,200 times. The annualized return was 101 percent per year.

That single investment helped define an entire industry.

What Venture Capital Actually Is

Venture capital is a specific flavor of private equity—money from investors pooled together to buy ownership stakes in companies. But while most private equity focuses on established businesses, venture capital chases the opposite: young, unproven companies with enormous potential and equally enormous risk of failure.

The basic mechanics are straightforward. A venture capital firm raises a fund from investors—pension funds, university endowments, wealthy individuals, and other institutions. The firm then deploys that money into startups, usually in exchange for a significant ownership stake. The venture capitalists don't just write checks and walk away. They typically get seats on the company's board of directors, influence over major decisions, and a deep involvement in shaping the business.

The goal is what industry insiders call an "exit"—a moment when the startup becomes valuable enough that the investors can sell their shares and realize a return. This might happen through an initial public offering, where the company sells shares to the general public on a stock exchange. It might happen through an acquisition, where a larger company buys the startup. Either way, the venture capitalists are looking to transform their early, risky bet into a substantial profit.

Most of those bets fail. Startups, by their nature, are attempting something new in markets that don't yet exist or against competitors with enormous advantages. The uncertainty is immense. A venture capitalist expects most investments in a portfolio to return nothing or nearly nothing. The business model depends on a small number of spectacular successes—companies that return ten, twenty, or a hundred times the initial investment—to compensate for all the failures.

The Stages of Startup Funding

Startup financing follows a predictable sequence, each stage marked by increasing maturity and decreasing risk.

It begins with seed funding—the earliest money a company raises, often before it has a product, customers, or sometimes even a fully formed business plan. Seed money might come from the founders themselves, from friends and family, from angel investors (wealthy individuals who invest their personal funds), or from venture capital firms that specialize in early-stage bets. This money typically funds the basics: building a prototype, conducting initial market research, or simply keeping the founders fed while they work on their idea.

If the startup survives and shows promise, it moves to what's called a Series A round. This is typically the first significant institutional investment—the moment when a professional venture capital firm commits substantial capital to fuel growth. Series A funding might be used to hire the first real employees, launch a product to market, or begin scaling operations.

Subsequent rounds follow the alphabet: Series B, Series C, and onward. Each represents a larger infusion of capital at a higher company valuation. By the later rounds, the company has usually proven its business model and is raising money to accelerate growth, expand into new markets, or prepare for an eventual public offering.

A company that reaches a valuation of one billion dollars earns the Silicon Valley nickname "unicorn"—a reference to both the rarity and the mythical quality of such success. As of mid-2024, roughly 1,250 companies worldwide had achieved this distinction. That sounds like a lot until you consider the hundreds of thousands of startups attempting to join their ranks.

The Aristocratic Origins

Before venture capital became a professional industry, it was essentially a hobby for the extremely wealthy. Families with names like Rockefeller, Vanderbilt, Whitney, and Warburg would invest portions of their fortunes in promising private companies—sometimes out of financial interest, sometimes out of personal fascination with a technology or entrepreneur.

Consider Laurance Rockefeller, grandson of Standard Oil founder John D. Rockefeller. In 1938, he helped finance both Eastern Air Lines and Douglas Aircraft. Aviation fascinated him, and his family's fortune allowed him to back that fascination with substantial capital. The Rockefellers held stakes in dozens of companies across multiple industries.

Eric Warburg, scion of the German-American banking dynasty, founded E.M. Warburg & Company in 1938—a firm that would eventually evolve into Warburg Pincus, one of the largest private equity firms in the world. The Swedish Wallenberg family, through their investment company Investor AB, backed companies like ABB, Atlas Copco, and Ericsson in their early years.

These wealthy families had three things that made them natural venture investors: capital to deploy, social connections to promising entrepreneurs, and the financial cushion to absorb losses from failed investments. What they didn't have was a systematic approach. Each investment was essentially a personal project.

The Birth of Professional Venture Capital

The industry's transformation began in 1946, immediately after World War II ended, in a confluence of patriotism, financial innovation, and academic ambition.

Georges Doriot was a French-born professor at Harvard Business School who had served as a general in the U.S. Army during the war, heading the military's research and development planning. As soldiers returned home, he saw both a problem and an opportunity. These veterans had technical skills, ambition, and ideas—but no capital to start businesses. Traditional banks wouldn't lend to unproven entrepreneurs with no track record or collateral.

With Ralph Flanders, a businessman and future senator, and Karl Compton, the president of the Massachusetts Institute of Technology, Doriot founded American Research and Development Corporation—ARDC. The company had a mission that blended capitalism with civic purpose: channel private investment into businesses run by returning veterans.

ARDC broke new ground in several ways. It was the first investment firm focused on early-stage companies to raise money from institutional sources rather than wealthy families. Unusually for the industry that would follow, it was publicly traded—anyone could buy shares and participate in its investments.

The firm invested in over 150 companies during its existence. Most of those investments returned modest gains or losses. But the 1957 investment in Digital Equipment Corporation changed everything. Digital Equipment pioneered the minicomputer—smaller, cheaper computers that businesses could afford without the massive infrastructure required by mainframes. When the company went public in 1968, ARDC's stake was worth over 355 million dollars.

Georges Doriot earned the title "father of venture capitalism" not just for founding ARDC but for training the generation that would build the modern industry. Alumni from ARDC went on to establish Greylock Partners, Charles River Ventures, Fidelity Ventures, and other firms that would define the sector.

The Other 1946 Pioneer

The same year Doriot founded ARDC, another firm emerged with a different lineage but similar ambitions.

John Hay Whitney came from American aristocracy—his grandfather had been Secretary of the Navy under President Grover Cleveland, and his family's fortune derived from streetcar lines, oil, and tobacco. Whitney had been making private investments since the 1930s, including founding Pioneer Pictures (an early Technicolor film studio) and investing in the Technicolor Corporation itself with his cousin Cornelius Vanderbilt Whitney.

In 1946, Whitney and his partner Benno Schmidt formally established J.H. Whitney & Company as an institutional investment firm. Their most famous investment turned out to be Florida Foods Corporation, a company that had developed a process for concentrating orange juice. The product eventually reached consumers under the name Minute Maid and was sold to Coca-Cola in 1960.

The Whitney firm showed the industry that venture investing could work both as a personal pursuit of the wealthy and as a structured business with professional management. The firm continues operating today, having raised hundreds of millions of dollars across multiple institutional funds.

Government Helps Build an Industry

A crucial turning point came in 1958 when Congress passed the Small Business Investment Act. The law authorized the Small Business Administration to license private firms called Small Business Investment Companies—SBICs—that would help finance and advise small entrepreneurial businesses.

The appeal for investors was substantial tax benefits that made losses less painful and gains more rewarding. The program created a template for how venture capital firms could structure themselves to attract institutional money while maintaining flexibility in their investments.

Through the 1950s, assembling a venture capital deal typically required cobbling together several partners and organizations—a cumbersome process that limited how many investments any firm could make. The SBIC program helped standardize structures and legitimize the entire concept of investing in unproven companies.

Silicon Valley Finds Its Name

During the 1960s, venture capital increasingly became associated with technology companies—particularly those emerging from the semiconductor industry in Northern California.

Arthur Rock, often credited with popularizing the term "venture capitalist," played a pivotal role in one of the foundational moments of Silicon Valley. In 1957, eight engineers at Shockley Semiconductor Laboratory—known to history as the "traitorous eight"—wanted to leave and start their own company. Rock, then working at an investment bank in New York, helped them find backing and establish Fairchild Semiconductor.

Fairchild became a seedbed for the entire semiconductor industry. Engineers who trained there went on to found Intel, AMD, and dozens of other companies. The pattern—successful company spawns alumni who start new successful companies—would repeat throughout Silicon Valley's history.

Early West Coast venture firms emerged to capitalize on this ferment. Draper and Johnson Investment Company started in 1962. Sutter Hill Ventures followed in 1965. These firms had a geographic advantage: proximity to Stanford University, to the semiconductor companies clustered in what would become known as Silicon Valley, and to the engineers and entrepreneurs they wanted to back.

The Structure That Still Exists

The 1960s also saw the emergence of the organizational structure that dominates venture capital today: the limited partnership.

Here's how it works. A venture capital firm organizes itself as a "general partner" that manages the fund. Investors—pension funds, endowments, wealthy individuals—commit capital as "limited partners." The limited partners provide the money but don't make investment decisions; the general partners deploy the capital and manage the portfolio companies.

The compensation structure has remained remarkably stable since it emerged. General partners typically receive an annual management fee—usually between one and two and a half percent of the total fund—to cover salaries and operating costs. They also receive "carried interest," typically twenty percent of any profits the fund generates above the initial capital.

This structure aligns incentives in important ways. The management fee keeps the lights on, but the real money comes from carried interest—so general partners only get wealthy when their investments succeed. Limited partners get professional management without having to develop expertise in selecting and nurturing startups.

Sand Hill Road Becomes the Center

In 1972, a new venture firm opened an office on Sand Hill Road in Menlo Park, California. The firm was Kleiner Perkins, founded by Eugene Kleiner (one of the original "traitorous eight" from Fairchild Semiconductor) and Tom Perkins. That same year, Don Valentine founded Sequoia Capital nearby.

The location was not accidental. Sand Hill Road sits between Stanford University and the Santa Clara Valley—the heart of what was rapidly becoming the global center of the semiconductor and computer industries. Venture capitalists could take a meeting at Stanford in the morning, have lunch with an engineer at Intel, and visit a portfolio company in the afternoon, all within a few miles.

Over the following decades, Sand Hill Road became synonymous with venture capital itself. Dozens of firms established offices along the road and its vicinity. The concentration created a ecosystem: entrepreneurs knew where to pitch their ideas, venture capitalists could easily compare notes on deals, and the networking effects amplified success.

In 1973, leading venture capitalists formalized their industry by creating the National Venture Capital Association, a trade group that would advocate for favorable policies and establish professional standards.

The Pension Fund Revolution

Venture capital nearly died in its infancy.

In 1974, the stock market crashed and took investor confidence with it. The same year, Congress passed the Employee Retirement Income Security Act—ERISA—which imposed strict rules on how corporate pension funds could invest their assets. The law initially prohibited pension funds from putting money into risky assets, including investments in privately held companies.

This was a potentially fatal blow. Pension funds represented an enormous pool of capital—trillions of dollars that needed to be invested somewhere. If venture capital couldn't access that pool, it would remain a niche pursuit for wealthy families and a handful of specialized institutions.

The rescue came in 1978 when the Department of Labor reinterpreted ERISA's restrictions. Under what became known as the "prudent man rule," pension funds could invest in venture capital and other alternative assets as long as such investments represented a reasonable part of a diversified portfolio. Money flooded into the sector.

That year, venture capital firms raised approximately 750 million dollars—a record at the time. The industry had found its permanent source of capital.

The Golden Age and Its Discontents

The late 1970s through the mid-1980s marked venture capital's first golden age. The public successes were spectacular: Digital Equipment Corporation had demonstrated what was possible, and now Apple Computer, Genentech, and dozens of other venture-backed companies were going public to enormous returns.

The industry exploded. At the start of the 1980s, perhaps a few dozen venture capital firms existed. By decade's end, there were over 650. The capital under management grew from 3 billion to 31 billion dollars.

But success attracted competition, and competition eroded returns. Too many firms chased too few promising deals. The market for initial public offerings cooled in the mid-1980s, making exits harder to achieve. Foreign investors, particularly from Japan and South Korea, poured money into American startups, driving valuations higher than fundamentals justified.

The stock market crash of October 1987 further damaged the environment for new companies going public. By the end of the 1980s, venture capital returns were disappointing compared to other investment options. Some established firms, including J.H. Whitney & Company and Warburg Pincus, began shifting their focus from venture capital toward leveraged buyouts and investments in more mature companies.

The Internet Changes Everything

By the early 1990s, venture capital had settled into a modest equilibrium. The industry managed about 4 billion dollars in 1994—barely more than a decade earlier despite inflation and economic growth. Returns were acceptable but not spectacular. The explosive growth of the 1980s seemed like an aberration.

Then the World Wide Web arrived.

The foundational companies of the internet age emerged in rapid succession: Amazon and Netscape in 1994, Yahoo in 1995. All were funded by venture capital. When these companies went public, they generated returns that dwarfed anything the industry had seen since Digital Equipment Corporation three decades earlier.

The initial public offerings kept coming. AOL in 1992. Netscape, with its explosive first-day pop that signaled a new era of speculation, in 1995. Yahoo, Amazon, and eBay by 1997. Each successful IPO attracted more investor attention. Money poured into venture capital funds—40 funds in 1991 became 400 funds by 2000. Annual commitments grew from 1.5 billion to over 90 billion dollars.

At the peak of the bubble, venture capital represented more than one percent of America's entire gross domestic product. For comparison, it had been less than six hundredths of a percent in 1994.

The Crash

The NASDAQ stock market peaked on March 10, 2000, and then began a collapse that would continue for over two years. Technology company valuations that had seemed invincible evaporated. Startups that had raised hundreds of millions of dollars ran out of money and shut down. Venture capital firms that had seemed like money-printing machines reported devastating losses.

By mid-2003, the industry had contracted to roughly half its 2001 size. Many venture capitalists were forced to "write off" investments—admit that companies they'd funded were now worth nothing or nearly nothing. Investors who had committed money to venture funds tried to sell their stakes on secondary markets for pennies on the dollar, desperate to escape their obligations.

Some funds were "underwater"—the current value of their investments was less than the capital investors had contributed. This was supposed to be impossible in an asset class that promised spectacular returns. The bubble's deflation revealed how much of the late-1990s success had been self-reinforcing speculation rather than fundamental value creation.

Recovery and the Modern Era

The venture capital industry never fully returned to its dot-com peaks—at least not measured as a share of the broader economy. But it rebuilt steadily through the 2000s and into the 2010s.

The turning point came around 2004 as a new generation of internet companies—often called "Web 2.0" to distinguish them from the first generation—began to demonstrate that the internet had not been a false promise, merely an overhyped one. Social networks, mobile applications, cloud computing, and software-as-a-service business models created new opportunities for venture investment.

By 2020, the industry was investing over 80 billion dollars in fresh capital annually. While still below the frothy peaks of 2000 in real terms, this represented a mature, established industry rather than a speculative frenzy. Venture capital had become a permanent feature of American capitalism—the established pathway through which ambitious entrepreneurs could raise the capital to build transformative companies.

Why Venture Capital Exists

The fundamental logic of venture capital addresses a specific market failure.

Young companies with innovative ideas but no track record cannot easily raise money through traditional channels. Banks demand collateral and stable cash flows that startups by definition lack. Public markets require regulatory compliance, financial history, and scale that startups haven't yet achieved. Angel investors—wealthy individuals writing personal checks—can provide seed funding, but they rarely have enough capital to fund significant growth.

Venture capital fills this gap. By pooling money from institutional investors, venture firms can write checks large enough to fund real business building. By taking equity stakes rather than making loans, they align their interests with the entrepreneur's success rather than demanding fixed repayment schedules that startups can't meet. By specializing in specific industries and stages, they develop expertise that helps them identify promising opportunities and support companies through growing pains.

The price entrepreneurs pay for this capital is significant: they surrender substantial ownership and often control of their companies. Venture capitalists typically receive board seats, voting rights on major decisions, and contractual protections that give them influence well beyond their percentage ownership. An entrepreneur who raises several rounds of venture capital may end up owning a minority stake in the company they founded.

For the entrepreneurs who succeed, this trade-off is worthwhile—a small percentage of a billion-dollar company is worth more than full ownership of one that never grew. For the many who fail, the venture capitalists' involvement can mean losing control of their companies entirely or watching their stakes get diluted to nearly nothing.

The Geography of Risk Capital

Although venture capital exists worldwide, it remains concentrated in a few locations—most notably the San Francisco Bay Area, which commands a share of total venture investment far out of proportion to its population or overall economic activity.

This concentration is self-reinforcing. Entrepreneurs locate in Silicon Valley because that's where the venture capitalists are. Venture capitalists maintain offices there because that's where the deal flow is. The density creates network effects: venture capitalists can easily meet with portfolio companies, entrepreneurs can pitch multiple firms in a single day, and the technical talent that startups need to hire is abundant.

Other venture hubs have emerged—Boston, New York, Los Angeles, Austin, and internationally in London, Berlin, Tel Aviv, Beijing, and Bangalore. But Silicon Valley's dominance has proven remarkably persistent despite decades of predictions about its decline.

What Venture Capitalists Actually Do

Beyond writing checks, venture capitalists provide what's sometimes called "smart money"—capital accompanied by expertise, connections, and active involvement.

A venture capitalist who has backed twenty previous companies has pattern-matched thousands of decisions about hiring, product development, sales strategy, and competitive positioning. That experience, when shared with entrepreneurs facing these decisions for the first time, can accelerate progress and help avoid costly mistakes.

The network effects are equally valuable. A venture capitalist can introduce a startup to potential customers, partners, and employees. They can arrange warm introductions to journalists who cover the industry, to executives at large companies who might become acquirers, and to other venture capitalists who might lead the next funding round.

Of course, this active involvement also means venture capitalists have opinions—strong ones—about how companies should be run. The relationship between founder and investor can become contentious when they disagree about strategy, timing, or priorities. In extreme cases, venture capitalists have the contractual rights to replace founders as CEO, to block strategic decisions, or to force sales of the company against the founders' wishes.

The Numbers Behind the Mystique

Venture capital carries an aura of spectacular returns—stories of investments that multiplied a thousandfold or turned modest sums into billions. The reality is more complicated.

Studies of venture capital returns consistently show that the industry as a whole roughly matches public stock market returns over long periods. The best-performing funds dramatically outperform, generating the spectacular returns that attract attention. But a substantial portion of funds return less than investors could have earned simply by investing in index funds—with far less risk and far more liquidity.

This creates what economists call a "power law" distribution. A small number of investments generate nearly all the returns. Within funds, a single spectacular success can offset dozens of failures. Across the industry, a handful of elite firms capture a disproportionate share of the best deals and generate returns that make the industry average look far better than the typical experience.

For limited partners—the pension funds and endowments that provide most venture capital—this creates a challenging allocation decision. Access to top-tier venture funds can be extremely valuable, but those funds are selective about which investors they accept. Investing with lesser-known funds may mean accepting mediocre returns in exchange for exposure to an asset class whose headline performance sounds impressive.

The Industry Today

Modern venture capital operates at a scale that would astonish its founders. Individual funding rounds now routinely exceed the total annual capital deployed by the entire industry in its early decades. Companies can remain private far longer than in previous eras, raising hundreds of millions of dollars without facing the scrutiny and disclosure requirements of public markets.

The types of companies that attract venture investment have also evolved. Software remains dominant, but venture capital now flows into biotechnology, clean energy, space technology, financial services, and nearly every other sector where entrepreneurs see opportunities to build scalable businesses.

Critics argue the industry has drifted from its original purpose—funding genuinely innovative, technologically risky companies—toward simply providing growth capital to proven business models. Others contend that venture capitalists have become too focused on software businesses with high margins and low capital requirements, neglecting "hard tech" companies that require expensive research and physical infrastructure.

Whatever its limitations, venture capital has established itself as the dominant pathway for building high-growth companies in America and increasingly worldwide. The firms that line Sand Hill Road wield influence far beyond their capital under management, shaping which ideas get funded, which entrepreneurs get opportunities, and which technologies move from laboratory curiosities to products that billions of people use daily.

From Georges Doriot's determination to help returning soldiers build businesses to the algorithmic pattern-matching of modern venture partnerships, the industry has evolved dramatically while maintaining its fundamental premise: that the risk of funding unproven companies is worth taking because occasional spectacular successes can compensate for frequent failures, and because the companies that succeed often change the world.