Harvard Business School Working Knowledg e Archive

Done Deals

10/10/2000
What is it really like inside the turbulent world of venture capital? In Done Deals (HBS Press, 2000), 35 top U.S. players, veterans and newcomers from the East Coast and the West, provide candid assessments of their work and the nature of the industry. In this excerpt, the late Benno Schmidt, one of VC's pioneers, and Geoffrey Yang, a member of the new guard, discuss venture capital's past and visions for its future.

Geoffrey Yang

Geoffrey Yang
Geoffrey Yang

In August 1999, Geoffrey Yang made a sudden and surprising announcement. He and two other partners from Institutional Venture Partners (IVP) were joining three partners from Brentwood Venture Capital to form a venture capital fund focused on next-generation and broadband Internet called Redpoint Ventures, capitalized at $500 million. "We're taking the spindle that turns yarn into gold and breaking it up," Yang told the Wall Street Journal. "But we think we can make a new spindle that will spin a bigger amount of yarn."

Under Reid Dennis's tutelage, Institutional Venture Partners became one of Silicon Valley's most established venture partnerships. But Dennis, who's been in the business since the 1950s, is from the old guard, most of whose members believe that a diversified portfolio is a better long-term strategy than a narrow focus. With Geoff Yang, IVP reinvented itself, forcing the firm to redefine its strategy and goals along the way. This interview was conducted in 1998 while Yang was still at IVP, but his comments shed light on his decision to form Redpoint a few months later.

The future, Yang likes to say, is in specialization. With the pace of technology change frenetic and the demands of building a technology business more complex than ever, the generalist fund can only provide capital and not much added value. The returns from a fund focused specifically on next-generation and broadband Internet are likely to be far greater—at least for the moment—than a diversified fund, Yang and many others believe. Representing both the industry's present and its future, Yang is a technology specialist and also a one-time entrepreneur; he embodies the focused approach to venture capital, the complete concentration on technology and, for the present, on communications and the Internet.

Industry Benchmarks

Done Deals: Venture Capitalists Tell Their Stories

When I first came into the industry, the standard metric was making ten times your money in five years, or a 58.3 percent internal rate of return. You ran all your numbers on a $100-million market capitalization. If you got to a $100-million market cap, that was outstanding.

Look at the business today. We just distributed Excite, where we made 300 times our money in three and a half years. We distributed MMC Networks, where we made 100 times our money in four years. What I look for now in deals is twenty or thirty times your money in two or three years; ten times your money in five years is really not that interesting.

One other thing that's different in the industry is that, you used to look at merits of individual investments. That's the reason people were generalists. However, the industry has grown so much and become so much more complex that it's hard to keep up with all segments of technology. Entrepreneurs are much more demanding in what they're looking for in venture capitalists, so you now have to have domain knowledge in order to sell yourself. There are a few people who can still sell themselves as generalists—they're the industry legends.

When I got into it, the venture business was much more reactive. Deals would come to you and you'd look at them as part of a portfolio. Now we've realized that the venture business moves in waves. That's the way significant market values are created. So now we're trying to pick what the waves are, and we're going to invest in every company, every segment of company that rides that wave.

The velocity of the business has increased dramatically. It used to be you'd raise a fund, invest the fund in three or four years, start getting returns in year four through year seven or eight, and then you'd wind down—or try to wind down—the portfolio by year ten. Often you'd need extensions because it actually took twelve years to earn back the fund. Today, fund investment cycle is one year for the most part and you start getting returns in year two. By year two through year four, you really know the story of the fund, and you're in distribution mode in years three through six. It's going to be much easier to wind funds down in ten-year periods.

Going for the Fences

We're at a very interesting point in time. The business has become much more of a home-run business. Everything is risk return, and the risk return is what the market pays you to play. Where we are right now, home runs have an incrementally small risk but an incrementally huge return.

At this point in history, technology is really becoming mainstream. Early-stage companies are changing the world, not just the back office. It used to be that for the most part IT companies changed the back office by reducing costs, but now they are pervasive in people's everyday lives. You look at the way people receive media and receive their goods and services. Look at the way communications providers are architecting their networks. Look at the way people get information.

We have an opportunity at this point in time, if we can visualize what an industry's going to look like, to change the way people live their lives. One of the things we didn't do in the past but we do today is say, "Okay, if we believe that vision, let's fund all the companies that will shape that vision. It's not because of us that this new industry will be created, but it might be accelerated because of the things we do. If nothing else, it's a great investment." It's very interesting to think that you can have a big impact in helping create new industries and new industry segments by the things you do. So, if you believe in the Internet, for example, you'd say, "Okay, to make the Internet work you can't do without fast routers. If you're going to use fast routers, you really have to have fast servers. And if you have fast servers and fast routers, you need fast access. So if we believe in the vision of the Internet, let's invest in all the pieces that make that a reality."

Benno Schmidt

Benno Schmidt
Benno Schmidt

The organization of the venture fund J. H. Whitney & Co. by John Hay (Jock) Whitney in February 1946 is arguably the official starting point of private venture capital in the United States. At the time, Whitney was considered one of the richest men in America, a champion polo player, a horse breeder, and a frequent backer of Broadway shows and Hollywood movies, including Gone with the Wind. The idea to raise a private pool of capital for venture investing was Whitney's, but it was the execution by Benno Schmidt in his role as managing partner that made the fund the most significant of its time.

The firm's mission statement, crafted by Jock Whitney, read: "We are here to invest in companies that we believe can succeed, companies with both management teams and purposes that we can wholeheartedly embrace, companies that it will be fun to work with as we build and companies of which we will be justly proud when we succeed." By the late '50s, however, Whitney had departed to become ambassador to the Court of St. James, and Schmidt was left to chart the firm's independent course as a venture capital firm, without any further support from Jock.

In subsequent years, J. H. Whitney has gone through significant changes—investing in start-ups, technology restructurings, and in buyouts. Today, it is once again a diversified fund that invests in start-ups as well as in mature companies, and it continues to be one of the industry's most influential investment funds, long after Whitney's death in 1981.

Benno Schmidt completed this interview in 1997, two years before he died at the age of 86. His retelling of the almost whimsical story of how Whitney began emphasizes the pioneering spirit the industry has taken on over time.

In late 1945 I had returned from a three-year stint in the army in Europe and was serving as general counsel to the economics division of the State Department when I got a call from Jock Whitney. When I answered the telephone, the voice at the other end said, "Hello, my name is John Hay Whitney, you may have heard of me as Jock … . If I came to Washington could we have dinner together?" When we met for dinner at the Mayflower Hotel a few evenings later, the conversation had nothing to do with State Department matters.

Jock told me that during World War II, particularly when he was a prisoner, he had given a great deal of thought to what he should do after the war. He had been fortunate enough to inherit a substantial amount of money and was anxious to use both his time and resources as constructively as possible upon his return to civilian life. He had given a lot of thought to the absence in the economy of any organized source of capital devoted to financing new ideas, ideas that might have great promise but also carried substantial risk.

Jock pointed out that neither commercial banks nor investment banks provided such a source of funding, and if corporations found new proposals worthy of funding, they would normally swallow up both the entrepreneurs and the idea. Prior to the war Jock had been presented with various proposed new ventures and in fact had even funded a few. But that effort was not particularly satisfactory because he had not had an organization to do the due diligence necessary for sound decisions. He also observed that, with respect to the new enterprises he had financed, he had lacked the ability to provide professional assistance to the new organizations he was putting together.

He said he had decided to use $10 million to capitalize a small private firm that would be devoted to financing new enterprises found by the firm to have appeal and merit. It was his belief that a free enterprise economy such as ours would lose its dynamism unless there existed somewhere in the economy a source of new money for prospective entrepreneurs seeking to start worthwhile new enterprises.

Jock strongly emphasized to me that there was no guarantee that such a firm would succeed, and referred to the fact that some of his advisors had expressed doubts about such a firm's chances of success. The advisors had suggested that some form of regular income business needed to be added to his plan, such as a bond business or investment counseling business, in order to "pay the rent."

Jock was determined to proceed with the plan as he had originally conceived it, without provision for continuing current income. He then said: "If I am wrong and my plan doesn't work, I will be $10 million worse off, but that will not change my life materially. However, you should give some thought to where you would be if this proposed organization is unsuccessful."

I replied, "In the first place, I believe that the business as you have outlined it will succeed. Secondly, if it doesn't succeed, you will be $10 million worse off, I will be right where I am now, so I believe I can handle the risk part okay. However, there is one thing you should know." "What is that?" Jock asked. "I've never had a day of business experience in my life, unless you call roughnecking or rig building in the oil field business experience," I said. Jock's reply was, "Why don't you just decide whether or not you'd like to come with us and leave it to me to pass on your credentials."

"Fair enough," I replied, "I just didn't want anyone to be surprised if they took out a balance sheet and I said, What's that?" Jock replied, "We'll learn together," with that wonderful modesty, wry smile, and quiet sense of humor that I came to know so well.

On February 1, 1946, we opened for business. Jock, Dick Croft, Web Todd, Malcolm Smith, Sam Park, and I were partners in the firm. Venture capital was born and Jock took his place in history as the founder of what was to become the most positive economic development of the post-World War II era.

The question as to whether or not J. H. Whitney & Co. would succeed was decided at a very early date. Our first investment was Spencer Chemical Company. This investment involved the purchase of a surplus war plant in Kansas by a Kansas native named Kenneth Spencer. Spencer had operated the plant as a munitions plant during the war and, under the Surplus Property Act, he was entitled to first refusal of the plant at the price fixed by the Surplus Property Administration, a government agency set up after the war to dispose of surplus war plants, materials, and supplies. Kenneth Spencer proposed to use the plant to manufacture ammonium-nitrate fertilizer and the price placed on the plant by the Surplus Property Administration was quite reasonable, as it was in most such cases in order to encourage the conversion of surplus war plants to civilian use.

Kenneth had arranged with the First National Bank of New York to borrow the money necessary to buy the plant, but they required that he put in $1.5 million of working capital. He came to J. H. Whitney & Co. for this investment. We put up the $1.5 million, $1.25 million as preferred stock and $250,000 for one third of the equity in the business. Spencer owned the other two thirds. The plant was rapidly and effectively converted. The fertilizer business was booming, and well before the end of the first year our preferred stock had been redeemed, and it was clear that the $250,000 that we had put in as equity was worth more than the $10 million of capital with which Jock had started the firm. After that, there was never a concern about capital, and no outside capital went into the firm until after Jock's death 36 years later. The successful Spencer Chemical Company was eventually acquired by Gulf Oil.

The term "venture capital" emerged in a very interesting way. When J. H. Whitney & Co. was formed, we described ourselves as a private investment firm. Unfortunately, the New York Times was not onboard, and they regularly referred to us as "J. H. Whitney & Co., New York investment banking firm." Since we were not investment bankers this reference was, of course, incorrect. Jock particularly disliked being referred to as an investment banking firm and at lunch in our dining room on a day the morning New York Times had referred to us as a New York investment banking firm, Jock said, with particular emphasis, "We've got to find a better description for ourselves so the New York Times will stop describing us as an investment banking firm."

In response, one of our partners, Alex Standish, said, "I think we should get the connotation of risk into the description of our firm." That remark prompted Bill Jackson to say: "I think the most interesting aspect of our business is the adventure." Putting those two thoughts together, I said, "How about private venture capital investment firm?" Jock's immediate response was, "That's it! From now or we will use 'private venture capital investment firm' to describe ourselves." Soon the term venture capital was being used not only to describe J. H. Whitney & Co., but also to describe the small industry group that formed after us. This group included Payson & Trask, Henry Sears & Co., and American Research & Development—all part of what became and is now known as the venture capital industry.

In our initial discussions at the Mayflower Hotel in Washington, Jock had emphasized the role that he hoped J. H. Whitney & Co. could play in making our free enterprise economy more dynamic. However, he recognized that we alone would have a relatively small impact on the dynamism of an economy the size of the United States' economy. In our discussion that very first night, he expressed the hope that, if J. H. Whitney & Co. were a success, others would follow our example so that there would be a real impact on the national economic scene. Farsighted as this thought was, I don't believe that Jock could ever have imagined that the venture capital industry would become what it is today.

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Related stories on HBS Working Knowledge:
Special Report - Done Deals: Venture Capitalists Tell Their Stories