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by James Currier | March 10, 2009


Traditionally, individuals, families, or groups of people in tightly knit communities have invested money in private companies in the U.S. In the 1960s, there were a few wealthy individuals in California who took to investing their money in early stage technology companies. These people were "angels." Returns on investments were excellent. Angels began to systematically search for and invest in companies. In 1971 three of these successful angels raised additional funds from other rich individuals and institutions and placed the money in the first venture capital funds.

Venture capital firms suffered a temporary downturn in 1974, when the stock market crashed and investors were naturally wary of this new kind of investment fund. In 1975 only one venture capital fund raised money, but that was the same year Tandem Computer took $1 million from a venture capital firm. Returns were tremendous for the few firms in the business in the late 1970s.

The Federal government lent a helping hand in the form of legislation through this period. In 1978 the government changed the pension plan rules under ERISA (the Employee Retirement Income Security Act), making it possible for pension funds to invest in alternative (and potentially higher risk) asset classes such as venture capital firms. Pension funds represented billions of dollars in capital, so an allocation of even 1 percent of funds represented an enormous increase in the pool of money available to venture capitalists. The industry raised $750 million in 1978.

In 1979 capital gains taxes were reduced from 49 percent to 28 percent, so anyone making profits from investing in venture capital firms, or any venture capital firms making profits from investing in private companies, had to pay less taxes. In 1981 the capital gains tax was further reduced from 28 percent to 20 percent.

Then came 1983 -- the year of excess. The stock market peaked and there were over 100 initial public offerings for the first time in U.S. history. That year venture capital investments jumped to a total of $4 billion. Some of 1983's funding went to newly founded companies that are today's largest and most prominent firms such as Apple Computer and Intel.

Due to the excess of IPOs and the inexperience of many venture capital fund managers, VC returns were very low through the 1980s. In 1991, disbursements from the venture capital firms to their investors hit a 10-year low. VC firms retrenched, working hard to make their portfolio companies successful. The work paid off, and returns began climbing back up. ~

But venture capitalists couldn't take full credit for the turnaround. Macroeconomic forces helped. In the mid-to-late 1980s, interest rates were relatively high, and the price/earnings ratios in the public markets were low. Ten years later, interest rates were low, and P/Es were very high (by historical averages). Pension funds grew dramatically. In 1987 U.S. pension funds held approximately $2.5 trillion. By 1997 that number reached $7 trillion.

The booming economy made pension fund managers more comfortable allocating up to 4 percent of their capital into alternative assets. The U.S. stock market had its greatest run-up in history between 1991 and 1999. Mutual fund assets grew from $1 trillion in 1990 to over $6 trillion in 1999. Finally, the rate of M&A activity has increased dramatically in the late 1990s, creating more opportunities for small, venture-backed companies to exit (cash out) at high prices.

Venture capital firms taking portfolio companies public in 1999 experienced record returns. In general, 1999 was a boom year for IPOs, and venture backed firms were particularly prominent. In 1999 544 companies went public, while in 1998 only 373 executed initial public offerings according to Securities Data Corporation. In 1999 271 of newly public companies (nearly half the total) were backed by venture capitalists. On average, these companies have done exceedingly well in the public markets. According to Securities Data Corp. statistics, the average offering size of a venture-backed IPO in 1999 was $87.2 million. This figure represents the average amount of money each start-up company gathered from the IPO. However, the average post-offering valuation (the average value of the outstanding shares in the public market) was a startling $502.7 million.

Venture capitalists were greatly rewarded for their efforts in funding new enterprises. According to Securities Data, as of September 30, 1999, the average return for all venture capital funds for the year was 62.5 percent. The venture capital industry is a very cyclical industry. Many industry observers believe 1999 represents the high point before a decline in rates of return. In 1984 45 new venture capital firms were formed and a long decline in returns and capital raised began. The number of new VCs declined every year through 1991, when the industry actually saw 17 more VC firms go out of business than were formed. In 1999 the industry netted approximately 100 new firms. Are we again seeing the peak? Time will tell.


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