Why should people want to read about an ex-U.S. General born in France who taught at Harvard Business School and formed the first venture capital fund? The answer is that this fellow unleashed an industry that is harvesting optionality in ways that are dramatically changing the world. Once people saw that was possible to generate 5,000X returns on a single investment as was the case with Digital Equipment Corporation (DEC) the world would never be the same. As venture capital proliferated new value started to be unlocked at rates that the world had never been seen before. The change unleashed by the new torrent of innovation is so dramatic that some misinformed and disoriented observers actually claim that innovations levels have gone down.
Who was this pioneer Georges Doriot?
“Born in France in 1899, he came to the U.S. to get an M.B.A. and extended his stay, working for an investment bank and teaching at Harvard Business School. In 1946, he founded American Research and Development Corporation (ARD), the first publicly owned venture capital firm.”
“ARD was formed as a closed-end fund. That is, it raised permanent capital by selling a limited number of public shares.”
“For the first few years, ARD struggled. But then Doriot backed Ken Olsen, who worked at Lincoln Labs at MIT and wanted to build something called a ‘mini-computer.’ Doriot put $70,000 into Digital Equipment ARD made 5,000 times its money on that one deal, and venture capital was off to the races…. Doriot, along with New England industrialist, banker and politician Ralph Flanders and MIT president Karl Compton, passed the hat to the stodgy old companies and old money with a unique proposition: Let’s set up a fund that will invest in promising young companies, often companies with little or no sales and with little management experience but with potentially breakthrough technologies. Investors in Doriot’s funds included the academic institutions (Harvard, MIT, Penn) as well as stuffy old companies (Hancock, Home Insurance, State Mutual, Mass Investors Trust).”
- “Someone, somewhere, is making a product that will make your product obsolete.” This is perhaps Doriot’s most famous quote. What Joseph Schumpeter called “creative destruction” is a constant process in the business world. Schumpeter said: “the process of industrial mutation—if I may use that biological term— incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” The paradox is that in order for productivity and standards of living to grow some aspects of the economy must be destroyed. Capitalism requires failure so new productivity and wealth can be created. Every business is in its own way constantly fighting this phenomenon: Warren Buffet once wrote: “Capitalism is all about somebody coming and trying to take the castle. Now what you need is a castle that has some durable competitive advantage — some castle that has a moat around it.” The moat of any business is always under attack by competitors even if you can’t see it. because moats are constantly under attack Charlie Munger points out that it is a rare company whose future is not a worse than its present. Schumpeter used the term “venture capital” as early as a paper written in 1943. Of course, ARD was itself a startup. The venture capital business itself once upon a time needed to find “product market fit.” As part of its business model discovery process, ARD eventually discovered that the venture capital business is driven by tape measure home runs. The idea that only one investment by ARD out of a much larger portfolio of scores on investments would overwhelmingly determine its financial success in venture capital was surely not anticipated by Doriot. The business world noticed that ARD’s success came from a single high tech investment, whereas ARD investments in businesses like tuna fishing failed. Merrill Griswold, a Director of ARD, once said to a Fortune reporter: “Some of our friends began to say: ‘Oh, Lord, not another longhair project. Why doesn’t ARD back something commercial and make some money?” We learned our lesson. Now we realize that our best things are longhair.” He is making the point I have made repeatedly in this series on my blog: in order to hit a tape measure financial home runs in venture capital you need to find a entrepreneur who is trying to create something that is half-crazy since that is where the necessary under-priced positive optionality can be found and purchased at a bargain. What Doriot did was highly unconventional at the time (H/T Ben Evans):
- “The hardest part is to help a company through its growth pains. That is particularly hard because we have to work with others.” “Too many bankers and counselors have forgotten the history of the early years of our industrial giants of today. The first fifteen years of companies and of human beings are very much alike: hope, measles, failures, mumps, reorganizations, scarlet fever, executive troubles, whooping cough, etc. are parts of one’s daily life. Hopes, disillusions, hard work, are all necessary, particularly during the first ten or fifteen years before a stable and healthy body or corporation can begin to exist.” This set of quotations reminds me of some of the points made by Ben Horowitz in his book The Hard Things About Hard Things. Horowitz describes this process as “the struggle” and notes that there are no formulas for dealing with it. Mike Maples Sr. has said: There’s something about the struggle, adversity, the trial and error and worrying at night about things that makes the entrepreneur better and stronger.” ARD itself was a startup trying to create a new industry which would help people create important new businesses in important new industries. In trying to prove that venture capital was financially viable, Doriot faced battles and struggles related to raising money, politics and company governance. The book Creative Capital: Georges Doriot and the Birth of Venture Capital by Spencer Ante describes this period of time at ARD. By today’s standards the amounts raised an invested by ARD were small: “By the end of December 1946, ARD offices and its partner banks were only able to sell 139,930 of the 20,000 shares, rustling up a total of $3.5 million Of the sum, just over $1.8 million was purchased by nine financial institutions, two insurance companies and four university endowments: MIT, Rice Institute, The University of Pennsylvania and the University of Rochester. Individual stockholders, required to invest the considerable sum of $5,000, contributed the rest of the capital.” It is clear that the leader of this movement to create a new form of finance for young companies was Doriot. Josh Lerner a professor at Harvard Business School points out: “Doriot is the founder of the modern VC industry. He is the first person who basically ran an institutional venture capital fund. And he played a lead role in getting the VC community to see itself as a real industry.” Doriot struggled to create a modern venture capital firm. He complained: “Yardstick measurements to be used in judging the work of a venture capital organization are very different from those of a normal industrial company. Methods of remuneration used by large manufacturing companies may be quite ineffective in attracting, keeping and rewarding personnel.” The task of ARD was described as follows by Doriot: “research and development, new technical ideas, and young small businesses are not in themselves the certain keys to great success. They must be supplemented by sound management, adequate financing, competent production methods, and aggressive merchandising.”
“Never go into venture capital if you want a peaceful life. Keep on financing concrete that doesn’t move, that doesn’t call you at 2am in the morning.” Pioneering venture capitalist Pitch Johnson once said that part of what you must give to be a successful venture capitalist is “commitment.” To be committed you can’t help but get somewhat emotionally involved and that means being available. Pitch Johnson said: “We invest stomach lining in those companies because any venture capitalist with his or her salt gets emotionally involved. You can’t be that detached because the entrepreneurs are very emotional people who want to succeed.” Doriot liked to refer to the businesses he invested in as his children since he was so emotional entangled in their success or failure. Doriot said once: “When you have a child, you don’t ask what return you can expect. Of course, you have hopes – you hope the child will become President of the United States. But that is not very probable. I want them to do outstandingly well in their field. And if they do, the rewards will come. But if a man is good and loyal and does not achieve a so-called good rate of return, I will stay with him. Some people don’t become geniuses until after they are 24, you know.”
- “The riskiest part of the spectrum has to date proved the most rewarding, and the greatest capital gains have been earned in companies which were started from scratch.” The venture capitalist Fred Wilson writes about the same topic raised by this quote from Doriot: “It’s not just the lower valuations you get at the formation stage, but it’s also that you are working from a blank slate with respect to everything and you can work with the founding team to form the culture, the strategy, the team, etc.” Venture capitalists like Doug Leone also prefer to be the “first outside dollar” in a new business saying the “DNA is set in the first 60 to 90 days.”
- “Be careful of attempting to get publicity too soon or too much on a new investment. Remember the French proverb: ‘to live happily, live hidden’. Otherwise one only alerts competition to what you intend to do; it may bring in other venture firms’ money into competing technologies; if it goes wrong, you have a problem.” Flying under the radar can be an advantage for some companies as they struggle to get started. Doug Leone is also a fan of very young startups using in stealth to gain an advantage. Other people argue that this is the wrong approach and suggest that the entrepreneur should want everyone to know what the business is doing since it will need as much help as it can get from as many people who will contribute. On this one: vive la difference.
- “ARD in making an investment is in no way ‘gambling.’ Gambling is win or lose; ARD is the opposite, invest and build.” People who gamble are engaged in an activity which is net present value negative. Investing, for that reason, is not gambling although an investment is often called “a bet” since there is a chance that you can lose. The best investors only bet when the odds are substantially in their favor and in the case of venture investing to find mispriced optionality (big upside and relatively small downside). Doriot wrote despondently at one point in the early 1953 “Venture capital is not fashionable any more. [People] search for security instead of hard work and daring opportunities. It is interesting to see how the great interest that existed seven or eight years ago in venture capital has disappeared and hoe the daring and courage which were prevalent at the time have now waned.” In December of 1953, ARD’s stock price hit an all-time low of $16 a share. That share price would recover, but it was not an easy time for Doriot at that low in the market. As is often the case in venture capital, it was one investment that turned the business of ARD around. ARD invested $70,000 “for a 70 percent equity stake and promised additional loans.”
- “I don’t consider a speculator — in my definition of the word — constructive. I am building men and companies.” This quote hits the Ben Graham/Warren Buffett point about the difference between investing and speculation. In their 1934 book Security Analysis, Benjamin Graham and David Dodd set out their definition of speculation: “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” Ben Graham in The Intelligent Investor added that “Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook.” Speculators focus on price and investors focus on on value.
- “The study of a company is not the study of a dead body… it is the study of things and relationships. They are very much alive and constantly changing… it is the study of people and people’s work, of their hopes and aspirations… a study of determination of successive goals and of victorious competitive drive towards them.” I have always been attracted to biological metaphors since both a business and an economy are complex adaptive systems and not something that is similar to a machine. This means that an evolutionary outlook is helpful and a reason why a strong and diverse team is so valuable in any startup since they can adapt as conditions change. Doriot was part of a movement that changed many things in business. Its sort of odd to think about a ex-general born in France who taught at Harvard Business School leading cultural change but there it is. The cultural change created by companies funded by ARD, including Digital Equipment Corporation (DEC) marked the beginning of what we see today in technology. In Creative Capital: Georges Doriot and the Birth of Venture Capital Spencer Ante writes:
- “At the time it is made, a vital error can seem like a minor decision.” An error which you made five years before can kill your business. At the time you make a fatal error it can seem to be really small. There are many types of fatal error, one of which is not knowing what business you are in. As an example, Doriot said once: “U.S. Steel does not know what business they are in. They are in the materials not the steel business. They are completely ignorant of aluminum and plastics.” One can make this same argument about many companies include Kodak. Spencer Ante Wrote: By 1951 the company had invested in 26 companies employing over 3,000 people. Twenty-one of these companies were profitable. ARD had also begun charging consulting fees to portfolio companies in an attempt to raise revenues and further reinforce its business model.”
- “A committee is an invitation to do nothing. Very few committees can perform better than the weakest man.” Modern business vocabulary is full of expressions which are often used so loosely that they fail to convey anything to a perceptive listener.” “Sometimes I use [the stopwatch on my desk] to see how long it takes someone in a meeting to tell me the same thing three times.” Georges Doriot was an early critic of bureaucracy and anyone who places too much emphasis on process. He was stuffy and conservative in other ways but for him time he was a bit of a rebel too. For example, he hated committees as do many other people. Of course, jokes about committees are common. A common definition is: “A committee is a group of the unwilling, appointed by the unfit, to do the unnecessary” The relevant Milton Berle joke was: A committee is a group that keeps minutes and loses hours.” Elbert Hubbard said: “A committee is a thing which takes a week to do what one good man can do in an hour.”
- “You will get nowhere if you do not inspire people.” On a road somewhere, three men were breaking stones. They were asked what they were doing: One said, “I earn a living.” One said, “I break stones.” One said, “I help build cathedrals.” Let us build cathedrals together.” That Georges Doriot was a believer in the importance of leadership is not surprising. He was sometimes quirky in terms of the advice he doled out as a leader. For example, “When traveling, always adopt the psychology of a suitcase,” “If any information is to be exchanged over whiskey, let us get it rather than give it,” and “Always look relaxed when you are very tense inside. Never look mad unless you need to.” “A real courageous man is a man who does something when no one is watching him.” There is not a lot to say about this last quote other than it is true and that the older you get the more you appreciate it when you see it.“Without actions, the world would still be an idea.” I have met many people in my life who would have loved to start a business but they were never willing to do the necessary work and take on the associated risk. Talking about something is not doing something. Doriot believed: “An average idea in the hands of an able man is worth much more than an outstanding idea in the possession of a person with only average ability.”
- “A creative man merely has ideas; a resourceful man makes them practical.” One of the more admirable things Bill Gates and Paul Allen did when the formed Microsoft was drop what they were doing, ignored conventional wisdom and moved to Albuquerque to chase what they saw as a huge opportunity that would not wait for them to finish other things. They acted. They and others in the technology industry grabbed fate by the ears and wrestled it to the ground. The most influential thing Georges Doriot did was fund Ken Olsen who created DEC. ARD invested $70,000 for 70 percent of what would eventually become one of the world’s largest computer companies. ARD eventually sold its holdings in DEC in 1972 for $450 million. It has been a recurring theme of these blog post that success in venture capital is driven by a tiny number of tape measure home runs. In the case of ARD, financial success was driven by one investment in DEC. Tom Nicholas of Harvard Business School wrote in his 2015 paper on the history of high tech venture investing in the US: “ARD was revitalized by a single investment, which also helped to spur the development of American VC more generally.”
Creative Capital: Georges Doriot and the Birth of Venture Capital. Spencer Ante. http://www.amazon.com/Creative-Capital-Georges-Doriot-Venture/dp/1422101223/ref=sr_1_1?ie=UTF8&qid=1464498641&sr=8-1&keywords=Creative+Capital%3A+Georges+Doriot+and+the+Birth+of+Venture+Capital
Fred Wilson: http://avc.com/2008/05/doriot-quote-6/