I am building men and companies.
—GEORGES DORIOT
Photo courtesy of the estate of Georges Doriot, all rights reserved.
Failure didn’t come naturally to General Georges Doriot. By 1957 (at age fifty-seven), he had long enjoyed renown as an inspirational teacher at the Harvard Business School and as a highly valued consultant and director for countless companies. The French-born Doriot was also in the final stages of founding INSEAD, which would soon become Europe’s premier business school. He had also seen success in the military, receiving the Distinguished Service Medal in 1946 for his efforts in World War II as a brigadier general. But now he was faced with the possibility of failure. His signature creation—the American Research and Development Corporation—was flailing, and in a move full of significance and foreboding for Doriot, the Massachusetts Institute of Technology decided to sell its ownership in the company.
Eleven years earlier, with high hopes for success, Doriot and MIT president Karl Compton had organized a group of prominent Boston businessmen to form ARDC as the world’s first institutionally funded and professionally managed venture capital fund. The rationale was compelling: MIT and other Boston-area universities produced an abundance of new technologies and commercially feasible products, but many didn’t make it to the marketplace due to a lack of financial sponsorship. ARDC’s role, as Doriot and Compton saw it, was to act as a gatekeeper to the marketplace by screening and funding developments that had commercial promise. With the highly regarded General Doriot directing the day-to-day operations and with a ready source of risk capital after a public sale of its stock, ARDC looked to be an ideal vehicle to spur Boston’s post–World War II economy and enrich its own investors. Compton put MIT’s imprimatur on the idea in 1947 by directing the institution to become one of the founding investors of the new company.
But when Compton died in 1954, the institution’s principal contact became Horace Ford, who served as treasurer of both MIT and ARDC. Ford had an insider’s look at Doriot’s operation and didn’t like what he saw. Some of ARDC’s early investments did reasonably well and were liquidated for a profit, but most turned in middling financial results or faded away into bankruptcy. The few-dozen portfolio companies that remained were producing aggregate cash flow that was barely sufficient to meet the day-to-day expenses of running ARDC, and there was little left over for the investors. And the telltale indicator of ARDC’s success, the performance of its stock, was distressing. The shares of the company rarely moved above their 1946 initial public offering price of $25 and had sold for as little as $16. The considerable risk that shareholders had assumed by purchasing shares in a venture capital company justified a major financial return on their investment. But after the first ten years, MIT and ARDC’s other investors would have done better by keeping their money under their mattresses. It seemed clear to Ford that ARDC was a losing proposition, and in 1957 he directed MIT to dispose of its holdings and not consider any future funding of the company. It was a dark day for Doriot when MIT threw in the towel.
But Doriot’s distress would not last long. In the same year that MIT divested its ownership, ARDC made a $70,000 investment in Digital Equipment Company, a small enterprise formed by two MIT-trained engineers that would finally validate the wisdom of venture capital investing—and make it painfully clear that MIT had sold its stock at precisely the wrong time.
Wunderkind Years
Doriot’s many successes during his long career—the eventual flowering of ARDC would become his last and most important—were a product of a no-nonsense outlook on life that valued accomplishment above all else. He could not countenance wasted time, and that included sleeping. He regularly woke in the early morning after only a few hours in bed and worked through the rest of the night at his desk—a desk with a stopwatch atop it so he could better control and measure the amount of time he devoted to his various tasks. He was a man of little frivolity and the caricature of the fussy and demanding martinet in the classroom. Pencil thin and standing at five foot ten, he is portrayed in the few available pictures of him as someone exceedingly formal and unbending in bearing, appearance, and habits. He wore a dark-colored suit every day—and required his MBA students to do likewise; “sport coats are for college kids,” he would caution them—with a neatly folded handkerchief protruding from his breast pocket and often with the Legion of Honor ribbon in his lapel. His shirts were white, with cuffs and stickpins in the collar. His pipe was a constant companion through adulthood (he died of lung cancer at eighty-seven), and over the years his triangular mustache remained unchanged, save for its eventual transition to grey.
Doriot’s drive and no-nonsense personality were likely shaped by the swings of fortune his family experienced in his early years in France. He was born in pre–World War I Paris and spent his childhood in a strict and financially comfortable Lutheran household. His father was a prominent automobile engineer who played a key role in the development of the first Peugeot, and business and manufacturing were imprinted on young Georges during frequent visits to the auto factories of the early twentieth century. During most of the war years he studied science and technology at a Paris lycée, interrupting his studies in 1917 to enlist in the French army at age seventeen. By that time the tide was turning in favor of the Allies, and he escaped direct combat, but based on his technical proficiency and leadership, the teenage Doriot was awarded an officer’s rank in an artillery vehicle unit.
The war was not so kind to Doriot’s father. The automobile manufacturing plants his father had a role in shaping had been converted to war-related production, and there was little prospect of a return to their original business any time soon in the badly war-torn French economy. His father made an abortive attempt to start an automotive venture on his own, but it failed for lack of financial backing, and the family’s modest fortune dwindled to almost nothing. Doriot, who returned to the lycée and received a baccalaureate degree in science in 1920, found France’s professional prospects similarly bleak. Upon his father’s advice, twenty-one-year-old Doriot left for America with the plan to study engineering at the Massachusetts Institute of Technology and, after a few years, perhaps return to France. His biographer, Spencer Ante, describes Doriot’s transition to the United States as follows:
He left France with two important items. In one pocket, he kept a letter of introduction to a gentleman named A. Lawrence Lowell and in his other pocket Georges carried a small French coin, a symbol of his father’s fortune, which had been destroyed by the war. The letter, which would radically change the course of Georges’s life, represented the bright light of the future; the coin embodied the dark weight of Doriot’s recent past.1
It must have been some letter that he carried with him. Although Doriot had allegedly never heard of Harvard University, much less its president Lawrence Lowell, he matriculated at the Harvard Business School rather than MIT shortly after his first meeting with President Lowell. Reflecting the nature of U.S. business at the time, manufacturing management was a major part of the MBA curriculum, and that line of education appealed to him more than the heavily technical curriculum available at MIT. The notion of graduate study in business was still a fairly new idea, with the Harvard Business School becoming the first to offer an MBA degree in 1908. With few credentialed scholars of business subjects available—there was little in the way of academic research in business disciplines at the time and few quality doctoral programs until 1922, when Harvard launched its own doctorate of business administration—the school relied on experienced businessmen, as much as academics, to teach its courses. Although Doriot didn’t have the requisite undergraduate degree, he was granted admission to the business school as a “special student,” much as he had become an officer of the French army at a very young age through a battlefield commission.
Like most of his classmates, he stayed at Harvard for just the first year of core curriculum studies, entering the workforce directly and forgoing the second year and a degree. Rather than returning to France, which was still reeling from the aftershocks of the war, Doriot took a job on Wall Street with an affiliate of Kuhn, Loeb & Company, the same firm that Paul Warburg had joined about twenty years earlier and the only real rival to J. P. Morgan & Company at the time. Unlike Warburg, however, Doriot was not related to anyone at Kuhn, Loeb, and the firm did not have a history of taking in non-family, much less non-Jewish, partners.
The ambitious Doriot would not likely stay long with a firm in which the top spots looked unattainable. But during his four years at Kuhn, Loeb, Doriot gained a window into the world of high finance—an experience that would serve him well in later years, providing invaluable insights and contacts he would need at ARDC. Although he lacked investment banking experience, he worked extremely hard and distinguished himself in the eyes of the Kuhn, Loeb partners. For example, when those partners organized a new company to pioneer innovative industrial processes, they chose Doriot as one of the company’s seven initial directors. He was just twenty-four at the time but clearly steeped in the ways of developing technologies and precociously competent in business analysis.
Doriot, however, seemed driven more by accomplishment that was measured by end products, whether in successful people that he nourished or organizations he created, than by the personal riches he could create for himself on Wall Street. When Harvard Business School dean Wallace Donham contacted him in 1925 to return to Harvard as an assistant dean, he quickly accepted the position. At the time, an assistant deanship was an administrative job rather than a faculty position, but Doriot, with his knowledge of manufacturing, was soon catapulted into the classroom to teach a course entitled Factory Problems and the Taylor System.2 And so began a teaching career in which Doriot taught hundreds of manufacturing classes during his long run at the Harvard Business School. He was brilliant in the classroom, with his courses generally oversubscribed. In 1929, shortly after his thirtieth birthday, he received a promotion to full professor, the highest rank available in academe, with the accompanying title of “professor of industrial management.”
Doriot’s brilliance shone outside the gates of Harvard as well. His reputation for insight into business problems spread throughout the business community, and he became a highly sought out consultant and board member, first for Boston-area companies and later for businesses throughout the United States. During the challenging years of the Great Depression, he sat on the board of around twenty companies, in some cases assuming the chairmanship, and acted as a consultant or advisor for countless more. He was also an active writer; during his Kuhn, Loeb days he published articles in the New Republic on the repatriation of war debt, and in later years he continued to publish other articles, most also dealing with global economic matters.
Through his thirties, Doriot kept up a frenetic pace of teaching, travel, writing, and consulting. All of his off-campus commitments took him away from the business school—and away from his wife, the ever-patient Edna, a Harvard research assistant whom he married in 1930—but with his workaholic ways and devotion to his students, there was no apparent ill effect on his teaching effectiveness. In fact, with the Harvard Business School having adopted its still highly vaunted case method as its primary form of instruction in 1924, Doriot’s extensive real-world experience only enhanced his courses. But in 1946 Doriot was presented with an opportunity that not only changed his life but that eventually transformed the landscape of much of American business.
ARDC: Before Digital Equipment Company
In the years just before World War II, several groups of prominent New Englanders—industrialists, financiers, and educators—saw the imminent decline of textile and garment businesses in their region and began making plans to develop replacement industries. One of the key actors in this effort was Ralph Flanders, an industrialist and inventor who later became the president of the Federal Reserve Bank of Boston. The case he made for nurturing new industries still resonates in the twenty-first century: “We cannot depend safely for an indefinite time on the expansion of our big industries alone. We need new strength, energy and ability from below. We need to marry some small part of our enormous fiduciary resources to the new ideas which are seeking support.”3
Two especially energetic groups soon sprang up to address the matter, the New England Council and Enterprise Associates, and they both recognized the opportunity and the problem. The researchers at local universities, particularly at MIT, were prolific in coming up with ideas and products with substantial commercial viability. The difficulty in developing them further always seemed to be a lack of financial resources. Joining forces, the two groups reached a consensus that a pool of “development capital” for investment would be crucial for turning university research into commercial enterprise. They began work on structuring a fund dedicated to providing risk capital for new businesses that were addressing fast-growing new markets and emerging technologies. It was to be the first large-scale, institutionally backed foray into what would later become known as venture capital investing.
At the time plans for a capital fund were becoming final, however, the United States entered World War II, and everyone’s focus, including Doriot’s, shifted to the war effort. Doriot’s reputation had spread to Washington, and he was summoned to the White House shortly before the war began to meet with Franklin Roosevelt. President Roosevelt proposed that Doriot join the armed services and assist in developing the nation’s readiness for what looked to be an inevitable conflict with Nazi Germany. Doriot readily agreed to the president’s proposal and entered the U.S. Army as a lieutenant colonel—after, that is, he gave up his French citizenship and became a naturalized citizen of the United States.
During the war, Doriot coordinated the work of scientists at the Pentagon with the Quartermaster Corps in the field, honing management skills that would later prove highly useful as a venture capitalist. Prior to his release from the army in 1946, he had risen to the rank of brigadier general and was awarded the Distinguished Service Medal, the highest recognition available in the armed services for a noncombatant. For the remainder of his life as a civilian, the outwardly modest but stiffly formal Doriot let it be known that “General” was his preferred form of address.
Developments in the wake of the war had only bolstered the case for the professionally managed venture capital fund the New England boosters had championed. The GI Bill, by underwriting the cost of college and postgraduate education for veterans, greatly expanded the skilled labor force necessary for running technology-based businesses. World War II had also brought about new and lasting partnerships between the U.S. government and research universities. Before the war, the estimated $40 million dedicated to basic scientific research was largely funded and conducted by private industry; the government was just a bit player. That changed with the need for defense-related research and development during the war, and the government began contracting with universities and foundations to perform the needed work. The Office of Scientific Research and Development alone entered into some $90 million in research contracts with universities in 1943.4 And as World War II transitioned into the Cold War and space programs, the level of scientific research contracted to universities only grew. In simple R&D terms, venture capital firms generally provide money for the development phase of a product, so the increase in the university research budgets only spurs the need for such firms.
What’s more, with the economy readjusting from artificially high wartime spending and capital investment, there was an immediate need for a fund dedicated to venture capital funding. The time was right for Ralph Flanders and the organizers of the proposed venture fund to revisit their prewar plan. As expected, they selected Doriot as their obvious and unanimous choice to run the business. Doriot agreed to head the budding company with two stipulations: that he be allowed to keep his academic rank and position at Harvard (with a greatly reduced teaching load) and that Flanders would hold the chief executive title until Doriot was formally released from the U.S. Army in December 1946. After Doriot agreed to take the job, a board of directors was formed, along with an advisory board of MIT scientists. On June 6, 1946, American Research and Development Corporation began operations. It was the world’s first professionally managed venture capital fund and, like virtually all that would follow, it was to be funded by sophisticated institutional investors.
At least that was the plan. Clearly Doriot would provide the professional management, but institutional investors, trained to operate with the risk-avoidance dictate of the “prudent man rule,” balked at an investment in ARDC. The fund-raising efforts were further imperiled by Wall Street underwriters who considered ARDC to be more of a social experiment than a profit-seeking entity. In the end, two second-tier investment houses agreed to sponsor ARDC’s initial public offering in late 1946, but only on a “best-efforts” basis at $25 per share. The two firms would attempt to sell the 200,000 shares offered, but if they couldn’t spark enough investor interest for the entire $5 million deal, they weren’t willing to backstop any shortfall with their own funds. At the offering’s conclusion, only $3.5 million was raised, and of that amount, just $1.8 million came from the targeted institutional investors.5 The remainder represented shares purchased by individuals, primarily ARDC directors and their friends and family.
Despite its disappointing initial public offering, the small staff at ARDC went to work. By the end of 1946, ARDC made its first investment: a $150,000 loan, convertible into common stock, to Circo Products, a Cleveland-based company that made low-tech equipment for the automobile industry. The next two investments were in companies founded by MIT scientists and were far more high-tech: a $200,000 investment in High Voltage Engineering Corporation (X-ray equipment) and a $150,000 investment in Tracerlab (radioactive isotopes).
Unmoved by the business or social connections of entrepreneurs looking for money, Doriot followed an egalitarian strategy of giving every proposal that reached ARDC a good look, no matter who was behind it. He and his small staff reviewed hundreds of business plans, but selected just a handful to invest in. The deserving few that ARDC funded, however, were the beneficiaries of much more than capital. Though Doriot and his lieutenants avoided any direct, day-to-day management of their portfolio companies, they were more than willing to tap into their vast network of contacts to help find customers and specialized advisors. They also lent wise and sympathetic ears to the entrepreneurs who ran the businesses. As the president of a successful ARDC company put it, “This is a lonely job and there aren’t many people I can talk to about the problems. I got plenty of psychic income from Doriot—and that was very important.”6
Yet Doriot received little such psychic income from the investors in ARDC. During their first decade running the company, Doriot and his associates climbed the learning curve of venture investing, creating and figuring out the business at the same time. After their exhaustive analysis and due diligence efforts on several hundreds of businesses, by the mid-1950s they had invested in just a few dozen companies. Those portfolio companies held great promise, but with ARDC’s decision to focus on “early-stage” businesses, tangible results would be a long time coming. For Wall Street investors (then as now), immediate profits tend to count more than future profits, and ARDC had little to show for its first several years in business. In the face of a rapidly ascending stock market during the late 1940s and early 1950s, the stock of ARDC was at best “flat,” and more typically trading well below its IPO price of $25. ARDC and its founder were more often derided by the investment community than praised.
Doriot once shot back, complaining:
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.7
The early and mid-1950s were challenging for Doriot, and he must have experienced a cognitive dissonance between the two worlds in which he lived. At Harvard he was “Le Grand General,” presiding over his classroom with authority and enjoying the adulation of students for his intellectual prowess and professional accomplishments. From the perspective of Wall Street, however, he produced little but disappointment and—perhaps for the first time in his professional life—began doubting himself. He bemoaned the fact that he was no longer able to find attractive investment opportunities and in 1954 wrote in his personal diary, “We do not know of any interesting projects. We do not know where to find interesting projects.”8 In that year his number-two person left the company, and Karl Compton, MIT’s president and a consistent cheerleader for ARDC, passed away.
But despite any doubts Doriot harbored, he remained a staunch defender of the business. When MIT cast a vote of no confidence by divesting its ownership in ARDC, Doriot attempted to downplay the broader implications of MIT’s stock sale by ascribing the decision wholly to the school’s treasurer, Horace Ford, whom he dismissed as “weak and uninteresting” and never a believer in ARDC in the first place.9 Those who still did believe in ARDC, however, would soon see their faith rewarded.
ARDC: After Digital Equipment Company
The second ten years in ARDC’s history were in stark contrast to the first ten, finally proving the ultimate wisdom of patient investing and the viability of the venture capital business—and making the investors in the company’s stock very happy. The turning point came in 1958, when a number of ARDC’s long-term holdings started to catch fire, including two of the three investments the company made shortly after opening its doors in late 1946: High Voltage Engineering and Tracer Lab. But the real transformation of ARDC’s fortunes came with its investment in a start-up operation called Digital Equipment Company.
In 1957, ARDC purchased a 70 percent equity position in DEC for $70,000, leaving the remaining 30 percent for the company’s two MIT-trained founders, Ken Olsen and Harlan Anderson. At the time of the investment, DEC was just a fledgling three-man venture, operating from the corner of an abandoned woolen mill. Its focus was on building small-sized computers for scientific and medical applications—soon to be called minicomputers, since they were dwarfed in size by IBM’s hulking mainframes.
Unlike the great majority of new ventures, DEC produced positive earnings from its first day in business. And with the DEC investment showing immediate promise, ARDC began to regain investor confidence. By 1958, the stock was consistently trading above its $25 initial offering price, and in 1959 it had climbed to $40 per share. With the stock at that level, Doriot launched another best-efforts sale of ARDC stock, raising $4 million through the issuance of 100,000 new shares. The proceeds from the offering enabled Doriot to solve his chronic problem of an inadequate level of investable funds. Through the first years of its existence, ARDC had to rely on dividends from portfolio companies or an occasional sale of one of the fund’s holdings to supply additional operating capital; funds available for new investments never climbed much above a million dollars. Following the offering, ARDC enjoyed a cash position of roughly $5 million, much of which Doriot and his staff, after their methodical due diligence and highly selective approach to investing, deployed into the new technologies of the 1960s. The increased magnitude of ARDC’s business also earned the company a 1961 listing on the New York Stock Exchange, and by that time the stock was trading above $60 per share. At the time of the NYSE listing, ARDC, after its prolonged and often barren gestation period, had finally attained critical mass, with investments in thirty-seven companies having a combined value of over $30 million.
ARDC’s success, however late and painful in coming, helped pave the way for an emerging venture capital industry that would operate beyond the confines of Boston. In 1958, the California-based Draper, Gaither & Anderson venture fund was organized and served as the forerunner of the Silicon Valley investment partnerships that eventually dominated the business.10 Also in 1958, a much larger competitive threat to ARDC arose following legislation by the U.S. Congress that created the Small Business Investment Company (SBIC) program with the charter to invest in new and emerging companies—and with the benefit of a host of special tax incentives, loan subsidies, and a $250 million initial appropriation of funds. In 1967, before the end of the first ten years of their existence, the several hundred newly formed SBICs passed the $1 billion mark in investments.
In 1967, despite the advent of new privately and publicly backed venture funds, ARDC was far and away the most prominent and successful player in the business. That year Fortune magazine published a major story on ARDC, “General Doriot’s Dream Factory,” in which it tabulated that the net-asset value of the company’s forty-five companies at the time of the article had grown to $160 million. The article painted a deservedly sympathetic portrait of Doriot and profiled many of the companies ARDC had nurtured and grown. But the takeaway piece of information from the article was that, of the $160 million of value cited, fully $125 million, or 78 percent, was attributable to its $70,000 investment ten years earlier in minicomputer manufacturer Digital Equipment Company.11
DEC itself had gone public in 1966 at an IPO price of $22 per share, and within a year its stock price had soared to $70 per share. Doriot’s decision ten years earlier to back DEC resulted in an 1,800-fold increase in that inspired investment. ARDC’s spectacular return on its DEC investment captured the attention and imagination of the business world, and DEC served as an early example of how a “disruptive technology” can quickly turn an industry on its head—and create unheard of wealth for its backers. Prior to DEC, computers were mainframe monsters that required a separate room with raised floors to channel the vast cabling and special air conditioning to control the heat they generated. DEC, with its computers the size of a file cabinet, was a direct challenge to the business of the then-dominant IBM. The company ushered in the second generation of computing and changed the world of technology.
DEC also changed the way investment bankers and commercial bankers viewed their role. In 1967, the major Wall Street firms more or less limited their clientele to Fortune 500 companies with a demonstrated history of paying dividends on their common stock and a near certain ability to make interest and principal payments on their bonds. When Lehman Brothers, then one of the largest and most prestigious investment firms, was considering underwriting DEC’s IPO, its partners were less than enthusiastic. The deal was assigned to a junior Lehman investment banker who would later remark, “I was a young associate and no one at Lehman had the slightest interest in doing an offering. No one knew what a minicomputer was. There was a prejudice that IBM was the only company that would ever do good. It was a throwaway and it was thrown at me.”12
Before long, however, all of Wall Street’s investment banks aggressively sought alliances with venture capital firms in the hope of handling breakthrough initial offerings. DEC’s success encouraged more adventuresome behavior on the commercial banking side as well; Morgan Guaranty Trust, as the banking offshoot of the House of Morgan was known at the time, virtually insured the success of the DEC deal by committing to purchase 20 percent of the shares the Lehman-led underwriting group had to sell. That represented a sea change in investment philosophy from the days when an earlier generation of Morgan partners felt it necessary to combine three separate businesses to form IBM into a corporation that was large and safe enough to finance.
The remarkable success of DEC and its IPO also served as a confirmation of an investing model that was subsequently adopted by all successful venture capital firms. A key component of the model is the common sense–dictated practice of diversification. A venture capital firm is similar to a mutual fund, with holdings in a sufficient number of companies so that the poor performance of some of those holdings is offset by the superior performance of others. With a venture capital fund, the portfolio companies are mostly privately held and their securities are essentially illiquid; they also produce a range of investment gains and losses that is exceedingly wide. With DEC, ARDC finally had the kind of outlier success that can make venture capital so lucrative.
As Digital Equipment continued to lead the migration of computer users away from their mainframes to its desk-sized minicomputers, the value of the stock of both Digital Equipment and ARDC grew rapidly and in tandem, with one being the proxy for the other in the minds of many investors. One could make the point that ARDC was responsible for DEC’s success through both its investment and the mentoring given to chief executive and founder Ken Olsen; the counterpoint is that the entrepreneurial Olsen, through his spectacularly successful Digital Equipment, created the success and viability of both ARDC and modern venture capital investing.
Whatever the case, it’s indisputable that DEC was by far ARDC’s best investment, illustrating the importance to venture capitalists of landing the occasional whale in an ocean of small fish. The annualized investment return that ARDC generated over its twenty-five-year life was 15.4 percent, a rate four to six percentage points higher than one would have realized during the same period by investing in a blue-chip stock portfolio such as the thirty stocks making up the Dow Jones Industrial Average. That would seem to be a fair premium for the risk inherent in venture investing. However, absent ARDC’s investment in DEC, the annualized twenty-five-year return would have been more than cut in half, to just 7.4 percent.13 That return would have been only slightly higher than that provided by a low-risk, investment-grade corporate bond—not nearly enough to stir the imagination of a venture capital investor.
Yet the fact remains that ARDC, after its very slow start, managed to produce those outsized returns for its investors. Throughout the go-go years, as the latter half of the 1960s would become known, ARDC was the first and brightest shining star of the venture capital business. But that enormous success also revealed flaws in the way the fund was structured—and flaws in the way Doriot managed it.
ARDC in Decline
After DEC’s public offering, Doriot and a handful of his longtime staff members became very wealthy based on their early purchase of founders’ shares of DEC common stock. But most of the other key players at ARDC did not share in the financial success, including several who had become upper-level managers of the fund. John Shane, an ARDC vice president recruited during the glory years of the 1960s, lamented, “It didn’t matter when it was dimes and nickels, but when it was $20 million per person we were somewhat disappointed.”14
Nor was there much wealth created for the venture capitalists at ARDC when other holdings ripened to financial success. Another vice president, Charles Waite, would later remark that after portfolio company Optical Scanning went public, “The CEO’s net worth went from 0 to $10 million and I got a $2,000 raise, and so that was what eventually led to my leaving the firm.”15 Shane soon followed Waite out the door. The biggest loss to ARDC, however, was the resignation of William Elfers, a fifteen-year veteran of the company and Doriot’s heir apparent. Elfers left to form Greylock Capital, a new venture firm organized in a partnership format that would allow for a more inclusive sharing of the wealth among its partners. Greylock, better able to recruit talent, would eventually overtake ARDC and become Boston’s premier venture firm.
The crux of the compensation problem was Doriot’s decision to set up ARDC as a mutual fund under the provisions of the Investment Company Act of 1940 and with accompanying supervision by the SEC. In the early years, Doriot was successful in negotiating important regulatory exemptions for ARDC, including how much stock it could own of a single business. That became key, since the 1940 act specified that a fund cannot hold more than 5 percent of the stock of any company, and ARDC almost always owned a greater percentage interest in its portfolio companies—most notably its 70 percent initial position in DEC. Doriot made little progress, however, in arguing for the issuance of stock options to his management team from the companies in which ARDC invested. Avoidance of a conflict of interest in the management of a fund is at the bedrock of the 1940 act, and it makes perfect sense in maintaining objectivity in the management of a typical mutual fund. But it is unworkable for a venture capital fund, where success—and financial reward—depend on a symbiotic relationship between the managers of the fund and the managers of the companies in which it invests.
Given the enormity of the problem caused by an inadequate compensation arrangement at ARDC, Doriot showed a perplexing lack of imagination in solving it. Conceivably, ARDC could have been taken private and freed from the inhibiting strictures of the 1940 act. Or more simply, it could have created affiliated new limited partnership funds along the lines of those successfully pioneered by the West Coast firm of Draper, Gaither & Anderson and followed by William Elfers at Greylock. A limited partnership turned out to be the perfect format for a venture fund. It was highly conducive to raising money from institutional investors who wanted to share in the investment returns but not assist the general partners in the management or share in their personal liabilities. And it was free from the constrictive SEC regulation that had long plagued ARDC. Indeed, when Elfers bolted from ARDC, he formed Greylock as a partnership and, based on the reputation he had established at ARDC, quickly raised $5 million from an A-list of wealthy families.
In the end, Doriot’s inaction on the matter seemed to be the result of personality rather than structural impediments. In the 1967 Fortune article, the author quotes Doriot as describing his job as “building men and companies,” with financial rewards only a by-product. “If a man is good and loyal and does not achieve a so-called good rate of return, I will stay with him.” And using his own modest lifestyle as a model, he worried that his “good and loyal” men would fall victim to wealth that was attained too quickly, with their professional drive stalled when they could “start buying twenty-cylinder Cadillacs, fifty-room mansions, go skiing in summer, and swimming in winter.”16
His overarching goal of creating the innovators and companies that would change the world—as opposed to the more worldly goals of producing an attractive investment return for ARDC’s shareholders and wealth for ARDC’s managers—was noble. Yet it often manifested itself in a somewhat patronizing manner, in which he referred to ARDC’s companies as his children (a weighty comparison, given that Doriot and his wife made an apparent decision not to have children, believing they could not adequately support them on a professor’s pay during the Great Depression). In the Fortune interview he told the article’s author that, “We have our hearts in our companies, we are really doctors of childhood diseases here. When bankers or brokers tell me I should sell an ailing company, I ask them, ‘Would you sell a child running a temperature of 104?’”
His views were those of a caring if condescending professor and an ascetic man nearing seventy. In addition, he likely had an overblown estimate of his influence on the men and companies he believed he was building. Peter Brooke, one of Doriot’s former students at Harvard and later a leading figure in the expansion of venture capital investing internationally, would remark:
A lot of mystique was created by the founder of the industry, Georges Doriot, who deserves every bit of the credit for inventing modern venture capital but who was also a bit of a showman. Doriot and his staff were very serious about all the good things they were doing for their portfolio companies. ARDC’s office was like a movie set, filled with earnest young men convinced that they were determining the future of American business.17
As the accelerating defections of his top talent vividly showed, however, it was unrealistic to think that all of these “earnest young men” would subscribe to Doriot’s altruistic view of the world. By 1970, the tangible financial rewards available to talented associates and young partners at other venture firms was growing only more apparent, and Doriot had a crisis of leadership on his hands.
Compounding the problems was another of Doriot’s management foibles: an unwillingness to delegate. With his inflexible personality and his proprietary view of his creations and ideas, he had little confidence that anyone else could deliver on his vision. During the course of his forced retirement from Harvard, which was in line with the policies of the institution at the time, he simply cancelled Manufacturing, the popular business school course he had created and long taught. In his eyes, no other professor could present it with sufficient effectiveness.
With ARDC he had more control over his succession—and decided there wouldn’t be one. His board members, taking their governance responsibilities seriously, set up a planning group called the Committee on 70, corresponding roughly to both the year 1970 and Doriot’s age. But Doriot did not see any need to step down and continually dodged the issue. He took a passive-aggressive approach to the process, determining that all the candidates the board proposed as his successor had one or another fatal flaw. In 1972, with nothing to show for the work of the Committee on 70, Doriot and his board essentially finessed the succession issue by seeking a merger partner. In early 1972, the board accepted a $400 million offer from Textron, one of the major conglomerates of the day.
With the keenness of hindsight, it’s hardly a surprise that the Textron arrangement failed. The compensation issue that had bedeviled ARDC only grew worse within a constrictive corporate structure and, after a brief time away from the controls, Doriot again became chairman of the company, now a subsidiary of Textron. With Doriot in his midseventies and just a skeleton management staff remaining, new investment activity dwindled to a trickle. By 1976, ARDC had atrophied to a dormant holding company, and Textron took the course of least resistance by liquidating its portfolio in as orderly and profitable a manner as possible during the lackluster economy of the mid-1970s.
The Private Equity Offspring
Self-inflicted personnel and structural problems led to an unfortunate ending for ARDC, but Doriot’s legacy remains large and the broader impact of his “dream factory” has been monumental, transforming the way new businesses and industries are developed and funded. In addition, in the 1970s and 1980s the venture capital industry produced a new offspring: the professionally managed and institutionally funded private equity firm.
In some ways private equity and venture capital are alike. They are both invariably structured as limited partnerships, and the general partners that run the show are highly selective in their search for investments. Their managers also add value beyond the initial capital infusion, providing invaluable advice and contacts, recruiting qualified and effective directors to the board, and guiding the company’s top management through a “liquidity event” when it is time to exit the investment by going public or selling the business.
Likewise, both types of operations seek high returns through high risk. Yet there is one essential difference: venture capital is about taking business risk and private equity is about taking financial risk. Doriot’s ARDC and latter-day venture capital firms invest in young companies with less than fully tested products and business models with the goal of creating revenues and profitable growth in entirely new markets. DEC remains the prototype of a company funded by venture capitalists.
Private equity is a much different story, with its success depending on well-executed and well-timed financial engineering, usually in some variation of a leveraged buyout, or LBO. Leverage, in the parlance of finance, is the use of debt; in an LBO, the underlying business of the company being invested in remains largely unchanged, but its balance sheet—and often its management team—is totally revamped.
As far as capturing the imagination of the financial world, the counterpart of the DEC story is that of Gibson Greeting Cards. In 1982, former secretary of the Treasury William Simon, through his company Wesray Capital Corporation, purchased all the common stock of Gibson Greeting, then the third-largest greeting card business in the United States, for a total of $80 million. Only $1 million of that purchase price was said to have been contributed through Wesray-supplied equity, with the balance of the funding coming from various forms of debt obligations. The leverage-to-equity ratio of the Gibson Greeting deal was roughly 80:1—highly leveraged by any standard.
Just sixteen months later, Gibson Greeting went public, with the proceeds of the offering being used mainly to pay off the debt that had been incurred for the purchase. After the IPO, the value of the shares of common stock that Wesray bought for $1 million grew to $44 million. Simon and his partners enjoyed an investment return previously unheard of—on the scale of DEC but realized much more quickly.
Following the success of the Gibson Greeting deal, many more LBO investment firms were formed, and the few that had already existed at the time, Kohlberg Kravis Roberts being the most notable, were able to substantially increase their access to institutional funding. At the same time, with the advent of plentiful debt funding through junk bonds, LBOs grew in size as well as in number.
Some of the existing venture funds, tempted by the highly publicized returns from LBOs, branched into the turf of private equity. But today venture firms rarely support both the traditional and private equity approaches to the venture capital business. The skills required are very different; the former entails evaluating new business growth opportunities, while the latter requires evaluating the opportunities through recapitalizing a balance sheet and rejuvenating a management team. Venture capital firms and private equity firms, though each large in number and scale, tend to go their separate ways.
A Proven Format
The successor firms to ARDC, both those operating in traditional venture capital and in private equity, were given a boost by favorable policy changes coming from the U.S. government during the late 1970s. In 1978 the U.S. Congress reduced the maximum tax rate on capital gains from investments to 28 percent from 49 percent, an obvious benefit to a business whose primary mission is to produce such capital gains. Then, in 1978, the Labor Department clarified the “prudent man” rule, opening the field of venture capital investing to pension funds. Following the latter development, private and public pension funds have consistently accounted for much of the money channeled to venture capital partnerships.
According to the National Venture Capital Association’s 2013 yearbook, there are now more than 1,200 active traditional venture capital funds, and the amount they currently have under management approaches $200 billion.18 Boston remains a major center for venture funding, but California, and in particular the Silicon Valley region, has long eclipsed New England as far as venture capital investing. The technology-driven entrepreneurs drawing their inspiration from success stories like those of MIT’s Ken Olsen still have a major presence in the technology-equipped buildings along the Route 128 ring around Boston, but that is all dwarfed by similar activity on or around Sand Hill Road near Stanford University.
Perhaps as remarkable as dollar and geographic growth is the basically unchanged modus operandi that Doriot pioneered at ARDC. Intense due diligence and extreme selectivity—ARDC investigated several thousand investment candidates from which it selected just a hundred or so over its thirty-year history—is the enduring practice in all successful venture funds. And the longer-term record shows that even with that careful approach, the results of venture investing tend to conform to that of its pioneer, and most venture-financed companies in the aggregate produce just mediocre returns on investment given the high degree of risk the partners assume. Yet just one standout performer in a fund, a counterpart of DEC, such as Apple, Oracle, Genentech, Starbucks, Amazon, FedEx, Facebook, or Google, keeps money flowing to venture funds.
As might be expected, that flow is highly erratic and fluctuates from year to year depending on recent successes and the availability of exit strategies for funds looking to liquidate their holdings. In periods in which there is ebullience in the market for IPOs and high equity prices—the dot-com frenzy of the late 1990s being an example of a particularly receptive market—money tends to flow to venture capital funds without limits. In those times, overcapacity becomes the concern, with too much money chasing too few quality deals. During periods of market pessimism and a drought of exit possibilities, the opposite problem occurs, and deals that should receive funding go begging.
Yet despite its notorious cyclicality, the venture capital business, using the format that Doriot invented many decades earlier, sows the seeds of innovation that propel the economy. In 1946, when Ralph Flanders, president of the Boston Fed, threw his support toward the creation of ARDC, he put his finger precisely on the broader benefits of venture capital investing:
The continued maintenance of prosperity and the continued increase in the general standard of living depend in a large measure in finding financial support for that comparatively small percentage of new ideas and developments, which give promise of expanded production and employment, and an increased standard of living for the American people.19
Flanders and the other backers of ARDC would have been happy to know that in the twenty-first century more than $20 billion flow into new companies each year from venture funds. And while that represents just about one-tenth of 1 percent of U.S. banking transactions, its impact is disproportionately profound. According to Tom Perkins, founder of the prominent Silicon Valley firm Kleiner Perkins Caufield & Byers and a former president of the National Venture Capital Association, venture capital investment from professionally managed venture funds has been leveraged over time into some twelve million private-sector U.S. jobs, which is roughly 11 percent of all such jobs in the American economy.20
Though Charles Merrill and Georges Doriot were contemporaries, they operated in very different spheres of the financial markets; it is not likely that they ever met. Yet both men made their impact by broadening the focus of American finance to the benefit of its smaller actors. Merrill gave retail investors, for the first time, a fair and even-handed approach to expanding their wealth by investing in securities. Doriot performed a similar task by creating a way for new businesses with promise to tap the capital markets. He gave each and every budding entrepreneur an audience—and for many he provided the means to build their dreams.
