The roots of venture capital lie in using money and markets to support and spread innovative ideas created through public institutions. However, this funding structure has morphed into a returns-focused machine that is stifling the very innovation it is intended to encourage.
Venture capital (VC) arguably began with a Harvard Business School graduate named Georges Frederic Doriot. During the Second World War, Doriot worked with the military to help plan and manage the scaling-up of industrial production and turn the USA into a war machine, discovering a gift for spotting innovations that could be rolled out more widely, such as water repellent fabrics and cold weather shoes.
Doriot subsequently founded the American Research and Development Corporation (ARD) in 1946 and raised $3.5m for the first ever Angel round. By the time he died in 1987, ARD had funded some of the great success stories of the prior 30 years: Textron; Teradyne and Digital Equipment Corporation (DEC) – where a $70k stake was turned into $400m at exit.
Doriot saw his companies as his “children”. Returns were an outcome, not an objective per se. Not so today’s investors: the focus of today’s VC is all about how much money VC firms want (expect?) to make out of their investments. It seems logical to want to make money out of your investment but for Doriot, he was also “building men and companies”.
Iteration not innovation
The issue with focusing on returns on a set timeline is that it will drive your investments to certain types of funding that can deliver on that objective. These are what I would call “improvers” rather than “innovators”. That is, you take existing ideas and reconstruct them into another form. This isn’t unique to VC – other speculative industries with low hit rates do the same. That is why we get so many Pirates of the Caribbean movies and why drug companies focus more on tweaking and re-registering existing patents.
Which brings me to the second point: true innovation often happens inside the government in some form – be it the military or public universities. Doriot leveraged what he had learnt inside the military into commercialised products.
Sourcing innovative ideas
Let’s consider a very recent and topical example: Uber. Now Uber is a pin-up for the VC industry. But what is the innovation of Uber? Leaving aside the illegalities of its operation in many parts of the world, it is an app that saves you calling for a taxi. And how do you use it? On a mobile phone – a mobile phone that built its technology from USSR military engineers and from one of the most extraordinary women of the 20th century in World War II. And how does your Uber find you? Via GPS, a technology that was developed by Doriot’s alma mater, the US Military, in 1973.
GPS is worth expanding on because it’s everything that VC is not. Over 30 years, 70 satellites were sent up and over $5bn sunk into a venture with no certainty for any commercial use beyond aircraft. If this had been proposed to a VC firm, I’d suggest to you that we’d still be calling for a taxi from fixed lines!
One of the perplexing things in the world today is the lack of true innovation and ideas that have completely changed our world – as evidenced by very low productivity growth. Over the last 30 years these have slowed, with productivity dwindling in the last 10-15 years.
Morphic has denounced the role of the Silicon Valley before, but I believe the VC industry is also contributing. Governments have cut back on funding for the military and funding for “basic research” (i.e. you have no idea if it’s going to work out) at universities (Figure 1).
So instead of cold fusion funding that could find a true breakthrough in non-carbon energy production, we get $120m funding for Jucerio and its $700 connected Juicers.
Improved incentives, improved outcomes
But I cannot blame VC too much, they just take the money given to them to operate to those parameters. I suggest instead of tax deductions for VC, there is a special windfall tax of 50% on all VC gains that is directly allocated to basic university funding. VC investors live off the externalities made elsewhere in the system and internalise the gains, economic theory would suggest these externalities be captured. Because at the current rate, the only R&D funding in the world will be for cat videos.
Chad Slater, portfolio manager of Trium Morphic ESG L/S Fund