The Matchmaker of the Modern Economy
ARD was the first professional venture firm that sought to raise money from nonfamily sources
Editor's Note: A legendary professor at Harvard Business School for 40 years, Georges Doriot was a pivotal player in the founding of the modern venture capital industry. As Spencer E. Ante's new book notes, venture capital per se is as old as commercial activity itself. What was special about Doriot's contribution? As Ante writes, "ARD was the first professional venture firm that sought to raise money from nonfamily sources—primarily institutional investors such as insurance companies, educational organizations, and investment trusts. This was a critical development since it greatly expanded the potential amount of money that could be devoted to venture capital."
In hindsight, it makes perfect sense that Boston would serve as a springboard for the venture capital movement. Since its founding in the seventeenth century, Boston has always been fueled by an Enlightenment belief in scientific progress and human perfectibility. It is home to America's first public school, Boston Latin School (1635), and college, Harvard College (1636). After the American Revolution, Boston became a major shipping port and leader in manufacturing new mechanical or scientific instruments. And the city has always had a revolutionary streak, with movements for women's suffrage, antislavery, and the American Revolution itself all being launched from its streets.
Georges Doriot embodied these same traits—innovation, risk-taking, and an unwavering belief in human potential. After the war, the stage was set for an explosion of innovation, and Doriot was in a perfect position to light the fuse. As a professor of a leading business school and a director of dozens of companies, Doriot had become an expert in finance and technology manufacturing. And thanks to the war, Doriot has gained a lifetime of experience in organizing and managing new ventures in a pressure-cooker environment.
It is not surprising, then, that the former head of the New England Council's Venture Capital Subcommittee was ARD's first choice for president. But Doriot could not take the job, as he was still employed by the Army. So in the interim, the directors named him chairman of the board of directors.[…]
The group of men who founded ARD believed it could crack the conundrum of the risk-less economy. And now that the war was over, they were in a position to do something about it. Money for new enterprises had been restricted, they believed, by the New Deal's onerous tax system, and by the increasing prominence of ultraconservative investment trusts. Investment trusts and life insurance companies accounted for an expanding portion of the U.S. savings market, but they were reluctant to invest in risky new ventures. Custom and prudence dictated that the trustees of these firms confined their investments to high-grade bonds or blue-chip securities. [ARD's acting president Ralph] Flanders, who observed this problem during his presidency of the Federal Reserve Bank, succinctly explained the purpose of ARD in an address he gave in November 1945 before the National Association of Securities Commissioners in Chicago.
"We have the [greatest] number of possibilities for new investments. We have various means for selecting the most attractive possibilities and for spreading the risk on those selected. Does this not furnish a sound business basis for trying new methods of applying development capital? We cannot depend safely for an indefinite time on the expansion of our old 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."
According to this theory, venture capitalists were like the matchmakers of the modern economy. They would marry money with people and their crazy, new ideas. And the result would be a stronger country with a growing supply of well-paying jobs.
In forming ARD, its founders were guided by an intuitive understanding of the dynamics of entrepreneurship. They realized that organizations with "enormous fiduciary resources" and the seasoned operators running them were not daredevils skilled in the art of invention, and that, conversely, inventors were struggling creative types with no money "trying desperately to become poor businessmen" in Doriot's witty description. ARD sought to bring together these two interdependent yet largely separate communities. Heeding the prewar lesson of Enterprise Associates, the founders agreed to raise $5 million in capital by selling two hundred thousand shares of ARD common stock at $25 a share.
The idea of venture capital was so new that the founders of ARD were forced to reengineer aspects of various financial regulatory structures in order to make it viable. Before ARD could offer its stock, for instance, it had to obtain a number of exemptions under the Investment Company Act of 1940 from the Securities and Exchange Commission. ARD was aided by the fact that one of its board members, attorney Warren Motley, was also a counsel to the National Association of Investment Companies who helped write the 1940 Investment Company Act, a key piece of legislation that aimed to restore the public trust after the 1929 stock market crash.
In writing the 1940 Act, Congress and the Securities and Exchange Commission sought to prevent investment companies from extending their control through investment pyramids, as was done frequently in the 1920s. Consequently, one section of the Act stated that an investment company could not own more than 3 percent of another investment company's voting stock. This would have precluded the Massachusetts Investors Trust from buying a large block of ARD stock.
Luckily, Motley used his connections and financial savvy to help ARD obtain exemptions from this section and others on the grounds that it was "in the public interest and consistent with the protection of investors." The most important exemptions permitted ARD to hold more than 5 percent of the stock of a company, permitted any investment company to purchase up to 9.9 percent of ARD's shares, and allowed ARD to sell its shares to not only investment companies but also to other fiduciary organizations. Final approval of the deal was based on ARD's receiving $3 million in subscriptions, with at least half of that coming from institutions.
ARD engineered other legal changes to boost its chance of success. The "blue sky" laws of some states prevented investment trusts from investing in common stocks that were less than three to five years old, or had not paid dividends for several years. Since ARD specified that half of its capital had to come from institutions, its founders felt it was necessary to lobby four states, including Ohio and New Hampshire, to modify their regulations. Dean Donald K. David of Harvard Business School; Merrill Griswold, the President of Massachusetts Investors Trust; and several other prominent industrialists and lawyers mounted a successful campaign to relax the laws of these states.
The formation of ARD was covered by many leading newspapers and magazines. All of the stories centered on its star-studded lineup on the firm's groundbreaking mission. A story in the Boston Globe started with the headline, "Venture Enterprise of Unusual Management," and concluded that "if the company does not pan out, it will not be because it has not plenty of the right kind of brains behind it." In explaining the purpose of the firm, its founders were unusually honest, admitting up front that failure was part of their financial calculus. "While all projects may not be successful," Flanders was quoted in a New York Herald Tribune story, "it is the consensus of those best acquainted with the mass of new developments coming out of the war activity that enough of the projects will turn out to be profitable so that the investment as a whole will be financially successful, as well as being an unquestioned social asset to the country."
Indeed, the war was a watershed for entrepreneurialism. While it was true that the war temporarily stunted the development of small business, it ultimately created a more fertile environment for the entrepreneurial economy to flourish. By its very nature, war encourages risk-taking, and this particular war proved the value of taking risks on new technologies and methods of production beyond one's imagination. As just one example, the rapid development of the synthetic rubber industry demonstrated that pushing unproved technologies could produce a spectacular outcome. In addition, war transformed the capital markets. The extraordinary results of wartime technology "prepared many individual investors and institutional fund managers to take greater risks in war-time investing." Equally important, the Allied victory wiped out the last vestiges of Depression-era timidity, injecting the nation with a jolt of self-confidence that encouraged experimentation.
This article was provided with permission from Harvard Business School Working Knowledge.
