The Fishy Origins of Venture Capital
A Whale of a Story
It may be true that software is eating the world, as Marc Andreessen observed, but it’s venture capital that’s given software its appetite. Venture capital, or VC as it’s often called, has undoubtedly remade our world by funding new ideas and technologies, from Google to OpenAI, that increasingly affect our day-to-day lives. The numbers are staggering: The amount invested in VC has climbed from $30B in 2005 to over $170B in 2023 in the US alone.1
VC has become such an essential part of our economic environment that it’s hard to remember a time when it wasn’t present. But how far does it go back? In researching this question as part of my ‘roots of AI’ theme, I assumed (I hope like others) that its origins have been intertwined with software, beginning with the computer revolution in the mid-20th century. But the truth is even stranger: As Tom Nichols shows, VC’s back story, told properly, begins with the 19th-century whaling ventures. While the traditional story of software isn’t wrong - those were the first firms to use the phrase ‘venture capital’ - the idea begins much sooner.2
What is ‘Venture Capital’ Anyway
Before we go further, we should be clear on what we mean by ‘VC.’ It’s tempting to lean into the name and think of it as any funding for early-stage ideas and companies. If we were to use this idea, we’d have to go back to time immemorial, as that would make VC as old as money itself.
Nichols argues, persuasively, that venture capital has two additional features that separate it from other forms of investing:
An equity system in which investors (‘limited partners,’ or LPs, in today’s parlance) give their money to an organization that then purchases shares in new ventures on their behalf. Additionally, these shares are often distributed to employees in order to align incentives between employees, the investment partnerships, and the LPs. This distinguishes VC from a seed or an angel investor, which are typically just one individual investing in another individual (or a very small group).
A distribution of terms in which a few investments do very well, while most do poorly. In today’s venture capital, most VC investments return little to nothing to the LPs. But when firms do well, they do really well, and that possibility makes it all worthwhile. The related feature here is that investors do not know which is which - i.e., they cannot determine the outcomes or even quantify the risk well - when making the investment.
While these two features may seem arbitrary initially, they are, in fact, closely related. Here, a bit of economics helps. If we assume investors are simply looking to make money (i.e., they’ll invest in whatever legal thing gives them the highest return), then they must eventually look beyond big companies, as everyone will be investing there, bidding down returns. But new ventures are inherently uncertain; there is a huge risk in trying to invest in start-ups that have no product, no revenue, and an unclear technology. Of course, if you put all your money into Google when Sergey and Brin were still in their garage, you’d be retired and living like Gary in White Lotus by now. But if you invested in literally any other start-up at the same time, you’d have lost everything, or, at the very least, made much, much less. What do you do with these odds?
You diversify. You pool your money across start-ups to ensure that not all your hopes are on the same dream. But that requires professionalization, because how else will you find that many start-ups? So, you pay someone. In fact, you most likely pay them to find, invest, and then manage the whole situation so you get ‘exposure’ to the asset class without all the headaches. Of course, that eats into your returns (taking 2% of your total investment plus 20% of whatever they make in a deal known today as the 2/20 rule of VCs and hedge funds).
So, in the spirit of structure following strategy, the venture capital structure follows from their strategy. They are, as the great Alfred Chandler would have predicted, inseparable.
Why Whaling?
But even with all this, whaling still seems like an odd place to start. The reason lies in the fact that whaling and venture capital had to solve a similar set of problems, albeit in very different markets at very different times.
While whaling is as old as time itself, commercial whaling only came about in the 16th century with Icelandic and Basque whalers. But even then, there were fewer than 100 ships attempting to hunt these behemoths. While the Europeans initially started the idea, much like software one hundred years later, the Americans took it over, and by 1850, a full 75% of whale ships were American. By this time, there were nearly 900 registered whale ships globally. Nantucket and later New Bedford, here in New England, rose to prominence, dominating the fleet.
The rise in whale ships reflected the tremendous increase in demand for whale goods. Sperm whales (the focus of Moby Dick) were used for their sperm oil; the solid vesion of the substance, called spermaceti, was used to make candles, while the liquid form, known simply as sperm oil, was used to lubricate the growing number of machines that formed the ongoing Industrial Revolution. While bowhead and humpback whales were also hunted, their blubber and oil were distinctly less valuable. Still, their baleen could be used to form consumer goods, and their blubber could be used to lubricate heavy machinery.
Though the data on prices is not exactly the NASDAQ, the values returned are startling. The average sperm whale could yield 25 barrels of sperm oil, while the largest bowheads could yield 275 barrels of oil and 3,500 pounds of whalebone. By 1854, the American whaling industry made $10.8 million (approximately $300 million today).
Achieving these returns required overcoming two issues. First, killing a whale is extremely risky. Sperm whales can reach 50 feet in length and weigh 45 tons; attacking them in a boat that was only slightly larger than the whale itself meant risking more than capital! The Essex, the ship on which Herman Melville based his Pequod, was 88 feet long, making it a rather large whaling vessel. And, despite its size, an angry sperm whale attacked the whole boat, sinking it while the crew watched from rowboats.
In fact, death was not uncommon on a whale ship. Capturing a whale meant spotting one from the main boat, getting into smaller rowboats to chase after it, then throwing a harpoon into the whale, and holding on while the whale went deep underwater or further out to sea. Crew members would often get tangled in the line and pulled down with the whale (a central theme in Moby Dick), or the boats would capsize in open sea. Sometimes the whales would attack and kill crew members on the ship. This is to say nothing of the more boring problems of life on a ship: scurvy, malnutrition, dehydration, exposure, etc. In fact, nearly one in three whale ships was lost at sea, meaning a complete loss of capital for investors and, for many sailors, a complete loss of life.
The second problem whalers faced was the principal-agent problem of captains and investors. Captains, being alone on the sea without any communication, held an unbelievable amount of power. They could be judge, jury, and executioner for the sailors, and they could determine entirely what happened to investors’ money. Had captains and crew been paid a salary, they would have had every incentive to avoid dangerous waters, take few risks when going after whales, and spend large amounts of time in safe havens and ports. Nearly one in three sailors (29%) would desert to avoid the harsh conditions at sea and captains’ violent tempers.
To avoid this behaviour (known as ‘shirking’ to economists), whale firms created a ‘lay’ system in which the returns of the ship were divided into percentages, the lays, and each crew member would get a certain lay. By linking performance to pay, the crew had a strong incentive to risk life and limb to catch whales and to ensure the boat came back in one piece.
Connection to Venture Capital
While some of the parallels to venture capital are probably obvious, it’s worth highlighting three aspects: The problem, the solution, and the legacy.
Perhaps the most obvious similarity between venture capital and whaling is simply the problem faced. In both cases, investors faced a lucrative market in which they were unlikely to get their capital back on most investments but would make a fortune on some investments. Thus, to get their money back, they needed to construct a rather elaborate investment scheme.
Similarly, the ‘crew’ - both shippmates and start-up employees - faced a situation in which their only hope of a high return was through a positive result on their venture, in which they could cash in their equity. Only by creating this rather bizarre ownership structure could the investors have a hope of a positive return.
In fact, the comparison between the two is striking. As Nichols shows, VC and Whaling had very similar distributions in returns. In both cases, nearly a third of returns were negative, and the majority were under 10%. But, both had a ‘long tail,’ in which the winners more than covered the losses.
Perhaps most interestingly, whaling left a subtle legacy that today’s venture capital owes a debt of gratitude. If this were a novel, I would trace the whaling investment firms back through to today’s software VCs. But reality is not so neat. A lot happened in between. In particular, cotton happened. Whaling investors, such as those here in New England, slowly divested from whaling as the Industrial Revolution invented the light bulb, and as the global stock of whales declined. Slowly, they pivoted to cotton and grew their investments there. But, while cotton had significant downsides, those differed from the problems of whaling, and the venture capital structure gave way.
In fact, by the early twentieth century, venture capital had essentially died out in the United States. Companies like Ford relied on corporate investors and angels to grow their investments. And, while software increasingly relied on venture capital, even in the 1980s, companies like Microsoft could be expected to grow organically through loans and partners.
But the institutional arrangement had been created and enshrined in law. And, as early VC funds, such as American Research and Development Corporation, headed by the infamous George Dideriot, could revive the whaling structure to boost the nascent software industry. As a result, much as Americans took over whaling, it took over software, too. But that is a different chapter.
“Value of Venture Capital Investment U.S. 2006-2023.” Statista, June 21, 2024. https://www.statista.com/statistics/277501/venture-capital-amount-invested-in-the-united-states-since-1995/.
In this post, I draw heavily on Nichol’s excellent book: Nicholas, Tom. VC: An American History. Harvard University Press, 2019.