The First Venture Capitalists
How whaling laid the bedrock for the modern venture capital industry
“It is not down on any map; true places never are.”
– Herman Melville, Moby Dick
Like many of the best inventions, the road to discovery is bumpy and worn – the tried and tested paths lead newcomers astray. As it never follows a straight and narrow path, we, of course, often have no idea what ideas will end up turning the world on its head. In truth, one can make the case that venture capital (VC) is one of these creations. It was derived to fund whaling journeys, but the industry kept evolving: it later financed many core developments around cotton and steel manufacturing, commercial aerospace, and certainly the high-tech industries we’re familiar with.
Though VC is not a Silicon Valley invention, the biggest VC funds today on Sand Hill Road are juggernauts whose actions can carry weight far beyond their oak-lined offices; they lie at the intersection of geopolitics, technological innovation, and diverse social issues. If you want to see where our technological future is heading, following the (smart) money is not a bad place to start. But it wasn’t always this way.
There is enough information about VC post-WW2 when the industry transitioned to funding the household names we know today (Intel, Apple, Genentech). Yet the question that was always on my mind was how the industry started; what’s the history behind such an interesting, multifaceted industry that attracts equal numbers of frauds and geniuses alike. I think that the arc of VC is a story of determined individuals betting on the long tail and more importantly, of spending a lifetime discovering the niche exceptions that prove a new rule. Hunting whales is only the first part of this tumultuous saga.
"As for me, I am tormented with an everlasting itch for things remote. I love to sail forbidden seas, and land on barbarous coasts."
– Herman Melville, Moby Dick
Venture capital’s roots begin with whaling expeditions at the beginning of the 19th century: the voyages were risky enough that only specific financiers were willing to finance these expeditions. People who had money, the first limited partners, didn't know which captains to invest in nor how to judge character. Therefore, they paid agents to work with each captain on choosing a steadfast crew and acquiring the best equipment.
Why did they use middlemen? LPs who tried to finance whaling ventures without industry knowledge miserably failed. However, the agents lived in the trenches so to speak: they knew which whales inhabited certain areas and hunting grounds that would have plentiful bounty. An interesting way agents would assess captains is through their logbooks (notes from all the voyages they had done), providing intimate details on each journey. This would harbor information like who is trustworthy or not, which lands were safe, and finances. Indeed, these had to be kept secret because other captains could steal this hard-earned knowledge for themselves. It was effectively whaling IP.
They didn’t just fund captains, agents were also caretakers who were incentivized to coordinate the captain’s home life while he was away. Agents would travel to distant lands to help families send messages to the crew while traveling. Why bother? It was for two reasons: the agent would have more information on the chances of his investment succeeding or failing and they often had a huge personal sum invested in the journey.
Peering at this closely, I’m reminded of a16z’s current model of acting as a talent agency. There is truth to giving the best people the tools they need to prosper and letting them handle the rest. It’s interesting how we’ve come full circle on that notion.
Whaling created the organizational model that VCs use today as shown below:
(Seeing the above makes me wonder if this is the best model in which to distribute capital to startups. Are there possible improvements in efficiency and output to be had in the model above?)
The Tantalizing Price of Success
“In 1845, US production reached a level of 525,000 barrels of whale and sperm oil. In 1854, whalers received net income of $10.8 million, the largest amount recorded in a single year—over $300 million in today’s money. In each year from 1853 to 1857, the total whaling haul sold for about 50 percent of the capital value of the entire whaling fleet. In other words, the return on assets in whaling ventures could be high.”
Yet, why were whales so special? Fundamentally, they were cornucopias who contained abundance and their bodily parts were used for cosmetics, corsets, and even umbrellas. At the start of the 19th century, plentiful light was the hallmark of kings – electricity wasn’t yet discovered. To eke out meager amounts of light, people burnt blubber and whale oil was amazingly flammable. Not all whales were useful (some, like the Blue Whale, sank upon capture). The sperm whale was highly prized because of two waxy substances called spermaceti and ambergris. Spermaceti was turned into smokeless candles with a bright flame while Ambergris helped create perfumes. Both of these substances by themselves would be desired all over the world – whales were the unlucky creatures who had them both.
But all whales weren’t created equal. It was the sperm whale that was the siren song to every hunter. Like a genie, it could turn fortunes around instantly. There was a significant price differential between regular whale and sperm whale oil to the point where “in 1871, the captain of the Myra dumped one hundred barrels of whale oil overboard when he “fell in with some sperm whales.’” It wasn’t enough for captains to catch whales – they had to be of the best breed. This explains the failure rates where some researchers estimate that ~35% of ships were lost at sea. Captains were obsessed with not failing; doing so might mean an end to their careers.
The majority of ventures were at best chaotic and at worst, pure insanity:
“Archibald Mellen, Jr., captain of the Junior lost his life on Christmas Day off the coast of New Zealand when between five and ten mutineers shot him and the third mate, beheaded both, and tossed them overboard…Out of 489 crewmen originally setting sail on fifteen whaling voyages made by eight different vessels between 1843 and 1862, only 16 (3.3 percent) were killed compared to 143 (29.2 percent) who deserted and 166 (33.9 percent) who were discharged.”
When the journey is this fraught with danger, the returns had better to be worth it.
Thankfully, they were (if you were lucky or good at your job):
It surprised me that most voyages never made much money for their effort, but then most startups never exit either. Still, the risks behind continuing the voyage were innumerable, including the death of the crew and perhaps even that of the captain. Today, founders can rest knowing that they won’t be jailed or incapacitated if the company goes awry (thanks to the invention of the LLC!). In those days however, the captain unceremoniously went down with this ship.
If I didn’t make it clear before, every part of the journey was dangerous:
“In 1829, Captain Abner P. Norton of the Victory was killed by a whale when he became tangled in a towline and was pulled overboard…The risk of illness was high, and treatment at sea or port was quite rudimentary…interactions with native populations in these places could also be perilous. Supply towns in Hawaii were especially violent places. Elsewhere, one account of a Pacific voyage by the Charles and Henry has a deserter being beaten to death by natives in Tahiti.”
The only way these shared teams could fight back against the odds were to make sure they could really trust their crew. For all the negatives of the whaling industry, it molded the idea of equity ownership into something that could make these men trust each other even in the most precarious of situations.
For this reason, agents, captains, and crew owned ‘lay’ or equity ownership on the voyage. Salaries for captains were decent, but were egregious for everyone else. One compiler of the salaries even wrote: “It seems incredible that an intelligent, active young American should pass through four years of labor…separated from family and country,” to make less than six dollars per month, he notes. “Yet such is the case.’”
Large salaries didn’t make sense in this industry as what was to stop someone taking the money and running away the first chance they had on land? People had no idea what they were in for, so the way to reward loyalty was to give everyone willing to risk their life a share of the proceeds (life-changing if all went according to plan). A keen observer will note that it’s the same for VC-backed entrepeneurs who are paid paltry sums for the off-chance that the venture actually results in profitability while enduring large opportunity costs. This is one of many reasons startups are hard.
“By the late 1850s, New Bedford was home to a cluster of banks and insurance companies, some of which had been financed because of wealth made in whaling. Most notably, when Merchants Bank received a state charter in 1825 its capital stock of $150,000 made it the largest bank in Massachusetts outside the Boston area. The bank’s founders, stockholders, and directors were leading New Bedford whaling entrepreneurs who also established the closely affiliated Merchants Insurance Company.”
The Silicon Valley (SV) of the 19th Century was New Bedford, MA. Much as tech is in SV, New Bedford was a whaling town – everyone and anyone had a part to play in some fashion.
New Bedford’s whaling ventures were financed almost off trust alone in this predominantly Quaker community. Banks were unwilling to take on such risks as they had no idea how to structure a seed-stage investment. Instead, the opposite happened – successful whalers became bankers much like post-exit founders become VCs.
This was an community built off organic growth; perverse incentives arise when financiers start funding projects without merit. It helped that only whalers had the courage to invest in other whalers and for their experience, some of this agents were duly rewarded. Whaling, unlike the early consumer internet, simply followed a rapidly growing TAM from the start and there wasn’t a clear bubble in the market, perhaps because demand always outpaced the scarce supply.
Trust was more so important in this industry than in others. Capital couldn’t just be raised by one or two people, so it was common to slice ship ownership into 1/16, 1/32/ and 1/64. Your average New Bedfordian could even own ~3% of a ship’s net proceeds. This was enforced through trust. Anyone deemed untrustworthy got the scarlet letter; reputational measures often curtail bad behavior more than any financial penalty.
Why did whalers choose to stick around the industry and become bankers? The returns of the premier whaling agents were telling:
There was a large compound nature within these firms – the best firms continued to outperform weaker ones year after year. It was because they had access to the best captains, logbooks, and could engineer ways of finding the best crews and equipment.
Therefore, these agents charged two fees (like 2/20): one for constructing the voyage and one for the proceeds on sale of whale product at the end of the journey. To maximize reward, agents went into deals as partnerships with their LPs with an average of ~39% equity on a voyage. Incentives were aligned because they had enormous skin in the game.
Experienced agents had to be iconoclasts so as to select captains that stood out from the crowd – herd mentality was rife:
“Captains in whaling simply followed what other whaling captains were doing, to the point that “ships almost without number” pursued whales in close proximity to one another. Possibly, for a whaling captain anxious to protect his reputation, it made more sense to fail along with other voyages than to risk failure as a contrarian.”
Just like phenomenal startup founders, the best captains avoided the herd. The herd mentality became apparent with the > 50% of whaling voyages entering the North Pacfic in the 1850s. The number of captains who copied each other reached unseen levels: when the Bering Strait was blocked due to icebergs in 1851, the whaling season ended in failure.
So why did young men decide to risk their lives as captains when the odds were entirely stacked against them? Herman Melville’s quote says it all: the thrill to rise above the rest and the "everlasting rich for things remote" characterized remarkable captains. Being a whaling captain is much like being a startup founder. The question of when one quits; when one listens to their team (who you have a responsibility to) versus your intuition; and most importantly, when one feels satisfied with their accomplishments.
Some never feel satisfied and they, like Shackleton, can never fit in with normal society. Exceptional personalities drive exceptional outcomes. These questions have not gone away in our time regardless if the industry is hunting whales, selling electric cars, or curing ALS. Before traversing on such a perilous journey, all of those questions above had to be thought and concretely answered. It was literally a matter of life and death.
Whaling influenced the modern VC industry in 3 ways:
“Although other industries across history, such as gold exploration and oil wildcatting, have been characterized by long-tail outcomes, no industry gets quite as close as whaling does to matching the organization and distribution of returns associated with the VC sector.”
People began to understand the consequences of power laws. New industries were consistently turned on their head to make way for power law upsides. New Bedford created a community whereby anyone could take part in whaling so as to de-risk journeys. They didn’t go as far as to reward failure. While success was handsomely rewarded, losses could turn even the best agents or captains into social pariahs.
To solve agency conflicts, LPs, captains, and crews created a highly simple but effective organizational structure still in use today. They also solidified the idea of carry in the form of ‘lay.’
Community-driven investing and trust was the main reason whaling could take off. Only renegade weirdos fund other weirdos. This is a tale that’s as old as time: find your crowd and do stuff together. Nobody except whalers, those who had braved those barbarous coasts, could empathize with that desire burning inside other whalers.
(*all charts & quotes without authors taken from VC: An American History)