|
Financing the commercial development of new technology often mandates the union of an entrepreneur (who is often an inventor) and a venture capitalist. To ensure that their innovative efforts have the best chance of success, entrepreneurs are well advised to understand venture capitalists' perspectives regarding technology, markets, and management before seeking project financing.
Venture capitalists are investors who provide equity capital for high-risk business opportunities. Venture capitalists hope to acquire extraordinary returns on investments primarily through the appreciation of the underlying value of their equity (i.e., their stake in an entrepreneur's business). Broadly speaking, venture capital can be provided by well-heeled individuals (sometimes referred to as angels) or large financial institutions with sophisticated investing operations, or organizations that fall somewhere in between.
Angels, public venture capital sources, and other funding sources have had a significant impact on business growth during the 1980s. Venture capital fund organizations, specifically designed to provide risk capital, represent the most stable and beneficial source of capital to budding entrepreneurs. Examining the insight and perspectives of this community may assist future entrepreneurs in grappling with the complexities of financing new technology enterprises.
Generally, venture capitalists can work with an entrepreneur during the very early stages of the research and development process. They often evaluate prototypes or examine early demonstrations of phenomena that could offer extraordinary opportunities for development (e.g., superconductive materials). Venture capitalists, however, tend to view themselves as experts in maximizing the application side of research and development, and shy away from projects that require extensive basic research or entail an extraordinary discovery yet to be achieved.
Evaluating Project Risks
Although venture capitalists play an important role in the commercialization process, they should not be confused with those who control the mission to provide basic research. The focus of venture capitalism is a commercial one. Consequently, venture capitalists want to know where an invention fits in the marketplace, whether the innovation fits in the marketplace, whether the invention offers a dramatic and sustained advantage, and whether there is compelling evidence to warrant building a business based on the invention.
These judgements are made on the basis of the risk profile of the project. Usually, venture capitalists use the following four risk-related criteria to evaluate both the strength of an innovation and the ability of the entrepreneur to motivate commercialization:
- The market risk -- This criterion helps venture capitalists determine whether the technology addresses a significant problem in the marketplace, what the competitive alternatives are, and whether the market is large enough to yield a significant return on the investment.
- The technology risk -- This criterion enables investors to evaluate the proprietary aspects of the technology, including patent position and ownership; further development work to get to the first product; assess manufacturability; and assess the potential breadth of the technology's application.
- The financial risk -- This criterion helps the venture capitalists to determine the amount of capital needed to achieve a sustainable market position, the potential sources of capital required by the project in addition to initial venture capital investments, and the possible investment withdrawals that may occur.
- The management risk -- This criterion enables investors to determine the strengths and weaknesses of the entrepreneur or founding team, whether additional management is needed, whether effective working relationships can be established, and whether the commercial objectives and expectations of the entrepreneur and the venture capitalist match.
- Although inventors sometimes overlook these risks, they should all be addressed before a venture capitalist is approached. If these risks are well understood by entrepreneurs, financial backing will be much easier to obtain.
The Market Risk: What Problem Is This Product Solving?
When a venture capitalist first looks at a project, the initial question asked is, What problem is solved by this technology or product? Technology-driven business development, in which technology is in search of an application, presents difficult problems. Introducing new technology and simultaneously creating a new market is often referred to as double-whammy investing. The high fatality rate of projects with these characteristics is well known to venture capitalists. Of course, there are exceptional successes and those exceptions provide extraordinary returns on investment, but they are rare.
An entrepreneur with a technology that clearly lacks a demonstrated market is in a difficult position for obtaining financing. The absence of an existing market forces the investor to assess risks through pure speculation--the most tenuous of analyses. In the absence of a demonstrable market, all entrepreneurs are strongly advised to thoroughly demonstrate a problem that the technology can address. If a problem can be seen as a market opportunity by the investor, obtaining financing and project success is more probable.
Unfortunately, venture capitalists often recognize that the entrepreneur's analysis and identification of the market is inadequate, in part because an entrepreneur typically becomes enamored of the technology and fails to sufficiently investigate the market. Entrepreneurs, who usually are not seasoned marketing executives, nevertheless must understand the market potential of and the competitive threats to the successful commercialization of their inventions.
In assessments of competitive market environments, the venture capitalist must be convinced that an invention can lead to a dominant market share regardless of the size of the market. In general, dominance requires a large market share of a given industry segment. The least attractive investment overture a venture capitalist receives is one in which the entrepreneur claims a $10 billion market and perceives the need for only a 2% market share for success. Such a small share of a large market is not viewed favorably because an undifferentiated (i.e., non-niche) market with numerous competitors will probably not generate the level of profits needed by small new entrants to sustain long-term growth.
Market segmentation, competitive analysis, and market sizing are important pieces of analysis that must accompany any entrepreneurs' overture to an investor. Without these analyses, no framework exists within which to determine the value of an invention.
The Technology Risk: Who Owns the Idea?
Establishing a proprietary position early in a technology's history is important because proprietary technology is what the entrepreneur is selling, and the technology determines the value of the business. Whether the entrepreneur approaches a venture capitalist for financing or tries to establish a licensing agreement with a corporation, establishing who owns the technology and who invented it is a critical first step in writing a proposal. It requires the expertise of both business and patent attorneys.
Ownership is often an assumed right to an invention when an inventor obtains a patent. Even if the invention or patent carries the inventor's name, however, some discrepancy regarding ownership of the project may result if the work was performed under the auspices of another party, whether for profit or nonprofit.
Ownership is often self-evident--for example, when a project has been funded by the inventor. The classic example is that of an inventor working in a garage, developing an idea that has had no prior art or similar concept. More common, however, is the situation in which someone who, in the course of employment, has an idea that may have been stimulated objectively by work in progress for the employer. To defend against future challenges, the entrepreneur must establish a distinction between work that was truly part of employment and work that was independently created. Written agreements that support this distinction must also provide proof of principle (i.e., the origin of the technology) and indicate where or how the funding or the particular resources may have been allocated or used to develop the idea.
Venture capitalists closely examine these factors early in their evaluation process. In some cases, ownership becomes dramatically important (e.g., at universities), where grant monies are abundant and most basic research is finished before the application of a new technology begins. Venture capitalists want to ensure that the relationship between the university and the entrepreneur is either well understood and documented or the commercial venture is well away from the campus.
Ultimately, the entrepreneur's goal is to ensure that all the necessary steps are taken to segregate the development of new technology from all resources that could potentially claim ownership. If the innovation was not made during the course of employment (when full disclosures were made) and was created using indirect funding sources and a logbook that documents and traces its discovery, showing how and where the development took place, the inventor generally ends up owning the invention.
Other aspects of technology risk, such as the technical feasibility, are typically well understood by the inventor and a sophisticated investor. These should also be presented clearly in a proposal for funding. (Because entrepreneurs in technology-based venture typically focus on these issues, they will not be covered in depth here.)
The Financial Risk: How Much Will it Take?
Evaluating the potential for taking an innovation successfully to market requires estimating the amount of capital needed to secure the desired market position. Obviously, a venture that requires $1 million to establish market position and one that requires $30 million present different challenges to the venture capitalist. First, the venture capitalist must assess whether sufficient capital can be raised--perhaps in stages--before one dollar is committed to the project.
In addition, most venture capitalists not only want to know what market share can be potentially attained by the product, but what return cash flow can be expected and when. The timing and method of returning invested capital (e.g., through an initial public offering or acquisition) are important considerations for the venture capitalist. For these reasons, the entrepreneur should thoroughly research the market, the probable costs to enter the market, and the likely scenario for providing investors with returns on their investments.
The Management Risk: Can the Market Opportunity be Exploited?
The problems that venture capitalists experience with investments rarely result from a technology that failed or a market opportunity that could not be addressed successfully. People problems, particularly management problems, are the primary cause of failure and distress.
A problem investment scenario typically features an inventor-turned-entrepreneur who becomes a jealous protector of an idea and harbors unrealistic expectations about the value of the invention. The inventor typically distrusts business partners and has limited business experience.
Most businesses that are attractive to venture capitalists begin as projects that are oriented to markets greater than $100 million. Companies of this scale tend to be multidisciplinary. They typically start with one core invention and develop a team approach to build a substantial product or family of products.
Many businesses with limited market horizons can be funded either by the entrepreneur or by the entrepreneur's friends and family. Local or regional service businesses are examples of this type. By comparison, businesses that secure venture capital are generally those in which the entrepreneur's expectations are to build a company on the $100 million scale, in which the markets are differentiated and sizable, the technology can lead to a significantly dominant market position, and finally, the entrepreneur and investor are well matched.
Licensing Versus Entrepreneurship
Armed with the knowledge that venture capitalists are critical evaluators of factors well beyond the technology alone, inventors who want to commercialize technology eventually come to a crossroad: they either seek royalties through licensing their invention to others or take the entrepreneurial plunge and start a new company.
Deciding whether to start a company based on a technology or to license intellectual property rights to someone else can propel the inventor in distinctly different directions. Venture capitalists have long understood the criteria that guide this decision, and the lessons they have learned can be helpful to the potential entrepreneur.
The most obvious factors influencing the decision to license are the availability of capital and market distribution facilities. For example, in medical devices, inventors with device innovations face enormous difficulties in forming distribution channels for new products. The cost of distribution, logistical support, and the conservative purchasing practices of medical providers severely constrain distribution by small new companies. Consequently, inventors and even small venture-backed companies often are forced to license marketing rights to a major company that demonstrates distribution dominance.
Similarly, from an investment perspective, in certain industries venture capitalists have found that capital raised to fund sales and marketing does not increase the value of the company nearly as greatly as capital expended for product development. Consequently, investing in only technology development and selling the innovation before market entry is a growing trend among influential investors.
Other factors that influence the decision of whether to license are whether the licensor owns technologies that are complementary to an innovation and whether the licensor can shorten remaining development time materially. Rapid development is particularly important if an innovation is incrementally advancing the state of the art and a brief window of opportunity exists in the market.
Entrepreneurs should be aware that licensing has its pitfalls and that some of the potential financial rewards to be gained from an invention will be forfeited.
The obstacles to be overcome for successful licensing are finding the companies that have a strategic need for the invention and negotiating favorable licensing agreement terms. The inventor can potentially lose control of commercial strategies. In addition, there is the threat of piracy and the loss of financial returns on extensions of the technology into other applications. Further, the inventor might often find that any leverage to negotiate an acceptable financial return for the invention is constrained. Frequently, entrepreneurs seek venture capital after concluding unsatisfactory negotiations with a potential licensor.
Choosing a Venture Capitalist
If an entrepreneur decides to start a business, the way in which the technology solves a major problem should be emphasized. Support of this basic premise from associates and attorneys often contributes to commercial success.
After deciding to create a new business and find funding, the entrepreneur must select a venture capital firm. This process should be undertaken with the same amount of care taken in choosing any business partner. This partner should clearly understand the particular mission and have the capacity to complement--and perhaps even expand--the horizons of the enterprise. The ideal partners bring contacts and experience.
Entrepreneurs must subjectively assess the venture capital firms they approach. These assessments have a lot to do with personal chemistry, the backgrounds of the venture capital firm and its members, and what the firm brings to the project. It is important to establish a well-understood, effective relationship with venture capitalists early in a new company's development.
The entrepreneur should examine the firm's area of specialization and select an established company with an outstanding reputation for making investments in related areas. The firm will probably then understand and recognize the characteristics of success and failure in that industry.
Furthermore, the particular venture capitalist that the entrepreneur will be working with must be able to enhance the project by remaining informed about the business issues that most affect the enterprise. Finally, to avoid the pitfalls of capital constraints on funds, it is crucial to find a firm that is not nearing its full investment capacity.
The most successful business ventures are usually those in which an entrepreneur has been sponsored by a leading venture capital investor. Often, the reputation of one venture capitalist can make the difference in obtaining financial support. For example, if one highly regarded venture capital firm validates a project by investing in it, the project gains a more desirable stature for further fund raising. Without initial support from the investment community, the entrepreneur may have difficulty in finding financing.
One Company's Experience: Combining Talents
A recent case illustrates how the entrepreneur should seek business associates and venture capital. The situation involved technology transfer at a university.
Albion Instruments, a think tank comprising six principal Ph.D. researchers, was founded in 1981 to develop a variety of biomedical technologies originated at the University of Utah. Through its research, this group decided to focus on one particular technology that they believed had commercial possibilities in a medical application for Raman spectroscopy, which uses a fixed single frequency of light scattered in a pure substance.
Because the Raman effect is a natural phenomenon, it is not patentable; however, the researchers invented a laser design that allowed technicians to differentiate certain gases by using Raman spectroscopy. At the heart of the company's patentable innovations was the ability to measure gases within the chamber of the laser. A potential imitator could not achieve the same light intensity without a much more expensive and impractical implementation. The laser design would be difficult to imitate because of certain critical tolerances and optical requirements.
The proprietary position of the company was very strong in technical know-how, and the technology was not easily reproducible using reverse engineering. An imitator would likely attempt a new implementation and would have to overcome substantial technical barriers.
The company demonstrated that the product filled a market niche for gas monitoring during anesthesia. The anesthesia gas monitor developed by Albion based on its new technology offered improved automation over existing technology, provided protection from malpractice litigation, and increased patient safety during surgery. It was also determined that the product could compete in a market segment with annual revenues of $100 million. The rate of market growth was predicted to continue at more than 20% per year.
Several venture capitalists looked at this project and decided that either they did not understand it or they had reservations that prevented them from investing in it. In 1987, an intermediate source referred Albion to another venture capital firm. Because this firm was so involved in medical product instrumentation, the project's potential was appreciated.
The venture capital firm recognized a unique technology that was protected by an initial patent. The Albion organization, run by academics who had only limited business experience, was incapable, however, of commercializing the product. Nevertheless, the venture capital firm decided to fund the project because it was able to provide guidance in product development management and a strategic framework for the business. More important, this initial investment brought in other investors and the complementary management that was necessary to make the technology commercially feasible.
The project was focused to meet market expectations in a first-generation product. Funding was provided to reach initial technical milestones. Management was brought in, including a CEO with appropriate experience and business acumen to provide the necessary leadership. The Albion team developed its first-generation product, entered its market, and proved that its instrument outperformed by far the existing alternatives in the market. The company gained a reputation under its CEO's leadership and was able to establish market acceptance. In June 1990, Albion was acquired at approximately 10 times its revenue base.
Forming Strategic Alliances
In the Albion scenario, the investors syndicated several million dollars of venture financing with firms from past working relationships, and that also provided added value. Although venture capitalists often compete for innovations that can be readily funded, these firms also have relationships with one another. At any time, two firms may be competing for one project but collaborating on another. Consequently, as the venture capital industry has matured, so have the relationships among the firms. More important, the dominant trend is toward creating strategic alliances among firms and focusing on important working relationships.
Cultivating the Relationship
The venture capital firms with the best reputations have assumed prominent industry positions because of the reputation of each member of the firm in addition to the quality of the investments made. Usually, investment executives are required to have general management backgrounds within their industry areas of expertise to bring an operating perspective to the investment environment. This requirement has been the most notable trend in the venture capital business. In addition, most business has now become global in scope, and international considerations for an enterprise are becoming absolute necessities. Entrepreneurs should look for combinations of these attributes when presenting a business proposal to a venture capital firm.
Directly approaching a venture capitalist by sending an unsolicited business plan is usually the least satisfactory approach. Developing a relationship with a venture capitalist should be viewed the same way as cultivating any other business relationship. Unless the entrepreneur takes the time to form a relationship with someone in the investment community, difficulties in attaining financing for the project are inevitable.
Some entrepreneurs have been in venture capital-backed businesses before and have been able to establish relationships with investors, but most people in technical and scientific fields have not been able to cultivate those relationships. The best way to develop an investment relationship with a venture capitalist is to be referred by such intermediaries as the attorneys, accountants, and bankers who will be working with the entrepreneur during the early phases of the business.
Securing funding for a project is a strenuous and difficult activity. Timing is critical, and the advice of an experienced executive or intermediary specializing in venture capital relationships can help with this aspect.
Finally, when choosing a venture capital firm to work with, the entrepreneur should examine both the reputation of the firm and the business integrity of individuals representing that firm. An individual claiming to be a specialist should have a verifiable track record to ensure success. |
