Broken Symmetry

Um. How is this different from any other kind of secured credit?

Financial engineering "news" from Tech Transfer Tactics:

An emerging paradigm called royalty-based financing — applied to early-stage start-ups — may be another, according to Gregory T. Huang of Xconomy Seattle. The concept is simple. Instead of buying equity in a young company, an investor agrees to receive a percentage of the company’s monthly revenues - but the upside is capped at a limit of, say, three to five times his or her investment.

It's a bond, folks. And people have been making venture loans in Silicon Valley for a long time.

What makes a market concentrated?

Does this qualify?

These days, bulge-bracket banks -- notably Goldman, Sachs & Co. and Morgan Stanley -- pretty much have a lock on underwriting new issues. (Goldman Sachs, for example, was co-lead manager on five of the seven IPOs that late-September week, and only Vitacost.com turned to bookrunners who weren't bulge-bracket banks.)

Not only does their "brand" dominate, but they've done a good job of convincing pre-IPO companies of their worth. "The common joke is that no CEO gets fired for hiring Goldman Sachs," says Cowen's Biele.

Domination means that these larger banks can pretty much dictate IPO terms. With very few exceptions, they demand IPOs of $100 million or more "to make it worth their while," one venture capitalist says.

That translates into a minimum valuation of $400 million to $500 million, which excludes a whole universe of high-growth, middle-market concerns.

But the FTC and DOJ by themselves cannot solve this problem. They need to work with SEC to clear the hurdles to smaller companies making offerings. Without an IPO option, these companies have to negotiate with potential acquirers with zero leverage.

Commentary Worth Reading in view of Stanford v. Roche

From an interview of Dr. Gerald Barnett at the excellent ip-advocate.org, which I just discovered:

Bayh-Dole focused on harmonizing agency patent policies and distributing opportunities to promote inventions to universities across the country. It wasn't directly concerned with innovation, but with using the patent system to promote use of inventions, development of collaborative relations with industry, and support for U.S. small business and U.S. labor.

The law itself hasn't constrained innovation - but the way in which universities have implemented practice under it has had mixed outcomes. In response to the law, many universities established Technology Transfer Offices (TTOs) to act as a central reporting agency and to facilitate the selection of inventions that will benefit from use of the patent system. This mixed a regulatory function (reporting) with an invention management function (patents). The result was pressure to monetize patent rights rather than to create an environment that promoted innovation.

The TTO works great for paperwork reporting, but not so well when you have a diversity of inventions, from biotechnology and nanotechnology and software and composters, moving through a single office. Even if the TTO is well-funded and staffed, you still only have a one in a hundred chance of a monetary success worth talking about.

What universities haven't done well is the use of the patent system to build working relationships with industry, support the development of research and early adopting practice communities, or support inventor-based insights into commercialization directions. For this last bit, TTOs find themselves cornered between processes designed to identify inventions with great "commercial potential" and a demand that everyone get equal treatment. As a result, it's difficult, especially in public research universities, to mobilize resources in support of any particular invention - beyond filing a patent application.

Second, and just as important, many universities also established employment policies that compel inventors to agree to assign their inventions to the TTO. This is a subtle but huge transformation in how invention is managed within the context of university research. A hundred years ago, when Cottrell invented the electrostatic precipitator, he was working with a company, at the University of California. He used the patents to found Research Corporation, which then supported research throughout the country and served as an agent for other faculty who had inventions they felt could benefit from Research Corporation's expertise. The system was voluntary, not compulsory. And it gave rise to the idea of the research foundation, as later established as university affiliated at Wisconsin, Kansas, Washington State and elsewhere.

Bayh-Dole gave universities an incentive to wrap voluntary inventor interests with a process-based policy, anchored in contracting regulations. These were then extended for consistency, if not convenience, to cover all instances of invention, not just those made with federal support. As you know, this move to compulsory claims based on employment, rather than voluntary offer based on recognition of resources, has created tremendous issues.

When you think about it, Bayh-Dole set up a classic struggle between bureaucracy and innovation. After all, innovation threatens institutional norms that bureaucracy seeks to codify. Given the opportunity to do so, institutions - agencies and companies included - inadvertently bottleneck and suffocate bright ideas with process. It turns out that consistency, compliance, efficiency and avoidance of risk are the dominant virtues of a process approach to research innovation. Mobilization for a purpose, risk-taking to achieve an outlier advantage, and preparedness for rare events don't count for much.

A very Drucker-esque view of innovation. Here's an important question for tech transfer offices to consider: given the bandwidth issues they face in addressing the many demands on their time, wouldn't now be a good time to consider working with a private intermediary like the Research Corporation?

In economic terms, the Research Corporation acted as a market-maker in those early days of university patenting. The Bayh-Dole Act seemed to have disrupted that model when a handful of universities were successfully able to patent and license innovations without the help of such an intermediary. But what the last decade has shown, I believe, is that entities like the Research Corporation performed an even more important economic function than the provision of professional (even legal) services. Intermediaries like Research Corporation help close feedback loops between universities and industry that are difficult because of the Prisoners's Dilemma of incentives and the asynchronous time horizons of universities and for-profit industry. Without such intermediaries, the tech transfer market is going to become more and more like the patent secondary market, with its litigation-driven norms and valuations. We need more experienced and culturally sensitive intermediaries to foster transactional norms.

Patent Auctions, Patent Artifice, and Patent Artistry

From today's NYT:

“Yes, you can move in the direction of trading markets for patents, but these are complicated assets that are individualized and hard to value,” said Josh Lerner, an economist at the Harvard business school. “They are more like works of art than stocks.”

Couldn't have said it better myself. As somebody who has attended a couple of patent auctions, and even helped sell a lot at one, it is surprising to see the market presented as growing. The auction market is winding down, as Ocean Tomo's recent cancellation of its event in Paris demonstrates. There will always be an auction market at the low-end, but the larger portfolios are going to be bundled and exchanged more privately.

That's not to say that there isn't going to be some growth in the IP market. It's just that it will be growth that accommodates the artisanal qualities of IP that Prof. Lerner notes.

Feedback Loops at Stanford

From Steve Blank's series on the Secret History of Silicon Valley:

The close tie between the two labs was a unique aspect of the Stanford Lab. Stanford had a Customer Development loop going on inside their own lab. The discoveries in tube and circuit research suggested new electronic intelligence and countermeasure techniques and systems; in turn the needs of the Applied Lab pushed tube and circuit development. With the Applied Electronics Lab Stanford was becoming something akin to a federal or corporate lab run under university contract. The university found government contracts profitable as the government reimbursed their overhead charges (their indirect costs.) This means they could fund other non-military academic programs from this overhead.

Carol Mimura on the Nuances of Managing IP Rights

Since I recently complained about the culture in technology transfer offices, I thought it only fair to point out that there are indeed a few universities that have developed or are developing a healthier approach to university-industry relations. Carol Mimura at UC Berkeley recently posted a draft book chapter on SSRN:

[Tech transfer] is an ongoing relationship continuum, not just a single transaction. A relationship continuum spans many years. It results from many points of contact, and many engagement types. It is akin to building a pyramid or climbing a staircase, or contributing different sectors of a pie to create a whole. Our networks are essential. We cannot accelerate innovation on our own; rather, our public-private partnerships and product development partnerships demonstrate that we can expedite translational research and bridge funding gaps through creative partnering and flexible contracting.

Success under the relationship model consists of rights transfer and knowledge transfer in both directions (into and out of the university) to enable innovation acceleration, deployment, uptake, and translation. By many measures, the relationship model has borne fruit. By valuing corporate relationships more than any single transaction, utilizing our networks to advantage, and valuing research support as highly (if not more highly) than license revenue, the overall industry dynamic has changed. Cultural and negotiation biases have been reduced, industry and foundation funding have risen dramatically, collaboration types and numbers have increased, barriers to gifting into the university have been lowered, and greater numbers and types of contracts and strategic alliances have been formed. We have also enjoyed reputational gains as a campus that has improved its corporate relations and contracting units.

The high-bandwidth feedback loops established through what Mimura calls a "relationship-based" approach to tech transfer are an example of the integrated complex systems that are a theme for this blog. Like the neural networks of its individual members, the social networks established can learn over time, gradually building up tacit knowledge of the science and engineering problems that pose challenges both to public and private organizations.

A key cultural difference between UC Berkeley's IPIRA and other university tech transfer offices is that Mimura and her team first took the time to learn about the needs of every stakeholder involved in these complex, multilateral agreements. As a result, the deals she has closed -- including the pathbreaking BP-Berkeley deal and the Socially Responsible Licensing Program (SRLP) -- are nothing less than the future of the IP market. Although it might be inconvenient for some market participants to acknowledge, ultimately the highest value of IP rights is realized through the increased collaboration (and hence learning) that they promote.

What is Wrong With Technology Transfer Office Culture?

Jon Sandelin from Stanford University's Office of Technology Licensing published an article in the Summer 2009 issue of an AUTM journal called University-Industry Relationships: Potential Risks. Perhaps unsurprisingly, the article is gated and available only to members. Already in the title you can see where Sandelin comes out on the idea of having more commercial ties with universities. One of the messages repeated on this blog over the past year has been that feedback loops promote innovation. The feedback loops between universities and industry are perhaps the most difficult to forge and maintain of any in our innovation pipeline. We should be promoting these feedback loops aggressively. Unfortunately, the tentative, preening, and antiseptic tone of this article is all too characteristic of tech transfer culture inside top-tier research universities.

Sandelin does a good job listing some of the benefits of tech transfer. But consider the "summary of risks" he comes up with:

1. That patenting and licensing by universities may inhibit rather than promote the progress of science and production of innovation
2. Of a loss of public trust in the university and/or its employees
3. Of unfulfilled commitments to research sponsors, students, or the university
4. Of bias when reporting research results or not reporting research findings that would be adverse to the interests of an industry patron
5. Of exploiting the work of students to benefit personal interests of their supervising professor
6. Of adverse and embarrassing reports in the media, whether actual or perceived, that affect the reputation of the university
7. That new discoveries made by university employees are not reported to the university or to a federal funding agency as invention disclosures, but are instead diverted to a company in which the employee has a financial interest

That's it. Wait. That's it?! Of these, only 4 is what I would consider an actual risk to the university. Look at the other six items on this list more carefully. What is really there?

First off, what on earth can he mean by one? If one is true, then why are we even bothering? The tech transfer experiment has been a wild success. As economist Kenneth Arrow noted recently, some of the best work results when academics are asked to work on a problem they've never thought about before. Tech transfer relationships work because universities get data from industry that is as valuable to academics as the theory that industry gets from universities.

Two just shows how little conviction Mr. Sandelin has in the fact that he is doing something important and beneficial for the university and its employees. Why would these people not trust the university if it is doing things that benefit society at large by cooperating and collaborating with private companies? Does he believe making money is inherently evil? If so, why not come right out and say that instead?

Three strikes me as very strange. Isn't the possibility of unfulfilled commitments to research sponsors a risk for the research sponsors? How is that a risk for the university? Similarly, why would students see more industry relationships as a risk? Students need jobs after they graduate, and somebody has to provide work.

Five would be hilarious if it weren't sad because it demonstrates how big a problem negotiating ownership rights is when it isn't done properly upfront. Universities love to ask graduate students to sign a thick contract when they start that gives away all of their rights. Most grad students, of course, never read the fine print and only find out how badly they've been taken advantage of later when somebody makes millions on their blood, sweat, and tears.

Six also makes me wonder. That's not a risk of relationships with industry. That's a risk of dysfunctional relationships with industry. Why would that be a problem for a university like Stanford, I wonder?

So of these seven risks, it is only four, the risk of bias caused by taking money from a particular group, that strikes me as very serious. But that risk is a risk for any institution, public or private, for-profit or not-for-profit. There's nothing really more difficult or challenging about solving that problem at a university. In fact, it's probably easier to solve that problem at universities, where most academics prize their professional reputations far above any particular grant money. Let the researchers themselves be the ones to decide whether it's worth risking their reputation on taking funding from some large corporation. Then just make sure that everybody can lookup and find out from whom researchers are getting their support. That's how we do things in this country.

It's very frustrating to see how backwards the thinking is at what is considered one of the best technology transfer offices in the world.

Who has the leverage with VC-backed real-time startups?

The new wave of VC investment in Internet-based startups focuses on "real-time" applications.

Long time readers of BS should know that I am quite enthusiastic, overall, about this development.

But on my way in this morning, I was thinking again of Fourier transforms. The goal of thinner and thinner slices toward the present time comes at a cost of wider frequency.

So who will be the biggest winners because of real-time startups?

Of course, if IRR expectations are reasonable, then everything will turnout just fine. Only they can't be with 2x what's coming out going in the last few years running.

I see a few bandwidth owners tenting their fingers and laughing maniacallly at this fortuitous development.

e: The Fundamental Speed Limit on the Organic Growth of a Startup

Fred Wilson had a couple of good posts on the Venture Capital Math Problem last week. I made a few comments over there, but I wanted to offer a few more extended thoughts on this problem.

Although I haven't found anything on this in the literature I've read on finance, it is well known in other fields, including physics and biology, that there is a fundamental speed limit to the rate of growth of any quantity -- namely, e.

There are many places where one can read about e on the Internet, so I'm going to confine my remarks to the question of how this fundamental speed limit is relevant to venture capitalists and entrepreneurs. For one good introduction to e in finance, see here. But for one tantalizing hint at how interesting things get when one starts looking carefully at e, note that because most quantities we are interested in measuring vary in time (i.e., they have a relative-phase that is a coefficient to the complex quantity i), e together with pi and i provide a fundamental connection between algebra and calculus, or (equivalently) between geometry and dynamics.

Entrepreneurs and the venture capitalists who finance them want their businesses to grow as fast as possible. At the nitty gritty level, this means building a product or service and creating a market for that product or service as fast as possible. In practice, this process of development, marketing, and sales, occurs in cycles. If things work right, with each iteration of the cycle, the product or service is adjusted to make a better fit to the existing or forecasted market, the market then expands either by word of mouth or by direct advertising, and the process repeats. Taking also into consideration the fact that as the market expands beyond a certain size it will begin eating into the money that used to be spent on other similar (but not identical) products or services, and you've got what Joseph Schumpeter called waves of "creative destruction."

Imagine you had the best product idea and the best team in the world. What is the fastest that you could possibly grow your startup? Would pumping more money into the startup help? Every venture capitalist would like to know the answers to these questions.

Some already know that the answer is that the very fastest that you can grow anything is by continuously compounding -- by feeding whatever new revenue you generate back into generating more revenue instantly. If you plot revenue as a function of time, and look at the base of the logarithm, the largest base results when you instaneously begin compounding every new bit of revenue as soon as it comes in. That base is e. There is no way to grow revenue faster than e.

In fact, you won't come close to compounding continuously most of the time. That's because there is always going to be some dissipative force in your organization that drains revenue off to processes other than the ones that are iterating and expanding your market share.

As a final thought, notice that if we assume a growth rate equal to f(x) = x^k (a power law), then log f(e) = k and log f(1) = 0. In other words, for our growth rate to scale up to new market sizes perfectly (that's what taking the logarithm requires) we have to be continuously compounding, which I just said we can't do. No startup's rate of growth is going to scale perfectly. The best one can hope for is to be closer to e than to 1.

UPDATE: It's worth pointing out that under the right conditions, change can happen faster than exponentially. Kurzweil has his double-exponential theory. Power-law fanatics have theirs. I can see how this might work by analogy to phase transitions in condensed matter physics. The organic growth described above would apply to a continuous transition. In some cases, however, there is a certain amount of energy that disappears from the system as local symmetries are broken -- like the latent heat of fusion as water goes from liquid to solid. In certain cases, one might be able to supercharge growth by adding a lot of resources into building out a basic structure that can scale with logarithmic increases in demand. But that would seem to be a risky proposition compared with organic growth in many scenarios.

Who are the customers for a venture capitalist?

The answer is not entrepreneurs, as much as they'd like you think so. Neither is it the public who buys IPOs nor the public companies that often acquire startups from a VC's portfolio. The answer is the limited partners who give their money to the VC to invest.

This central fact has been overlooked by some entrepreneurs. Thanks in part to the work of people like Nivi at Venture Hacks and Fred Wilson at Union Square, that is changing. Expectations for entrepreneurs are coming into line with the expectations of VCs and their customers. This is absolutely crucial to the long-term survival of venture capital!

But as always in life, things are more complex than the most correct answer can summarize. What makes VCs profitable for investors, after all, is in part a function of how good their relationships are with both entrepreneurs (on the entrance side) and investment banks or established companies (on the exit side).

I have been wondering about something for a long time, and I hope that this post will generate some feedback from those experienced in venture capital. It seems to me that most VCs get the part about being entrepreneur friendly. Although some VCs in practice are surely more entrepreneur friendly than others, to some extent when somebody calls a VC "founder friendly" or "founder unfriendly" this may reflect the dynamics of a given deal rather than the bigger picture. The sample is too small to say.

What I have not observed, however, is a VC marketing and broadcasting to LPs their connections and relationships with investment bankers or established public companies. Why not? Why are these stakeholders in the VC market kept in the wings?

There is a practical point to this question, which is that most established companies are getting less innovation through venture capital-backed startups than they could if these relationships were cultivated, and more feedback were flowing from these large company "customers" back to the startups who will probably be acquired by the same large companies since the IPO market is closed for the foreseeable future.

Readers, what do you think? Please email or leave comments below.

UPDATE (7/7/9): I noticed recently that Fred Wilson a few years ago did a post about how, in fact, his view is that entrepreneurs are his customers and limited partners his shareholders. That model has much to recommend it, but I'm not sure that the incentive structure created by the LLC/serial LP model is consistent with it. A different legal structure would make more sense if that were the intent. But maybe it's just the tax issues and other restrictions on transfer of LP interests that prevents the different legal structure.

Also, I eventually answered my own question by reflecting on the limited leverage that startups have in negotiating with one or two potential acquirers without a healthy IPO market available. I agree with Ben Graham that IPOs are not for individual investors. But startups need an IPO market to get a fair price for their work from potential acquirers.

Where's the Exit for Venture-Backed Startups?

From Alan Patricof in the NYT:

The sum and substance of all of these developments is that the minimum economic level to bring a company public today is at least a $50 million offering at a $250 million market value. With realism back in the market and a return to rational metrics, like multiples of revenues and, better yet, profits, venture capitalists have had to face the hard reality that it is highly unlikely that taking a company from start-up to a point where it can justify this type of market capitalization in a three-, five- and even seven-year time frame is realistic, except in a limited number of situations.

For these reasons, I believe that the paradigm has changed for the venture business. We can no longer realistically expect the same kinds of absolute returns that were achieved in the past through a quick turnaround from start-up to liquidity through an I.P.O. Rather, I believe that most of the companies that venture capitalists are funding today will find an exit through merger or acquisition. And if we expect to achieve a return in a reasonable time frame of three to five years, we are probably looking at a sale price of $20 million to $100 million. This is the valuation range where most young companies are being acquired.

Formal Education and Innovation

Since Mike Speiser stopped blogging, Fred Wilson has provided the best blog connection to the venture capital world. Fred is a thoughtful guy, and has put tons of work into building a wonderful community through his blog. Check out out how many comments he responds to. Unlike so many other bloggers, he's really interested in what his readers think about, and reads and responds to many comments.

Which is why I was a bit disappointed with his latest post. As I see it, he's pandering a bit to his younger readers here. His post is about how you don't need a college degree to be an entrepreneur.

Precocity attracts attention. We all know the stories about how Bill Gates dropped out of college. But for every Bill Gates there are probably thousands of college dropouts whose new businesses never really got off the ground. Many of them would have been better off taking the time to learn what was already known and written down in books. Some young people have a hard time with that. Yet that is what I believe we should encourage young people to do.

The Kauffman Foundation published an interesting study last year that provides some empirial basis to support this view:

Challenging the perception of American technology entrepreneurs as 20-something wunderkinds launching businesses from college dorm rooms, a new study by the Ewing Marion Kauffman Foundation and researchers at Duke and Harvard universities reveals most U.S.-born technology and engineering company founders are middle-aged, well-educated and hold degrees from a wide assortment of universities.

I know it's true that you learn some things from trying to start a business that you cannot learn in school. But you can always start a business after you graduate. It's harder to go back to school.

The larger point is that innovations -- including new businesses -- require the cooperation between a creator and a group of people who recognizes the work of the creator as a contribution. Young people are better creators because of their naivete. But older people are better at listening, watching, and meeting needs.

Stephen Quake calls for Change in Technology Transfer

This op-ed by successful academic, inventor, and entrepreneur Stephen Quake is a landmark piece. The current system of technology transfer must evolve for the United States to maintain its competitive advantage as a producer of new technology:

Licensing is often a protracted process, and licensing officers so paralyzed with fear about making a mistake and not maximizing licensing revenues that they discourage all but the most persistent licensees. Because universities are non-profit institutions, the true measurement of technology transfer success should not be the total amount of licensing revenue, but rather the successes in helping faculty members patent inventions, in forming new ventures that create jobs, and in facilitating the commercialization of technologies that in many cases will help improve our society.

The best way for universities to achieve this would be to make the same decision the federal government did, and relinquish their control over licensing. Since in most cases faculty know the context of their invention and how it can be best commercialized, they should drive the licensing process, and the OTL should play a supporting role. The university deserves to receive some compensation, but this should be fixed by a simple formula and limited — bearing in mind that the vast majority of research funding that leads to inventions has been obtained by the faculty through grants, and that the university has already taxed a fair bit of that to support its facilities.

Please read the whole thing. There is almost nobody with more first-hand experience than Quake. He's telling us what's wrong with the system.

Commercial entities (from venture capital funds to public corporations) and universities face a prisoner's dilemma when it comes to IP rights. Cooperation offers benefits to both; but the incentive in individual transactions is to defect. Quake is calling for inventors to have more control over the process, and that will help. But even better would be for technology transfer offices to recognize a bigger role for private equity funds in assisting with the process. An intermediary with equity incentives will outperform even the best organized and well-meaning of in-house technology transfer offices.

Read the comments on the NYT page too. See how many in industry are frustrated with the technology transfer offices?

Feedback Loops in the Innovation Pipeline

Check out the many feedback loops in this Figure. Notice in particular how the loops connect both adjacent and non-adjacent stages in the cycle, wrapping the pipeline back on itself several times:

Now guess when the Figure in this article was published. Leave your answer in the comments below, and click through here to see if you're right.

Innovation in Idaho

Tech Transfer Tactics reports:

Mahoney envisions multiple revenue sources for I-Cubed, including selling IP and taking a percentage, negotiating royalty agreements with public partners, buying ownership stakes in companies that receive funding, and charging a percentage for managing the investment fund. The clearinghouse would employ a sales and marketing team to market Idaho technology globally. Most licensing revenues would be returned to the source company or institution. Although all three state universities have tech transfer departments, they must “go back to the legislature every year for more [funding], which doesn’t breed consistency,” says Brian Dickens, administrator of the Idaho Department of Commerce’s Commercial Innovation Division. Universities have been thus far receptive to I-Cubed, whose business model “seems to supplement efforts that are already underway here and other places,” says Mary Givens, TTO director at Boise State University. “Once it is up and running, Boise State will look for ways we can work together.”

Sounds like a great idea to me. I'd say that even more established tech transfer offices would be interested in that sort of partnership if I didn't know better from personal experience. But the real story here is the innovative source of funding -- a great example of creative entrepreneurship:

I-Cubed is seeking foreign investment under the federal EB-5 immigration program, which grants visas to foreigners in exchange for committing at least $500,000 to rural or high-unemployment areas and $1 million to urban areas for at least two years.

This is a terrific way to foster the growth of human capital here in the U.S.

Does Silicon Valley Face an Innovation Crisis?

From the NYT:

“Starting in 1998, there was such a shift in Silicon Valley toward chasing money and short-term returns,” she said.

Part of the reason, she said, was that Cisco and other fast-growing big companies started acquiring start-ups with innovative technologies instead of developing new ideas internally. Entrepreneurs began founding companies with the goal of selling to a big tech company, and venture investors encouraged that.

I'm seeing the same thing.  One way to break out of the norms we've settled into since the dot com bubble would be to formally recognize two different types of funding: traditional VC funding for Schumpeterian innovations and more IP-driven funding for incremental innovations.

Why don't VC funds employ in-house lawyers to do work for portfolio companies?

A while back, Jason Mendelson wrote a great post about his frustration with "startup lawyers," by which he means outside counsel who work on transactions relating to portfolio companies.  Like many consumers of legal services, Jason is frustrated with a trend toward lower quality and higher cost.

I don't want to get into the discussion of what trends have emerged and why here.  Rather, I want to ask the question of why more VC funds haven't hired outside counsel to come work in-house doing work for portfolio companies.

Benefits:

• Lower fees from outside counsel, probably more than offsetting the salary cost
• Better quality services from outside counsel (higher bandwidth communication, especially when it's with a former colleague)
• Less worry about the billable hour clock by the in-house lawyer, which means more efficient allocation of time to various legal problems
• Lower cost to lawyer spending time on-site with portfolio companies to proactively avoid legal problems
• Lawyer also available for consulting on fund-related issues when not needed at portfolio companies

Disadvantages

• Requires outlay of cash-flow from management fees to cover salary
• Agency costs that could result from soft kickbacks between in-house lawyer and outside counsel (relatively easy to reduce with monitoring)
• Misalignment of incentives between lawyer and portfolio companies because salary is paid by VC fund (but this one is shared with the VCs!)

Note that nobody could eliminate outside counsel because of the superior access to information about new case law, unusual market scenarios, the database of internal legal documents built up over years for use in a variety of client matters, lower cost ability to generate stock ledgers, etc.

Often, VCs invest millions of dollars into a new round of financing, only to demand that the startup company turnaround and pay outside counsel for the tens of thousands of dollars in costs of advising on the transaction.  I understand why this is done from an accounting perspective.  But it is not so cost efficient.

Why the Venetians didn't invent a Prize system for Inventions

Over at PatentlyO, Dennis Crouch covers the news that McCain has proposed a publicly funded prize for developing a better battery for cars.  Dennis also points out how this strategy worked historically for England in solving an important navigational problem: John Harrison solved the timing problem by miniaturization.

One can only hope that this is a symbolic gesture by McCain toward the need for patent reform.  $300 million is only a drop in the bucket that has already been spent on solving this problem.  Ballard Power Systems, for example, has by itself spent at least that amount developing fuel cell technology, which many scientists believe to be a more viable alternative to the battery as a non-oil alternative power plant for cars.

I point this out not because I want the government to spend more money than McCain has earmarked for this R&D, but because I want the government to spend less money.  That money has to come from somewhere folks.  And that somewhere is taxes.  Don't bet on it coming from a higher capital gains tax if McCain were elected either.  The possibility of having another "conservative" president in office, increasing spending, decreasing taxes, and increasing money supply is terrifying to me.  Already it appears that the United States has indentured itself to the rest of the world for the foreseeable future thanks to our profligate spending and inflationary monetary policy over the past few decades.

There is a proper role for government "prizes," a role that the NSF and NIH have been performing quite well for decades.  That role is in funding the curious exploration stage of scientific discovery.  Observations of nature are often the source of inspiration for later innovations by authors and inventors.  Few businesses in the history of the world have been willing to pay for curious exploration of the natural world.  We still need government funding for that.

But we should limit government funding to that stage, and let the needs of industry drive funding for development of those natural observations into new products and services.  The distortions in the food market that resulted from government subsidies of ethanol production are Exhibit A as to why government funding of R&D is a bad idea.  Government starts with a noble plan: to reduce global warming.  But it ends with people starving in the developing world.  To avoid catastrophe, investing must be disciplined by market needs -- a discipline that government, by definition, lacks.  Private markets and firms are a cheaper way to make things than government because they don't make money unless they match (i.e., synchronize) their outflow of things to an inflow of demand for those things.  Government doesn't have to (at least not over the short-term).

The United States should follow the example of the 15th Century Venetians, who harnessed the power of market-based incentives to encourage innovation in solving the most important problems their society faced.  Read this description of how inventors worked together at the Arsenal, the 16th Century equivalent of Ford's Highland Park manufacturing plant (but for boats, not cars):

Everything concerning ship-building and armament, direction of the works, purchase of wood and iron, organisation of the workshops, discipline of the workmen, commanding of the troops, training of the seamen, storekeeping, provisioning and contracts was under the provveditori. They formed themselves into a committee for testing and examining all the new inventions submitted by their fellow-countrymen or by foreigners.

Rather than $300 million for the particular purpose of batteries, why not  $300 million for marketing and public education about the patent system?  The provveditori are like a combination of modern day venture capitalists and patent examiners.   I don't think most Americans have any idea how important the patent system is to our future.  Maybe patent law is too important to be left to the patent lawyers.

Update: I can't find a good modern analogy to the provveditori.  Their work is performed by a combination of people and computers today.  In some ways, they are like a heijunka box.  In others, they are like patent examiners, lawyers, consultants, or investors.  Their role in many companies today seems largely to be filled by goods and services obtained from various markets external to the company.  Have we made a step forward or a step back?

Are there too many ideas... or not enough (good ones)?

Anybody who has spent time working in venture capital in Silicon Valley, almost no matter how short, has observed that it is common for multiple teams to be pitching the same startup idea at around the same time.

The conventional wisdom, accepted by nearly every venture capitalist that I've ever heard, is that this is evidence that ideas are cheap, and that it's the team and execution that matters in separating the winners from the losers.  If the supply of ideas is fixed and inelastic, then the team of entrepreneurs and investors that can make the best use of that inelastic supply will end up winning markets over the long haul.

But I have literally never heard any venture capitalist ask what seems to me like an obvious question given the undersupply of ideas relative to the teams available for execution -- namely, how can we increase the supply of ideas?

Now some of the venture capitalists -- particularly the small minority that have succeeded despite the drastically limited supply of ideas -- are likely to respond that the teams not funded are better off doing other things.  I'm not so sure about that.  I like the idea of more ideas, more startups, more innovation.

In fact, I think the great strength of the United States has been its encouragement of inventors and entrepreneurs.  Perhaps everybody would benefit if the differences between the supply of ideas and the supply of execution talent were more readily distinguished, and the supply of ideas got more funding.

The difference between Venture Capital and Venetian Capital

To a thoughtful student of European history, Silicon Valley of the 21st century might cause deja vu.  For there was another culture and place in which entrepreneurs and financiers lived within a small radius of one-another, and were constantly bumping into one-another at social and business gatherings: 15th century Venice.

• Venice was isolated from Florence, Rome, and Constantinople in much the same way that Silicon Valley is isolated from New York, Los Angeles, and Washington, D.C. today.
• Venice was geographically limited in its extent by the lagoon in much the same way that Silicon Valley is limited in its extent by the mountains and San Francisco Bay.
• Venice was home to an aspiring group of artisans who had something to prove to the elder statesmen in Florence and Rome in much the same way that Silicon Valley is home to entrepreneurs with something to prove to the CEOs, investment bankers, and politicians in New York and D.C.
• Venice was home to a network of merchant bankers, many of whom knew one-another personally and shared in the burden of diligencing investment in much the same way that Silicon Valley is home to a network of venture capitalists who know one-another and share in the burden of diligencing investments in new ventures
• By the mid-15th century in Venice, most of the prominent merchant bankers knew who the best artisans were, and were happy to work exclusively with those artisans on deal after deal much as Silicon Valley venture capitalists are happy to work exclusively with the same serial entrepreneurs on startup after startup.

But there is one way in which Silicon Valley differs from 15th century Venice, which went on to spread its technology and art throughout Europe in the centuries thereafter:

• Venice, unlike Silicon Valley, was home to the birth of patent law in the late 15th century.

The Venetians were smart enough to realize even in the 15th century that they would have to feather the nest for new artisans and inventors in order to ensure that a pipeline of new art and technology kept flowing freely. Not coincidentally, when Venetian glassworkers carried their new technology with them to the rest of Europe, they carried also, like the fire of Prometheus, the idea of a patent system.

Stranded R&D

In 1980, Congress passed the Bayh-Dole Act.  Overnight with its passage, universities and government-funded R&D labs gained a comparative advantage in funding R&D.  Universities and government labs have a cost advantage in that many had already spent tens of billions of dollars setting up research labs for non-commercial purposes, including teaching and curious exploration.  Many scientists and engineers found the prestige of academia, and the increase in professional freedom it promises, a compelling offer.  The result has been a gradual shutting down of corporate R&D labs, and an expansion of industry collaboration with scientists and engineers now employed by universities and government labs.

Many people think of the Bayh-Dole Act as an unmitigated success story.  Several multi-billion dollar technology companies that are now household names (such as Genentech and Google) started in graduate school research labs.  Many inventors are happier in the more collaborative environment that academia offers.  Collaboration is an under-appreciated driver of innovation.

Unfortunately, so far universities have underperformed private benchmarks for the successful transfer of technology.  Despite spending almost an order of magnitude more on R&D (about $50 billion), the AUTM reports only about a factor of two more revenue from R&D (about $2 billion) than does IBM (about $1 billion on about $5 billion in R&D) over an overlapping period from the mid-nineties to the mid-zeroes of the present decade.  Although it is tempting to attribute the difference in returns entirely to the diversion of R&D funding into pure science (an attribution that ought to silence the Bayh-Dole critics who favor pure science), it is important to remember that there was a net inflow of the most productive researchers from industry into academia over the same period of time.  This concentration of the brightest minds of science and engineering within academia would probably have led to a faster increase in returns from R&D if there weren't something else going on.

And there is something else going on.  The costs of licensing and litigation of patents has skyrocketed over the same period of time.  The biggest reason for increasing costs has been the inelastic supply of patent lawyers relative to the exploding demand for their services.  Unlike patent prosecution, which can be done by non-lawyer patent agents and examiners, patent licensing and litigation are services that require a state bar license (and the three years of ABA-accredited law school that this usually requires).  Law firms are struggling to meet demand by increasing starting associate salaries (patent boutiques started the chain reaction in both instances over the past ten years), but the corresponding increase in associate to partner ratios at most law firms (necessary to keep profits-per-partner high and retain top partners) has led to a decline in the quality of services overall.

It is worth noting that many technology transfer offices are staffed by non-lawyer scientists and engineers with formal or informal business training.  Many of these employees are probably undervalued by the legal services market because of their lack of state bar credentials.  Seeing the value, university tech-transfer offices and other government and private firms not constrained by state bar requirements are scooping these types of employees up.  Non-lawyers will probably play a growing role in R&D funding and technology-transfer going forward, even in providing "legal" services.  The investment banks (such as Altitude Capital) and venture capital funds (such as Intellectual Ventures) that have recently entered the secondary market for patents are early signs of this trend.

The result of these macroeconomic trends in R&D is a market in which many startups and smaller companies are realizing only a fraction of the intrinsic value of their R&D.  Technology is stranded in later-stage startups and other small private companies that are not eligible for further venture capital financing, acquisition, or IPO.  Problems in the credit markets and the passage of the Sarbanes-Oxley Act have further exacerbated the problem for these companies in the acquisition and IPO arena.  In effect, the United States is piling up a vast, invisible junkyard of stranded R&D that could be socially valuable if placed into the hands of the right owners.

As the returns to investment in R&D decline, so too do the number of jobs available for researchers outside academia.  This is a problem that is vital to the health of the U.S. economy within its global environment.  If current trends continue, there will be more Ph.D. engineers living in China than in the U.S. by 2010.  The number of U.S. patents issuing to foreign entities is already nearly equal to the number of patents issuing to the U.S.  If the U.S. were to strengthen its patent system, we would be far better positioned than any other nation in the world to bring the power of market-based incentives to bear on the problem of attracting the most talented human capital -- the single most important problem we face in our long-term prospects for economic growth.

People are starting to recognize these problems.  Recently, the Brookings Institute has called for the government to setup a National Innovation Foundation.  But aren't the market-based incentives of a strong patent system a better way for the government to encourage R&D funding?  Although a handful of firms, including Intellectual Ventures, Ocean Tomo, and other new entrants are struggling to meet immediate needs, the inventors and startups most in need cannot afford to hire anyone to answer the lobbyists hired by the large corporations that are net payers of patent licenses (when forced to pay at the end of protracted litigation).

Although the big picture of innovation is so large and complex that it is difficult for most people to understand, the solutions are actually simpler and easier than most would imagine.  First, the patent laws should be reformed in ways that would promote private settlements of disputes over patent infringement rather than litigation.  Some recent changes to the patent law have been beneficial in this regard, and some detrimental.  Unfortunately, the Supreme Court's recent holding in Medimmune makes it harder than ever for inventors to get to the table with large corporations without ending up in litigation.  And after Mercexchange, startups and independent inventors do not have the threat of an injunction to keep licensees at the bargaining table when those startups and inventors have failed to find funding to themselves commercialize the technology.  Neither of these by themselves is fatal.  The threat of injunction was no doubt abused by opportunistic speculators from time to time over the past few decades.  But not in decades has it been more difficult for investors in R&D to see a return through patent licensing.

Second, if the government is going to provide funding to solve these problems, that funding might best be used to lower the barriers to entry for the practice of patent law.  For scientists and engineers, especially those who understand business, the opportunity costs of wages are probably much higher than the costs of a law school education.  Public funding of scholarships for scientists and engineers who intend to study law would over time decrease the transactions costs associated with patent licensing, and gradually decrease the amount spent on litigation as it becomes easier and easier for opposite parties to reach agreement on differing valuations of a technology.

Third, institutional investors should consider allocating a larger share of their funding to hiring more employees for their technology transfer offices now, and later for investing in private equity funds that specialize in R&D investment.  The technology transfer offices are now overwhelmed by the demands on their time in many cases.  As a result, they tend to focus on the biotech and pharmaceutical inventions that are likely to provide the largest payouts, ignoring the many other areas of R&D that could nevertheless have a transformative impact on our society.  In terms of private equity investments, over the short-term the lack of licensing revenue is going to impede the returns for these funds.  But restarting the R&D engine of economic growth is going to require the public and private sectors to work together.

These are complex problems that it will take teamwork to solve.

Update: Silicon Valley never fails to disappoint in its farsightedness.  Jaisen Mathai, Michael Arrington, and Stu Phillips are all groping around the edges of the problem.

Update 2: I was recently asked whether the figures for IBM and AUTM include capital gains from equity.  The answer is no, neither do.  I have seen no evidence and have no reason to believe, however, that the AUTM should be seeing larger returns from equity on its R&D than IBM.  So the larger point about relative efficiency in technology transfer seems still to be sound.

A tabloid for every profession? The democratisation of gossip.

It is commonplace for us to observe that the Internet is changing the face of modern mass media.  One interesting consequence of the granularization of media coverage made possible by declining costs of distribution and marketing is the emergence of tabloid-style gossip rags for relatively small markets.

In the past, newspapers or magazines serving niche markets couldn't afford to be too risque in their news coverage because of the need to appeal to everyone in the niche market in order to maximize circulation and hence advertising revenue.  For example, it would have been unwise for a venture capital newspaper to run stories on the sex trade.  Similarly, it would have been unheard of for a newspaper on events relevant to practicing lawyers to report on the affairs of prominent legal academics.  But we have seen both over the past few months on Valleywag and AboveTheLaw.

In the future, we might expect to see similar developments in nearly every professional or non-professional field in which writers can pander to the prurient interests of readers educated well-enough to know and care about the gossip in a given field or industry.  A gossip page for dentists?  Why not, we already have too many straight-laced dental blogs: see here, here, and here.  What about a gossip blog for pharmacists?  We've already got The Angry Pharmacist,  The Angriest Pharmacist, and  Drugs 'R' Phun!  Even postal workers have their own blog.

Here's another prediction: the common law of defamation, libel, and slander isn't setup for this world.  How are courts going to handle defamation claims that arise from posts on the Internet?

Externalities and Semi-closed Platforms

Jason Calacanis warns companies away from the Facebook platform because of the uncertainties associated with how Facebook will share revenue with third-party application developers.

I don't disagree with many of the points he makes.  There is considerable uncertainty at this point as to how exactly revenue will be shared, what metrics will be used, and so on.  And there is no doubt that the companies that can successfully generate their own user base will monetize those users at higher margins than the companies that must rely on Facebook for customer acquisition and distribution.  That's the deal.

Rather I want to point out that Jason seems to ignore an important class of potential economic benefits for users that can be achieved by a semi-closed platform.  These benefts may enlarge the economic pie enough so that the deal is still better than what companies could achieve by monetizing at higher margins (with a smaller user base).

As I have eluded to in an earlier post, Facebook as a semi-closed platform promises to solve some of the collective action problems associated with user-generated content on the Internet.  Facebook is mostly spam free because it is a semi-closed platform.  An analogy is that Facebook:books what the open Internet:magazines.  We can expect to see a better valuable content/page ratio (and hence more users and more time-spent) on Facebook because it is a semi-closed platform.

Series FF stock and the Friedman-Savage Model for Risk Profiles

The Friedman-Savage model was developed to explain an economic paradox: assuming rationality, why would the same person buy both insurance and lottery tickets?  The answer that Friedman and Savage proposed is a double inflection utility curve:

The x-axis here corresponds to the size of the payout for a particular activity, the y-axis to the utility actually gained from the payout.  (Click on the graph for a larger version.)  Imagine that right now you have wealth = zB, and thus have utility = B.  The uncertain future forces you to take two different gambles: one with a payout somewhere between A and B and another with a payout between B and C.  The expected value of the payout is shown by the chords E and E'.  Although the expected value is everywhere lower than the actual utility gained from the payout between points A and B, a risk-averse person will prefer the certain result of E.  Thus, a risk-averse person would choose paying an insurance premium costing E over an uncertain result between A and B.  Likewise, a risk-preferring person would prefer the certain result of E' (which might be obtained, for example, by squandering income on lottery tickets) to the uncertain result between B and C.

The need for Series FF stock, which was pioneered at The Founders Fund where I work, can be explained by assuming that entrepreneurs (in particular, company founders) bear a similar risk profile.  Series FF stock can be issued to founders in place of common stock when the company is founded.  But unlike common stock, at later rounds of financing, a portion of the Series FF stock can be sold (subject to board of directors approval) to a later-round investor, and converted into whatever series of preferred stock is being issued at that round of financing.  For example, if a company founder held a 25% stake in the company through Series FF stock at formation, that company founder could one or two years later choose to sell 10% of that stake (or 2.5% of the company) to a Series A investor.  The company founder would get cash equivalent to the 2.5% stake at the Series A valuation.  The investor would get a 2.5% stake in the company in Series A stock.  Why should this be preferred to the status quo, in which company founders (usually) keep their common stock until the company is either acquired or goes public?

Entrepreneurs are extremely leveraged in their startups, and take a relatively small salary for the amount of value they create.  What they get in exchange is the payout on their equity when the company hits liquidity.  Although the timeline from seed stage to liquidity is shortening in some areas, the period is still on the order of 10 years.  This presents a problem from the point of view of maximizing the value of a company when, 5 years in, the entrepreneur is under pressure from personal creditors at the same time she is entertaining acquisition offers from a larger company.  In that situation, the entrepreneur has a strong personal incentive to sell the company at a low (but certain) price now, rather than holding out for a better offer in the uncertain future.

Referring to the curve, if the average person (including the average entrepreneur) tends to be risk-averse at lower payouts and risk-preferring at higher payouts, then it makes sense for investors to compensate for that by (1) monitoring management through board seats, thereby avoiding the excessive risk-taking between points B and C that is probably more common at later-stage companies, and (2) offering some liquidity, thereby avoiding the excessive risk-aversion that is probably more common at early-stage companies.

Most venture capital investors are already doing (1).  Series FF is the first formal, concerted effort that I know of to do (2).

Update: From the hypothesis of periodicity, we can get a new insight into the Friedman-Savage curve.  Most often, I believe the concavity and convexity obatain over different temporal ranges.  What you get is a two-dimension surface, with time along the y-axis and utility along the x-axis.  What you're looking at a above is a cross-section in that curve at the inflection point.

VCs and NDAs

Today I'm attending the 14th Annual Private Equity CFO Conference in Redwood Shores, California. The speaker right now, a lawyer from Wilson Sonsini, is talking about whether VC firms should sign NDAs.

Just over six months ago I was defending a VC who had been named in a counterclaim brought by a defendant that my client was suing for patent infringement. I was amazed back then that a startup company that might be in need of VC funding would take such a risk -- who's going to meet with a company that might just sue for trade secret theft later? But here I am listening to a speaker explain that more and more VCs are breaking the industry rule against signing NDAs. What to make of this?

The legal issues are taking a back seat to the economic realities of the market. There is too much VC money chasing too few good new companies. Lower tier VC funds are trading more favorable legal terms (such as willingness to sign NDAs) in order to get access to the best deals.

But this just shows how some VCs aren't thinking clearly enough. Signing an NDA makes little or no economic sense for either the VC or the startup. Startups benefit from both the regular capital (i.e., $) and human capital that VCs offer. That human capital includes the network of potential recruits, other portfolio companies, and other VCs (with whom they may syndicate later financings). A VC who signs an NDA could be hamstrung from adding this value.

On the other hand, the VC firms who have this kind of human capital will also be the firms that are least likely to sign such NDAs. So maybe not much harm is done.

The takeaway for startups: ask if the VC will sign an NDA. If the answer is YES, then stay away. They're not going to contribute much besides money to helping your company succeed.