Wednesday, February 20, 2008

Are VCs, rather than patent law, thwarting innovation?

According to a variety of patent "reformers," the current patent law stifles innovation and the proposed reform "would foster greater innovation by American companies and enhance U.S. competitiveness."

In a bit of "new look", we now have a debate on whether or not venture capitalists stifle innovation. NJEN, on March 5, is sponsoring:

Topic: Does Venture Capital Investment Kill Innovation?

Speakers: BART STUCK, Managing Director, Signal Lake
FRED BESTE, Partner, Mid-Atlantic Venture Funds

In this season of debates, as we recall the encounters between Lincoln and Douglas and
Kennedy and Nixon; NJEN is pleased to bring you THE GREAT VENTURE CAPITAL DE-
BATE. The question: Does Venture Capital Investment kill Innovation? For the Affirmative:
BART STUCK, Managing Director, Signal Lake, a Boston based venture capital and consult-
ing firm, and author of numerous articles on this topic; Arguing the Negative: FRED BESTE,
Partner, Mid-Atlantic Venture Funds, well-known venture capitalist, luncheon speaker and bon
vivant. As with most big fights, the “trash talking” has already begun. Fred noted in an email
to Bart “you’ll have the advantage of a way-early, heavily researched start, and I’ll have the advantage of a sneak attack.”

In an IEEE spectrum piece in April 2005, Stuck noted:

The reasons for this failure are complicated and deeply entrenched in the VC way of doing business. But a common thread runs through many of them, and it has to do with risk. Based on our experience, we believe that VCs really aren't the risk takers they're often made out to be.

To Understand This Risk Aversion, you've got to know more about how VC firms are organized. First, a venture capitalist isn't a guy with a giant bag of money over his shoulder, dollar bills and gold coins spilling out. Behind the cartoon character is not one but several different people with different roles. The people with big money to invest—sometimes billions of dollars—don't know much about technology and innovation. Instead, they turn their money over to people who do (or so they hope).

Basically, venture capitalists combine these investments into a sort of mutual fund of start-ups. As the start-up passes through various well-defined stages of development, other investors are brought in to fund the company, thereby lessening the risk, and also the potential reward, as the fund matures. It turns out that most investors won't fund an operation before it has a measurable cash flow, so it takes a special investor to put money into a company at its earliest stages of existence.


This short life cycle for venture funds has dramatic consequences for innovation, none good. Typically, when a fund invests in a new company, it needs to reserve additional funding for up to three follow-on rounds, just in case the start-up runs out of money, which is inevitably the case. When you total up the bills for management fees; accounting, legal, and other expenses; and reserves for the follow-on rounds, an initial funding round of $200 million to $300 million might involve a $1 billion commitment over seven years. If that $1 billion sum represents the entire fund, the VC may need to start a new fund to invest in even more companies beyond the ones in the previous fund. Thus, the gap between one fund and the one that immediately follows it might be only two to three years.

That's a big problem, from an innovation standpoint. To raise fund [n + 1], institutional investors are going to look at the interim results for fund [n].

They want to see the start-up company booking substantial revenues or showing other signs of progress, such as contracts awarded or design agreements with major customers. In other words, VCs need to see a company end its start-up phase and become a real business in three years at most.

The upshot is that VCs won't look favorably on funding proposals involving years of research—regardless of the potential payoffs. It's not that they are not interested in innovation. They just won't fund innovation that takes time.


Engineers who work with VCs for any length of time are inevitably frustrated by what they see as the VCs' limited ability to understand revolutionary technology. Combined with the VCs' strictly bottom-line orientation, the result is an inability to accurately access technological risk.

As a result, most VCs are more comfortable with business plans that are logical extensions of existing technologies. They're also good at conducting reams of due diligence. The typical VC firm today has lots of junior associates who love poring over market and growth projections and cash-flow forecasts.

VC investing is all too often a mechanical process of reviewing business-school checklists. The dearth of venture capitalists who can really understand fundamental research and who eagerly talk to brilliant researchers with exotic, extraordinary ideas is one of the key challenges facing the industry. Unfortunately, the average Ph.D. scientist or engineer knows little about business, and in our experience, most VCs really don't want to talk to people like that.

***See also

An unwitting dupe?


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