By Jack Mason
Small Times Correspondent

NEW YORK, Feb. 26, 2002 — Charles Harris made his first small tech investment in 1994, a $500,000 initial stake in nanopowders-maker Nanophase Technologies Corp., then a privately held spinoff of Argonne National Laboratory.

He even eventually made money on the deal. His total investment of $1.16 million, made in several stages before Nanophase’s 1997 IPO, netted a profit of more than $3.1 million in August 2001 for shareholders in Harris & Harris Group, an early-stage, high-tech venture capital firm that also happens to be a public company.

Today H&H is focusing all new business activity on small tech.

It recently announced a $700,000 seed investment in Nanopharma Corp., a spinoff from Massachusetts General Hospital that is developing nanoscale drug delivery systems. In August it invested $490,000 in Nantero Inc., a company developing carbon nanotube-based memory chips. Harris was part of a group that invested a total of $6 million in Nantero, including Draper Fisher Jurvetson, Stata Venture Partners, and Alex d’Arbeloff, chairman of MIT and founder of Teradyne Inc.

Harris, CEO of six-person H&H since 1984, says that the decision to concentrate on small tech evolved over years. “I became more and more convinced that this was going to be a major area of technology development for the rest of our lives.”

As a veteran venture capitalist, he also came to the conclusion that small tech would be “the next frontier for capital formation and company building.” With nano and MEMS applications running the gamut from information technology to medical and biotech devices to industrial materials and coatings, Harris also believes that H&H’s portfolio can remain diverse, even with a small tech focus.

Harris and Mel Melsheimer, chief operating officer, say that while much of small tech may be new, their fundamental approach to evaluating small tech startups is not. It begins with four key criteria: does the prospect have solid management, a product or service that fills a real need, proprietary technology and is it aimed at a market of significant size?

Another factor H&H gauges when considering a startup is “ease of market entry,” or how challenging it may be for a company to land real customers. Companies with truly new products — nano or not — often have a “disruptive” technology, one that may require a customer company to drastically change manufacturing processes, invest in new equipment or develop new employee expertise. For the moment, Harris and Melsheimer think that market entry is something of a disadvantage for small tech concerns.

While technological innovation often has to wait for industry to catch up, Melsheimer and Harris say they are confident many industries are approaching the point where benefits of embracing small tech solutions will outweigh adaptation costs.

As early-stage investors, H&H also looks at a startup’s ability to attract additional capital, whether in later rounds of financing or through an IPO or acquisition. On this front, they believe that despite the economic “nuclear winter” that has sent many VC firms into hibernation, small tech companies focused on large market opportunities are in relatively good position to attract capital.

Still, right now Harris is seeing only “a handful” of the very best small tech prospects getting funded by VCs, with the rest either still on the sidelines or reliant on “angels,” wealthy individuals with an interest in helping a company get off the ground. That’s not unusual — even in better economic conditions, most new companies aren’t funded by venture capital.

They are, however, seeing a surge in the number of small tech ventures approaching them. “We’re getting several inquiries a week. A year ago it was maybe one every few months,” says Harris.

Harris says that it is vital for a startup team to include someone with proven experience launching and building a company. While in his experience scientists and engineers are much more knowledgeable and sophisticated about what it takes to create a company than they were a decade ago, a startup’s chances are greatly improved with professional management and legal advice from people who know the drill.

Overall, Harris looks for technologies that can be a “good building block” around which a company can grow, with people involved who care deeply about what they’re doing.

When H&H identifies a small tech company it wants to consider seriously, it begins the due diligence process, which can last from weeks to months. A large part of the time and money in “DD” is, Harris notes, spent on evaluating a company’s intellectual property. The firm looks at factors such as how well a patent can be protected, whether its scope can be extended and if its production can scale.

One issue Harris is finding with IP is that as the number of small tech patents rises around the globe, “it’s always possible that someone in Japan may have published ‘prior art’ that hasn’t yet been translated into English or seen by the U.S. Patent Office.”

Once H&H makes an investment, its involvement can be very close to arm’s length. While Harris says that the firm is not a business incubator, it may guide a very early stage venture through the important hoops of finding accounting and legal services, setting up its corporate structure, or recruiting senior management. In some instances Harris or Melsheimer may serve on a startup’s board of directors.

Lita Nelsen, director of MIT’s technology licensing office, which has helped the university start more than 200 companies including 25 in 2001, knows H&H from the startup side of the equation.

“Charlie Harris has good instincts about people and technology,” she says. Because H&H may get involved in a startup when it is at a very formative stage, Nelsen sees Harris as a unique blend of angel investor and venture capitalist.

What also sets H&H apart from other VCs is that as a public company, it has a “permanent” capital base (of $24 million as of Dec. 31, of which about $13 million is cash or equivalents) that Harris says allows the company to pursue long range investment goals, including holding stock in a company even after it might go public. In contrast, Harris says VCs set up as private partnerships may, for example, have to liquidate assets after a number of years.

H&H, structured under SEC rules as a “Business Development Company,” also offers the public an opportunity to participate, through ownership of its shares, in pre-IPO companies and provides certain tax advantages.

“We may live with a company for six, seven years or even longer,” says Harris. “We’re committed to small tech in the long run, and we have the corporate and capital structure to do that.”

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