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Mar. 7, 2005 – Micro and nanotech have many supporters, yet few put their money where their mouth is quite like venture capitalists. Four veteran VCs recently took a break from doling out dollars, and put their due diligence to work on a few questions posed by Jeff Karoub. They are Mark Brandt, managing partner of the Maple Fund, Jeff Fagnan, partner at Atlas Venture, Matthew McCall, partner at Portage Venture Partners, and Waqar Qureshi, vice president at Chevron-Texaco Technology Ventures’ Molecular-Diamond Technologies.
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During the first three quarters of 2004, investors put $122 million into nanotechnology companies, leaving the sector on track to fall far short of the $301 million invested in 2003. However, the number of deals has remained fairly consistent. What is your take on the trend?
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BRANDT: I know that investment dollars are down this year but I still consider that a good thing because the deals that are getting done are the ones with promising products. What we see is more nanotech-enabled technologies that are closer to market than most people know. My read is more deals are getting done in this arena than the stats may be accounting for.
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FAGNAN: I think people are realizing that non-macro scale applications of nanotech are very high-risk right now because the time to market is on the order of 5 to 7 years. I believe good companies are getting funded but with fewer dollars and are expected to do more with less. Not investing significant money until the applications are well-understood and true traction is achieved is simply good common business sense.
MCCALL: I would assume that you either have a different mix of companies, such as tools and diagnostics vs. large platform plays. There have been fewer blockbuster rounds this year, so it also could be argued that companies are trying to manage their burn more carefully and hence raising less money.
QURESHI: Investment from venture capital is only a small percentage of the total investment going into nanotechnology. From the perspective of advancing the science and technology it doesn’t really matter that there is less investment from venture capital.
Venture capitalists get criticized for a herd mentality, but the same can be said of analysts, media, etc. What share of responsibility do the VCs bear, and do you think it’s been an issue in micro and nanotechnology?
BRANDT: You can say whatever you want about venture capitalists but this much is predictable: We are accountable to our investors for our returns and we will follow methodologies that we believe will give us the best returns in the funds that we are currently investing. I think MEMS has seen some nice progress in the past 10 years but being a MEMS company did not drive up your exit strategy price. Nanotech is a much earlier sector and we have seen no exits yet. Nanosys had some amazing IP and maybe even some promising products, but the market said that they were not willing to bet that at sometime in the future the value will come. It wanted to see more evidence before buying that stock.
FAGNAN: VCs get a little too criticized for the herd mentality. They have a fiduciary responsibility to get the highest returns to their limited partners whether that involves investing in the flavor of the month or not. If a market is ripe for entrepreneurial attack, you will find several qualified teams who are going to go for it with a good product. On the other hand, I believe it is paramount to be allergic to the herd. I think there was an initial herd mentality in small tech. People found the science ultra-compelling and rushed to make investments and prognostications. I think the herd is gone in small tech and savvy entrepreneurs and investors are spending their time solving fundamental market pain points using nano and micro solutions.
MCCALL: When momentum investing swings into vogue, the public markets suspend core fundamental analysis and decisions are made more by the fear of missing a rise in the stock and not fundamentals. Once this fervor begins to grow, for better or worse, all parties jump into profit, ranging from stock analysts to bankers to investors to venture capitalists. Venture capitalists are not responsible for the bubbles since we are at the end of the train, but we definitely can benefit from environments where the public markets are more speculative.
I would say that at present, the bankers and venture capitalists are acting fairly rationally if you look at the quality of companies going out. Some of the nano-related issues are being driven by VCs looking to bring later stage funding into their more promising companies. It is clear that there has been a pretty dramatic return to momentum investing in the nano stocks and their run-up. This is being driven by the press and analysts, and exacerbated by the public’s fear of missing out on the next big updraft. I won’t mention specific names, but you have to scratch your head on some of these valuations.
QURESHI: Herd mentality is not yet an issue in nanotechnology. There is really only a trickle of VC money going into nanotech. There is some hype, of course, but that hasn’t affected most people’s perception that although there is huge potential, this is a long-term play.
Many startups find financing from non-VC sources, such as government grants, strategic partnerships and angel investors. Some manage to make tens of millions of dollars going that route. In the early stage, how do you determine when to write a check or walk away?
BRANDT: Team and technology! If the team is strong and the technology is stronger — defined as protectable and commercializable — we are very interested in investing. Some technologies are just that, others are the base of a solution that can change something that we believe could be a huge market.
FAGNAN: I love companies that bootstrap through grants, partnerships and customers. I call this free money, as it’s usually dilution free from an equity perspective. I also like to pull free money into deals after I have already invested in them. I don’t think free money and venture capital contraindicate each other.
MCCALL: We have two situations when we have to decide whether to write checks or not. The first is during the initial due diligence. VCs look for promising markets with sizable potential, business models that are rational and management teams that you trust can do as they say and generally have a history of doing so. Most plays in the nano and micro realm are solid niche technologies that don’t have the breakout potential required in venture capital. Government and angel funding are great sources to take some of the risk factors off the table before pumping significant amounts of institutional capital into a deal.
The second situation is where we’ve already invested in a company and new funding is required. In these situations, VCs will assess if the company still has a compelling and credible business proposition and if they have trust in the management team to execute. We all make macro bets and assumptions when we back companies. Sometimes it’s clear that the company is treading water, if not sinking. We have to sit down with the management team and assess if there really is a business here or if everyone agrees to find a home for the company. In other cases, you try to manage down the burn rate until the business model is clearer.
QURESHI: One of the important keys is to assess whether the startup truly has a unique and sustainable competitive advantage over the long term, such as through intellectual property. Intellectual property is particularly important for any platform technology. For example, intellectual property around diamondoids and their applications is a key focus area for us at MolecularDiamond.
When so many promising small technologies take years to commercialize, how do you strike the balance between getting in on the ground floor and garnering near-term returns?
BRANDT: It is all about milestones toward a commercial product and whether we feel the milestones can be met and, if so, how much return we would get after reaching all these milestones. The Maple Fund is an early-stage fund so we need to get in early. For this reason we spend a lot of time with the scientists. Larger funds can come in later and do quite well. No one strategy works every time.
FAGNAN: I don’t think it is unwise to invest in a business that is still developing a product if the fundamental technology has been proven and the technology is targeting a compelling market opportunity. The question is how many dollars and years is it going to take to get revenue from customers. I would prefer that the answer to both of those questions be zero. But personally, I am willing to spend several years, a few million dollars and lots of anguish to transform a powerful technology to customer-centric, generally available product.
MCCALL: Each venture firm has a different profile for what they expect or what their limited partners expect. Some firms like ours are willing to take a chance on a novel technology if it is exponentially better than other solutions, that if successful is a significant win and where you have faith in either the technical leader or the CEO. In reality, many companies have too many uncertainties to invest at a seed level. Deals with more near-term potential, while less risky, often also have less upside potential. The higher return potential offsets the higher risk profile.
QURESHI: There are only a small number of VCs that are investing early and getting in on the ground floor. Most are interested in near-term returns.
What area of micro and nanotechnology would you be funding if you could follow your passion rather than return on investment?
BRANDT: I think the advent of nanotech and medicine will lead to some huge gains for our population and the populations around the world. The Cleveland Clinic was very early with its commitment to MEMS and has stayed true to that commitment with eight researchers working in that lab today. They are now building a nanotech research focus that will have a similar commitment. I have seen great things come out of the MEMS research area around spine and brain tumor sensors as well as drug delivery systems, and will continue to support the science and education side with hopes for the commercial side of these systems.
FAGNAN: Anything that can repair DNA, cells and other body matter. I’m very interested in any solution that allows me to continue to mountain bike, rock climb and extreme ski without worrying about the consequences to my aging body.
MCCALL: Any applications that exponentially improve the lives of humans, especially those in less developed parts of the world. This includes water purification technologies, stem cell research and straight biological applications. Think of the impact that an affordable and easily deployed water filtration system or agent would have. The same goes for affordable energy.
QURESHI: Nanomaterials that are well patented and have highly desirable properties will provide the fundamental building blocks for nanotechnology and big return on investment over the long term.