Wednesday, 16 March 2016

Let Luck Be a Lady: Picking Winners in Early Stage Technology

It is common knowledge that investing in early stage companies is risky – over 90% of start-ups fail (Forbes/Entrepreneurs 2015).  It is also widely believed, at least among the investment community, that technology based companies are even more risky.  But does that have to be? If all MIT spin-off companies were aggregated their net economic contribution would make them the eleventh largest economy in the world (Roberts and Eesley, 2009).
How do you pick technology based winners?  With an emphasis on life science based businesses, let’s look at the contributing factors.  They can broadly be divided into factors that you can control, and those you can’t.
Controllable Factors

1.    License terms
It is not necessarily the case, but policy makers assume that all new technology originates in universities and other research centres.  Commercialising this technology requires that it be licensed either to an existing company, or to a start-up.  Terms of licenses to exiting companies are likely to be dictated by the company, particularly if it is a large one. Not so for start-ups where the academic institution has the controlling hand, even more so if it is also going to provide seed funds.  MIT takes a 5% equity stake in its spin-off companies.  In the UK in contrast, leading universities demand a 50% equity stake as well as fees and royalties, and retention of ownership of the IP in the (likely?) event the spin-off fails.  This short sighted policy is a disincentive to the management team and makes it more problematic to raise further rounds of finance.  Time will tell whether the US or UK approach is more successful in the long run.

2.    Management
There is a fairly widely held belief that VCs back management teams.  While there is some truth in that, it is also true that the management team is a controllable factor.  If they don’t work out, they can be replaced.  The replacement is likely to have been a successful entrepreneur, at least once and sometimes two or more times.  Experience counts, as does an established network of the people you need to know to make a company grow.  

Uncontrollable Factors
It is undoubtedly true that there is an element of luck in a new venture being successful.  Successful and serial entrepreneurs always deny this, preferring to attribute their success to management skill.  Consider the steps a new drug or medical device needs to go though, after successful laboratory demonstration:  three or more clinical trials, production scale up, regulatory approval, and finally market acceptance, before one or more competitors appear; statistical risk factors for these steps are fairly well known in the drug discovery business.  Getting to win is rather like pulling off a multiple race accumulator bet; nobody denies the risks in doing that.
So are there issues which can be assessed at the early stage of a start-up, which help predict the probability of success, or at least mitigate against failure?  Assuming a new technology has been demonstrated to proof-of-concept level, there are four factors which need to be, and can be, assessed before further investment in the technology:

1.     Health economics
Does the technology (drug, medical device etc.) have favourable economics, so that its economic benefits outweigh the economic cost?  Does it produce better patient outcomes compared to the gold standard at lower cost – the usual US criterion?  Is it something that US third party payers, whose unwillingness to part with money is legendary, are likely to support.  Would it satisfy NICE in the UK, with its questionable QALY (quality-adjusted-life-year) approach?

2.    Patent Due Diligence
Of course the new technology is protected by one or more patents,  a pre-requisite for granting a license, although not all UK universities see the need for doing so; graphene for example was not patented.  What the grant of a patent does is grant you the right to make, use and sell products based on the new technology, and exclude others from doing so.  However, being granted patent rights does not answer the question:  does this technology infringe one or more exiting patents?  In other words, do you have freedom to operate in the technology space of your innovation?  An exhaustive search of the patent literature is a necessary pre-requisite to growing a company, but in reality is rarely undertaken.

3.    Competitive Advantage
Business plans written for early stage technology commercialisation often contain the assertion that there is no competition for the product to be developed: it is unique.  That is always incorrect – there is invariably one or more other ways of filling this technology need.  A realistic strategic assessment must be made of how the proposed new technology is superior to the existing approach.  The more worrying, and difficult to forecast, issue is who else is developing the same technology?  It is extraordinary how quickly competition appears after the launch of a new technology product.  Expecting competition must be part of every strategic plan, based on a detailed study of potential or likely competitors.

4.    Financial Value
Developing new technology products is a lengthy and expensive business, particularly in the life sciences; the new venture will require an injection of capital, often several times.  Evaluation of the technology requires an assessment of whether or not it is likely to support the acquisition of investment capital.  Different investors have different approaches to valuing technology: angels may do it on the back of an envelope; VCs look at multiples, when the company is finally sold; corporate partners may use very sophisticated tools including real option analysis.  Most analysts today would regard the risk adjusted Net Present Value (rNPV) as the standard valuation tool.  This approach, which requires forecasting sales some way into the future, also incorporates the risks associated with the development process.  Stochastic models can incorporate not only early stage risks, but longer term market fluctuations, the possible entry of competitors, and even black swan events such as a successful challenge to a patent.  Technology based companies which are unable to develop such models (“we don’t know what the long term applications are going to be”) are not in a position to interest serious investors.
Assessment of the preceding four risk areas can only be helpful in selecting technologies which have an above average chance of success.  A random sample of MIT spin-off companies has been shown to outperform the average VC portfolio (Ed Roberts, Entrepreneurs in High Technology: Lessons from MIT and Beyond, 1991) Do MIT spin-offs undertake the rigorous assessment advocated here?  Not always, and possibly sometimes not at all, but it is perhaps less than surprising that spin-offs from one of America’s leading technological universities,  with a long history of successful innovation, achieve a high success rates.  Those of us who don’t benefit from that association are well advised to look at the risk factors up front before blindly entering on a pathway littered with failure.
Michael Brand PhD SM FRSC
Captum Capital Limited

Captum capital will be participating in a one-day conference:

Wednesday, 20 April 2016
The Møller Centre
, Churchill College
Storey’s Way, Cambridge CB3 0DE