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
mjb@captum.com

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

Evaluating technology: techniques and tools

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

Valuing Private Companies

It's been a couple of year since I added to this blog, largely because I have been spendning most of my time building Sensor100 and the very successful Sensors in Medicine Conference series.

However, I really shouldn't neglect Captum, and will try to adhere my original resolve of adding a new blog, if not weekly, then at least once a month.

One of the questions I frequently get asked is how to value an unlisted company, where the shares are privately held, and there is no public market for them.  Opinions vary on the answer to this question.  I recall a university technology transfer manager who rather forcefully took the view that there was no meaningful way to value very early stage  university spin outs.  My own view is that it makes sense to form a view of the value of any privately held company, whatever stage of development it is at.  This helpful if you are an owner (am I owning a worthless asset?) and particulary if the company is entering into a transaction (investment of new funds, sale etc).

So how is it done?  Among the plethora of methods a Google search will reveal, there are really only four approaches:

1. Market value
2. Cost and/or replication value
3. Risk adjusted discounted cash flow
4. Real option valuation

Most valuations will be based on a combination of two or more of these methods.

It doesn't have to be a black art.  At Captum's MasterClasses we explain how these methods work in simple non- mathematical terms appropriate to beginning/intermediate expertise.

The fad and falderal of leadership

I have long held, that given an innovative technology which meets a large enough market need, three things distinguish between success and failure: sufficient finance, strong management and a large slice of luck. I tend to witter on a lot about entrepreneurial finance, so today I want to say something about management.  I'll leave the luck for another time, but in passing recognize that successful entrepreneurs invariably deny the luck element; possibly that is why so few of them are successful twice.

I have to admit the luck piece isn't entirely my own; the idea was shaped by John van Maanen, a senior professor at the Sloan School of Management at MIT.  John taught the required course in organizational behavior when I was there thirty years ago, but I don't suppose he does that anymore.  I became friends with him when he helped me reorganize Occidental Chemical's R&D department, and we devised an effective technology team building workshop which was rolled out in Oxy, and has been used elsewhere.  Nothing to do with drum beating or having fun outdoors, but contrary to today's team building culture required some serious thinking about how teams work together.   

John was recently in the news when he gave an interview in Canada on the relationship between management and leadership.  He basically said there was no difference; tends to have quite interesting and challenging thoughts, does John.  You can see the interview here (skip the ad first).  Leadership, he said, is a current fad, which will be replaced by something else in three or four years.  He sounded apologetic that MIT had had to develop a leadership model because everyone else has one - the Sloan model requires Sensemaking, Relating, Visioning and Inventing - you can read about that here.  

John's point is that it is very unlikely that any one individual will possess all four attributes, but several people in an organization might - the concept of distributed or shared leadership.  "So if you don’t distribute decision rights, if you don’t distribute the ability to contribute to the overall plan, then organizations are going in the wrong direction."  So management and leadership are the same concept, with different names.

I hesitate to disagree with John, but it is unlikely that he will read this, so allow me to try.  Prior to my doing a management degree at Sloan (MIT didn't have MBA's back then, but that is what it was)  I worked for a company called Technicon Instruments in NY.  Big T, as it was known, was the world market leader in clinical laboratory instruments, at one time holding a 98% market share.  It was also, in my experience, among the worst managed companies I have ever worked for.  Indeed, my belief that there had to be a better way, was in part, what drove me to Sloan. But here's the thing, the company owner, Jack Whitehead, was an inspiring leader.  He attracted some of the leading clinical scientists of the day and we all worked hard and long for him.  It was an amazing place, Big T, and I would love to be able to recreate that environment again, but never have. Sir Paul Nurse, President of the Royal Society, is planning to build the Francis Crick Institute in London which will house 1500 of the world's leading biological scientists - just needs the last $100m.  Sir Paul has said that the Institute will not have a conventional management structure, so the there will be freedom to be creative. An interesting experiment to watch.

Financial Support for Innovation - has the UK got it right?

One of the stories I like to tell to British people concerns a senior member of my staff at Occidental Chemical; this is now some years ago.  He was a long term employee and had accumulated four weeks annual vacation - you started with two weeks (to be taken after you had worked for a year) and then accumulated an extra day a  year.  Most Brits are appalled and disbelieving at this point, but it gets worse.  Sam (not his real name) was a family man and elected to take off the whole of August to take his large family camping.  For some reason, this came to the attention of my boss.  "Fire him," was his terse instruction, "if he can be away for an entire month, we don't need him at all".  I didn't do it, and although the US culture has gradually changed to slightly longer vacations, it still represents a rather dramatic difference between the US and UK work ethics.

The reason for telling this story is the announcement by the Technology Strategy Board that it is shutting down its Smart program for a month starting March 1st.  The Smart program used to be managed by Business Link, then it was taken over by the TSB, who changed its name to Grant for R&D, and has now changed it back to Smart.  It is not entirely clear why the TSB thinks it is OK to stop processing applications for innovation grants for a month, but no doubt they are making some important changes to make Smart smarter.

I applied for one of these grants once.  It was summarily rejected after review by a single reviewer.  It was a "novel" idea in his view, but not "innovative".  Among a myriad of other flaws he found in my proposal, his version of the risks involved was entirely at variance with my own.  There is no opportunity to question or rebut the assessors solitary views, but the applicant has an opportunity to resubmit a revised application - presumably to be reviewed again by the same rather narrow visioned individual.  Hint to the TSB - people are notoriously bad at assessing risk but a panel usually is more effective; come to one of Captum's Technology Valuation MasterClasses to learn more.

The TSB application was in stark contrast to my application a few years ago in the US to the NIH for a Small Business Innovative Research (SBIR) grant for a new medical device.  All US government research organizations are required to allocate a fixed percentage (it used to be 3%) of their budget for SBIR grants.  Another helpful hint - why don't all the UK government backed research organizations, EPRSC, BBSRC, etc, do the same rather than just fund university research?  My application, which was very much at the concept stage, without patents or an impressive management team (I'm being modest - aside from me I had two very well respected partners), was given a thumbs up by the assessment panel for a $100k grant, no match funding required.  However, because we didn't comply with the requirements for human experimentation - we planned to try out the non-invasive device on ourselves - we were asked to reapply at the next round.  Unfortunately, I moved to the UK before I could make that happen.

All of which takes me to the report issued this month by FINNOV  (Finance, Innovation and Growth)   a research collaboration between seven (high powered) European Institutions aimed at understanding the relationship between changing financial markets, innovation dynamics, and economic performance.   Among a number of recommendations, they suggest less emphasis on university spin-outs, which usually fail, and more investment on research (see my blog of 27 January); credit scoring criteria should be revised (19 February blog); public funding of innovation should be reformed to function as venture capital (also 19 February).  I always tend to agree with eminent bodies who recommend my own ideas, but I'm not totally convinced that FINNOV is right is asserting that the Green Economy is the next big thing after the Internet- energy technology will be a key issue as we run out of hydrocarbon deposits over the next 20 - 40 years..  I do think they have it right in asserting that what we need is Finance for Innovation, not Innovation for Finance. Let's hope that the UK government listens to that.. 

The Case for a New ICFC

Do you watch Question Time on BBC1?  I watched the program last Thursday, and the last question was "How would the panel create growth in the UK?"  The short answer was: none of them had a clue!  Poor Julie Myers, who was mocked by David Dimbleby for using entrepreneur in every answer, suggested more internships.  John Prescott said that wouldn't help much, and then waffled for a few minutes.  The coalition representatives, Ken Clarke and Baroness Kramer, rolled out all the government measures, but noted "you may not have heard of them".  Too right, we haven't!  Someone called Owen Jones took the position that anything the government was doing was wrong.

The real answer is that growth will come from the small business sector but to fuel that it needs capital. Banks won't invest, the supply of business angels is limited, and the VCs have almost all gone upmarket. What the UK needs is a modern version of the old ICFC - the Industrial and Commercial Finance Corporation.  ICFC was set up after WWII by a consortium of banks to re-invigorate the small firms private sector.  It operated through a series of regional offices, each headed by a local director who was bit like bank managers used to be.  ICFC made small investments, from £25k up to a few £millions, and its usual scheme was a mix of loan and equity - "debt with an equity kicker". It evolved into 3i.  It was hugely successful, made a lot of money, which caused its banking owners to decide to float it as an investment trust, so they could access the cash.  Does that sound familiar? Post the flotation, the regional offices were closed down, 3i has gone up-market with the size of its investments, and is no longer making money for its owners.

Now we hit the political barriers.  The Governor of the Bank of England, among whose first actions on taking office was to terminate the Bank's work on small business finance, is unlikely to be a supporter, although just 1% of the last £50billion round of printing money (sorry, quantitative easing) would have set up new ICFC nicely.  Party politics is also in the way, because Lord Mandelson in the last government was working on the scheme back in 2009.  Is it anathema for this government to accept  that their predecessors may have had a good idea?


We're not talking about a lot of money - perhaps a few hundred £million.  It doesn't need to be run by the banks, or the civil service, but it does need to be started soon.  Wouldn't it be helpful if it made its investment decisions not on credit scoring (driving by looking in the rear view mirror) but by scoring on the Business Model Canvas (see last weeks blog).  What we need now is grass roots momentum to get the ball rolling.

Business Models for Innovation

Innovation is the Olympic gold medal of the business world; many compete for it, but few are successful.  In the UK, one in three start-ups fail in the first three years.  Since 2002, the UK venture capital industry has returned 9.8%; you would have made double that return in the stock market by re-investing your dividends.  Why do we accept, perhaps not cheerfully, that technology innovation is high risk, and that it is difficult to make money from indulging in it?

I'd like to suggest that the time is right to re-examine the business models we use for technological innovation.  In the US, creativity in business modelling is a hot topic.  The Business Model Canvas, a creativity tool devised by Alex Osterwalder and Yves Pigneur, generates over four million hits on Google, but is possibly less well known and used in the UK.  BMC forces users to think about their model creatively, with a strong emphasis on customers, who they are, how to reach them, what is your relationship with them.  Only when you understand that can you think about the value of the product or service you offer to each of your customer segments, and the other elements needed in your business. By creating, building and testing robust, innovative business models, your enterprise can significantly improve its chances of surviving its first customer meeting,  and into year 3+.

I lead a MasterClass on Business Modeling for Innovation in Cambridge last week.  The audience was a tad smaller than I would have liked, but included representatives form big pharma, the NHS and the lone entrepreneur community.  In half a day, they managed to create an entirely new business for farm animals, multiple uses for a  new cryogenic technology and an impressive variety of market avenues for organic popcorn.  Certainly none of these were robust business models, but they were creative first steps, which provide the basis for the development of new business enterprise models with further research. 

At the MasterClass, we discussed the difficulty of getting these approaches adopted more widely, particularly in big corporates with their commitment to leading consulting companies, and variations on the BCG matrix. Using creative design methods, visualization techniques and learning to tell supporting stories are all helpful in overcoming the resistance of nay-sayers along the way.   Let's develop a culture of creative business model design for sustainable innovative enterprise?

Investor Risk Aversion

My first job, after graduating from MIT with a bright, shiny, MBA in technology innovation management, was to head the R&D department for Occidental Industrial Chemicals Group.  This was daunting task, not just because I had never managed so many people before, but mainly the department had floundered without a director for 18 months.  I managed to sort out the people and program issues and we evolved a system in which we had a number of early stage projects (relatively inexpensive), a few which looked more promising (starting to spend real money) and a couple which were in pilot stage advancing towards commercialization (which cost mega bucks).  I was quite proud of this funnel system at the time, and only realized later that it was quite a usual management approach adopted, for example, by DuPont,  who were much better at developing new products than we were at Oxy.

Fast forward my career by a decade, and I joined a venture capital company in Boston.  I imagined, expected, that they would use a similar management system - lots of early stage investments, and some later stage ones in a portfolio.  But they didn't do that at all.  What they tried to do, was de-risk investments as far as possible, by buying into existing private companies, syndicating investments and other approaches to protecting their capital. Even that didn't work particularly well, and I still recall the chagrined face of one of my colleagues when he announced the write off of $2 million.

There was an early stage investment division at the VC, somewhat curiously named "Ventures", which looked for opportunities to get into the next Microsoft, but would never back a very early stage technology.  Ventures was looked down upon by the "real" VCs.

Which leads me to Red Script Ventures, started by Johnson & Johnson in 2009, a start-up accelerator program designed to bring one new venture a year into the company; reported by MIT's Technology Review -Inside Johnson & Johnson's Innovation Shop.  It is good to see that at least one major corporation recognizes the need to nurture high risk early stage ventures.  It's just a shame that the venture capital industry has forgotten what business it is in.