The dozen venture capitalists were easy to spot at the California NanoSystems Institute in Los Angeles last fall. They were the only ones at the 300-person gathering who didn’t rush the buffet.
Clutching a Diet Coke in one hand and a white notepad in the other, Lyndon Lien, a principal with Coastview Capital in Los Angeles, cornered a scientist, firing questions. How far along is the research? What are its broader applications? And, when will it hit the market?
Most of the venture capitalists at the nanotechnology event sounded cautious, but that hasn’t been the case for VCs as a whole. Private equity investors funded 34 nanotech startups to the tune of $427 million last year, up from 19 deals worth $190 million a year earlier, according to Venture Economics and research by Venture Capital Journal. And the number of brand new deals is growing-from three A rounds for $8.9 million in 2001 to eight A rounds and three seed rounds totaling $73.3 million last year. As a whole, the companies that received fresh funding in the past two years have collectively raised more than $1 billion since their inception (see charts, pages 20 to 23). It looks like the Internet and optics bubbles weren’t painful enough to discourage VCs from buying into the next big thing.
Draper Fisher Jurvetson-with a record eight nanotech investments-isn’t the only firm hoping to make millions from tiny technology. Many of the biggest names in venture are betting on the sector, including Advanced Technology Ventures, Apax Partners, ARCH Venture Partners, Kleiner Perkins Caufield & Byers, Menlo Ventures, Morgenthaler Ventures, MPM Capital, New Enterprise Associates, Sequoia Capital, Sevin Rosen Funds and Venrock Associates.
Unfortunately, like the Internet and optics stories, the nanotech story is doomed to have an unhappy ending, industry experts say. It isn’t that nanotech has no future; it’s just going to take a lot longer and a lot more money to actually create commercial products.
Still, the buzz is getting louder and louder. You know something is hyped when angel investors want in on the action. California’s Central Coast Angel Network held a seminar on nanotechnology for its members late in October.
Nanotechnology researchers say investors have been hypnotized by H.G. Wells-type claims about nanotech and are investing too much money in a market where only a few companies will likely produce commercially viable products in the next several years. As one scientist with the California NanoSystems Institute says: “The VCs just don’t get it.” The science is risky, and if the risk is not factored into the price of a company’s equity, if the project goes bust, so will the capital.
Even terribly smart people are buying into the nano nonsense. “I don’t know much about nanotechnology, except that VCs are hovering around it,” says Lien, who holds a doctorate in molecular genetics. “We thought the genome would take 20 years to sequence, but with the technology platform,
money behind it and smart engineers, it took only a couple of years. Nanotechnology is like that.”
No, it’s not. The science is hard and expensive. Nanotech requires the fusion of some of the best minds from materials science with those from biology, chemistry, engineering and physics. It’s a young field, a place for university and federally funded research, but not necessarily a place for private equity investors. Even if a startup has the brains and the cash to fuel its research, there are complicated intellectual property issues to throw a wrench into the best-laid business plans.
“Those who excel at popularizing the field are not necessarily those who understand it,” warns nanoelectronics pioneer Stan Williams, director of quantum science research at HP Labs, the Hewlett Packard research wing that tries to figure out where technology will be 10 years into the future. Williams says the financial backers of nanotech deals “don’t understand its physical limits or what’s physically possible. If it sounds too good to be true, then it probably is.”
This isn’t to say nanotechnology is something off in the distant future. Materials developed with nanotechnology have already hit the market. Burlington Industries spinout Nano-Tex signed its first licensing agreement two years ago, giving khakis maker Galey & Lord rights to its wrinkle-resistant, stain-repellant fabric. And Germany’s Nanogate supplied its ski wax to several teams during the 2002 Winter Olympics and plans to make it available to ski bunnies worldwide.
Nanotech sensors are out there, too, courtesty of Agilent Technologies and Caliper Technology. Such ultra-sensitive sensors can be used for genetic profiling of diseases or to detect chemicals in water or air before they reach dangerous levels.
With patents on materials and sensors, large corporations have cornered the market for existing nanotech applications. The opportunity for venture-backed companies, therefore, is in futuristic technologies-next-generation drug delivery systems, electronic and optical components (like high-density memory chips) and energy storage. But getting those applications onto the market may take as many as 10 to 15 years, despite the optimistic promises of venture-backed companies.
The Time Problem
At least one-third of this year’s nanotechnology deals are seed-stage companies spun out of universities, which puts them on a three- to five-year revenue runway. Seed-stage nanotechnology companies often have little more in their chest of intellectual property assets than a proof of concept, and private equity investors may not have deep enough pockets-or enough patience-to fund such a startup to profitability.
It’s not just a question of how far along the science is or how long it may take to transform it into a commercially viable product. It’s also a question of whether the technology is scalable and reliable-and how investors can hedge the technical risk.
“There’s lots of inexperience out there and overly optimistic entrepreneurs,” says Williams of HP Labs. “Often a scientist conveniently forgets that a project may take decades when they’re looking at funding now. Different people think in different time frames: Scientists think in decades, engineers think in years and investors think in quarters.”
Nanolayers, an Intel Capital portfolio company spun out of Hebrew University in September with an undisclosed seed round, has no product in the pipeline. What it has is a technology platform, an emerging patent portfolio and a team of researchers. What it doesn’t have is a business plan, a business strategy, a defined marketplace or a management team, says Michael Dierks, a strategic investment manager with Intel Capital in Silicon Valley.
Nanolayers has not set a launch date for its technology: It is still in the earliest stages of research and has not told the market exactly what it plans to produce. It has only said that its technology may change the way Intel manufactures its chips.
The path of successful companies-successful in the sense that they’ve met their milestones-shows that going from concept to actual product takes many years. Take Quantum Dot Corp., founded in 1998. It needed five years before it was ready to ship its biosensors. VCs, including Abingworth Management Ltd., Institutional Venture Partners and Technogen Associates, were so bullish about the company, that they followed up a $7.5 million Series A deal in 1999 one year later with a $30 million Series B, doubling the company’s post-money valuation to $80.2 million, according to VE. Joel Martin, Quantum Dot’s founding CEO and now a partner at Forward Ventures, says the original material used for the biosensors couldn’t be reproduced on a commercial scale, so the company had to re-engineer its entire product. The delay put some partnerships hold and squashed Quantum Dot’s two-year lead over competitors.
Patience is a key ingredient in any nanotech deal, says Charles Janac, chief executive of startup Nanomix and a former entrepreneur-in-residence at Infinity Capital. “The challenges are bigger than the usual ones of making a startup go-managing the people, building a company and building the technology, because in nanotech you also have to get the science right,” he says. “Initially the science risk lowers the company’s valuation, but ultimately it increases the valuation because of the number of patents and differentiation it generates.”
Nanomix, based in Emeryville, Calif., was spun out of the University of California at Berkeley by two professors in September 2000. It scored its first venture round in October 2001-$4.5 million from Alta Partners, EnerTech Capital Partners and others.
Nanomix had to prove it could grow nanotubes on silicon on a commercial scale. (Nanotubes are the building blocks used throughout the industry for creating miniature electronics and super-strength materials.) It hired more than a dozen Ph.D.s to build chemical sensors that could detect gas leaks. After two years in the lab, the company scored another round of financing, pumping enough capital into the company to create a market-ready sensor chip. It expects to ship its first sensors to paying customers at the end of 2003.
IP Is the Key
Even if they can surmount technology hurdles and get a product to market, venture-backed companies must still be able to navigate a minefield of patents if investors are to ever see a return on their money.
Intellectual property is a sticky issue in nanotechnology. It is an emerging technology where much of the research is focused on describing the basic properties of life on the nanoscale. So many broad patents protect the basic science that younger companies and entrenched players may run into problems, especially with overlapping patents. On top of that, there are university technology transfer offices to contend with and, in some cases, researchers who want the intellectual property all to themselves.
Nanotechnology patents can protect manufacturing processes-low-cost, high-yield recipes for carbon nanotubes, or mass fabrication methods for molecular electronic components. Patents can be architectural; they can protect a molecule used for drug delivery or drug encapsulation. Patents can protect designs for unique nanomedical machines and the modeling techniques used to build them.
A single patent owned by IBM could throw a wrench in the nanotech industry. The seven-year old patent relates to building single-walled carbon nanotubes. Some researchers argue the patent is too old to be relevant and that companies like Carbon Nanotechnology Inc. and Hyperion Catalysis International have already developed alternative techniques for producing nanotubes that they plan to commercialize. But IBM’s patent still puts companies that build nanotubes at risk, a group that includes companies making materials for the aerospace industry that are lighter and stronger than any in use and companies using them as semiconductors and insulators for the electronics industry.
“For companies that build nanotubes, if you know what you’re creating or the business you’re building is going to run into IBM’s patent, you have to be prepared for IBM to enforce its patents,” says Kelly Kordzik, an attorney who represents IBM and is the head of Winstead Sechrest & Minick’s Nanotechnology Practice Group in Austin, Texas. “You have to believe that IBM will enforce its patents because they make lots of money with their patent portfolio.”
The fact that there has been little or no litigation over nanotech patents to date is simply an indication of how young the industry is. “Companies are developing stout portfolios of intellectual property and then looking to enforce them,” Kordzik says. “There has to be something to fight over. There’s very little by the way of money being made by nanotechnology companies so there’s little reason to be sued at this time.”
Some young companies plan to use their patent portfolios as a way to make money. They can license their intellectual property to create a revenue stream. That strategy may be smart for a company, but it poses potential problems for venture investors. Often a company’s technology platform is based on years of university research, entitling the sponsoring university to the researchers’ intellectual property.
There are already some indications of the kind of money that can be made from patents. Advanced Micro Devices learned how costly it can be when it went in search of a material more efficient than one it uses to build DRAM and Flash memory chips. It learned that one of UCLA’s microfabrication labs had a polymer that could pave the way for a memory chip that could store more information and use less power than AMD’s conventional silicon chips.
But AMD couldn’t just license the technology from UCLA. ITU Ventures had already beat it to the punch, securing the rights to all the intellectual property inside the UCLA lab and spinning out a company named Coatue Corp. with a $700,000 seed investment in May 2002. (The University of California holds an equity stake and stands to make royalties down the line.) Since the technology was so valuable to AMD, Coatue was able to secure new financing and a joint development deal with AMD worth $10 million.
In the world of nanotech, VCs themselves run the risk of paying a premium for IP. Sometimes university researchers are savvy enough to know the premium investors will pay for intellectual property. Take the case of Stephen Chou. He’s a celebrated researcher in the field of nanoimprint lithography and an engineering professor at Princeton University, as well as the founder of two nanotech startups: Nanonex and NanoOpto.
VCs came to learn a little late in the game that Chou had tied up NanoOpto’s core intellectual property in Nanonex. Chou is NanoOpto’s founding chairman and still sits on the company’s board of directors, and he sits on Nanonex’s board of directors.
When NanoOpto scored its first round of venture financing-a $12 million deal in February 2001 that included Bessemer Venture Partners, Morgenthaler Partners and New Enterprise Associates-the company came to the negotiating table with its licensing agreement with Nanonex. NanoOpto had licensed the chip-printing technique from Nanonex to build chips for the communications industry.
The investors didn’t know about NanoOpto’s arrangement with Nanonex until the deal was about to close. They were unpleasantly surprised, and even though the company’s intellectual property agreement limited the company’s ambitions to telecommunications, they went ahead with the investment.
“It became obvious at the first round that that’s the way [Chou] wanted to do it,” says a NanoOpto investor. “He’s a prolific professor who created a structure to control all this intellectual property.”
Chou, who remains chairman of NanoOpto’s board, declined to comment. Instead, NanoOpto Chief Executive Barry Weinbaum defended the company’s position. “Investors wanted the company to be focused,” he said. “If the company was going after 10 or 12 markets, then it would be like trying to boil the ocean: You can generate a lot of heat, but not a single bubble.”
Proceed With Caution
With so many things that can go wrong with a nanotech investment, smart VCs are proceeding with caution, letting Uncle Sam do the angel funding and tying performance milestones to every dollar they invest. They understand that the process is going to take years.
In the 11 months since taking the lead of JPMorgan Partners’ nanotechnology effort, Executive in Residence Alan Marty has looked at 180 deals and advised the firm to invest in just one. (The deal had not closed by the time VCJ went to press.) Marty says he will not make more than three investments over the next few years.
“Even if a company has done its lab work and proof-of-concept, I’m still not convinced a company can scale,” Marty says. “Working at such a small scale, results are very hard to measure and very hard to control, and it’s even harder to make a whole bunch of them.”
VCs proceeded very carefully with Genicon, putting performance milestones in place for each round of funding. It was a wise move, since Genicon needed four years before it was ready to ship its first sensors to paying customers in August of last year.
When San Diego-based Genicon secured its first venture capital ($4.5 million) in 1998, Forward Ventures, Oxford Bioscience Partners and Utah Ventures gave it one year to prove that its technology could be manufactured and reproduced and to show that the chip could actually detect and signal for certain genes. To secure a second round of $2.5 million nine months later, Genicon had to provide third-party validation to those same backers to prove that its chip could be packaged and sold. The venture capitalists also demanded proof that Genicon could secure a partner to promote and distribute the technology. The strict set of milestones ensured that Genicon developed a scaleable product.
Industry veterans advise VCs to let the government and large corporations subsidize early research. “Strategic money helps to substantiate and verify you’re building a product someone wants to buy,” says Vic Kley, chief executive of General Nanotechnology, a nanotools maker in Berkeley without venture backing. “You can bring in VCs in the second or third round of funding. It’s harder, in our experience, to deal with venture funders at the early level.”
Money is burning a hole in Uncle Sam’s pocket. The federal government planned to spend $604 million on nanotechnology research in fiscal 2002, and 10 government agencies, from NASA to the USDA, have requested $710 million from the next federal budget. The National Science Foundation will take home the biggest chunk of cash: It will spend $199 million making grants to nanotechnology researchers. The Department of Defense-the Air Force, Army, Navy and DARPA-has asked for $110 million. The DOD will make grants to researchers who work with electronics, materials, solar cells, photonics, anything and everything related to nanotech.
Companies like Nanosphere, a biosensor maker based in Chicago, have jumped on the opportunity. The National Institutes of Health have awarded the company two grants totaling $1.5 million to develop diagnostic kits to test for genetic risk factors for blood disorders and cancer. Nanosphere has another contract with the U.S. Government Technical Support Working Group-the agency that is coordinating all anti-terrorism research-to develop detection systems for biological warfare agents like anthrax and plague. The vote of confidence from the government helped the company secure a $10 million Series C round in December, raising its total funding to $18.5 million.
Although it may take as long as 18 months to write a proposal and tinker with it until it meets the government’s specifications, once the funds are approved, the money comes with few strings attached. A company gets to hold on to all the intellectual property it develops with federal dollars. Although it has to submit quarterly reports to a federal agency, the company does not have to meet performance milestones. The money is not dependent on customer wins or how much the market will pay for it, and it comes in one lump sum. And, the government is likely to be the company’s first customer.
Even if a company has government funding, investors should proceed with caution and sift through the mad science to find startups with more than just technology and promises of changing the world. Nanotechnology is like any other technology worth investing in. To commercialize the science, a company needs a solid business plan, a ready market, an experienced management team and a clear path to profitability.
“A lot of it is science, and investors shouldn’t be interested in science projects,” says Peter Hebert, a managing partner with New York’s Lux Capital, one of the nanotech’s biggest cheerleaders. “There’s a lot of hype and bubble, but it’s an exciting science and lots of technology can be developed out of this.”
Martin,the Quantum Dot co-founder turned VC, is also cautious. It’s a sector he’s watching closely, not because he’s driven by the buzz, but because it’s a science that has real applications for biotechnology, computing and materials science. “I invest in people and products,” he says. “I’m looking for applications-not technology for technology’s sake.