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Investing in Nanotechnology (Part 3)

Michael Butler, NYU School of Law


A recent Wall Street Journal article warned investors to steer clear of Silicon Valley's latest "fad" - Nanotechnology. What the article failed to note was the $1 trillion estimated market for "Nano" products by 2015, offered by Michael Rocco of the National Nanotechnology Initiative, (NNI) the government agency sponsoring research in the field. It also failed to recognize that, of the large number of states and localities currently investing in Nanotechnology startups, only one of those places is Silicon Valley, as investors across the country, and indeed the globe, are rushing to embrace the companies that will define Nanotechnology's future. Finally, when it comes to bringing any new products to market, the first step necessary is for the venture capital community to come to the fore and invest in the companies that will make the idea a reality; something that until now, has happened on a relatively limited scale for Nanotech.

The question addressed by this article is whether the environment surrounding Nanotechnology has reached a point that is attractive for venture investors. This article will attempt to answer that question by approaching it from several angles. In part one, we defined Nanotechnology and introduced the reader to the ground covered thus far by scientists in the field. In part two, we looked at why venture investors have only recently entered onto the Nanotech stage. In this final section, we look at the problems faced both by entrepreneurs and venture investors in Nanotech and a look at the potential future of venture investing in the "Small Tech" industries.

Problems with Venture Investments in Nanotechnology

Having gained an understanding of Nanotech, its investors, and its markets, the final set of issues revolves around the problems to be faced in the near-term for the companies attempting to make a go at a Nanoscale product, and for the Venture Capitalists who are willing to take the on the risk of backing them. While the problems for the companies are often the same problems that the venture capitalists are seeing, and vice-versa, the discussion below has been broken into these two perspectives in order to better organize the discussion.

Much of the material suggested here is speculative as the industry is too new to indicate its tendency to resist or absorb such difficulties. Ultimately, it is the fact that most technologically advanced industries at the early stages of development faced similar issues that makes the analysis below relevant.

Problems for Nanotech Companies

Customers and Markets

The primary question for companies and venture investors in the Nanotechnology space is who is buying these technologies? Without clearly defined markets, including customers with known uses for technologies, many Nanotech companies are currently languishing in a limbo brought on by markets that have not formally materialized. Examples of companies with this problem include many of the companies described previously who produce carbon nanotubes. As described above, carbon nanotubes are touted by many as the building blocks of a Nanotechnology future - appearing everywhere from computer chips and monitors to indestructible skyscrapers. However, at current, uses for carbon nanotubes are largely theoretical with only a handful of products on the horizon. Thus, while producers of nanotubes such as Nanocs and Carbon Nanotechnologies, Inc. wait for their products to go from technology to commodity, they are left selling largely to bigger companies who are conducting their own research.

Luckily for many Nanotech companies, a large number of Nano products in production or under development bear the trait of classic "disruptive" technologies; products which, if they do not oust previous products from their first sales, are at least able to harmonize with existing products before replacing them as cheaper, faster, and smaller. Examples include a variety of products produced by Nanophase Technologies Corporation, which are used in everything from vinyl flooring to ceramics in order to improve their conductivity, abrasion resistance, or strength. A second example is NanoMuscle, Inc., a company that, when faced with the challenge of what to do with its miniaturized motor technology, turned first to the toy manufacturing industry as a safe place to begin making its mark.

Largely, the acceptance of Nanotech products into established and new markets is a function of time. The use of Nano scale products within one company leads to further acceptance by others. More importantly, as companies come to use Nano products and gain a level of comfort with their suppliers in the various Nanotech industries, the credence of such companies and their products will increase. Even in the case of Carbon Nanotechnologies, Inc., which has identified no more than a handful of uses for its Nanotubes, has seen demand by researchers outstrip its ability to keep up with demand and is currently constructing a factory that will produce, in a single day, a quantity of Nanotubes equivalent to that which has been produced over the history of Nanotube production.

Intellectual Property (IP) Transactions and Protection

As has been the case of virtually all investments in the venture capital arena, the question of how to successfully patent and protect intellectual property is a key component to any successful venture investment. Nanotech and the products developed have fit that description like no other technology before. Nanotech patenting describes the limit of what is difficult about the patent process. Given the complexity of most of the technologies, the proprietary nature of their means of development and production, and the positioning of many Nano products as pieces of more complicated products all make the necessity of patents, business process, and trade secret protection, extremely important. It is also no coincidence that many Nanotech researchers and advocates are also worried about the ability of the United States Patent Office to understand and properly handle patents in the Nanotech space.[1]

Such a situation provides both a boon and a potential pitfall for companies and investors in the Nanotech space. The upside is that the complexity of the materials and products created by Nanotech companies is such that products are often difficult to copy, or even reverse engineer to such a degree that the costs of R&D by potential competitors is likely to fall outside the range of economic viability. The problem is that without defined markets and uses for Nanotech products, the difficulty in defining a claim for patent protection is complex both for the company and its counsel. The design of a patent, such that the claim encompasses a substantial scope but does not fail a broader market test before the Patent Office, is indeed a difficult task for a Nano product that has yet to be successfully tested or implemented in a commercial product. Moreover, much of Nanotechnology exists largely in a theoretical plane that may not reach fruition for years to come. The difficulty of pursuing such a claim before the Patent Office is overshadowed only by the potential loss that could ensue if a company fails to file the claim, invests significantly in R&D, and is subsequently second to market following a competitor.

The only upside to this situation is that the IP problems associated with Nanotech are by no means new to the legal profession, and represent a variety of situations that have been faced by patent attorneys throughout their history. The law firm of Foley and Lardner, perhaps the first firm to significantly invest in the burgeoning Nanotechnology industry, has recently produced a report on IP protection for Nanotechnology companies operating in the development of Quantum Dots. Ultimately, the position taken by their staff is simply to come to them as early as possible to help establish a claim before competitors reach the Patent Office first.

Skilled Labor

Perhaps the single most pressing logistical problem for companies in the Nanotech space is the dearth of skilled labor to act as potential employees for development of Nanotech products. The problem for companies is that while the market for general labor is at its most pro-employer state in recent years, the need for skilled engineers is still high. Coupled with this fact is the need for staff that posses skills not only in a single area but often, in a multitude of disciplines.

There is some hope for the growth of staff particularly suited to work in the Nanotech sphere. Recently, several universities including Cornell and Princeton have introduced graduate level curricula designed solely for those interested in the field of Nanotechnology. In the meantime, the hope by many in the field, particularly in the US, is that the economic benefits of coming to the US to work will be combined with a more liberal stance taken by the federal government on an open admissions policy of skilled scientists and engineers wishing to immigrate to the US. Such a position has already gained some traction, including support from individuals otherwise unlikely to articulate such a stance, including former House Speaker Newt Gingrich.

Bad Press

A final potential hurdle faced by Nanotech companies and venture investors alike is the general tone that has beset both professions in recent days. The Wall Street Journal article referred to in the introduction, along with several other pieces that have occurred in places as seemingly pro-Nano as the MIT Technology Review and Small Times have pegged Nanotechnology to fall somewhere in the range of the burnt hopes of Biotech and the burnt investors of the Internet.[2] Simultaneously, the venture capital community has been weighed down by a spate of journalistic coverage that is anything but unbiased.

There is no clear cut solution for winning the approval of the popular media and eventually, the investing public, either for Nanotech companies or their venture backers. It is apparent that if Nanotech opens to a round of successes at introducing new products or reinventing old ones with benefits of speed, efficiency, and cost savings, then naysayers will be offered a serving of crow. However, there is the corollary benefit that a watchful media will help to turn investors away from the "vapor ware" companies that they were willing to back over the history of the Internet bubble.

Problems for Venture Capitalists

Management

If "bet the jockey, not the horse," is the motto of every venture investor, then the Nanotech community better start looking for some riders. At the recent NanoBusiness Alliance - Spring 2002 conference in New York, time and again, the word from investors to companies was to find talented and experienced management before looking for venture dollars.[3] The bulk of Nanotech companies to this point, are little further along in management structure than the founder, usually a professor with little or no business experience, and perhaps as many as three of his/her graduate students. While there are venture capitalists, such as Sevin Rosen Funds, who have shown a willingness to bet on single inventors based solely on the weight of the IP that they bring to the table, the risky nature of such an investment leaves many VCs behind as they are prepared to place money only on talented management.

The strategies attempted by both companies and venture investors in such situations has varied. For companies, a typical solution is to attract management from related industries which already have established management teams - such as Carbon Nanotechnologies Corporations hiring of several key employees from the PetroChemical field - and use their general business experience to help comfort investors and drive sales. Conversely, investors have used the technique of milestone investing to help move a company from sole proprietorship to the main stream. An example is Sevin Rosen's recent investment in currently un-named company where Sevin tied several trenches of the full amount invested to the hiring of key employees, such as an outside CEO.[4]

Both of these strategies have distinct positives and negatives. For companies hoping to bring management from outside the Small Tech field, the problem is often "chicken-and-egg" where the company cannot attract skilled management without sufficient economic incentives, but venture backers are unwilling to make investments prior to seeing a strong management team. On the opposite side, examples of situations where the VC has helped to place management have the difficult characteristic of inserting a manager with limited knowledge in the field, into a very small team, often composed entirely of scientists, who may view such outside imposition as a threat or as the venture investor wielding too large a role. Ultimately, until Small Tech has built up a backlog of successful entrepreneurs who have already moved through the startup phase of their own companies and are back on the employment market, such techniques as those listed above are likely to be the only possible means of connecting great ideas with great management.

Skill / Knowledge of VC

In the preceding discussion about management of Nanotech companies, another significant issue lay in the background of why venture investors are unwilling to back companies in the Nano space; their own lack of knowledge and experience. This lack of knowledge or skill in the Nano arena exists in several forms, all of which are likely to turn venture investors away. First and most simply, Nanotechnology is complicated science, and many VCs, particularly at the seed stage, lack even the most rudimentary training to recognize the potential of any given product or even whether or not the product is a good idea. Unlike the Internet boom of the late 1990's, which saw a variety of companies that had largely just adjusted real world sales and distribution models and made them "web friendly," virtually all of Nanotechnology rests at the juncture of very complicated science and engineering fields. For many, the complexity underlying many Biotech business models pales in comparison to that of Nanotech. Even more critical than the complexity of the technology, is the rate of evolution that it is undergoing. Like the speed of computer chips, what is new one month is old hack in the next when it comes to Nanotechnological developments. For any one VC to keep abreast of the changes in Nanotech, the likelihood of success in such an endeavor would be comparable to trying to memorize the daily changes in the listings found in the Manhattan Yellow Pages.

It will be some time before VCs feel technically comfortable with investing in Nanotech startups, and even to reach that point, several changes are necessary. First, VCs wishing to enter the Nanotechnology space need to either rapidly self-educate about the field of Nanotechnology or find and hire individuals who do. These techniques, combined with the efforts of the Nanotechnology industry to educate investors and the general public about the field, such as the efforts made by the Foresight Institute, are critical to raising the comfort level of investors in the field. Moreover, it will soon be necessary for venture investors who enter the field to move quickly towards one or two segments of the Nanotech industry which they prefer for their potential. Without such segmentation and focus by VCs, the likelihood that many unworthy companies might be backed by unskilled VCs interested in ridding a bubble is raised to significantly dangerous levels.

Exit Strategy and Timeline

A final pair of factors which will drastically effect the nature of VC investing in Nanotech, at least for the foreseeable future, are the nature of viable exit strategies for the investor and the timeline for their investments to be realized. With the IPO market effectively closed and corporate spending on acquisitions and R&D at significantly low levels, the likelihood that a Nanotech company will have a predefined path to exit from the point of its inception is highly unlikely. While there has been a growing number of companies that have outsourced their R&D function to startup or small companies as a means of cost savings,[5] it is not the case that such contracts will culminate in a guaranteed sale of the startup.

Moreover, Nanotechnology does not operate on "Internet Time." While it is readily apparent that the market is not likely to return to the late 90's "Embryo-to-IPO" timeline of, for some companies, under three years, such a rapid transition is virtually impossible for the bulk of Nanotechnologies under development. While the "Two-Week Revolution"[6] would be the equivalent of the venture capitalists' dream come true, such a phase for Nanotech development is not likely for a longtime if ever. For the moment, the lack of coherent markets for Nanotechnology's products and services combined with the huge amount of R&D required to bring a Nanotech product to market, makes the field available to only the most patient of investors.

Luckily for Nanotech companies, such investors already exist. Harris & Harris, for one, is a venture company operating almost entirely in the Nanotech space that makes apparent its characteristic as a "patient" investor. However, it is not clear from this one example that such investors are plentiful, given that Harris is actually a publicly traded small business investment fund, (NASDAQ ticker symbol TINY) and its ability to be patient rests largely on the fact that it is backed with public money. Additionally, while several of the "Trophy Funds" such as Draper Fisher Jurvetson and Sevin Rosen have entered this market, it is largely due to their huge economic backing and their virtual lock on continued institutional investment that makes such patience possible.

Conclusions and Commentary

If the question were posed as, "is now the right time for venture investors to begin funding nanotechnology" the answer would be a qualified yes. Nanotechnology, at this stage of its development, presents a fabulous opportunity for investors to enter an emerging field at attractive valuations and to earn their stripes as investors in this nascent technology. However, while these observations are accurate, investing in Nanotechnology at this time is not for the faint of heart. 2002 investors in Nanotech must be patient, well backed financially, and skilled / educated enough to recognize the risks associated with this emerging field. If caveat emptor was ever meant for the venture capital community, the unskilled venture investor in Nanotech should take the phrase at face value. Ultimately, and has been the case through every wave of venture investing, those VCs who are able to get out ahead of the pack and make intelligent investments in successful companies will see their clout and pocketbooks fill like never before but the risks associated with such investments are higher than ever, and need to be weighed with great care.


[1] Doug Brown, US Patent Examiners May Not Know Enough About Nanoech, Small Times, February 4, 2002.

[2] David Rotman, The Nanotube Computer, MIT Technology Review, March, 2002.

[3] See Nanobusiness for an overview of several addresses from VCs who addressed this issue.

[4] Daniel Leff of Sevin Rosen Funds described this investment at the NanoBusiness Alliance Spring 2002 conference.

[5] See NineSigma Technologies, an R&D matching services.

[6] The "Two Week Revolution" is a concept that was considered by such individuals as Dr. Drexler as a NanoEutopia where, upon the invention of "assembler" devices, a backlog of nanotechnologies would be developed in a miniscule amount of time, resulting in massive, instantaneous changes to human civilization.