No A’s for Effort in Venture Capital

Two weeks ago, I described how universities are encroaching on the space of traditional venture capitalists, initiating small funds to commercialize their own research. Their deal flow, driven by internal entrepreneurs, should move at a healthy clip, because the lousy returns of the last 10 years will force many mid-tier venture funds out of business.

Meanwhile, universities eagerly trying to replace vanished endowment dollars will convince key stakeholders to scrape together pots of money to form modest (US$20 million) venture funds, ideally to create annuities but also to attract top faculty members.

I did not, however, mean to suggest that the returns of these funds would outpace those of established — or even newcomer — venture capital funds.

Let’s imagine that an average university initiates a new $20 million fund to capitalize on its bounty of innovation. This fund faces the same economics as every venture fund, namely that 1) it will be forced to endure the J-curve, where the losers fail long before the winners pay off; 2) the majority of the winners will be solid singles or doubles, generating modest returns; and 3) it likely needs a tenfold return on a winner to pay for the losses.

Will the university tolerate this long maturation period? These funds face three significant limitations.

Many Patents, Few Deals

First, generating sufficient deal flow might not be as easy as one might think. Consider the licensing rates at top innovative universities such as Caltech, MIT and Stanford.

At this level, schools annually file one or two thousand patents, and they enter into approximately 50 license or option agreements. However, this does not create 50 companies per year. Some companies are formed with a portfolio of several patents, the innovator licenses new developments to an existing small company, or the license goes directly to a large strategic partner.

In fact, the Office of Technology Transfer at Caltech advertises that it forms about eight startups per year. This is common in the tech industry; the Association of University Technology Managers reported that as recently as 2008, 5,000-plus new licenses were issued — but to only 600 new companies.

Thus, the typical university is unlikely to see a huge bounty of prospective deals. We should probably assume that a fund would be lucky to see four startups in a given year. Does this small number of prospects mean that fund management is expected to invest in all of them, regardless of the quality of the business plan?

Devastating Down Rounds

Second, a $20 million fund is severely undercapitalized. Typical annual operating expenses of 2 percent add up if it takes 10 years to see an exit, as is common today, thus reducing the fund’s investable assets to $16 million (assuming you can find a qualified person to manage a fund that small).

Given our potential portfolio of four startups, investing $250 thousand in each startup and spending appropriately on securities lawyers and other specialists takes care of another $1.5 million, leaving $14.5 million available.

This quantity has to sustain the fund through larger financing rounds, which is fine if the fund managers like being diluted. Any down rounds (in which the valuation decreases) can be devastating to small investors, because they can be wiped out if they do not pay up when the valuation swings back up.

Marketplace Disconnect

The final and most threatening limitation on university fund success is the lack of connection to the marketplace. Faculty members accustomed to pleasing government funding agencies may not be used to a world in which you eat what you kill.

A university’s structure doesn’t require close interaction with the marketplace. How many researchers are working on the equivalent of garlic toothpaste? It may be easy to manufacture, but who wants it?

Research institutions generally don’t staff marketing teams skilled in determining trends, and faculty members are usually not practiced in articulating value propositions. The Field of Dreams marketing model — if you build it, they will come — doesn’t ring true to those of us who have actually sold products.

Thus, while university funds are an interesting development in the venture capital world, they run three risks: 1) The deal flow is very small in a typical university, thus reducing management’s ability to be selective; 2) The funds are likely too undercapitalized to generate a good return if any of the companies falter in future financing rounds; 3) Fund management may not be skilled in using market insight to identify potential successes.

These concerns are sobering to university administrators hoping to replicate Stanford’s $337 million windfall from the sale of Google equity.

Thus a stronger university component in the changing venture capital landscape calls for a good dose of caveat emptor. Unlike other university activities, there are no A’s for effort in generating returns.