Nanotech: what makes investors bite

Investing in technology that's a few years from commercialisation can be tricky. Lori Valigra finds out how some venture capitalists sort the wheat from the chaff.

The initial public offering by UK nanotechnology company Oxonica on London's Alternative Investment Market (AIM) in July created waves across the venture capital community on both sides of the pond. It not only was one of the first pure nanotech companies in Europe to go public; it also signalled to investors that the nascent nanotech market is worth another look, and that a merger or acquisition isn't the only exit strategy available to investors (see Is AIM a viable alternative?).

The Oxonica IPO came at a time when London's IPO market was on the rebound, outpacing that of the US NASDAQ and New York Stock Exchange (see chart of LSE vs. NASDAQ vs. NYSE). It also came about a year after US nanotech bellwether Nanosys Inc of Palo Alto, California, withdrew its $100 million IPO on the NASDAQ because of adverse market conditions. Nanosys recently raised $40 million from a private equity syndicate, an indication that while venture capitalists will bite, the US public markets remain bearish about IPOs.

"In Oxonica people saw a nanotech company that was able to find an exit strategy and some liquidity in the public market. You haven't seen that in the US really," said Douglas Jamison, vice president of Harris & Harris Group. a New York City-based, publicly traded venture capital firm that focuses on "tiny tech".

Harris & Harris is one of the investors in the recent Nanosys round. Jamison doesn't see Nanosys going to AIM, but says it may be a strategy for smaller US companies that want to raise $10 million to $20 million and get a bit more liquidity than they would get from private investors.

VCs tighten the screws

Oxonica, based in Kiddington, Oxfordshire, netted £7.1 million with its IPO. The University of Oxford spin-out also raised £4 million in its first round in 2002, during the doldrums of venture capital financing, including the first direct investment by BASF Venture Capital GmbH, Ludwigshafen, Germany.

But the reality for most nanotech companies spun out of university research, especially in the United States, is they need a compelling story and some strong fundamentals to get the attention of venture capitalists. Topping the list: technology with a potentially broad market, solid management, intellectual property assets, a product or prototype, large corporate partners, ongoing government funding, and typically more than one venture capitalist willing to invest.

In return, venture capitalists expect start-ups to manage their money better: a new trend is for the investors to dole out funds sparingly as milestones are met. Venture capitalists will commit a certain amount of money, but tie outlays to milestones. This puts a tough burden on start-ups, because it is common in nanotech and other new fields for the technology to take longer than expected to develop, and for the time between milestones to stretch out.

"There are not enough tools in the toolbox to solve nanotech problems, so milestone payments will get pushed back with the technology," said Jamison. "Companies need to have capital efficiency and run leaner in the early stages."

Venture capitalists also are proceeding with very conservative due-diligence processes to assure the commercial viability of any technology, said Dan Coyne, a principal at investment banking company Adams Harkness of Boston, Massachusetts. "That may require them to do milestone-based investments from a risk-management perspective, so they're not totally exposed at too early a stage for something that, as it develops, may not have as much viability," he said.

Also alleviating the risk: the continued encouragement for early-stage companies to continue to go after government funding, even after their first round of venture capital, said Jamison. "Nanotech is taking far more money and time than expected," he said.

In the first half of 2005, investors put $242 million into nanotech companies, which means this year could break the record of $301 million in 2003, according to SmallTimes, a publication that focuses on small technologies like nanotech. That compares with $196 million in 2004.

Assessing intellectual property

Intellectual property can be fraught with hazards in nanotech, because most of the time nanotech is a piece of a larger puzzle of intertwined technologies, such as in the semiconductor memory chip and biomedical areas. And in some areas, companies are overwhelming patent offices with broad claims that often overlap, or that are "entangled”.

Take small nanotech-based semiconductor crystals called quantum dots, which usually need to be used with other intellectual property to get a product. Robert Paull, co-founder and managing partner of Lux Capital, a venture capital company based in New York City, studied the 3,800 nanotechnology patents filed with the US Patent and Trademark Office over the past decade or so. "The quantum dot space was entangled. That inhibited companies from investing in the nanotechnology space, because it was too much of a minefield," said Paull. (see Terms of the trade in References, left)

Entanglement is a huge issue, Jamison agreed, because it can increase the cost of doing business. While a company may be granted a patent, it may not have a freedom-to-operate opinion. That means it may have improved on a fundamental technology to which another company holds a patent, but it still must get a licence to the underlying technology before it can act on its own patent. A freedom-to-operate opinion, typically paid for by the company, can cost $30,000 or more.

"Venture capitalists need to know what the intellectual property landscape looks like," said Jamison. "We see 600 deals a year. If a technology or lab is entangled, the lab needs to be really good or we'll triage it."

But what Jamison lurks in the back of his mind is the potential threat of "patent trolls”, or companies that get broad patents in order to get royalties from other companies. "People fear the trollers, who sit on a technology until it becomes popular, like what happened in software. It's not happening yet in nanotech."

Because nanotech typically needs multiple technologies to make a product, he predicts there will be a lot of cross-licensing of patents in five to 10 years.

Big markets, syndicates

High on venture capitalists' lists in an investment is a big market that promises big returns. "We looked at 600 nanotech business plans last year, and invested in four. We want to like the market and the company," said Paull of Lux, whose portfolio companies include Nanosys, which is developing nanostructures for semiconductors, life sciences and other industries; Massachusetts Institute of Technology spin-out Cambrios Technologies of Mountain View, California, which uses biology to help grow electronics and semiconductors; and Kereos of St. Louis, Misssouri, which has a broad licence from Washington University in St. Louis and is using nanotech to develop targeted therapeutics.

Jamison likes a hot technology like that of Nantero, a Harvard University spin-out that is using carbon nanotubes to develop a very fast and dense non-volatile memory device that could eventually replace flash cards, dynamic random access memory (DRAM) and other types of memory in personal digital assistants (PDAs), cell phones, digital cameras, MP3 players and other mobile devices. Nonvolatile memory does not have to have its memory contents refreshed periodically, so it is good for portable devices. The people behind the technology, the intellectual property and the huge potential market made the investment attractive. Jamison said his company looks at smaller, directed investment plays, and it is holding onto its stable of companies until the IPO market window opens again.

"The technology is only 5 per cent of the success of a company," said Jamison. "The other 95 per cent is building it." He said the determinants of success are the quality of the management team and a large market opportunity with unique technology to which the company has rights, and that can be validated in the early stages.

Because nanotech can require a lot of time and money, a strong investment syndicate with deep pockets and corporate partners are important as well. The recent $40 million Nanosys round was led by El Dorado Ventures and includes ARCH Venture Partners, Lux, Harris & Harris, Polaris Venture Partners, UOB Hermes Asia Technology Fund of Singapore, Venrock Associates, Intel Capital and In-Q-Tel, the venture capital company run by the US Central Intelligence Agency. Nanosys also has development relationships with companies including Sharp Corporation of Japan and chip-maker Intel.

But the small nanotech companies aren't the only beneficiaries, Paull of Lux emphasised.

"Intel has a $4-billion R&D budget and can't do what Nanosys is doing with $55 million in venture funding," he said. "That's why Intel is an investor in Nanosys."