Sunday, 28 February 2010

Venture Capital; Up or Down? (And What about IP?)

"Venture Capital"-- The words (and their anthropomorphic derivative,"the VC") are virtuously synonymous with start-ups, entrepreneurship,and innovation. According to the common wisdom, the US has done well because of its VCs, Europe less so. Whatever you think about the winners and losers in the VC race, careful attention should be directed to the current state of Venture Capital, lest past perfect, at least with start-ups, fail to achieve the future perfect that so much depends upon for future growth and development and, for IP professionals, the engine for continued good fortunes.

Against that backdrop, I took another look at an interesting column that was published in what may have been the last free-standing issue of BusinessWeek magazine (it is now called Bloomberg Business Week, after its acquisition by the eponymous media giant late last year). The article, entitled "How Venture Capital Lost Its Way", and authored by Carl Schramm and Harold Bradley, appeared in the November 30, 2009 issue.

First a word about the authors and their affiliation. Schramm is president and Bradley is the chief investment officer of the Ewing Marion Kauffman Foundation. Located in the American heartland of Kansas City, the Foundation is reported to be the largest foundation dedicated to the promotion of entrepreneurship. It has tended to focus its activities on the U.S. (which be a function of its mandate), but its influence extends beyond North America. Attention should be paid whenever the Kauffman Foundation opines on weighty issues concerning entrepreneurship.

The gist of the article is as follows:
1. Venture capital has been a critical component of innovation. However, venture capital seems to be on the wane. The amounts funded and the number of companies supported by such funding continue to decline. The industries most requiring VC funding, clean tech and biotech, are being shunned in favor of info tech, which have much less need for substantial capital investment.

2. The root of the problem is the VC financial model, most notably the "2 and 20 rule", where fund managers charged an annual 2% management fee and took 20% of the proceeds of an IPO or sale. Historically (that means the 1980's), VC types were structured as partnerships, where the funds invested mostly came from wealthy individuals. This allowed them to maintain a patient capital outlook for their investments. Choose your companies carefully, and permit yourself a time horizon of 10 years or more for the success of your investment, were the defining characteristics of VC investing in those days.

3. However, when institutions entered the VC game, the dynamics changed. Able to aggregate larger sums than even the most well-heeled private investors, the focus changed from nurturing growth to increasing fees based on ever-larger investment pools. The result is that the venture capital industry has aped the business model private equity, namely the short-term "flip." To keep their investors happy, in the words of the article, "VC funds are ...going for maximum liquidity, creating early payoffs via premature "exits" ...."

4. The result is that investment capital is no longer being put to work for long-term use, including for such capital-starved industries as clean tech and high tech. Moreover, the investors themselves are not reaping appropriate return on their investment (over the decade, "an investor would have done better in a small-cap Russell 2000 index than in VC").

5. Schramm and Bradley offer several suggestions to ameliorate the situation: (i) tie management fees to a budget rather than the size of the fund: (ii) pay investors a guaranteed amount before the fund can claim its 20% share; (iii) require the VC fund itself to put more its own funds in the companies in which it invests.
I am hardly the person to evaluate how successful these suggestions for change might be. In a world of "short-termism", I reckon that the problem is deeper than altering the arrangments for the VC investment community. That said, from a more modest perspective, I wonder how the changes in the VC world described by Schramm and Bradly has, or might in the future, affect IP practice. The following questions immediately leap to mind:
1. Are more patents being filed early on, whatever their quality, mainly in order to "improve" the position of the company for an early exit?

2. If so, does this affect the compensation arrangements for patent drafting and prosecution?

3. Do changing VC patterns affect the staffing requirements of patent law practices?

4. What is the role, if any, in providing strategic IP advice to companies funded by VC's?

5. Do trade secrets or branding matter in such a world?

6. I guess that the overarching question is this: If Schramm and Bradley are correct, and the VC ship is not righted, will the IP profession be better or worse off at the end of the decade?

1 comment:

Michael F. Martin said...

Schramm and Bradley are correct, and not just about venture capital. Their observations about the misalignment of interests between managers and investors applies to public companies as well, although it takes a longer argument and more facts to make the case of course.

Why not give big tax breaks for very long-term capital gains (5+ years?) Give patient capital a obvious leg up on the more agressive, short-term traders.

1. Depends on the technology, with the constant being that if you don't file early, you don't file at all.

2. Yes. The need to file to preserve rights guarantees a certain floor level of workflow for prosecutors (not just attorneys, by the way, since agents do a lot of in-house work these days).

3. Not really. The bigger companies are still a bigger portion of the total apps filed. In some areas, however, (like Silicon Valley), they might be a bigger fraction of the work at a particular firm. Or all of it at some.

4. Again, depends on the technology. In some areas, it's the main source of competitive advantage. In others (think consumer internet), it's about managing down risk of infringement liability while the company outperforms its competitors by quick iterations on its releases to customers. The rate at which the product evolves in the consumer internet industry can be 2x or more the rate at which patents can be drafted and prosecuted.

5. Trade secrets are always an option. But to reduce infringement liability and misappropriation risk, companies ought to have some kind of formal recordkeeping of their work. For many companies, an outside patent agent or lawyer is actually a cheap way to do this. And again in many industries, the technology evolves so fast that the benefit of being able to keep it forever is negligible. (Remember that the time value of money falls off to nothing within 20 years.)

6. I guess that the overarching question is this: If Schramm and Bradley are correct, and the VC ship is not righted, will the IP profession be better or worse off at the end of the decade?

Only time will tell, but on my view, there is no private solution to the problem of gap funding -- i.e., the gap between early-stage science and VC-backable product development -- that will outperform the patent system. We have a highly evolved mechanism -- albeit imperfect -- for defining and allocating ideas. Why not use it?