Venture capital, the funding of high risk business ventures, is often perceived by innovators as the sole and complete solution to completing commercialization of a new technology. However, most innovators and their technologies cannot obtain venture financing. Such failure is usually attributed to a greedy stereotype or the ‘Valley of Death’ syndrome. In actuality, the failure to obtain funding is due to the fact that the opportunity presented by the commercialization of the technology is inadequate to pay the price of venture financing. Instead, these innovators must look to other funding sources or license their technology in order to complete commercialization.
A SHORTFALL OF CAPITAL
As new innovations progress from stage to stage of commercialization, they require greater and greater amounts of capital funding to cover the costs of each stage. Many of these innovations were created with little or no funding. Many others have exhausted all funding long before completion of commercialization. Without additional funding, these technologies will never reach the marketplace and the benefits that they represent will never be realized.
It is a well recognized phenomenon that there are relatively larger amounts of capital for the stage of research and for the stage of manufacture than there is for the stage of development. This represents the transition between government funding and debt funding. This stage of capital shortfall has been labeled the ‘Valley of Death’ in recognition of the many technology businesses that fail during the stage.
It is assumed that additional capital funding in the form of venture capital will enable these technology businesses to naturally advance through the commercialization process to a point of success. To many innovators, the lack of funding is viewed as the only obstacle to success. Therefore, obtaining venture capital becomes the sole strategy.
Many innovators naively believe that the more venture funding obtained the better. More funding is viewed as directly related to the speed with which the market can be entered and the size of the splash upon entry. This follows the saying that “You can never have enough money!”
When venture capitalists refuse to fund a given technology or request an ownership position that leaves little left over for the innovator, accusations are made about the stereotype venture capitalist. As a group they are assessed as having a character deficiency and are labeled ‘vulture capitalists.’ More objective commentary seeks to convert these wayward individuals and bring them back into the fold of public minded philanthropists.
In recent years, there has been much discussion about the ‘Valley of Death’. This tag given to the long term between research and manufacturing funding bears more than a little similarity to its origin. Innovators plunging recklessly forward into development activities without sufficient funding often do not survive as business enterprises. Commentators on this phenomenon seem unwilling to place the blame on venture capitalists, but rather attempt to excuse their conduct as a force of nature. Holding unconstrained pride in mankind’s ability to overcome all obstacles, there have been many programs launched to deal with this problem.
The assumption that additional capital will automatically lead to success reflects a failure to understand the concept of the cost of capital. To lay the blame on venture capitalists or the state of the economy is improper. The truth of the matter is that most, if not almost all, technologies cannot afford venture financing. Money, like any other resource, comes at a price. The price of venture financing is higher than that of corporate financing or debt financing. The variance in the price is directly attributable to the higher risk of new technology ventures. The greater the risk, the higher the price. At some point the risk becomes so great that it can no longer be considered a business venture, but a gambling adventure.
TEQUITYÒ METHODOLOGY DEVELOPMENT
In 1994, Dakin LawTek LLC began testing of a new technology transfer model. This effort was directed towards the ‘Valley of Death’ problem. However, coming from a background in technology transfer, the approach relied upon licensing instead of venture capital to achieve commercialization. A common question posed by innovators was whether or not the licensing of their technologies would ultimately put more money in their pockets. The classical approach of venture capital followed by an initial public offering or by acquisition and merger was widely accepted as the optimum strategy for maximizing wealth.
An answer to the question posed by innovators was not immediately available. The early editions of the model featured different characteristics and attributes and were applied in many different situations with technologies at different stages of commercialization. Over time, this initial model
has been refined and has been labeled as the TEKQUITY Project model. A feature of this model is the venture financing of the costs of transfer. This feature only served to amplify the question posed by innovators as to the superiority of licensing or venture financed commercialization.
To reach an answer, a number of technologies were analyzed and projections were developed for both licensing and commercialization. Comparison of these projections enabled identification of criteria upon which a decision could be based:
· The amount of capital funding invested
· The timing of the investment
· The price of money measured in terms of an interest rate
· The term of the investment
· The volume of sales necessary to pay back the investment and the price of money
These criteria were then employed in a hypothetical situation, representing an average technology opportunity, a common amount of capital funding and a standard period of time between investment and cash exit. This resulted in three defined commercialization paths.
ILLUSTRATION
The first path represents an innovator without necessary funds that utilizes venture financing in a start up business enterprise to complete all stages of commercialization. The second path represents an innovator within an established business that already has all the resources necessary to complete commercialization. The third path represents an innovator without necessary funds that licenses the technology to an established business that already has all the resources necessary to complete commercialization.
Example 1: Venture Pricing
In Example 1, a technology owner elects to complete commercialization of its technology in a start up business enterprise by performing all commercialization activities: research, development, manufacturing, and distribution. Upon completion of development activities, it has exhausted its available resources and lacks funding to cover the manufacturing and distribution activities. Cash flow analysis indicates that it will require $5,500,000 of additional funding before it can achieve break even and pay further expenses out of revenues. In order to obtain this funding, it must first raise an additional $50,000 to cover the cost of raising the $5,500,000. This is accomplished by going to friends and family and selling equity in the business enterprise. The $50,000 is expended in fund raising efforts, resulting in receipt of $500,000 from the sale of additional equity in the business enterprise. The initial fund raising process takes one year. During the second year, the technology owner ramps up the business and continues fund raising efforts. The $500,000 is expended in setting up manufacturing and fund raising, resulting in receipt of an additional $5,000,000 from the sale of additional equity in the business. This second stage of operations takes an additional year. The cost of the funding, when measured in terms of interest rates is calculated to be thirty percent per year compounded. No additional capital is required as the business enterprise achieves a positive cash flow in the third year after expending the full $5,000,000 dollars. The business continues until the end of the seventh year, when the business enterprise is put up for sale. For the technology holder to payback the value of the capital invested, it must demonstrate that it has or that it can complete a minimum of $141,945,314 of sales with a net profit margin after taxes of fifteen percent. This reflects that:
· capital funding and the price of money will be paid back out of earnings,
· the current value of the total invested capital, representing capital funding and the price of money, at the end of seven years is $21,291,797, and
· sales at 15% profits must equal nearly seven times the value of the invested capital to generate the necessary earnings.
For the technology holder to receive anything after payback of the total invested capital, it must demonstrate even higher sales.
Example 2: Internal Pricing
In Example 2, a technology owner elects to complete commercialization of its technology within an established business by performing all commercialization activities: research, development, manufacturing, and distribution. Upon completion of development activities, it still retains sufficient funding to cover the stages of manufacturing and distribution activities. Cash flow analysis indicates that it will require $5,500,000 of funding before it can achieve break even on the technology and pay further expenses out of revenues. It requires no funding in the first year to raise the required funding. In use of its own funding, it assigns a price to the money equal to its own internal rate of return. The cost of the funding, when measured in terms of interest rates is calculated to be fifteen percent per year compounded. No additional capital is required as the business enterprise achieves a positive cash flow for the technology in the third year after expending all funding. The business continues until the end of the seventh year, when the business enterprise represented by the technology is put up for sale. For the technology holder to payback the value of the capital invested, it must demonstrate that it has or that it can complete a minimum of $74,755,442 of sales with a net profit margin after taxes of fifteen percent. This reflects that:
· capital invested and the price of money will be paid back out of earnings,
· the current value of the invested capital at the end of seven years is $11,213,316, and
· sales at 15% profits must equal nearly seven times the value of the invested capital to generate the necessary earnings.
For the technology holder to receive anything after payback of the invested capital, it must demonstrate even higher sales.
VOLUME OF SALES
By depending upon capital priced at the venture capital rates of return, a start up company is faced with a much higher price for the same invested capital. The technology owner must pay back $21,291,797. By comparison, an established company, using its own capital priced at its own internal rate of return, must pay a much lower price. In Example 2, the technology owner must pay back $11,213,316. The price of venture capital is double that of internal capital.
To properly frame the distinction between venture capital and internal capital, one must consider the volume of sales necessary to achieve the payback of the invested capital. With net earnings of 15%, nearly seven dollars of sales are required to generate one dollar of earnings from which the capital investment may be repaid. In Example 1, the use of capital at venture prices results in a necessary sales volume of $141,949,314. By comparison, in Example 2, the use of capital at internal prices results in a necessary sales volume of $78,755,442.
The question is posed whether the technology represented in Examples 1 and 2 can generate sufficient sales to enable the innovators to pay back the value of capital invested. The potential of different technologies will vary greatly. Some will have the potential to pay back capital invested at venture prices and leave a sizeable remainder for the innovator. Some will have the potential to pay
back the invested capital at internal prices. Some will not have the potential to pay back capital invested at either venture or internal prices.
Less Money is Good
The comparison between venture capital and internal capital demonstrates that an innovator must minimize the capital investment in the technology or face the prospect of failure. Even if the innovator is successful in attracting capital funding, too much money creates a burden on the business which must be repaid, if the market opportunity is large enough to do so.
If a technology is first examined based upon the maximum possible sales that it may generate, the examiner may calculate the maximum amount of capital that may be invested at the given price of money, whether that be venture or internal capital. This calculation serves as a guideline in determining the potential commercial viability of the technology and whether any investment should be made.
Venture Capital Too High
When it is stated that venture capital won’t work, this is not so much a negative reflection upon venture financing. Rather, it is a realistic appraisal of the potential of the given technology. Due to the higher threshold of sales required to pay back capital at venture prices, most or nearly all technologies will not be suitable for venture financing. The exact number is unknown, for technologies are not tracked or measured in this manner. This fact is important in that aspiring technology owners must realize that the venture capital path to commercialization is not available to them.
Those technologies that do not represent sufficient sales volumes, in order to progress through commercialization, must gain access to capital at a lower price. This may be accomplished in a variety of forms:
· Government grants
· Economic development programs
· Technology Transfer
Example 3: Technology Transfer
In Example 3, a technology owner elects to complete commercialization of its technology by performing all commercialization activities: research, development, manufacturing, and distribution. Upon completion of development activities, lacks sufficient funding to cover the manufacturing and distribution activities. Cash flow analysis indicates that it will require $5,500,000 of funding before it can achieve break even on the technology and pay further expenses out of revenues. Rather than attempting to raise this funding, the technology owner elects to sell the technology to an established company. However, it must first raise an additional $50,000 to cover the cost of transfer activities. This is accomplished by going to friends and family and selling equity in the business enterprise. The $50,000 is expended in sale of the technology, resulting in adoption of the technology by an established company that bears the remaining costs of commercialization. The sales process takes one year. The cost of the funding to cover the lost of licensing and transfer, when measured in terms of interest rates is calculated to be thirty percent per year compounded. Thereafter, the cost of funding is assigned a price equal to the buyer’s internal rate of return of fifteen percent per year compounded. No additional capital is required as the business enterprise achieves a positive cash flow for the technology in the third year after expending all funding. The business continues until the end of the seventh year, when the business enterprise represented by the technology is put up for sale. For the technology holder and the buyer to payback the value of the capital invested, they must demonstrate that the buyer can complete a minimum of $75,757,768 of sales with a net profit margin after taxes of fifteen percent. This reflects that:
· capital will be paid back out of earnings,
· the current value of the invested capital at the end of seven years is $11,363,665, and
· sales at 15% profits must equal nearly seven times the value of the invested capital to generate the necessary earnings.
For the technology holder to receive anything after payback of the invested capital, it must demonstrate even higher sales.
Near Equivalent to Internal Pricing
Example 3 reflects the value of technology transfer. By shifting the responsibility from a start up business enterprise paying venture prices to an established business paying internal prices, the cost of invested capital is greatly reduced. Even though the technology owner has paid venture capital prices for the funding necessary to complete the transfer, such funding is relatively inconsequential. It results in a value of investment capital that is roughly $150,000 greater than that if all capital had been priced at internal capital prices. Its impact on required sales volume is likewise relatively inconsequential. When compared to the required sales volume for capital priced in its entirety at venture prices, there is a substantial savings in the price of money. Furthermore, the reduced price creates a substantially lower sales threshold, one which is potentially attainable by a much greater number of technologies.
From the perspective of the technology owner, the lower sales threshold and lower price of money not only improves the probability of successful commercialization, but it also serves to leave more money for the technology owner. In structuring the sales price of the technology, the savings over venture capital may be shared between the technology owner and the buyer.
