I had two things happen recently that made me think more about how a board is perceived by the employees of a venture funded company, specifically the non-CEO managers:

First:  After I learned about a portfolio company crisis that had been brewing for months (about 12!), I asked the company’s managers “why didn’t you tell me about this problem?”.   What I got back was “well, we just did as we were told”, “you were the board, we had to be careful in telling you things”,  and “we were instructed by the CEO not to talk to you”.  I am still scratching my head at these answers…it’s 180 degress from the way I want a management team to think.

Second:  Around the same time, I visited a portfolio company without advanced warning just because I was in the neighborhood with some extra time.  The team there was totally stressed that a board member visit might mean something bad…  I guess I can understand the reaction, many times the only time some company employees see the board is when they come in for board meetings or to fire someone, shut the company down, etc.  That’s not the case at all here, I just wanted to drop in and see how things were going and the CEO had told me to stop in if I found myself with a little extra time that day.  Plus I enjoy working with this team and wanted to see how I could possibly be helpful.

These two interactions got me thinking about how perceptions of what the board (of directors) is and what it wants might interfere with really beneficial information flow and interactions.  Specifically:

  • The VC directors are not there to simply evaluate how their investment is doing.  They should be a resource and to help the company with skills and relationships that might not be in the company normally.  In other words, make the board work for you (and everyone work for the shareholders).  VC’s actually want to be asked to help with problems, find resources, etc.
  • The directors do not want to funnel all communications through the CEO.  We absolutely want to have open discussions with the team.  Just lay it out there…the good, the bad and the ugly.  CEO’s will not succeed if they create barriers between the directors their team or, worse, create some fear of the board (“we can’t tell them that because they would pull our funding”).
  • Some members of the board will understand the company and nuances of strategy faster than others.  Everyone should recognize this and work to keep all the board members up to speed, not by managing information but by proactively educating.  The fact is that some directors will not really pay attention until there is a crisis, even if the team is being fully transparent.  CEO’s have to actively educate and manage those board members because they can become loose cannons if surprised (because they panic when the company is under stress).
  • The board is not exclusively focused on objective financial measures.  Companies can grow in value (or potential value) by building a great team.  Yes, ultimately it needs to translate to revenues and profits but in the early stages, a good director is also focused on team development.  Board members sometimes  fail to attend to this though and leave it to the CEO.  I let this issue go for far too long with one company that failed to build out a complete team and the team fell apart at the same time that it landed the first big customers.
  • Directors do not always agree with each other on strategy – that’s OK as long as a decision is made and everyone stacks hands and moves forward together.  Because a startup almost always has to pivot once it understand the customer needs, it is natural that there is an ongoing dialog about where that pivot point is. The non-director management of the company should learn to value a range of opinions from the board just like it values a range of ideas from the employees.

This idea of open communication is easier to say than to do.  A manager can’t really call the board and say that the CEO is wrong – it breaches trust.  What I think teams should do is to separate the people from the problem and focus on bringing issues forward.  The CEO needs to create a culture where, if a manager is concerned about a problem, this concern gets exposed to the board.  It isn’t really that much harder than having the managers speak their minds in the board meetings (where most of the senior managers of the company should participate).

What I plan to try with my next company is having an explicit policy from day 1 where (1) every new employee gets some explanation of what the board is and how it can be used as a resource, (2) board members are expected to pop in and chat with any employee, and (3) every board member will visit, at least by phone, at least once a quarter, with every C and V level executive to get an unrehearsed view of the company  status.  The goal is not only to help the directors better understand how the company is doing and head off problems but also to find out where the directors can be a valuable resource for the company.  Some of my companies already operate this way (because of the culture set up by the CEO) and my observation is that they are more likely to stay out of the ditch and, if they end up there, are more likely to have everyone pulling together to get back on the road.

The Solyndra blame game is in full swing.  The company, having previously filed an S-1 to go public and taken over $500 Million in US government (USG) loan guarantees, filed for bankruptcy last week presumably losing all or most of the investor equity capital as well as the USG backed debt.  Given the nature of the risk here, I think it is fair to say that USG has been acting as a VC.

Good VC’s know that they won’t get every call right.  Hey, I sold a bunch of Apple stock after they failed with the Newton.  Similarly, sometimes we are wrong about investments and sometimes we are right, sometimes wildly so.  That’s why VC’s, including USG, build a portfolio.

Should the USG be making what are essentially VC investments?  Personally, I think not, for the obvious reasons.  But a public flogging on “why the USG lost this money” misses the point and shows is that the armchair quarterbacks in congress don’t understand the first thing about startups, venture capital, technology entrepreneurship.  For instance, this week, a congressman said, basically, “how can you be wrong after doing nine months of diligence?”  A VC knows that the ones that fail always looks stupid in hindsight.  To you and to everyone else.  VC’s also know that there is no amount of diligence that will guarantee success.  If it were only that easy we wouldn’t have had to bail out a bunch of smart investment bankers for buying mortgages at the wrong time.

For the record, here is what I suspect where the real mistakes by USG (based on the limited information out there so far):

  • This is just a guess but I suspect that the Dept. of Energy felt safe going in behind brand name investors.  However, the availability of such large amounts of non-recourse debt may encourage those VCs to take riskier investments, partially because the leverage will increase returns but also because it usually comes in after most of the venture capital so the “pot odds” drive a rational investor to stay at the table.
  • Manufacture of a commodity product is probably not where we should spend USG capital.  Alarms go off in my head when management tells us that they will be profitable when they get to massive scale.  As a nation, we need a race to low cost on low margin manufacturing like we need a hole in the head.  Solyndra would have been pulled overseas eventually even if it had initially succeeded.
  • The DOE/USG should have set public expectations for a J-curve (i.e., losses show up early, making the fund look like a bad idea but winners take more time to build value).  The DOE Loan Guarantee portfolio is $36 Billion so the Solyndra loss is less than 2% of the portfolio.   I realize that being debt guarantee, the portfolio will not “make it up on the winners” like a regular VC fund would hope to do but, if the outcome metric is more businesses and more jobs, there is plenty of opportunity for a net positive outcome to the loan program.

Regardless of how you feel about USG engaging in direct venture capital or whether the USG portfolio “returns” the investment, Solyndra is just one failure in a high risk venture fund.   The same thing happens with failed designs for military aircraft but we generally perceive that, over a portfolio of projects, these expenses provide “returns” to the country.  Get over it.

Question: Should Universities put money into startups to bridge the so-called “valley of death”?  I hear that more and more lately.

Answer: It is a terrible idea.  However, there is a way for the university to spend far less and create more.

Let me explain. Universities are frustrated…there is all of this “research and nobody is commercializing it”  and “if VC’s won’t do it then we should invest”.  Unfortunately, the simple solution, invest in our own startups, is a recipe for financial losses.  Picking startup winners and helping them succeed is just not the core competency of universities (and looking at the numbers, it isn’t the core competency of many VC funds either).  Also, as I have said before, there is a tendency to over estimate how many really commercializable technologies are sitting around at one time.

What a university CAN be good at is creating a culture where there are more opportunities for commercializable research to be generated and to have a shot at commercialization.  In fact, if you look at the success  of the Rice Alliance, it can stimulate much more than the commercialization of university research – it can have a huge impact on the local startup ecosystem at a very low cost.

So, I think that having the university act to select and finance startups is not such a good idea but spending money on mentoring entrepreneurial faculty, helping them refine their story and their target market or technology and connect with the business and investment community is absolutely worthwhile.  Mentoring and connecting the university with the business community go hand in hand. It is not expensive, the university can have a lot of shots on goal and, if there is a strike out on a particular technology, the experience still gets into the university, the business community gets engaged …all for the benefit of the next deal.  This approach is highly leveraged with sustainable benefits versus the rifle shot model where the university spins out a company, puts money into it, hires a CEO and hopes for the best.

I just had four days of jury duty.  It was a civil case, a real estate deal turned sour.

One thing I always enjoy about jury duty is the jury itself, how a diverse cross section of the population looks at an issue and how they often all come to the same logical conclusion.  Gratifyingly, that happened here.

In this trial, I also received the benefit of some continuing business education about mistakes that can come back to haunt you in a deal.  Specifically, it reminded me that, in any agreement, partnership, or other legal relationship, you should:

Work for the best relationship but plan for disaster. Just because you trust someone now does not mean that you won’t be at war in the future (even the bitterest divorce was preceded by a happy wedding).  All those things your lawyer does “just in case things go south” are really necessary.  When the relationship sours, emotion takes over; one or both sides want to destroy the other, often at the risk of mutual destruction.  Good business “partners” should recognize that they need thoughtful agreements in place in the pre-nuptual stage of their relationship.  If paying the attorney fees now seems like a lot of money, just wait until you have to deal with the cost in time and money of a bitter lawsuit.  Also, that huge stack of documents your lawyer drafts really is necessary but, if the dispute gets in front of a jury, nothing beats also having clear, easy to understand language in letters and correspondence.

Only sign important documents after having someone else, with an attention to detail, read them. For instance, in this case, there was a document providing for a 3-year, $500K plus, consulting agreement described in 3 sentences. Nothing about expected performance, termination clauses, etc.  A good lawyer or CFO would have caught this.

Let the other party know when they deviate from an agreement and you expect performance. Even though a contract might say that failure to demand your rights does not mean you waive right, a jury expects reasonable behavior.  In this trial, both parties complained about actions not performed or payments not made 5 years ago.  Neither side sent a single letter or email to the other side saying “hey, you are not doing what you said you would do.”

Worry about perception and err on the side of more (documented) disclosure. In this case, the plaintiff tried to make hay with the fact that he signed an agreement with an entity that the defendant dissolved a few weeks later.  It looks bad but the defense argued that it didn’t change any of the rights of the plaintiff and was done for tax purposes, something that the defendant, IMHO, was within his rights to do.  What the defendant should have done is also to have sent the plaintiff a plainly worded letter, telling him about the entity change and assigning the old agreement to the new entity.

Avoid using the term “partner” incorrectly. I’ve seen this in three different disputes …where one party claims, retroactively, that he was in a legal partnership (and therefore due a higher fiduciary duty from the other party).  We all often say things like “this is my partner” when what we really mean is that we are working closely with this person on a company or project.  A Partnership is a legal concept where, among other things, a higher fiduciary duty is required than what would exist between two companies or individuals with a contractual agreement to work together.  When you come to the bitter divorce, one party will find it advantageous to cast the relationship as a partnership.  So, be careful about using the term partner when it is incorrect.

In the pursuit of government spending reductions, questions have been raised about whether university research should be economically justified.  For the specifics about the questions raised in Texas, Eric Berger of the Houston Chronicle does a very nice job on his blog here and here.

It is safe to say that the fundamental objective of the proponents of the “economic justification” idea is to reduce government funded research by eliminating “waste” rather than to optimize current spending on economically valuable problems.  Nobody can reasonably argue with the idea that a portion of a nation’s or a state’s research budget should be relevant to solving real problems (like disease or energy costs) or creating new products and thus competitive advantage.  However, economically justifying the research projects individually is a bad idea. There are just too many ways to destroy what already works and too many impossible questions:  Who is qualified to judge the economic value of early stage research?  How to they factor in the creative process of innovation? How do you gauge risk vs. reward in an area where most approaches fail?  How do you measure the benefit of basis research to create the foundation for more applied research?  A state or university that tries to change research this way will likely lose its top researchers, both basic and applied, in no time flat.

I would argue that university research is already justified by the number of companies and jobs created around the science or around the people involved in university research.  Secondary benefits include exposing undergraduates to more than just book-learning.  The experience of working with a team at the cutting edge of science and engineering creates better, and probably more, engineers and scientists – both an economic benefit.  Some research, like clinical trials around drugs or environmental studies, can have a very positive impact on societal problems, like disease, without an economic benefit.

That being said, I believe that we could, as a nation, get more economic benefit out of our fundamental research budget without changing the things that work well.  People outside the university environment would probably be surprised at how focused many researchers in the hard sciences and engineering are on providing an economic and societal benefit from their research.  To be sure, not all think this way.  A professor in my graduate told me that production of graduate students is the real objective of research…of course he is now retired and the new generation of scientists and engineers is much more focused on making a difference.  In fact, I very often hear about universities competing for scientists where a key factor is what the university can do to support commercialization of the scientist’s research. So, the big question is not “How do we eliminate research that has an unclear economic objective?” or “How do we force all researchers to justify their grants?” but rather we need to be asking “What can we do to encourage and enable researchers to be more effective in having an economic/societal impact?”

If you believe, like I do, that having strong university research contributes to a national advantage, we should be doing everything to move it to the next level.  And we should be doing it rather quickly if you look at the competition coming from other countries, particularly China, that used to send their best and brightest students to the US where many stayed.  Our lead is not as great as it once was but our research universities are still a huge asset.  If you want to see the impact of just one good university, read the Kauffman report on MIT’s economic impact.

To me, the question is not “How do we chop unjustified research?” but rather “How can we take what we do well and improve it (or do it at more universities across the US)?”.  The answer is to give researchers, especially the next-generation “Young Guns”, better access to important problem statements and to provide better support for entrepreneurship in an around the university.  If we provide researchers a top academic environment AND enable them to change the world (and create wealth) the national economic payoff can be tremendous.

There is so much potential for improvement here, even at universities that think they are doing it right, that there is no reason to even worry about the costs of basic research (though I happen to think basic research is a necessary part of the productive academic ecosystem).  As I have mentioned before, I believe that improvement in these areas can be driven by fairly low cost initiatives by the federal funding agencies.

BTW, SBIR funding absolutely should have a strong economic justification. These programs are focused not on university research but on commercial companies with the objective of a national, economic benefit. In my opinion, these programs have not even come close to reaching their full potential.

More on Patent Reform

March 16, 2011

It is spring break here so I had a little more time to poke around on the issues surrounding patent reform, particularly the First-to-File/Weakened-Grace-Period (FTF/WGP) issue that I wrote about yesterday  I was surprised that both the Kauffman Foundation and AUTM are in favor of the reform so am wondering what I am missing.  I still believe that it is a mistake and agree with this letter from Senator Feinstein.

Let me describe the situation that concerns me under the new law.

First, lets set up a scenario where a startup or university invents something.  Remember that invention in this case is often not a eureka! moment but rather an observation followed by improvement followed by more improvements and applications.  All of those might be patentable.  My key point is that invention of a new polymer, a new drug, a new type of solar cell, etc. is not like invention of a new paperclip.  Instead, the invention value improves as the scientist works on it.  For purposes of this example, consider a scientist that discovers a new polymer but is still working on how to better manufacture it, optimal formulation, and new applications that were never possible before.

Under the new laws, as I understand them, you would either have to be FTF or, to get a grace period to file, you can get a grace period of a year if (AND ONLY IF) you publicly disclose the invention.  So, the startup or university is faced with a choice – (1) file good provisional patents for every possible invention right away, (2) disclose the invention to the public to retain the grace period or (3) keep it secret, file a patent application later, hope that nobody beats you to the patent office.  Lets walk through each one:

(1) File good provisional patents on everything. Universities cannot possibly do this (if you disagree with me on this, you have never worked with university technology transfer to see how busy they are already).  A startup might be able to do it but it would have a cost.  I think that best practices for a VC funded startup might be to file provisional patents on EVERYTHING once a month, probably requiring 0.5 to 1.0 FTE plus increased legal expenses.

The Problem with (1) is that you can still be scooped. You invented the polymer, talked to half a dozen venture capital funds about it before getting funded.  VC funds don’t generally sign NDAs but you are going to have to tell them something.  Those funds sent your general, non-confidential description out to a number of really smart polymer scientists, some at large companies, to see what they think.  What are the odds that some of those scientists either connect the dots to figure out what you are keeping secret or, now that they know that your miracle polymer is possible, start to think about how to create one? Or what if they just start filing patent applications on the applications.  This can result is a much more limited business model (for instance, you own the idea on the polymer but someone else has patented applications).  As a VC, I can probably live with this but it does raise the risk that a large company positions its patent applications to limit the startup.

(2) Publicly disclose all inventions. First, though it is not explicit, I assume that while this preserves rights in the USA, the public disclosure is a bar to foreign patent filings.  That is a deal killer for VC funded deals.  You need to have rights into the rest of the world, not just the US.  Also, it has the same problem of letting the other guys know what you are doing, but worse – now you are showing the competition how to make your new, perhaps unoptimized polymer and letting them invent improvements before you have had a chance to do so.

A university may have other issues with this one – scientific journals usually require no-pre publication of research AND research funding is very competitive so, I doubt that the researchers will want to disclose exciting new work publicly before putting in more grant proposals in the area AND good researchers want to confirm and re-confirm before publishing, that can take months after the initial “invention”.

(3) Keep it Secret. That might be doable for a startup but I’ve always had my companies keep good lab notebooks and records because first-to-invent allows you to keep it secret without the risk of someone figuring out what you are doing and patenting it first.  In that case you can at least argue that you invented it first.  Why would a VC put money into a company when any researcher, anywhere in the world, could come behind you and take all the intellectual property rights? This is a particularly large risk with a transformative technology – the risk of leakage of information (at least hints that the other guys can follow) is high.  Universities have an even more difficult time with this one.  What happens when your graduate student goes for a job interview? They have to present their work.  What happens when you file for an NSF/NIH grant that 20 or so colleagues will read?

So, in my opinion, we are left with only one viable option for startups- continually file provisional applications (unless those get reformed away).  I can see this working (however with some expense to the company) for startups that have VC funding but for those startups that have yet to get funding, with limited budgets, there is a catch-22.  If they don’t spend the money, that they may not have, VC and other investors will be less likely to fund the startup because risk is increased.

I don’t see how universities win in this situation given the difficulty in continual provisional filing which is why AUTM’s support is puzzling to me.

Patent reform is finally coming.  While I hope and agree that shortening the process will be good for innovators (see this hopeful presentation from the whitehouse), one change, from first-to-invent to first-to-file (FTF), GREATLY favors large companies over startups and universities.  The primary argument made by FTF proponents like the NY Times is that it costs a lot to litigate the first-to-invent issue and that large companies prevail anyway …give me a break.  With all due respect, the NYT is neither a small innovative company or a technology innovator.  In this thoughtful article from the web site “The Hill”, an experienced entrepreneur raises a great question (that I will paraphrase here): While harmonizing with the rest of the world is a nice idea, what if the nuances of the US patent system are what drive our historic innovation advantage versus the rest of the world?

An excellent, detailed explanation of why the new patent reform is misguided is found in Medical Innovations & Business.  In this article, the authors point out that the problem identified as FTF change is really the weakened grace period (WGP) that tags along with it. I agree, though it is part and parcel of the FTF so lets just call it FTF/WGP.  Under the new law, the US inventor would no longer be allowed a year to tinker with the invention in secret, figure out whether it is valuable or discuss it with investors before spending the money on a patent filing.  Instead, the inventor would need to run down to the patent office and file quickly on any new invention – whether valuable or not.

My biggest concern is what happens with universities. Sure, filing a provisional application is cheap but the fact is that universities struggle to keep up with the process:

  • First, secrecy is hard in a university.  The current US academic system rewards publications not invention disclosures to the technology transfer office.  Research in a university is not really very secret – graduate students come and go, faculty from other universities visit, proposals with confidential information are shared with “peers” through the NIH/NSF funding process (more on this one in a moment).
  • Second, technology transfer offices are drinking from a firehose when it comes to new intellectual property and cannot possibly pursue everything with their limited budgets.  It takes some time to shake out what IP is valuable and what is not.

FTF/WGP supporters argue that there have only been 500 or so interferences as proof that we are practically FTF now.  That’s kind of like saying that the 35 mph speed limit can be raised to 100 mph because there are so few accidents.  My opinion is that passage of the new law could dramatically change behavior.

Here’s how: currently a large corporation will not bother filing patent applications when it hears about a new technology now because some startup or university appears to have it locked up (the large company would not know whether the IP is in a grace period and not filed yet or a patent application or provisional application is filed).  Under the new law, the large company’s logical behavior would be to file more patent applications (or provisional applications) to try to beat the slower startup or university researcher to the patent office.   Don’t believe it? Well, Canada went to FTF/WGP in 1989 and patent applications went up 50% in two years.  It is hard to attribute that behavior to increased innovation.  In fact, studies have shown that FTF/WGP did not produce any increase in Canadian R&D but it did skew ownership of patents toward large businesses.

Bottom line – we should be very careful about changing a process that seems to work.  Making the patent office faster, letting it keep its own fees, and general modernization are are all good things but I am very concerned that the FTF/WGP that tags along with these changes favors large corporations to the detriment of universities and the smaller inventors.  And, as I have said in prior blogs, these are the exact entities that disproportionally contribute to job growth in this country.