Check out these slides on Internet trends from Mary Meeker, partner at Kleiner Perkins and former analyst at Morgan Stanley:
Check out these slides on Internet trends from Mary Meeker, partner at Kleiner Perkins and former analyst at Morgan Stanley:
A few weeks ago, a friend of mine forwarded me an article that analyzed the correlation between the velocity of start-up creation at American universities and total research expenditures. The author, Jerry Paytas of Fourth Economy, makes an argument that universities become more efficient at start-up creation as their research expenditures increase. The article notes,
“As the volume of research increases, institutions become more efficient. At $200 million to $400 million in R&D, institutions can expect only a modest increase in startup rates – getting one startup for every $92 million in research. The very best schools, those that produce more than 4 startups per year, are able to generate one startup for every $77 million in research. For the smaller institutions, implementing the best practices and doing everything you can to be efficient at producing startups might add one more startup every other year.”
It is true that smaller institutions do not create a whole lot of start-ups, but that does not mean they are not good at it. In fact, smaller schools can be quite efficient at creating start-ups.
If research productivity is really correlated with research expenditures, then the mega research centers (e.g. Caltech, Harvard, MIT, Stanford) that have research expenditures greater than $500 million should significantly outperform smaller institutions.
Interestingly enough, when weighted by research expenditures, the University of Kentucky outperforms both Harvard and NYU with regards to the average amount of research dollars that are required to create a start-up. Admittedly, Kentucky is a bit of an anomaly (later in this entry I will show aggregate data on mega research center performance), but it does highlight the fact that efficiencies do not always correlate with scale.
What my data also shows is that it costs Kentucky more money to generate a license than it does Harvard.
Licenses are important drivers of innovation, yet often play second fiddle to sexy start-ups. The reality is that both licenses and start-ups are proxies for the innovation efficiency of universities. My reasoning is based upon the theory that if a license was not transformative or valuable (e.g. “innovative”), then no one would license it.
Given the important role licenses play in promoting innovation, shouldn’t the measurement of university innovation productivity be a blending of licensing and start-up activities?
The chart above is compiled from a list of universities that have research expenditures that are greater than $200 million. I chose $200 million as a cutoff point because schools with research budgets smaller than $200 million typically have research programs that are either incredibly specialized or lean heavily toward basic research. Also, omitted from this list are state systems (e.g. State of Texas System), which aggregate research expenditures on a system-wide basis instead of at the university level. In total, 59 universities made the list.
In line with the Fourth Economy data, the 59 universities in my data set required about $93 million of research expenditures to spawn a single start-up. Interestingly, it took roughly 1/9 of that amount of investment to generate a license. And, when licenses and start-ups were blended together, it took only $8.7 million of government investment to create a transformative piece of technology.
Some might argue against this, but I think that $8.7 million is a reasonable return on investment for the government and is a testament to the efficiency of American universities.
Also in line with the Fourth Economy data, mega research centers do seem to be more efficienct drivers of innovation than smaller institutions. That is not entirely surprising since schools like Caltech, MIT and Harvard typically attract premiere researchers.
What I did find surprising was the fact that universities with no medical centers seemed to outperform those with medical centers on a cost per innovation (license or start-up) basis. Given the fact that non-medical funding sources are more scarce than medical, I did not expect non-medical schools to be more innovative than those with medical schools – and, to do it with less money!
American universities are highly innovative and productive; however, the metrics commonly used to track innovation (e.g. start-ups per year) typically do not represent the full picture. By leveling the playing field via weighing of research dollars, smaller schools can perform (i.e. be “innovative”) as well as large schools and non-medical universities can outshine those with medical schools.
Alex notes, “Partnering strategy appears to be more important to a company’s long-term stock success. The more US rights a company on our list has kept, the more chance it has to outperform its peers on the stock market.”
This has been an exciting summer for the biotech community as two highly anticipated approvals for targeted therapeutics, along with their respective companion diagnostics, were given the green light by the FDA. The approvals of Zelboraf (Roche/Plexxikon) and Xalkori (Pfizer) was a great highlight for the pharma industry this summer, and could result in the accelerated development of other personalized medicines.
Zelboraf and Xalkori are both orally administered therapies that address a specific patient subpopulation that is identified via a companion diagnostic. While these two drugs address modestly sized markets (see chart below), their ability to effectively treat a specific patient population enables them to garner premium pricing. Some industry insiders are now referring to similar drugs that address niche markets and command pricing power as “nichebusters”.
There are pros and cons to the nichebuster model as it relates to companion diagnostics, and I thought it might be helpful to lay out some of the facts regarding the recent approvals of Zelboraf and Xalkori. Though quite a bit older (approved in 1998) than the other two therapies, Herceptin provides a good comp:
These three oncology products have markedly different approaches to pricing - but why?
Diagnostics offer pharma companies the ability to create new therapeutic sales channels and strengthen already existing ones. Regulatory changes have decreased doctor access for sales reps, which then limits the ability of reps to drive the adoption of high margin therapeutics. Diagnostics, and even devices, provide another avenue for sales reps to garner more face time with doctors. By creating in house diagnostic divisions (ex: Novartis purchasing Genoptix) or partnering with existing diagnostic players (Roche, Abbott, LabCorp), pharma companies can leverage those diagnostic sales channels to better position and sell their therapeutics. As pharma companies increasingly ramp up their diagnostic efforts, expect nichebusters to become a greater portion of pharma companies’ pipelines.
Companies in high growth sectors such as Cleantech, IT, and biotechnology are coveted by states around the country. To facilitate the establishment of companies in those sectors, many states offer a variety of incentives, including grants and tax abatements. More recently, states have focused on capital investment in venture capital funds as a way of attracting high-growth companies. As VCs have historically invested in high-growth sectors, many states have chosen to either align themselves with existing venture funds or start their own state-affiliated funds.
In 1976, Connecticut started the first state-promoted venture endeavor, the Connecticut Product Development Corporation (CPDC). Through direct equity investments by the state, the CPDC enabled entrepreneurs with compelling ideas to obtain early stage capital. This model proved to be quite successful and was eventually copied by a number of other states. Today, there are approximately 150 state-affiliated venture (including Fund of Funds) funds.
Should States Act as VCs?
As the competition for jobs has ramped up, many states have felt the urge to provide a guiding hand to drive companies to their state. State assistance is often seen as necessary since few states organically have the tools (abundant capital, cheap real estate, and abundant human capital) necessary to draw companies to their state.
While most states recognize the need to promote start-up creation, few are in a position to effectively deploy the capital and resources necessary to manage a cohesive start-up promotion program.
Running a cohesive start-up programs requires:
These are real challenges that need to be fleshed out before a state decides to allocate significant capital into start-up creation.
Investment Structures Used by States
Unlike state pension funds which invest from a defined pool of capital, state capital investment programs often borrow money to make their investments. States are able to obtain low-interest loans from banks by using future tax receipts as collateral. The loan is then used by the state to invest in venture funds. If the state’s investments in venture capital funds return all of the invested capital plus interest, then the state’s investment will be cost neutral. However, should the venture funds not provide enough return to cover the loan plus interest (excluding other costs to keep things simple), then the state is required to make up the difference by tapping into its tax receipts.
Below is an example of how state capital investments are structured:
The opportunity cost of capital for the state is quite substantial in this model due to the various management and service fees that have to be paid yearly to the venture funds, fund of funds, banks, lawyers, and auditors. In aggregate, these fees have an 8-10% cost structure built into the state’s capital investment. Therefore, the structure I outlined is only cost neutral if the investments provide an IRR greater than 10% - meaning that the state’s pooled venture capital investments must return at least double the capital invested just to break even.
That being said, setting up investment structures like the one I charted out can be quite effective, even if the venture funds do not perform all that well. For instance, by requiring venture funds to make investments in local companies, those funds will contribute to local job creation and a larger tax base. Even if tax payer money is needed to pay off the LOC to the bank, that money will have contributed to job formation in the state.
I don’t think any one state has perfected an incentive model for start-up creation, but I do think Pennsylvania does a pretty good job of supporting start-up creation.
Pennsylvania is fortunate to have numerous top tier research universities within its borders, and can leverage the talent at those universities to spur technology transfer and start-up creation. Additionally, numerous corporate headquarters are located in the state and provide a large and stable talent base for start-up companies.
Even with great research centers and corporate support, Pennsylvania is in a constant race to attract companies that can generate jobs for the Commonwealth. Over the last 30 years, Pennsylvania has launched three major initiatives (I refer to them as the “Three Waves”) to promote job creation.
First Wave - Ben Franklin Technology Partners
Started in 1982, Ben Franklin Technology Partners (BFTP) operates four regional non-profit organizations to serve and promote companies across the state. BFTP’s activities are subsidized by a yearly budget of $20 million to make investments in start-ups that range between $30,000 and $150,000. The effect of BFTP on start-up creation in the state has been profound and BFTP has become the go-to source of start-up capital for most start-ups. Since inception, BFTP has invested over $173 million that has been subsequently matched by over $408 million of private investment.
In 2008, the U.S. Economic Development Administration, an arm of the U.S. Department of Commerce, named Ben Franklin “the most effective regional economic development organization in the nation.”
Second Wave – The Tobacco Settlement
As part of the Master Settlement Agreement of 1998, the major tobacco companies were required to contribute funds to ease states’ burdens in caring for residents with tobacco related illnesses. With some of the proceeds generated from the tobacco settlement, Pennsylvania approved two one-time appropriations for strategic areas of investment - the Health Venture Investment Account and the establishment of three regional biotechnology research centers known as the Life Science Greenhouse program (LSG).
The Health Venture Investment Account invested $60 million in four life science venture capital funds that pledged to invest that capital in Pennsylvania companies. Those funds also pledged to match every public $1 with another $3 from private investors, thus turning the state’s $60 million commitment into a $240 million war chest.
The Life Science Greenhouse program was created to address a lack of valley of death (gap between academic work and early product refinement needed to attract VCs) capital for start-ups. The three Greenhouses provide not only early stage capital (up to $1.25 million in companies over the life of an investment), but also mentoring and consulting services.
Third Wave – Venture Capital Investment Programs
In 2004, then-Governor Ed Rendell, put forth an ambitious $2 billion stimulus plan to help boost job creation in the state. Knowing that Pennsylvania lagged its peers in start-up creation, Gov. Rendell carved out $310 million from the stimulus plan to directly fund two new venture programs: PA Venture Guarantee Program and the PA Venture Capital Investment Program.
Launched in 2007, the PA Venture Guarantee Program sought to leverage $250 million of capital to attract VC investors to the state’s start-ups and businesses. The Guarantee Program was quite novel in that it incentivized VCs to take on more risk in high growth businesses by protecting against the potential loss of investors’ principal. In return for investors committing at least $15 million of capital to a Pennsylvania start-up, the PA Venture Guarantee Program would cover the first loss of the aggregate amount of principal invested in the company up to 50% of the total principal invested (i.e. $7.5M covered on a $15M investment). This program essentially encouraged VCs to double down on investments made in Pennsylvania companies.
To participate in the program, the state created a prerequisite that the recipient (VC fund) would maintain an office in Pennsylvania staffed with at least one senior-level partner for the duration of the guarantee
Philadelphia and Pittsburgh attract the lion’s share of start-up capital, leaving vast regions of the state without funding sources. Structured as a $60 million Fund of Funds, a second venture program - the PA Venture Capital Investment Program – was launched to promote investment outside of metropolitan areas. Like the Health Venture Investment Account, the Venture Capital Investment Program has a 3:1 matching component, turning the state’s $60 million investment into $240 million of capital.
The success of the PA Venture Capital Investment Program has been quite remarkable over the last five years and the program currently has 12 participating venture funds, 5 of which were 1st time funds. Those 12 funds have collectively invested over $117 million in 45 Pennsylvania companies.
Like entrepreneurs who are looking for their first seed funding, VCs often struggle to find anchor investors. Given the current economic climate, states might want to consider playing a greater role in spurring venture fund creation and helping maintain the capitalization of existing funds.
Five first time funds were funded over the last few years through the PA Venture Capital Investment Program. Without the state stepping up to the plate as an anchor investor, it is hard to believe that those funds would have been raised during the economic downturn. Yet, it is in such down economies that VC dollars are so impactful – providing needed capital to start-ups as exit windows remain closed and creating jobs through the funding of new companies.
With the proper incentives and prerequisites in place, capital investment in venture capital funds by states is a proven driver of job formation via the growth of start-up companies.