Venture Capitalist Planning Is Irrelevant to Successful

Chapter 16

Downloaded by MONASH UNIV on June 11, 2016 | http://pubs.acs.org Publication Date (Web): September 4, 2014 | doi: 10.1021/bk-2014-1169.ch016

Venture Capitalist Planning Is Irrelevant to Successful Entrepreneurship in Chemicals, Materials & Cleantech J. M. Ornstein*,1 and Hongcai “Joe” Zhou2 1President,

framergy, Inc. 800 Raymond Stotzer Parkway, Suite 2011A, College Station, Texas 77845, United States 2Professor, Department of Chemistry, Texas A&M University, 800 Raymond Stotzer Parkway, Suite 2011A, College Station, Texas 77845, United States *E-mail: [email protected]

In 2010, Dr. Hongcai ‘Joe’ Zhou and cleantech commercialization firm J.M.Ornstein explored the possibility of licensing Metal Organic Framework materials funded by ARPA-E through Texas A&M University as the foundation for a new startup. The founders felt that the underlying technology was ripe for early commercialization and in support of US Federal funding goals, thought that the time was right to stimulate future jobs growth through entrepreneurism. But there are specific qualities of the chemicals, materials and cleantech (CMC) sectors that limit their appeal to venture capital by pressuring their J-Curve; these include high upfront research and development costs and the long-term nature of time to a liquidity event. To counter these challenges, the founders established a low cash burn plan for the framergy™ by leveraging university assets and making costs a priority. framergy™ was able to execute a market valuable license with Texas A&M University and strategic plan leading to seed funding of $250,000 in 2011 and Series A funding of approximately $1,600,000 in 2013. Many great frontier chemical and material sciences can reach the market through entrepreneurism if they match market realities with cost management.

© 2014 American Chemical Society Cheng et al.; Careers, Entrepreneurship, and Diversity: Challenges and Opportunities in the Global Chemistry Enterprise ... ACS Symposium Series; American Chemical Society: Washington, DC, 2014.

The J Curve


The J-Curve in sociology traces its origins to three economists from the early ninetieth century who independently sought to explain why devaluation of currency would first lead to current account deficit, and then would quickly swing positive. Alfred Marshall (1), Abba Lerner (2) and Joan Robinson (3) defined this condition where the sum of elasticities for imports and exports with respect to the exchange rate is greater than one.

This effect, later known as the J-Curve based on its shape as expressed in figure 1, was adapted to country status by Ian Bremer (4), and revolution modeling by James C. Davies (5).

Figure 1. The J-Curve. (Courtesy of author). In the last ten years, many economists and financial journalists began to see that this curve reflected a scenario for private capital investment where the sum of elasticities for investment and return with respect to capital employed is greater than one. Of particular note were Exposed to the J Curve by Ulrich Grabenwarter and Tom Weidig (6), and Beyond the J-Curve by Thomas Meyer and Pierre-Yeves Mathonet (7). By the late 2000’s, the J-Curve became an essential tool to explain venture capital returns. In venture capital (and private equity), the J-Curve X-axis represents time and the Y-axis represents the net of negative capital outflows and positive capital inflows. As the venture capitalist makes investments into one or more startups, the curve will be negative. This is not uncommon with startups regardless of sectors, but the relationship between loss and gain will be more pronounced in new technology. In consideration of a one firm investment, the net of negative capital outflows will be offset by earnings, with the point of inflection representing the maximum financial needs of the investment. This is when the firm is cash flow positive and the burn rate, the rate observed over a specified time, becomes less 174

Cheng et al.; Careers, Entrepreneurship, and Diversity: Challenges and Opportunities in the Global Chemistry Enterprise ... ACS Symposium Series; American Chemical Society: Washington, DC, 2014.


relevant to the venture capitalist. These venture capital attributes are associated to the J-Curve in figure 2.

Figure 2. The Private Investment J-Curve. (Courtesy of author). Venture capital funds typically have a term of ten years, with all returns, liquid or ill-liquid, returned at the end of this legal period for final accounting (8). Typically, within the first four years all funds committed by limited partners are drawn, with huge penalties imposed if the limited partner reneges (8). This puts pressure on the venture capitalist to invest the money, otherwise committed capital sits with low return and time exacerbates poor performance. Usually by year five, the venture capitalist would want to have all funds committed so that there will be at least five years to grow investments. Little has been innovated into this structure and each investments J-Curve reality will dictate a funds overall return. With this understanding, the J-Curve reveals that a successful venture capitalist will seek startups where: 1) The date of cash flow break even is within five or six years, 2) the burn rate is low, 3) the maximum financing needs are lower when compared to like investments, and 4) where negative capital outflows are offset by aggressive earnings. Unfortunately, different industries have diverse financing needs, and different earnings potential over like time horizons. To encourage venture investments and/or limited partners, some firms may mislead the design of their J-Curve.

VC Market Realities Since 2012 when the groundbreaking WE HAVE MET THE ENEMY … AND HE IS US was published by the Erwin Marion Kauffman Foundation, an investor in venture capital funds, the realities of lower than expected returns from the venture capital industry were exposed (9). This report raised doubt as to why the industry was generally considered to offer outsized returns in the media. Clearly huge successes in the Dotcom bubble associated with Netscape, Google 175 Cheng et al.; Careers, Entrepreneurship, and Diversity: Challenges and Opportunities in the Global Chemistry Enterprise ... ACS Symposium Series; American Chemical Society: Washington, DC, 2014.


and EBay, and in the Web 2.0 period associated with Facebook, Groupon and Twitter, impacted media and encouraged the high risk, high return nature of early technology investing. “The structure of the venture capital industry, in which a small number of firms each needed to invest big sums in a handful of start-ups to have a chance at significant returns” (10) plays on the emotional nature of gambling versus the market realities. It is true that venture capitalists since the 1960s appear to have had excessive returns (8), but this led to a crowding of the field. Unfortunately, over the last measured twenty years, 62% of venture capital funds failed to return to limited partners, their investors, returns higher than public markets (9). Yet entrepreneurs look to these firms as the holy grail of how to make a startup a financial success. Entrepreneurs should look at ten-year market returns (11) and the measure this against risk to understand a venture capitalist’s financial risk profile. According to Cambridge Associates U.S. Venture Capital Early Sage Fund Index, end-to-end pooled return/net to limited partners for ten years is 7.36 percent (12). To understand why the market realities of venture capital firms are poor, one must ignore the media hype and look at the statistics. One must also understand their structure and profit motivations to manage their ‘advice’ value proposition. For example, less than one percent of US companies raise money from dedicated venture capital firms (13). In addition, as new venture capital firms show success, they raise larger funds; this scaling is correlated to lower returns (13). Many venture capital firms become dormant, with some estimates of up to 400 dormant firms in the US (14). The average venture capitalist is perceived as a risk-taker, on par with the entrepreneur, but who’s deep experience and training will lead to advice on how to succeed. VCs (venture capitalists) are often portrayed as risk takers who back bold new ideas. True, they take a lot of risk with their investors’ capital—but very little with their own. In most VC funds the partners’ own money accounts for just 1% of the total. The industry’s revenue model, long investment cycle, and lack of visible performance data make VCs less accountable for their performance than most other professional investors. If a VC firm invests in your start-up, it will be rooting for you to succeed. But it will probably do just fine financially even if you fail (13). While much of the venture capitalist’s personal return is associated with fees charged to their limited partners for advice and mentoring startups, the advice is driven by their J-Curve and not long-term results. This advice is often pitched to entrepreneurs during term sheet negotiation to favor the venture capital firm’s returns over the entrepreneur. For the chemistry, materials and cleantech (CMC) entrepreneur, doing due diligence on offered advice is important.

176 Cheng et al.; Careers, Entrepreneurship, and Diversity: Challenges and Opportunities in the Global Chemistry Enterprise ... ACS Symposium Series; American Chemical Society: Washington, DC, 2014.


Market Realities Returning to the limited time that the venture capitalist has to demonstrate return, one can identify that there is a motivation to inflate revenue expectation. This motivation can come from the entrepreneur, venture capitalist, or become an unintended consequence of their cooperation. Ten years from startup to a liquidity event is very short, and most investments will not have the full ten years of the fund’s vintage. In addition, the venture capital fund may return the investment to the limited partner in the form of securities if there is no liquid market. Sales frameworks taught in business classes are based on strategies employed by mature firms. These firms don’t have to develop product credibility and overcome customer-switching costs. This leads to an inevitable circumstance where the entrepreneur is lowering price as an incentive, eroding sales forecasts from year’s prior. This is supported by a legitimacy curve (15), which pushes the J-Curve to the right on the X-axis, when the technology has a higher degree of adoption risk. In venture capital, the legitimacy curve can be overcome through innovation leading to rapid desirability and substitution. This process was first described by Bryce Ryan and Neal Gross in 1943 (16), and then more precisely by Everett Rogers in Diffusion of Innovations in 1962 (17). Rogers went as far as to numerically pinpoint market penetration over successive sets of consumers. What allowed venture capital to integrate this into their J-Curve revenue expectation horizons was the impact of network computing on adaptation models. Network computing decreased the time to expose innovation to markets, but more importantly, allowed for transparent “contagion through direct network ties” (18). By the late 1990s, the Dotcom sector was self-fulfilling this contagion and many thought all technology sectors could shift the J-Curve to the left. But the reality is that a decade later, the clusters of internet, software, mobile/telecom and electronics were the capital concentration of venture capital (19). The reality is that social networks could only overcome 1960s technology diffusion rates where perceived ‘trialiability’ and complexity (17) were not obstacles; which they are in CMC. Market realities, irrespective of the final impact on the J-Curve, must be used in forecasting revenues. Every MBA knows to start revenue projections with the total size of the market. But the entrepreneur must measure reach, adoption and potential market share into revenue forecasting, as graphically depicted in figure 3. Many startups don’t measure new technology adoption, rather integrate it into market share. Rogers’ 1960s era technology diffusion curve and other rational carve-outs will give the CMC entrepreneur a real tool to evaluate the worth of their investment opportunity.



Figure 3. Ration Market Sizing. (Courtesy of author)

Cost Management Again under the consideration of the limited time that the venture capitalist has to demonstrate return, another motivation would be to deflate financing need expectations through unreasonable cost projections. This motivation can come from the entrepreneur, venture capitalist, or become an unintended consequence of their cooperation. And again, the ten-year vintage of a venture capital fund will pressure this motivation. The lean startup movement is gaining popularity; with failing fast as the ultimate solution to cash burn (20). Here, entrepreneurs are encouraged by venture capitalists to move closer to the consumer with the ‘minimal viable product’, thereby reducing the high cost of planning. Many researchers are being pushed in this direction by governmental grant requirements for tie-up with industry or support letters. In 2012, the National Science Foundation called upon lean startup proponent Steve Blank to design an entrepreneurship curriculum for scientists (21). This lean startup process supports the venture capitalist’s desire to shift the J-Curve up and to the left. But the entrepreneur in CMC needs to be cautious of the designs under the lean startup movement as they are intended to counter issues that challenge the J-Curve for internet and software startups. For example, ‘agile development’ encouraged in the lean startup movement is derived from software development (10), where product life cycle is far shorter than CMC. Social networks and open source software can dramatically reduce research and development costs, but this type of resource is more readily shared in internet and software sectors. For CMCs, these resources are found in non-IP driven research, non-profit institutions and science incubators that understand the sector. But unlike software resources sourced on the web, this requires the CMC entrepreneur to be more proactive in engaging actual gatekeepers of resources. Often these gatekeepers are competitors with vast scientific and legal resources. One good example of a lean start up would be virtual biotechnology companies, which surfaced in the 1990’s to counter the costs of bringing new 178


medicines to market. Many technology diffusion issues are shared between CMC and ‘virtual pharmas’: “These companies consist of as few as one full-time employee who oversees a drug from preclinical development to tests in patients, all in the hands of outside contractors” (22). The CMC entrepreneur should also be cautious of venture capital micromanagement, which can increase total financing needs:


As (Fred) Destin (of Atlas Ventures) explained, “Entrepreneurs often complain that VCs show up at meetings late, they micromanage, they are too busy to understand the subtleties of their business and they apply over-simplified solutions to problems” (23). In fact, risk actually is measured to rise when venture capital firms apply more control (measured through board control or liquidity preference) (24). Virtual management and other rational cost management techniques such as efficient management will give the CMC entrepreneur a real tool to evaluate the worth of their investment opportunity.

Conclusions Venture capital funds are known to “bury their dead very quietly” (25), but it has been revealed that their results differ from the media perception of extraordinary investment success. A small and contracting venture capital market (13) should not discourage the entrepreneur from forming a startup from new science in the CMC sectors. The venture capital motivations of the J-Curve may not exist for high net worth individuals and strategic corporate investors. For framergy™, this became clear at the annual 2012 ARPA-E summit, curated by the source of the governmental funding that financed much of framergy’s technology. “Many VC (venture capital) firms parted ways with their cleantech teams in 2012. While February’s (2012) ARPA-E conference had a record number of attendees, venture investors were scarce – replaced by a bumper crop of corporate types” (26). The moral hazard of venture capitalists is that the financial risk of their investment is often shifted to their limited partners and entrepreneurs through deal structuring. framergy™ successfully closed a seed round and series A round to fund its CMC startup by ignoring motivations to manipulate its J-Curve to venture capital standards. Instead of seeking out venture capitalists, its entrepreneurs marketed the investment opportunity to the other 99% of US corporate capital providers. Frontier chemical and material scientists, and entrepreneurs, should avoid the perverse incentive of adjusting market realities and cost management to meet the needs of a select few.

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Venture Capitalist Planning Is Irrelevant to Successful

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