One of the biggest barriers to innovation is often the lack of early stage funds available. I recently had a bizarre conversation with a manager at an n early stage technology fund who told me that “we don’t invest in anything more than 12 months away from profitability.”

Now I know that early stage investment is risk and scary for a lot of people (despite the potential returns) but 12 months from profitability? That would have cut out Google, Hotmail, Amazon, Facebook, Twitter and just about any company giving the returns that VCs slaver over.

Any business that close to profitability would surely be able to factorise orders, get a loan, negotiate advance payments from customers in exchange for a discount or engage an investment bank to raise funds. The last thing you would do in that position would be to give up equity in exchange for funding.  I wonder what they do invest in?

While working on our report on Using Emerging Technologies to Address Global Risks, one of my favourite SciFi authors, Neal Stephenson, popped up with an essay on Innovation Starvation.

It echoes Tyler Cowen‘s arguments that all the easy big stuff has been done,  and that all we have left to look forward to are incremental improvements rather than world changing technologies.

Stephenson, being a science fiction writer, looks at space as an example where a culture of risk avoidance, cost cutting and politics combine to stifle innovation. As he points out, even China’s space program is merely copying what the USA and Soviet Union were doing 50 years ago rather than doing anything innovative.

It is undoubtedly a problem that plagues the world.  Whether it is large ambitious space programs, or providing a government stimulus for technology companies, the emphasis is always on avoiding failure, which involves avoiding anything innovative.  The million lost by a failed company always generates more headlines for governments than the hundred million successfully leveraged as we can see with the furore over Solyndra – although governments have a poor track record of picking winners.

So how can we kick start global innovation? As I argue in Using Emerging Technologies to Address Global Risks we need to focus on the big issues that we can all agree on. Water might be a good start.

Over the past five years I have come across numerous innovative approaches to water scarcity, from desalination plants that double as greenhouses to nanostructured membranes that dramatically cut the energy needed for desalination, but I cant remember a single one of them attracting significant investment. That wasn’t because the technology is poor, it is simply because of the costs involved in getting it to market put it outside the risk which any early stage investor would be comfortable with. Raising $50 million for social networking is relatively simple, but for water remediation it is a stretch too far. Development times in excess of 3 years and uncertainty about who will pay for the technology combine to make it almost unfundable.

For a small fraction of the current cost of dealing with drought – something that will only increase in the future – we could develop a suite of technologies to mitigate the shortage of potable water. But we won’t.

I’m not convinced by the innovation starvation argument, I think we have plenty of innovation but we lack the political will to deploy them.  The challenge isn’t so much stimulating innovation as effectively making the case for governments and international institutions to use it.

NESTA released an interring report comparing the difference between US and UK venture Capital funds.  It’s mostly grim reading as most VC funds gave struggled to produce much in the way of returns since the dot com era, but the report does identify early stage investing as a useful, if risky strategy.

Fund managers face several strategic choices that may impact fund performance, such as the number of companies to fund, the round at which to invest, the amount of initial funding to commit or whether to syndicate with other venture capitalists. We find that only one of these choices is significantly correlated with performance: funds investing in earlier rounds admittedly a more risky strategy, performed better than those investing in later rounds.

This is true both in the UK and the US. This relationship is also quite robust over time (albeit weaker in the earliest period). On average, making the first investments one round earlier is associated with 2.4 percentage points higher returns.

Or rather everyone involved in nanotech is beating a path to Russia and their new high tech cluster at Skolkovo.

Not letting the grass grow under feet after splashing out a billion dollars on deals for Magnetic Random Access Memory (MRAM) from Crocus Technology and $700 million on organic electronics with Plastic Logic,  to coincide with the St Petersburg International Economic Forum RusNano have been having a busy few days.

Announced so far this month are

• $15m into SiTime for MEMS based timing chips
• An investment in the $100 million Asia Pacific Nanotechnology Fund along with the Singaporean Economic Development Board (EDB) and Singapore-based investment group 360ip, the South Korean Economy Ministry’s Institute for the Advancement of Technology (KIAT), the St. Petersburg municipality and South Korea’s Samho Green Investment Venture Capital
• A joint venture with Alcoa for a pilot manufacturing line for nanocoatings and production of advanced cables designed to address the issue of icing and breakage of power transmission lines because of bad weather conditions
• An investment in South Korean ultracapacitor maker Nesscap Energy
• An investment in Polar Quartz to create “a vertically integrated production complex for quartz micro- and nanopowder and ultrapure quartz concentrate” although some think the project is doomed
• Another in Terwingo who produce high tensile strength sawing wire for solar and microelectronics applications
• Yet another in Lafarge, a Russian cement company for “the development of innovative and sustainable construction materials”
• A project to crreate an RFID driven “store of the future”
• And even an online shop for nanotech solutions

Lots of risky stuff in there. but all with the long term aim of developing Russian high tech industry. Perhaps the only way to replicate the Silicon Valley model is to wave lost of cash around? Maybe that is why this happens in Russia while Britain can just about afford a roundabout.

Now, just wait until you see what the Chinese are planning!

Seeking Alpha has a bit of a puff piece about Harris & Harris, the doubly eponymous nanotechnology investors founded by the late Charlie Harris but misses the big story, which is simply this.

To invest in an emerging technology takes time, ten to twenty years, which is three or four times the lifetime of an average venture capital fund, which is why most investors in “the coming nanotech boom” got their fingers burned. Harris & harris were one of the few firms that not only spotted the opportunity, but were also smart enough to make sure they could invest for the long term. While their performance on the NASDAQ hasn’t been stellar, it’s been good enough to provide a decent return, and given the timescales involved, the best is probably yet to come.

Good to see a new report from the Judge Business School in Cambridge highlighting some of the myths about how high tech firms are created. Much of Europe tends to focus on large multi partner research schemes such as Framework 7 whereas much of business wold prefer something like the SBIR and DARPA contracts common in the US.

The report found little enthusiasm amongst successful, fast growing high-tech firms for the kinds of multi-partner research grants involving university-industry collaboration that are favoured by UK policy makers and, in contrast to the US, a dearth of R&D contracts with public sector customers. It argues that for decades UK Government policy has been based on three fundamental myths about how new hi-tech firms are created:

-       that university research is the key source of technology and innovation for new hi-tech firms

-       that venture capital is the primary source of finance

-       and that the best way for Government to support technology development in companies is by funding multi-partner research collaborations between universities and private sector firms

While the first two points may be true (to some extent) in Silicon Valley (at certain times),  countless billions have been frittered away trying to create new Silicon Valleys in various parts of the world.

The report also calls “for the establishment of “Intermediate R&D Institutes”, similar in some respects to the Fraunhofer Institutes in Germany, to provide a more mission orientated environment than is possible in universities to develop and commercialise technologies with long lead times.”

That’s the question posed by Charley Polachi at Private Equity Hub.

The results of a survey of over 1,000 VCs seem to indicate that it is, and the industry as a whole is in need of a ‘reset’ – both in terms of the number and type of companies involved, and in terms of their attitude to ‘innovation.’

Although in one conversation, one of the partners shared with me an ironic observation – he works in an industry that preaches innovation and it is all about creating new businesses and investing in new ideas, but the venture industry itself – doesn’t want to change! It is barely a 30 year old industry but slow to change, almost institutional in its view of itself as it relates to structure, fees, compensation, succession planning, etc.

Lets hope the "innovation economy" works better than the "knowledge economy"

The European Union is getting increasingly interested in innovation, and convened a Business Panel on EU Innovation Policy to help it. The report is here, and  a blogged summary by Diogo Vasconcelos is here.

While it’s all good stuff, and the recommendations about broadening the concept of innovation and creating new infrastructure and financing models are sensible, much of this, and other similar reports tend to ignore the elephant in the room, the question of whether governments can do anything at all abut innovation?

Of course chucking plenty of money around will result in some of it sticking to to something useful, but most of it won’t and of course if huge wads of money are available for innovation then there will be plenty of companies rebranded as innovative that were clean tech the week desperately sticking their paws in the honey pot.

A better suggestion from the Panel is to improve infrastructure, making sure that everyone has access to fast broadband is a step, but one has to wonder whether we are already approaching the stage where everyone who wants superfast broadband internet access already gas it, and piping it into households who have no need or interest in technology will only stimulate innovation in the online gambling and pornography industries.

Rather than building new institutions and putting in soon to be obsolete wiring, Europe should look at what it already has and try to make that more efficient. There s no shortage of decent universities, or of scientific talent. If I were to start throwing taxpayers money around chasing an nebulous concept like innovation, Universities would be a good place to start.

UK Announces £1Bn Innovation Fund and Outstanding Achievements at No.3 Tractor Factory in Hartlepool

The UK Government’s £1Bn Innovation Fund was announced for the fourth time this week (although I’m still waiting for the promised explanation from Lord Drayson). I wasn’t too impressed last time it was announced, or this time, and Mark Littlewood at Business Leaders Network is also sceptical

It may well be that the money will be raised and will be used to do something imaginative like backing successful angels and entrepreneurs through side-car funds or some similar mechanism. There are some interesting possibilities here that could make sure that the money is spent to ‘kick start British Technology investment’. But putting it into established funds, particularly ones without decent track records, will just create fund managers who are doing it for the management fees, won’t take the kind of risks that are needed and don’t have the experience to make success happen. Oh and it could create a false market.

It might be better if the government could wean itself off the addiction to announcing half baked ideas involving big numbers and actually implement something. It is hard to see the value in constantly re announcing something and the latest news about the fund rings as hollow as a set of Soviet era tractor production statistics.

I’ll be back in Dubai next week for what is describes as the “World’s Largest Brainstorming”

The Wall Street Journal points to further evidence of the collapse of Venture Capital.  Typical of the doom laden quotes is this:

“Dallas is an entrepreneurial city, but it won’t be driven by venture capital going forward,” said Daniel T. Owen, a venture capitalist at the 16th-floor firm H02 Partners, which plans to wind down its venture business over the next few years. “The pure venture-capital model is really thriving in just Silicon Valley and Boston.”

The bottom line is, in this case the bottom line, as VCs who haven’t managed to make any money for their investors are left bemused by the unwillingness of anyone else to hand over cash. I’m bemused as to whether that’s an arrogant or stupid view of the world.

Toto, This isn’t 1997 any more!

@Lord Drayson had a quick look at my take on the new innovation fund and tweeted

This article misunderstands how this fund will work. I will blog on the BIS site to spell it out.

I’m looking forward to it.

There is no doubt about the commitment of the Lords Mandelson and Drayson to stimulating the UK economy though science and technology, they have been banging on about it for years. It’s rare to see one person in government who ‘gets it’ let alone two, but the devil is always in the details (cue another rerun of Yes Minister)

In fairness, I haven’t heard a squeak about science and innovation from the opposition Conservative party recently apart from a few general remarks to the Royal Society.

Perhaps a half baked plan is better than none at all?

I’m probably nor the only one to be underwhelmed by the UK governments new £1Bn “Innovation Fund” – it’s actually £150m but there are hopes that with private sector leverage it could swell to £1Bn by, erm, 2019!

The main worry is that the UK government has made a habit in recent years of announcing things and then forgetting about them. There was a a £750 million fund for innovation to “stimulate growth in the UK’s industries of the future” announced in April, and according to the Telegraph

This new ‘UK Innovation Investment Fund’ is not the first initiative launched this year. The much heralded £75m Capital for Enterprise fund, set up in January to take stakes in over-indebted companies, has still to announce its first investment. A women’s enterprise venture capital fund, launched almost a year ago, has also so far resisted the temptation to profile its progress.

One has to wonder whether the true purpose of these initiatives is simply to produce sound bites such as

“This fund will help build Britain’s future by investing in key sectors. It will provide crucial support for our most promising start-ups and existing small companies just when they need it most. Venture capital finance is the lifeblood of innovation and crucial to ensuring the commercialisation of the discoveries coming out of our research base. The fund will boost future UK competitiveness,” the Prime Minister said..

or headlines like this

Government Launches £1 Billion VC Fund!!!!

The fund hopes to make investments by the end of the year, but the maths does look a bit dodgy, even for the VC industry as discussed here

We’re obviously not in receipt of the facts (and this sort of addition might be responsible for MP allowances scandals). £150 million of public money plus equal participation from the private sector equals £300 million and not £1 billion. Now – we can make allowances that this is over 10 years so the revenue gained from licensing and exits of companies funded might contribute sufficient back to increase the value of the fund. Might.

Either way, the £150 million will barely cover the administration fees of the various private VC funds that will be needed to make up the other £850 million to make this into a £1 billion fund.

Given that the Lords Mandelsonand Drayson are passionate about the need for technology investment, I’d love to think that we are missing something and that there is a solid and well thought out initiative behind this announcement, but for the moment it does look somewhat half baked, especially in light of the fact the government doesn’t appear to have any money to pay for any of this!

One of the biggest threats to scientific innovation has always been the lack of capital. Venture capital only really makes sense if companies can grow rapidly, and most other equity investments tend to be illiquid until an exit is found.

Brian McConnel at Gigacom takes a look at ‘Class R’ stock, a possible investment model that is halfway between a conventional investment and a loan. Here’s how it works.

Let’s say for rough numbers that a group of angels invest $500,000 for a 10 percent stake in an early-stage company and 5 percent of gross revenues with a 5X cap (total payout: $2.5 million). The company does OK and turns into a nice small business with revenues of $2-$3 million dollars a year. Happy with that, the owners decide not to sell or try to grow much bigger. The investors in this situation will be receiving $100,000-$150,000 per year (off $2-$3 million/year in revenue), which is not a bad annual return, and will get up to $2.5 million over the life of the agreement. In other words, everyone wins — the entrepreneur is rewarded for creating a viable business, and the investors do well without having to force a sale. And they still have 5 percent equity so that if, 20 years later, the founder retires and the company gets bought, they are very happy vs. just merely happy.

Of course there is no downside protection, but then again there rarely is. However it does address one of the major problems with commercialising technology, that of what happens if the company is just a nice company, rather than a spectacular success. In some respects it’s not too different from paying a dividend, which most companies prefer not to do, certainly in the early stages, but it may be a way , combined with tax breaks, that would actively encourage much needed angel investment.

PS it’s worth looking at the comments for some other alternatives.

The chart below shows the recent decline in valuations of late stage venture backed companies as reported by the Wall Street Journal.

It’s a decline that hurts everybody, with cash starved companies taking whatever they can get, which is often a far cry from what was promised and according to the WSJ, existing investors are increasingly resorting to propping up valuations, something that is clearly only sustainable in the short term.

In the first quarter, 57% of all venture rounds in the U.S. were done by insiders only, according to VentureSource. The prevalence of such financings has raised concerns that venture firms are propping up valuations to avoid write downs that would affect fund performance. A new investor is more likely to question whether a company is over-valued.

No doubt everyone is hoping that a recovery will take place ans valuations will soar once again, but if we are in for a longer slump it;s a dangerous game to play and we will see more VCs becoming over exposed and undercapitalised.