Quantum Creep
By Joanna Glasner, Senior Editor

Venture capitalists have invested in excess of $8 billion in more than 750 nanotech startups over the past 10 years, but they have yet to record a single big exit. What will it take to speed up the snail’s pace?

Nano-science has already produced materials for such wondrous innovations as stain-repellant pants, scratch-resistant auto paint and high-performance sunscreen. And, if one believes enthusiasts’ projections, nanotechnology promises to enable even more splendid things in coming years-from carbon nanotube semiconductors to wrinkle removers that actually work.

For venture investors, however, the short history of nanotech funding has provided much less cause for excitement. In the three years since passage of a $3.7 billion U.S. R&D; funding initiative cemented nanotechnology as a favored buzzword among VCs and penny stock pushers alike, profits from nano deals remain scarce. Few venture-backed nanotech companies have gone public. Among those that have, few have maintained or exceeded their early valuations. Acquisitions, meanwhile, have failed to bring in the blockbuster sums VCs and limited partners hoped for.

“Looking back there seems to have been a collective frenzy to grab a piece of this new emerging technology,” says Tim Harper, founder of Cientifica, a London-based nanotechnology research firm. “Companies have been promising to have things on the market in the next two to three years, and it just hasn’t happened.”

In the past 10 years, VCs have poured $8.3 billion into 766 companies developing nanotechnology or microelectromechanical systems (MEMS), according to Thomson Financial (publisher of VCJ). What do they have to show for it? Of those VC-backed companies working exclusively on nanotech, just 19 have gone public or have been acquired, says Lux Capital, a nanotechnology research and investment firm. Among public companies, none is a superstar. “There has not been a classic example, like the Netscape IPO,” frowns Lux analyst Ted Sullivan.

Today, a backlogged patent review process and tepid IPO climate are making it harder for early stage backers to exit. Patent delays are in some cases depressing valuations of IP-focused nano companies. Investors, who already expected R&D; to take longer in nanotech than other tech sectors, are revising their projections for profitability further out.

“Nanotech companies have been promising to have things on the market in the next two to three years, and it just hasn’t happened.”
Tim Harper, Founder, Cientifica

“Venture industry wide, the bloom is probably off the rose a bit, and people want to see some financial exits out of these companies,” says Clint Bybee, managing director at Arch Venture Partners, which made its first nanotechnology investment in materials company Nanophase in the early 1990s. Bybee is confident that the exit pace will pick up as more nanotechnology companies move from R&D; to earning revenue.

Surprisingly, the scant number of exits to date hasn’t prompted VCs to run for the hills. They invested $950 million in 77 nanotech-related startups in 2006, compared to a little over $1 billion invested in 94 such companies in 2005, according to Thomson Financial. Last year’s totals aren’t that far off the 2000 peak in investment dollars, when VCs collectively invested $1.45 billion, or the 2002 peak in number of deals, when they backed 117 nano companies. And venture capitalists aren’t just supporting existing investments. About one-quarter of the nano investments they made in 2006 were first-round deals, up significantly from the prior year when just 13% of nano deals were Series A or earlier.

It may appear that venture capitalists are still gaga for nano deals, but that’s not the case. Whereas some VCs were investing in startups four years ago because they had a nanotech angle, today they are investing in startups that are fundamentally solid companies that just happen to be working with nanotechnology. VCs say they understand that nanotechnology is an enabling technology and they are just as focused on end markets and products for nano-related investments as they are for any other tech deal.

As cautiously as they choose their words about nanotech today, some VCs can’t mask their enthusiasm for tiny tech. Steve Jurvetson, dubbed “Mr. Nanotech” by Forbes magazine in 2003, gets visibly excited when asked about Draper Fisher Jurvetson’s nanotech portfolio. “We have major breakthroughs percolating in our portfolio in quantum computing, nanoimprint lithography and in the field of new forms of memory,” he says.

So the $200 million DFJ has invested in nanotech and MEMS startups still looks like a good bet? Yes, Jurvetson says, noting that three DFJ-backed nanotechnology companies are currently exploring IPO options.

“There has not been a classic example, like the Netscape IPO.”
Ted Sullivan, Analyst, Lux Capital Group

Time is not on their side

Time is a problem for any venture-backed company trying to solve a difficult problem, but it is an even bigger hurdle for nanotech startups to get over. While an IT startup takes three to five years to mature, a nano company takes six to eight years, or longer, to develop into a viable IPO or acquisition candidate, says Sullivan of Lux Capital. And it isn’t a problem that can be solved by bringing in a new CEO or throwing more engineers at it. “These are fundamental science problems,” Sullivan says.

Consider the nano outfits that promise to replace traditional computer memory with super-cheap nano alternatives. Among them are NanoChip ($25 million in VC), Nantero ($31.5 million) and ZettaCore ($30 million). They appear to be making strides. For example, Nantero announced in 2003 that it had figured out how to position nanotubes on a semiconductor wafer. Then, in November, it said it had “resolved all of the major obstacles that had been preventing carbon nanotubes from being used in mass production in semiconductor fabs.” If it is successful, Nantero could ultimately replace the $100 million-per-year PC memory business.

The operative word, of course, is “could.” And the world isn’t sitting still while Nantero and the others work diligently on their breakthrough technology. Flash memory was expensive when Nantero raised its first round in 2001, but now it’s “dirt cheap,” says Harper of Cientifica. Flash will only get cheaper as market leaders Samsung and Toshiba ratchet up production.

Another challenge for nano investments is delays at the patent office. Companies that filed nanotech patent applications in the 1990s typically waited 2 1/2 years for approval, but today the process takes nearly four years, says Stephen Maebius, a partner in the patent practice at law firm Foley & Lardner. Those holdups are affecting applications of the carbon nanotubes and nanocrystals used in the semiconductor and energy industries, he notes.

“Venture industry wide, the bloom is probably off the rose a bit, and people want to see some financial exits out of these companies.”
Clint Bybee, Managing Director, Arch Venture Partners

Modest expectations

Faced with the sluggish patent office, long development times and other issues they can’t control, VCs are focusing on those things they can exert influence on.

For one thing, they’re being more selective about who they back in the first place. Arch Venture Partners wants to see a demonstrable path to exit within the lifecycle of its fund and a really big idea. Because of that high bar, Arch has backed just four nanotech companies out of the hundreds it has considered in the past few years, says Bybee. While he’s interested in life sciences investments, Bybee is waiting for others to set the costly precedent of getting regulatory approval by demonstrating the non-toxicity of nanomaterials traveling through the body.

Arch’s careful selection process led the firm to ALIS Technology, a Peabody, Mass.-based maker of microscopes that enable scientists to see at the atomic level. Arch invested $5.7 million in the company in 2005 with Kodiak Venture Partners, and by July 2006 ALIS was acquired by German semiconductor industry supplier Carl Zeiss SMT. Bybee would not disclose the sale price, but says it was a profitable exit.

Along with a clear path to an exit, nano investors also want to see low burn rates. Because the investments take so long to pay off, startups need to find ways “to pay the electricity bill and keep the lights on,” says Sean Doyle, director of strategic investments at Intel Capital. That parsimony appears to be at work with NanoChip, which makes memory MEMS for consumer devices. Unlike many tech companies, it didn’t raise its first round until it was 8 years old. And it has raised less rather than more money with each of its venture rounds. Its first round in 2004 totaled $20 million, but its third round last August was just $5.5 million.

“If your goal is to make the Amgen of nanotech, you’ve got a long, hard road.”
Darrell Brookstein, Managing Director, The Nanotech Co.

Another strategy VCs hope will mitigate losses is to make a smaller investment up front and follow it up with a big round only after a company has met certain technical milestones or “Eureka-gates.” The Eureka-gate strategy was evident in last year’s monster round for Nanosolar. VCs were already sold on Nanosolar’s IP, but they wouldn’t open the purse strings further until the company could demonstrate that its nano-solar cell technology was scalable, says Erik Straser, a general partner at Mohr Davidow Ventures, one of the company’s investors. VCs seeded Nanosolar with $2 million in 2002, followed by $5 million in 2003, $20 million in 2005 and then $76 million last year. The new capital will be used to build a factory to take the company’s solar cells into volume production. Even if a nanotech company already has sucked up a ton of money, a VC may still choose to back it if the startup can demonstrate that it will put the money to good use. Look no further than NeoPhotonics, a San Jose-based optical component maker that raised its first VC back in 1998 under the name NanoGram. By 2005 the company had worked through $120 million and had even gone through a reorganization. Thankfully, it also used that time to focus its strategy and grow its revenue, which now tops $100 million annually.

When NeoPhotonics went back for more venture capital last year, it had a specific goal: raise enough money to buy two other VC-backed optical startups-LightConnect and OpTun-so it could beef up its product line. Draper Fisher Jurvetson, Harris & Harris and others stepped up with $80 million. Jurvetson says the venture round will help NeoPhotonics to grow its revenue even more by capitalizing on a recovery in demand for photonic components led by Asian data communications equipment makers.

The road ahead

With more than $8 billion invested in nanotechnology over the past 10 years, venture investors will need to see a notable pickup in IPOs and high-dollar acquisitions for their foray into tiny tech to be deemed a success.

“We have major breakthroughs percolating in our portfolio in quantum computing, nanoimprint lithography and in the field of new forms of memory.”
Steve Jurvetson, Managing Director, Draper Fisher Jurvetson

What will it require? For one, more venture-backed companies will need to go public on U.S. exchanges and generate valuations of $100 million or greater, says Lux’s Sullivan. Deep-pocketed industry giants will need to open their wallets wider to nanotech startups, generating returns for venture backers in excess of 5x cash invested. Add in a blockbuster IPO for a closely watched company like Nanosolar, and some funds could profit handsomely overall from their nanotechnology holdings.

The most likely scenario, says Sullivan, will be an upswing in the number of nanotech companies going public on London’s Alternative Investments Market (AIM), as regulatory burdens continue to slow the pace of U.S. IPOs. Valuations on AIM will be lower than what’s customary on NASDAQ, but they should be big enough for VCs to get a return on investment, Sullivan predicts. At the same time, nanotechnology acquisitions ought to pick up moderately, with a handful of later stage companies-such as optical networking companies NanoOpto and NeoPhotonics-being likely candidates for corporate suitors.

More acquisitions of nanotech startups by materials and chemicals companies could also tip the balance in VCs favor. Harper sees such a development as a distinct possibility, given that several nanotech startups in the materials sector are generating revenue but lack the clout and connections to penetrate global markets. Still, Harper thinks it is more likely that VCs will see a gradual deflation in valuations of nanotech companies over the next few years. It will be a subtle downturn, he predicts, filled with down rounds and trade sales to acquirers at prices that either are below or barely cover the sums VCs put into the companies.

Darrell Brookstein, managing director of investment and advisory firm The Nanotech Co., advises VCs who are looking for near-term nano ROI to think small. “If your goal is to make the Amgen of nanotech, you’ve got a long, hard road,” he says. If your aim is to make money for limited partners through an acquisition, royalty licensing agreement or stock offering on AIM or the Toronto Venture Exchange, “then there are a lot of interesting things to do,” Brookstein says.

Bigger payoffs will require patience, Harper says, as startups find applications for their technologies after long delays or in markets they hadn’t previously targeted. Entrepreneurs who claim they can put a product on the market within two years usually don’t deliver. Even when they do, revolutionary technologies have a history of not taking off.

Entrenched industry leaders won’t cede market share without a fight-nor will they agree to partner without promise of radical cost savings. Just imagine, Moran says, a startup trying to convince a leading light bulb manufacturer to jettison a longstanding and highly profitable product line and to adopt instead light-emitting quantum dot technology. The response, he predicts, will be: “We’re not really interested yet. Please come back when your quantum dot costs less than a penny.”

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