Downing College
“Living with Uncertainty/Investing in Ignorance”
28 March 2015
Book of two halves: How I learned/What I learned about how the Innovation Economy works
Talk of two halves: First the Reading/Then the Sermon
Part I: The Reading
Context: Eberstadt –Fundamental research in the science-based industries – an honorable profession when subsidized by brokerage commissions – But NYSE Monopoly ended May 1, 1975 – Ultimate Fate = Commoditization or Prostitution
Doing Capitalism: pp. 52-9
By surviving BRL, I earned the opportunity to spend 30 years in the core of the Innovation Economy…and this is what I learned
At Eberstadt, before fleeing from the dual dooms to which the research business was fated, we attempted to escape by moving upstream, incrementally shifting our role from that of investment banking agent to venture capital principal….
This shift in our center of gravity was not entirely voluntary. Not every one of the companies we backed as investment bankers performed [as they said they would]. Given our commitment to our institutional clients, when a company performed badly, we had no choice but to intervene. As I said regularly to our investors, “If we ever lose one of these companies, I will be in the emergency room with my thumb on the carotid artery, covered in blood.”
In such circumstances, our challenge was to work our way out of the role of hired gun in order to sit on the venture capitalists’ side of the table. This was not an easy task, especially given that we had sold and our clients had bought common stock that carried neither preferential rights nor board representation. But in critical circumstances, our relationship with our institutional clients provided the necessary source of leverage. Before we came to establish our own modest venture capital funds and beyond any commitments our clients made to them, our clients had deep pockets, far deeper than those of any venture capitalist or all of them in combination. In practice, these funds were accessible only with our active support and on terms we recommended, which endowed us with the ability to act as principal by proxy.
So I learned the venture business by coming in the back door as a sort of cross between a police officer and a garbage collector. By far the most effective mentor I had in this career-changing transition was Fred Adler…. While he was operating under the guise of a venture capitalist, Fred’s excellence lay in his ability to take a business apart analytically and dissect the interaction of its functional operations and its financial cash flows. He was a notoriously difficult human being, treating CEOs as subordinates and subordinates as trash. I used to tell him that the greatest compliment he ever paid me was that he never offered me a job. But it was through two collaborations with Fred that I learned the substantive consequences of taking responsibility as a financier for the economic life of an operating business.
The first of these collaborations concerned Bethesda Research Laboratories (BRL), a pioneering producer of enzymes and other biological products needed by all who were active in the nascent field of molecular biology and the technologies of genetic engineering….
At…Eberstadt, we had become intrigued with biotechnology in the late 1970s. In 1977 Bob Swanson, the business cofounder of Genentech and a former Wall Street analyst, had called me to introduce his start-up. After some serious exploration of the emergent science of molecular genetics and its potential to deliver clinically effective, commercially significant therapeutic and diagnostic products, we decided not to participate as financiers. Despite the government’s growing support for research in the life sciences through the National Institutes of Health (NIH), the time line from laboratory to clinic was certain to be so long, and the rate of attrition from candidate molecule to FDA-approved drug was certain to be so high that investment returns were bound to be hugely speculative. No biotech start-up could be expected to reach positive cash flow from operations during the lifetime of the venture funds that launched it. Investment success across the prospective new industry would be far more dependent on the varying state of the public equity markets, for both primary financing and ultimate liquidity, than on the scientific and operational success of the ventures.
[BUT] we were … attuned to the potential for a “Levi Strauss opportunity.” Rather than backing any of the host of start-ups panning for gold, we wanted to find a business that delivered what all of the prospectors needed to do their work, including those still ensconced in Big Pharma and in academia. This is what BRL did, offering a growing range of the molecular tools needed to conduct genetic engineering. With the National Institutes of Health as its anchor client, BRL was growing fast and had already attracted a major venture capital investor. Given our demonstrable understanding of the company’s market and technology and a growing track record of success in bringing institutional equity to support the sort of company that BRL appeared to be, in 1981 Eberstadt was hired to execute a private placement that would carry the company through the estimated two years needed to reach the promised land of positive cash flow from operations. And this we did, selling some $20 million worth of common stock (more than $50 million in today’s money) to our best institutional clients.
In barely three months, we learned the truth of the adage “No business is so good that it cannot be destroyed by incompetent management.”… in January 1982, we discovered that the young entrepreneur and his scientific partner, despite the presence of that major venture firm on the board, had gone mad. The capital that was to fund BRL over the better part of the two years needed for the achievement of sustainable cash flow had disappeared in a spending spree on people and equipment and facilities unconstrained by any business discipline at all.
I recall hearing the news on a Friday. The initial shock expressed itself in preemptive regret for the loss of what had been a promising business: not BRL, but our own post-venture corporate finance business—and with it, of course, my own career as an entrepreneurial financier. Through the ensuing sleepless weekend, however, I worked my way through the pragmatic logic of the situation. BRL was indeed a promising business with more than ten million dollars of annual revenue, and it was growing rapidly in a rapidly growing market. In other words, it was worth saving. To save it, however, was going to take time and money: money to buy the time needed to cut costs and stabilize operations. Our clients had ample additional resources from which to fund the turnaround, but we could not ask them for more cash unless we could do so in partnership with new leadership whom we and they could trust to use their money effectively. But, of course, we were hired agents with no seat on the board, and our clients owned common stock with no defensive protections against just such circumstances.
The order of action resolved itself into a conceptually simple sequence of events, each of which had to occur so that BRL—and our business and my career—might be saved. First we had to secure the commitment of an experienced, credible, operational war leader who would join forces with us. Then, in partnership with this leader, we had to secure effective control of the company, subject to raising the needed new capital. In turn, we would bring our new leader and an agreed turnaround plan, to our investors as a trustworthy steward of the requisite incremental investment. Subsequent to the radical surgery necessary, we would jointly recruit long-term successor management. On Monday morning, with the unanimous support of my partners, I called Fred Adler.
Fred had substantial capital in his Venad fund, but I began by explaining that we had no need for his fund’s cash. In fact, it was critically important that we clear the way for our investors to be the sole funders in the turnaround operation in order to maximize their opportunity to recoup the loss on their original investment. Rather, I told Fred, we wanted to hire him to plan and execute the turnaround, and to this end I offered him 10 percent of BRL’s equity if, as and when we secured effective control and refinanced the business. Of course, at the time of the offer it was not yet legally or practically possible for us to deliver on it. I subsequently learned that Fred’s acceptance of our proposal generated intense conflict with his junior partners, who understandably objected to the obvious conflict of interest with his own obligations to his firm and the fund he had raised. At the time, both issues proved to be blessedly irrelevant to his decision to join the project.
The next step was for Fred and me to invite the principals of the incumbent venture firm to meet us in New York for what proved to be a remarkably efficient confrontation with reality. It did not hinder the process that the junior partner, directly responsible for the investment, was in a state of shock and that the senior partner arrived drunk. Their choice was clear: immediate and very public bankruptcy and loss of all of their investment, or surrender of their protections against the substantial dilution that our investors’ refinancing of BRL was bound to entail. They acquiesced completely.
The following step was more melodramatic. We had to secure complete agreement to our plan by the two founders of BRL, who still owned effective control of the company. My partner John Hogan and I arrived at the company’s building in Gaithersburg, Maryland in the afternoon, knowing that if we did not get a signed agreement by that evening to the terms of an emergency bridge loan, which carried with it transfer of control, BRL would not meet its payroll on the following day. Fred was in New York, available to join us by phone at any time.
The founders’ incompetence as businesspeople was easily matched by their powers of denial and evasion. Fred’s extensive repertoire of threats and promises was not prevailing until, long after nightfall, a telephone message was delivered to the office where we were meeting. BRL’s products… physically existed inside inoculated eggs that were held in a special-purpose rented warehouse. The owner of the warehouse now advised that if he were not paid his overdue rent by the next morning, he would literally pull the plug on BRL’s eggs, which meant pulling the plug on all its inventory of products for sale, which meant pulling the plug on the company itself. This, finally, was the catalyst for capitulation.
Within twenty-four hours, Fred had become chair of a newly created executive committee of the board. Within weeks he directed a substantial restructuring of the business, while we brought in $5.5 million of new capital from our investors. My own transition from passive agent to active principal was confirmed as I, too, joined BRL’s board.
One year later, …[we]… led a strategic process to merge BRL with the GIBCO life sciences division of the Dexter Corporation (which, not coincidentally, had been the first strategic advisory client of new Eberstadt’s research-based corporate business). This merger created Life Technologies, a strongly profitable business with $100 million in revenue—indeed the Levi Strauss of the biotechnology industry.
…
Does the specific instance of BRL’s rescue convey some more general lesson? It does. The conjunction of available surplus cash and our success with Fred in leveraging access to that cash to wrest effective control of the company from its founders constituted a retrospective hedge against the adverse consequences of having incompetent managers and inattentive directors. But the succession of contingencies on which our improvised rescue mission depended was terrifyingly tenuous. How much more efficient (as well as less emotionally arduous!) it would have been to hold effective control in the first place so that, if needed, the surplus cash could have been deployed without the necessity of the face-off with the venture capitalists and the late-night cliff-hanger with the founders.
Ever since BRL, I have known that Cash and Control represent the sole conjoint hedge against the radical uncertainty that comes with the opportunity to seek outsize returns from making illiquid investments. This is a more complex proposition than venture capitalists’ clichéd Golden Rule, “Whoever has the gold makes the rules,” which addresses the straightforward, bilateral game between the venture capitalist and the entrepreneur. Cash and Control relates to the open-ended, multidimensional game we are doomed to play with the universe at large, addressing the infinite range of possible threats to continuity from outside the frontiers of the enterprise.
Part II: the Sermon
The Innovation Economy: Economic Development from Tech Innovation
Upstream: Discovery and Invention
Downstream: Exploration of New Economic Space
Both proceed by Trial and Error and Error and Error…
In between: the technologies that matter have been embedded in Transformational Networks of Infrastructure (canals, railroads, electricity grids, highways, the internet) whose Value in use cannot be known at onset of Deployment
All phases depend on sources of funding decoupled from concern for economic value: Financial Speculation and the State
Role of the State:
In pursuit of politically legitimate missions -national development, national security, conquering disease – state investments have driven economic development for 200 years
For all nations playing catch-up: mercantilist policies of protection and subsidy, direct or indirect, can work! - US and Germany v. UK in the 19th century to Japan and Korea in the 20th to China in the 21st
Catching up through state guidance is infested with corruption and rent-seeking and many efforts have failed as a result.
AND Huge challenge moving from Follower to the Leader at the Frontier: only US has succeeded, due to World War II and state investment in science: succeeding the philanthropic angels of the first Industrial revolution and the great monopolies that emerged from the second.
US Defense Department - key role in constructing the Digital New Economy - from silicon through software to the internet – pulling the suppliers of new technology down the learning curve to where they could address commercial markets
Nixon’s “War on Cancer” not just a play on words: “War” means cost-benefit analysis cannot serve as “prior restraint”
Role of Speculation
Bubbles are banal, wherever liquid markets in assets arise – from tulip bulbs to social media
(1) Investors can’t afford to miss the wave
(2) Investors can win even when project fails
(3) Get out before Find out!
Occasionally object of speculation is fundamental technology: given the radical uncertainty about the value of the new technology, bubbles are also necessary
Financial bubble mobilize capital on a scale unavailable if investments were only made when positive returns are already visible
Bubbles always burst: 2 D Matrix – Locus of Speculation/Object of Speculation – 2001 versus 2008:
Liquid capital market and the Commercialization of the Internet vs. the core banking system and beach houses in the Nevada desert
The Innovation Process necessarily generates Waste
Efficiency is the Enemy of Innovation: investing in uncertainty means tolerating waste, whether it is the state or speculators who lose when projects fail
BUT Pursuit of Efficiency not only DIScourages Toleration of necessary Waste on the long-run Supply Side of the Economy: Schumpeterian Waste
It also ENcourages Toleration of unnecessary Waste on the Demand Side: Keynesian Waste
In a high-growth fully employed economy, more innovative projects will be financed and people stranded in legacy industries will be more rapidly employed in the new ones…and very much vice versa.
So Austerity joins Efficiency as the enemy of Innovation
US Venture Capital illustrates the double dependency:
VC industry rose with the greatest bull market in the history of capitalism - 1982-2001 - its returns are closely correlated with the public market so it has been contracting since the Bubble burst.
80% invested in ICT and Biomedicine, where state “constructed a platform on which entrepreneurs and VCs could dance”
Biotechnology: Special Case or Model for the Innovation Economy?
The Biotechnology Paradox: venture investors fund project that will not generate revenues – let alone positive cashflow – during the life of the investing fund
Biotech ventures repeatedly able to go public with no revenues: since Genentech 12/1980 - 19 US Biotech IPOs in Q1/2014 >50% of total
One explanation: irrational investors –
2 states of the world: We make a gazillion dollars or lose everything. Half a gazillion is good enough for me!
Second explanation:
High degree of Technical Risk more than offset by very Low Degree of Market Risk
At start-up, can forecast future revenues and cash flows conditioned “only” on passing clinical trials: not true of any other domain
Third explanation:
Biotech investors are funding distributed R&D for Big Pharma whose internal R&D has become less and less productive
IPOs now also reflect speculation that Big Pharma will buy the venture before investors have to fund final clinical trials
Generalization: with effective closing of IPO market for non-Biotech ventures, rational strategy for venture investors = “Sell too Soon”
Success depends on absorptive capacity of acquiring enterprises
Easy for Big Pharma to buy a molecule and insert it into the development/regulatory/manufacturing/marketing machinery
But where venture carries High Market Risk as well as High Technology Risk, much harder to acquire and absorb innovation from outside: acquiring a vision and a strategy as well as IP
Conclusion: Where are we now?
Government underwriting of investment in innovation squeezed: generation of market fundamentalism renders the state illegitimate as an economic factor and encourages futile attempts to predict returns on investment in fundamental science [e.g., REF]
PLUS; austerity in Europe/anti-science in US/China struggle with corruption
Speculation generally restrained as private and public sectors both deleverage
BUT: can’t end on pessimistic note
2008 = gift that goes on giving
Reconstruction of Financial Economics
Keynes famously concluded The General Theory by asserting the power of IDEAS:
“…[T]he ideas of economists and political philosophers, both when they are rightand when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else….I am sure that the power of vested interests is vastly exaggerated compared with the power of idea. Not, indeed, immediately, but after a certain interval….But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.”
“The ideas of economists” are in process of becoming more dangerous for good!