[In Stanford I lived on Sand Hill Road, the heart of the American venture capital industry, and could watch it from a vantage point; these are my impressions. This column was published in Business Standard of 12 September 2000.]
The spread of equity
Ashok V Desai
Why did the software industry not grow up as an offshoot
of the hardware industry? One answer is Microsoft. Bill Gates set it up as a
software producer, and has established and defended its primacy against all
comers. IBM would have been a software power; Microsoft fended it off. Another
reason is that the software industry is in a major part a repairer; it is not a
part of hardware for the same reason that car repair workshops are not a part
of auto manufacturers. Since the 1960s, businesses have been using software;
but the new generations of machines made old software obsolete, and made it
necessary to rewrite software. And finally, the sheer labour-intensity of code
writing. It has made firms very ephemeral: a firm may do great business today,
and may be gone tomorrow if its key personnel fly away. And there have been
many opportunities for them to fly: there has been such a labour shortage that
people are constantly being stolen.
Thus it happened that the software industry was not
funded out of the profits of some other industry, and had to get outside
capital. That capital could not have come from banks, because the industry is
inherently risky and unstable. It could not be flotations either, because to
start with, software firms were unknown, they had no track record, and they
could not command the confidence of portfolio investors. There had to be
someone to hold their hand while they wrote and sold software. That was the
venture capitalist. The software industry is located in Silicon Valley, within
30 miles north and south of Stanford. The venture capital industry is even more
concentrated: 60 per cent of America’s venture capital is on Sand Hill Road, a
two-mile stretch on the western border of Stanford where I live; and probably
another quarter is in San Francisco.
A venture capitalist is not an investor; he is an
intermediary. He provides three services. First, he enables the investor to
spread risks by investing in a number of risky ventures: he serves as a mutual
fund manager. Second, he grills entrepreneurs. He asks them tough questions
about what is unique about their ideas and where they are going to find the
market. He weeds out the commercial risks. And finally, he assumes sufficient
control on the start-ups he finances to ensure that if the entrepreneur shows
signs of failing, he can be quickly replaced.
So who then is the investor? Investors who place their
money with venture capitalists are very rich people. They are people who do not
need their money to live; they are people who can gamble with money. The
venture capital industry arose in the US because there are more super-rich
gamblers in this country than anywhere else. Some of them go to Las Vegas, some
invest in start-ups. The investors, the venture capitalists and the nerds
together created the IT industry.
But then came the meltdown earlier this year; market
valuations of IT declined sharply, and their prospects ceased to look so
glittering. Venture capitalists did not know where to put their money. So they
have started looking at other industries with the same eyes they used for the
IT industry: they are looking for high risks and high returns.
One of the activities where they are to be found is
biotechnology. Here, various molecular materials are made and tested for
possible use as medicines, fertilizers, pesticides etc. The more promising ones
are given clinical trials. Those that look like commanding a large market are
commercialized.
Earlier, the entire process used to be in the hands of
pharmaceutical companies. The promising materials were identified by their
R&D departments, evaluated by their marketing departments, and finally
produced by their production departments. And because the risks were great,
drug development was done by the largest pharmaceutical corporations. The drug
industry is one of the most concentrated and multinational industries in the
world.
This picture changed somewhat in the past 15 years with
the emergence of independent biochemical research. As the properties of
molecules became better understood, it became possible to apply science to
narrow down the range of molecules that might serve particular uses.
Identification of promising drugs was no longer a mechanical process of trying
them out; clever biologists could get quite far without the paraphernalia of
big application research. And then came the genome mapping project; it opened
up an entirely new field of possible treatments.
But once they had found a promising drug, they still had
to go to a big pharmaceutical company. At that point they generally sold the
formula for a fixed sum. The price could be handsome, but the big profits still
went to the big companies – not because they took a bigger risk, but because
they could invest more.
Now, however, venture capitalists at a loose end for good
bets are taking a closer look at biotech companies. And as a result, the latter
are able to go further down the road to commercialization. Recently, Andrew
Pollack reported on a number of such companies in The New York Times. In the past, a venture capitalist would have
given a biotech company $30 million. Now, with money going abegging, he might
give it $100 million. And the sums are going up. In March, Celera Genomics
raised $1 billion in a secondary issue – more than all biotech companies raised
in the whole of 1998.
With that kind of money, biotech companies can run
clinical trials themselves, and prove the drugs; then they are in a much
stronger bargaining position vis-à-vis pharmaceutical companies. Earlier they
might have got a 5 per cent royalty on sales; now they can ask for a 50 per
cent share of profits – and be much surer of making profits.
This opens up a golden opportunity for good brains. Let
us see if Indian brains are as quick to take it as they were in software.
