The real thing

Real Deals, 7 March 2002

When the internet bubble burst, venture capitalists turned to 'real' technology. But how can you tell that the groundbreaking gizmo that you are about to invest in really does what is says on the tin?

If you're going to invest in a technology proposal, you've got to be sure that the groundbreaking gizmo on the table actually does what it's supposed to do. But when most investors are more at home analysing revenue projections or judging an entrepreneur's track record than reviewing a stack of scientific papers, how can they best make this call?

Technology due diligence runs alongside - and is intertwined with - the usual judgements on the management team, route to market, and financial needs and prospects. Leading technology investors say that the process they follow plays a key role in giving their firms a competitive advantage. Usually it's a case of calling in the experts.

Expert witness
"What we try to do is get a view from a number of people so we get a richer picture of what's going on," says Ian Lobley, director of 3i's communications group. "One thing we find very useful is using existing portfolio companies to test and validate the technology. Because we have a substantial portfolio right across the technology spectrum, we can normally find someone with a view on any particular piece of technology."

When recently considering a second round investment in KaVaDo, a security technology firm initially backed by Neurone Ventures, 3i called on Articon-Integralis, another portfolio company involved in integrating security products. "We were able to get direct validation of the technology. That's something we always try to do," Lobley says. Satisfied with KaVaDo's technology, 3i led the $6.8m round.

Distinguished technologists serving as non-executives on portfolio companies are also a common source of advice, as are the large technology corporations such as IBM and BT. For a detailed validation exercise, external experts are usually paid with a straight fee, although 3i sometimes offers more entrepreneurial individuals a small equity interest.

For companies that already have products or late-stage prototypes, the opinion of existing or potential customers is vital. "The most important thing we do is talk to the customers about whether they want the technology and how much they will pay for it," says Mark Danby, director at Royal Bank Ventures. "Depending on the routes to market for the company, they often have shadow partners like IBM or Cap Gemini. We talk to them as well because they have an overview of the market."

Many of the large technology groups now have their own corporate venturing wings. One of the largest is Intel Capital, which takes small stakes alongside commercial VCs in companies which can help to grow Intel's markets. Intel Capital uses the expertise within the group to validate the technology in a potential investment, but does not share this with its investment partners. "We do our thing and people might say 'Intel like it so it must be good'," says director Tim Keating. "We don't say it's good, we just say we're in the investment."

Perfect vision
Knowing when to bring in external experts is critical. Passing out every business plan to your network will soon lose you friends, while waiting too late might mean you waste time on a proposal with an unrecognised flaw.

According to Hans Schreck, ICT partner at TVM Techno Venture Management, technology assessment begins with constant alertness by in-house specialists. "We rely heavily on our own intelligence where investment managers and advisors set out in the market, look at deals and go to conferences to stay sharp on a number of topics," he says. "You cannot stay up with the cutting edge of technology unless you have that knowledge within the firm." TVM maintains a permanent network of advisors who receive a small percentage of carried interest in the firm.

The second phase involves more in-depth assessment to pick out the few likely winners. "It's a key consideration to empty the basket as quickly as possible to stay with a few deals we can really spend time on," Schreck says. "I can drag the company to an advisor and see how they see it. That can happen on a very short notice - we have had some companies that have gone through this in 48 hours."

Advisors at this stage are usually in business development or product management functions, and are generally not paid a fee. If the proposal still looks good, the full diligence process begins, involving the full network of contacts. But unlike other forms of due diligence, there's no set list of questions.

"The kind of questions we look at can really vary depending on what you're trying to do," says Schreck. "If you're looking at a company with some key technology ingredient which is looking to occupy a new sales channel, it's important to understand how they will get their sales strategy in place as quickly and effectively as possible. If the success of the company hinges on technology leveraging the assets of its customers, then clearly we need to understand how all this can be done."

The fourth and final phase is the post-investment equivalent of the first, a state of constant monitoring of the changing technological landscape. "We have to be just as sharp in competitive intelligence post-investment," Schreck concludes. "Sometimes the landscape can suddenly change and you need to keep abreast of that."

Skimming the cream
Penta Capital's early-stage fund Pentech Ventures follows a similar phased approach. "To get a handle on the technology and market opportunity we take the view we really need to do our diligence in-house," says director Eddie Anderson.
"That's the only way we can really get a good in-depth understanding of whether a business makes sense."

Anderson says that around a tenth of incoming proposals get past an initial filtering and are circulated around the Pentech team. Half of those are approved for further examination and sent out to members of Pentech's permanent advisory group for detailed diligence. Around half of these will survive to the actual dealmaking stage.

"Most of the advisors are investors in the fund so we all have a shared interest and they're an extended part of the team," Anderson says. "They're committed to providing a number of days a month to Pentech and are rewarded by participation in the carry. Everyone's economic interest is aligned."

Successful investors are clear on the benefits of thorough technology diligence. Ernie Richardson, communications and software specialist at fund manager MTI, gives the example of internet telephony business VegaStream. "At the point when we first invested around 1997, this was very, very new technology," he says. "We commissioned an outside consultancy, and what they did for us was a great exercise in trying to identify how a piece of technology is actually going to work out in the market. That also helped the company see areas that needed attention."

VegaStream was sold to Pace Micro Technology in 2000, with an IRR for MTI of 264%. "The technology due diligence in that really was extremely valuable," Richardson says.

Technology validation proved no less valuable when Richardson was considering a proposal involved with overcoming the physical limits of high definition displays. "When we looked at this it became apparent that the technological obstacles that would have to be overcome were likely to be much more profound than the management team envisaged," he recalls. "They had a neat technology that was only part of the solution, and for the other parts, the hurdles would have been prodigious.

"People sometimes imagine technology due diligence is trying to uncover a management team deliberately trying to hide difficulties. More often, what you get is these guys haven't looked at the full picture."

If you've IP and you know it
Ensuring that the technology does what it is supposed to is just part of the process. You also need to be sure that the company possesses the intellectual property that gives them the right and ability to fully exploit it.

"That's one of our key requirements, that there is ownership of IP and they've developed it themselves," says Richardson. "That's a really critical distinction. Sometimes we get people who'd bought the rights to IP, but you need to have the people internally who've actually done the work for it to be valuable to us."

The most secure form of IP is registered patents, but can also be knowhow or development expertise. In some sectors such as software, speed to market remains the main consideration.

"The first thing is to work out in your own mind how important you think the IP play is," says 3i's Lobley. "The IP is important but it has to be seen as part of a package of attributes the business has."

Licensing is a particularly thorny issue. Many universities, particularly in the US, prefer to license exploitation rights rather than grant patents to their researchers. "Quite often you find the IP portfolio is made up of a complex patchwork of in-licensing and out-licensing and there's areas where you cannot be sure there's no competing claims," Lobley points out. "You have to accept there's an element of risk to that decision. Very rarely do you get a squeaky-clean piece of IP with no challenges."

One stop shopping
For investors without substantial in-house expertise, an increasingly common solution is to outsource some or all of the technology diligence process.

"None of us are technologists because we are trying not to just do technology deals, and we always employ a firm of experts," says Gary Le Sueur, associate director at Scottish Equity Partners. "That might be a one-man consultancy or a big firm like Generics. We do diligence on the diligence experts first, to make sure we're getting the best person for the job."

Cambridge-based Generics Group last year launched a dedicated due diligence subsidiary, Technical Investment Services Ltd. "Our clients don't root through the technology themselves, they outsource the whole thing," says TISL director Mick McLean. "They welcome the fact that they can get a third party to look at the whole thing and get a different view."

TISL offers a mix of market as well technology services. "You cannot investigate the market for something unless you understand what it is, and you cannot understand what it is unless you understand the potential market for it," McLean says. "Checking out the competition is often completely non-trivial." For example, TISL were asked to assess a psychometric test for a mental dysfunction, and found that the main competitor was a genetic test.

TISL charges around £1,500 a day for a private report for an investor, which usually takes eight to ten days' work. "It's not a huge amount of money when you think about the size of transaction," McLean notes. "I think the real costs of doing it the other way are greater because it ties people up who could be looking for the next deal."

Early developers
For particularly early stage investments, a thorough assessment of the technology may not be possible, simply because it is still early in its development. "If you're making a table that needs four legs to be stable, due diligence is about making sure the legs are there," says Laurence John, chief executive of the new Amadeus Mobile Seed Fund. "At seed stage, the legs may not be there."

The actual technology can come second to the quality of the key technologists and managers. "What we're looking for is are there star performers in the team and are they known in their field as star performers?" John says. "A key part is referencing these people - are they good, is what they do good? What we are looking for at the seed level is a clear audit trail. Some people will say: we're very good at semiconductor design, we've worked with these groups. Other teams don't have that. Referencing is absolutely critical in deciding which plans to pursue."

A very early involvement with a technology company can also help the management address markets they might not have considered. "You can find out from your network if there are other areas where this technology can be applied. It's crucial at the early stages to do this because it's very difficult to change the approach later on.

"The technology issues are quite easy to check and address," John concludes. "Could this be done? - that's not too hard to check out. Even though we're a deep technology VC, and we love deep technology, that's the part we find easiest to check."


Life questions
According to the Association of the British Pharmaceutical Industry, it takes an average of 10-12 years and £350 million to develop a new medicine. If you're going to spend that much time and effort on bringing a product to market, you've got to be sure that it will then be able to exploit it without rivals rushing out a generic equivalent.

"You cannot start a life science product without solid patent protection because you need the ten years of the product lifetime to justify the enormous expense of clinical development," says Axel Polack, biotechnology investment manager at TVM Techno Venture Management. The solid barriers to entry given by patents is the reason why life sciences is one of the few sectors where a company can go all the way through IPO without a product.

The value of such a company is in how far it has progressed along the development ladder, and this is the key object of due diligence. "We evaluate how far the company has gone, what is already being tested. This is all adding to value," Polack explains. "A company starting out with a new drug target has very low valuation. The question for VCs is: is it viable to invest in a company with only one target? I would rather invest in something that has several targets."

The greatest opportunities are in mass medical applications. "As a medical doctor you usually know very well where the pain is, and you start with things where people present proposals that deal with the highest pain," Polack says. "This is why you see very many proposals in cancer, HIV, hepatitis, and all the neuro-degenerative diseases where there's almost no treatment available, like Parkinson's and Alzheimer's."

With a relatively small number of such major disease markets, there's inevitably a host of start-ups from around the world targeting each, most of which will be taking the same basic biological approach. "Usually we see the same ideas from a number of people at the same time," Polack says. "The decision then is in the details. Usually they're very close to each other and it comes down to IP."


Keep it simple
When they start talking to potential investors, smart technologists soon realise that the exacting terminology of a research report won't help them win attention. "The first things VCs say is: 'Tell me about it in 30 seconds'," says David Pickard, a medical physicist at University College London who has been on the fundraising trail for his cancer detection technology. "If the technology itself cannot be condensed into a sentence or two, you may well not be able to get a VC interested."

The ability to describe their technology in a simple way is key for any start-up seeking investment. "What's absolutely crucial is describing the research programmes within the company in a way that can be understood by non-specialists - they're not technologically na•ve, but they're certainly not research scientists themselves," says Louis Nisbet, healthcare partner at Sitka, an advisory boutique for entrepreneurs seeking funding. "That can be very challenging for an early stage business, because often they've come out of academia where they only had to explain their research to other scientists."

Setting out a series of clearly defined research goals can also be a valuable exercise. "What we aim to do is set out clear milestones which are important technical milestones but also translate through to enhanced commercial or financial progress," Nisbet says. "You have to recognise that technology is not exciting for its own sake, it's exciting for what it can do."

Collecting any information that can back up the technological claims, including full details on all relevant patent filings, is also vital. "There's a lot that companies can do to prepare themselves for due diligence that can help the process," Nisbet emphasises. "It won't stop a venture group doing their own diligence, but it will give an enormous amount of comfort and probably accelerate the progress of the deal."