— The polite term is "VC-funded R&D," though the cruder descriptions — "Daddy co-signs for the loan" and "TFT" (Testicle-Free Transaction) — are a lot more accurate. But whatever you call it, this innovative new funding model may be the key to getting high tech out of its current investment doldrums.
The problem is not a shortage of investment capital, but of capital being invested. Venture capitalists are sitting on mountains of money these days. Hell, they're turning down new cash every day. The problem is that they aren't investing it. Burned by the dot-com bust (which was largely their fault), and seeing no IPO end game for their current investments anytime in the near future, VCs have become embarrassingly risk averse.
This general gutlessness comes in several forms. Though money continues to be offered by institutions, high-tech VCs, especially in Silicon Valley, have grown wary of establishing new funds. And though the rate of investment has largely come back to mid-1990s levels, the cost of that money has become exorbitant: a typical Valley VC these days wants so much of the company in exchange for its investment that only the most desperate entrepreneur would ever say yes. And you can almost forget about early stage, much less seed round, investments. Plan on mortgaging your house.
And the VCs aren't the only ones who've come down with a bad case of risk aversion. A few weeks ago, I sat through a presentation by a start-up company before a well-known group of Silicon Valley angel investors. The new company had thousands of customers, a major new contract, and was on the brink of profit, and needed less than a million bucks to get into the black. All in all, the kind of start-up investors used to dream of. And yet, after extensive grilling and several call-backs, the company didn't even get a dime. In the end, they found most of their money in Southern California.
A few days later, I ran into the founder of the program at a cocktail party. When I asked him what happened, he shook his head in dismay, "I don't know what it is, but nobody wants to take chances right now. It's very un-Silicon Valley."
The New Gutlessness
Indeed it is. And this New Gutlessness poses a major threat to the future health of the U.S. economy. For the last quarter-century, most of the new job creation in the United States has been product of young entrepreneurial ventures. And most of those have been in high tech. And most of those have been founded in Silicon Valley and the other tech enclaves around the country.
Thanks to wary and parsimonious investors, and the resulting shortage of available capital, we are at a very great risk of losing an entire generation of new technology companies. Recessions are always the best time for starting new companies: there's lots of talent available thanks to layoffs, you've got plenty of free time, your biggest competitors are distracted, you can operate under the radar screen because the press is looking elsewhere, and you've got time to get your product to market.
But to do all of that, you need money. And if the money isn't there, you'll never make it.
Some people get it. Many of the start-ups I've talked to in the last few months have managed to find money from the most unlikely places, like Asian banks. Up in Portland, venture capitalist Wayne Embree of Concordia Partners is trying to start what he calls "a new channel for early stage equity capital." This "fund of funds" would manage as many as 10 individual venture funds, all of them very small ($50 million to $75 million) and focusing exclusively on the earliest-stage investments.
It's a timely idea, but Embree is faced with having to sell it to the same risk-averse VCs he's trying to save. You can only wish him luck.
A New Funding Strategy
Meanwhile, last week I heard of another funding strategy. This one has the advantage of leveraging off the VCs' own timidity.
I heard about it from K.C. Murphy, who is something of a Silicon Valley legend from his long and successful career in the semiconductor and equipment industry (AMD, Cadence). For the last few years, Murphy's been making a killing as an investor and entrepreneur.
It was over lunch that Murphy set out the "TFT" strategy for VC-Funded R&D.
TFT works like this: Since VCs are so risk averse, the key is to reduce that risk. Needless to say, entrepreneurs aren't known for inducing a sense of security in money people.
But corporations are. And that's the trick. The entrepreneur goes to a large corporation, say HP, IBM or Cisco, and makes the following offer: If the start-up can complete the development of its new technology, the corporation will enjoy certain rights to that technology, including (as negotiated) anything from licensing to ownership to outright purchase of the new company.
What does the big company have to do to earn these rights? Stand behind the start-up when it goes to the venture capitalist, guaranteeing one of those end results. In other words "Daddy co-signs the note" to help Missy buy her new Miata.
The VC sees a guaranteed return on the investment, and a real, non-IPO, exit strategy. The big corporation saves on R&D expense and gets a new technology merely for agreeing to be a customer if the technology is ever developed. And, most important, the start-up company gets funded.
Fallback for the Risk Averse
One of the biggest weaknesses in this model — getting access to the big corporation — turns out to be a strength: it forces start-ups to go out and find veteran managers who have big Rolodexes.
The TFT model also has the weight of history behind it. There is a nice symmetry to the fact that HP is experimenting with this model. Nearly a half-century ago, this was precisely the strategy David Packard used with a group of engineers who had an idea for a new kind of display technology. Packard sent them away with his blessing, and an agreement to buy their company at a future date if they pulled off the design.
The team did just that, and helped to create the modern diode industry. (Characteristically, Packard bought their company for several times the agreed-upon price.)
Does the TFT model work in the real world? Well, Murphy just did it with a new start-up in Austin that he's running. And he claims to have heard of another 20 such deals in the works around the country. New business eras call for new business strategies, and this one sounds like a trend.
It would be nice to think that the VCs will wake up to the short-sighted, self-destructive path they've put themselves on, and that they will soon start making riskier investments. Short of that, perhaps they can insure their futures by putting some money behind seed round players like Embree and Guy Kawasaki at Garage.com.
But if they don't even have the cojones for that, it's nice to know that now, at least, they can fall back on TFT, a term that is both a process and an accurate description of at least one of the players.
Michael S. Malone, once called “the Boswell of Silicon Valley,” most recently was editor-at-large of Forbes ASAP magazine. His work as the nation’s first daily high-tech reporter at the San Jose Mercury-News sparked the writing of his critically acclaimed The Big Score: The Billion Dollar Story of Silicon Valley, which went on to become a public TV series. He has written several other highly praised business books and a novel about Silicon Valley, where he was raised.