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Q&A with Steve Lazarus on Industry Intermingling



MIND INTO MATTER
ARCH Transforms Science Into Sustainable Enterprise

Steve Lazarus and former WSJ writer, Udayan Gupta, explore the history of technology transfer from university research labs to the marketplace, and chronicle ARCH's 20-year effort to support the transition.

"Discovery creates the future.  The world is filled with secrets and fortunately there has always been a small set of people who devote their lives to solving these mysteries.  They are driven by a variety of motives and incentives – the pursuit of wealth or fame or power, the drive for a better life, the itch of curiosity, the goad of competition, or simply an obsession with a problem.

Through the centuries these explorers, researchers, inventors, tinkerers stood on the shoulders of their predecessors to reach the next new thing.   Some observers hailed what came to be called progress, some resisted it.  Change was seen as threatening or disruptive (well before this word achieved something of a positive connotation).   Chinese mandarins passed rules to suppress new ideas.  Dutch weavers threw wooden shoes into new machines.  New concepts about the motions of the universe were condemned as heresy.  Galileo was forced to recant his conclusion disputing the central unmoving position of the earth in the solar system.  Nevertheless, under his breath he muttered, “But still it moves.”  The world moves, and generally it moves forward and upward.  The new thing will out – eventually.

But where and when discovery is made, who will employ it, and how it is used, can be seriously affected by legal, political, and economic systems and by education, communication, and transportation infrastructures.  Intangibles such as the general freedom to question, the appetite of risk, even the level of respect for failure influence the location, timing, and consequences of discovery.

There is enormous distance between the point of discovery and the point of fully diffused take-up in the society.  This diffusion requires effort and capital.  In the United States, for the last half of the century, the first increments of this effort and capital have been supplied by a class of entrepreneurial financiers called venture capitalists.

Venture capitalists gather pools of funds from private equity investors and invest these funds, and more importantly their concentrated effort in the creation of vehicles for the distribution of new products, and the diffusion of new ideas.  The riskiest segment of this investment cycle is the origination, the moment when nothing becomes something.  The money that lights the fuse on this rocket is called “seed” and “early stage” venture capital.  It is the smallest slice of the venture capital pie.

In 1986 the trustees of the University of Chicago created an unusual organization.  It was cumbrously titled the Argonne National Laboratory/The University of Chicago Development Corporation.  This was quickly shortened to the AR-CH Development Corporation and the organization soon became known as ARCH.  This year marks the 20th anniversary of that initiative.

During the course of those twenty years ARCH evolved from a small under-funded technology transfer function on the second floor of Walker Museum in the Hyde Park campus of the University of Chicago (sometimes described as “on exhibit” at the museum) to a unique seed and early stage venture capital partnership with offices throughout the United States.  ARCH is governed by the same four people who began with it in 1986, it has founded or co-founded 115 new companies, and manages over one billion dollars.  It has maintained an unwavering fidelity to its original objective.  ARCH finds ground breaking discoveries in university, government, and the corporate laboratories and transforms this science and technology into viable entrepreneurial start-up companies.  ARCH then nurtures these companies to independence.  Along this twenty year span there have been some successes, some failures, and many lessons learned.  This is an attempt to share those lessons."

STEVE LAZARUS is Managing Director Emeritus of ARCH Venture Partners.  In 1986, he became the founding CEO and President of the ARCH Development Corporation and Associate Dean of the Graduate School of Business at the University of Chicago.  From 1974 to 1986 he worked at Baxter Health Care retiring as Group Vice President of Health Care Services.  He served as Director of Amgen Corporation for 17 years.

Lazarus retired from the U.S. Navy with the rank of Captain in 1974.  While in the Navy, he served as Deputy Assistant of Commerce for East-West Trade and was the founder and first Director of the Bureau of East-West Trade.

He holds an AB degree from Dartmouth College and an MBA for the Harvard Business School.

 UDAYAN GUPTA is a software and publishing entrepreneur.  He studied economics at Harvard and upon graduating went on to earn a Master’s degree in film at Boston University.  For over a decade, Gupta served as a Senior Special Writer for The Wall Street Journal covering many of the characters and companies who figure prominently in this book.  Gupta also was a Walter Bagehot Fellow in Business & Economics Journalism.

His recent books include A NATURAL WAY OF BUSINESS: An Unusual Partnership in Sustainable Tourism (Bayeux/Gondolier); THE FIRST VENTURE CAPITALIST: Georges Doriot On Leadership, Capital, and Business Organization (Bayeux/Gondolier), and DONE DEALS: Venture Capitalists Tell Their Stories (Harvard Business School Press).


The VC View

By: Steven Lazarus.
Published: Intellectual Asset Management magazine supplement, March 2005.
Issue: From IP to IPO, Key issues in commercializing university technology.

Steven Lazarus, Managing Director, Emeritus, ARCH Ventures, Chicago, IL, is a venture capitalist who has been working at the university/industry interface for the last 16 years. Here, he describes the lessons he has learned.

About 15 years ago I attended a conference in Aspen, Colorado, that, for the better part of three days, attempted to formulate a generally accepted definition of the term ‘technology transfer’.  The first day was given over to the parsing of the word technology.  After about six hours the only thing that people could agree on was that it had something to do with tools.

Well, it does have something to do with tools, in an extraordinarily important way.  Unfortunately, the generic catchall word – tools – does not evoke excitement.  And any prolonged discussion of the process of technology transfer usually causes the eyes to glaze over. But I suspect this is exactly because it is discussed as a process.  All too often we begin in the middle of things and then drill down to a molecular level of detail, while losing track of why we are doing the drilling at all.  There is a human tendency to dwell on process at the sacrifice of outcome.  Process, though dull, is easier.  Outcome is hard.  Outcomes are what interest me.

We are a curious species and consequently we tinker, we experiment, we perform research.  Most of the pure researchers I have known perform research in order to create new knowledge.  They are usually agnostic as to the value of any particular experiment.  A failed experiment can often teach as much as a successful one.  Edison experimented with thousands of materials before he settled on the carbon filament to illuminate the light bulb.   We have learned over the centuries that virtually all new inventions, all new innovations, all new cures, emerge from the work of this indispensable class of people – the experimenters.

We now know that research is a major contributor to job creation, to improvement in the quality of life and to victory in international economic competition.  But research conducted in isolation and yielding little more than esoteric papers in learned journals is not enough to achieve practical outcome.  There has to be a way out of the laboratory and into the economy.

At the dawn of civilisation there was no laboratory.  There was simply the need to survive.  Thus, the plough was the primary original tool.  As James Burke has written: “If every innovation acts as a trigger of change, the plough is the first major man-made trigger in history, ultimately responsible for almost every innovation that followed.”  The plough created the possibility of surplus.

There has long been a debate as to whether the sudden dawning of a new invention triggers what Clayton Christianson calls a disruptive change, or whether a changing culture and an evolving economy demand the new invention.

Or is it a case of happenstance?  Of unintended consequences?  In 1906, Theodore Vail of AT&T made trans-continental (and later transoceanic) telephone service the central strategic aim of the company.  But by the 1930s the vacuum tubes on which the service depended had become too unreliable.  So AT&T set out to develop a solid state substitute for the vacuum tube.  In 1948, Shockley, Brattain, and Bardeen developed the transistor.  Today it permeates every aspect of life on the planet, arguably the most important invention of the 20th century, its influence light years beyond that of a simple vacuum tube replacement.

Throughout the centuries discoverers followed no particular methodology or form of organisation.  The discoverer could work alone, as did Galileo and Newton, or with a supporting team, as did Edison, or as part of a loosely connected group such as the 18th century Lunar men of Birmingham, England, who included, among others, Josiah Wedgwood, James Watt and Joseph Priestly.  James Watt was not the inventor of the steam engine, but he did devise a way to heat and condense steam so that the energy release would drive a piston.  The first practical utilisation was the draining of mine shafts.  Use as power for transportation came later. The Lunar men were an interdisciplinary group.  Most were both theorists and experimenters. Together they carried ideas from the theoretical to the practical; they worked to solve problems. They rubbed off each other and created sparks, and they took their inventions to market. Technology transfer was a contact sport that took place in the parlours of these men who met once a month when there was a full moon.

A changing university environment

The research university, as we know it today, began to form in the first third of the 20th century, but it was immediately marked by strife between the theorists and the experimenters.  For decades there was at Harvard a feud between the department of chemistry and the department of chemical engineering.  At the University of Chicago, Robert Hutchins forbade the creation of a graduate school of engineering, a trade school he called it.  The scientist’s objective was to be pure.  It was to find new knowledge irrespective of its potential utility.  Engineers committed the sin of working towards a goal, towards a given end.  And if engineering was less respected, commercialisation was worse – a demeaning activity.

World War II changed everything.  First, particularly in the United States, an enormous amount of money was pumped into the research structure and the structure expanded in multiple directions.

New facilities such as Los Alamos and Tuxedo Park were created to achieve particular purposes – the atomic bomb, radar.  Theorists and experimenters were forced to work side by side towards a given end.

By the end of the war the different breeds of scientist and engineer had learned they could work cooperatively.  A new model had emerged, a set of serial activities, compatible and progressive – discovery, development, basic research, applied research, development engineering, manufacturing engineering and, ultimately, testing, marketing and selling.

And like a cattle baron consolidating a land grab, once into research, the government remained. Research became a public policy objective.

The money increased.  Channelling agencies grew larger.  The National Institutes of Health became the primary funding authority for biological research; the National Science Foundation funded physical research; the National Energy Laboratories funded all disciplines.  The research component of the defence budget was substantial (yielding among other things the progenitor of the internet) and, after the flight of Sputnik in 1957, NASA began to grow geometrically.

A gigantic research structure, unique in the world, was in the process of being created.  Sponsored research was something the great universities competed for.  Superstar scientists carried their grants and moved from university to university the way star free-agent ball players move from team to team.  The government research budget rose above US$150 billion.

As the cold war wound down, however, Congress began to question the economic benefits of this investment.  Was intellectual property being created, protected and, more importantly, utilised?  Japanese companies were referencing the National Technology Information Service far more extensively than US companies and also generating more patent applications.  Of greatest concern – was this investment ultimately creating jobs?

Legislation was passed allowing universities to take title to discoveries that had been financed with government funds and encouraging them to become active commercialisers.  But the universities were not commercial creatures.  Commercialisation was antithetical to a culture of freely traded ideas. Some intermediating entity was clearly needed.

The rise of venture capital

There is a small component of the alternative asset class of private equity investment called venture capital.  Until the 1950s this had largely been the province of wealthy families such as the Rockefellers, Whitneys, and Phippses.  Two engineers, Georges Doriot at Harvard and Fred Terman at Stanford were encouraging the development of a professional group of venture capitalists.  Their purpose would be to finance ideas in their rawest form, to make bets on new enterprises, to take risks that would be unacceptable to most conventional forms of finance.  And in return these venture investors would have a chance of owning part of a property that could experience substantial, sometimes extraordinary, growth and appreciation.

This was risky business.  There was great potential for failure.  I am convinced that the frontier entrepreneurial tradition of the United States played an important role in the establishment and growth of its venture capital industry.  Particularly there was what Walter Massey, at the time head of the National Science Foundation, referred to as a respect for failure.  The United States was a place where one might not succeed but be credited for the effort and get a second chance.  This was not necessarily the case in many other western economies.

Venture investors were often the first managers of their investments.  They expected to work side by side with entrepreneurs and discoverers to develop the new enterprise.  Their potential to act as intermediaries between academia and commerce seemed attractive.

In the early 1980s, universities struggling with the mandate (and the opportunity) to commercialise rarely considered the creation of new enterprises as an option.  Almost all either adopted licensing programmes or subcontracted the function to one of a small number of service companies that visited periodically and scanned the invention disclosure reports which had accumulated.  Many faculty members considered this an unsatisfactory arrangement.

A few other models existed.  WARF, the Wisconsin Alumni Research Foundation, was created in the 1920s in part because he leadership of the University did not believe commercialisation was an appropriate role for an academic institution.  With the important exception of the great technology institutes, this cultural snobbery was pervasive.  In at least one institution, faculty members who spent time working on patent applications were handicapped in the competition for tenure.

ARCH is born

The University of Chicago is an interesting case (and the one I know best).  In the early 1980s it had highly regarded Nobel laureate-quality departments in both the physical and biological sciences.  Although Hutchins had prohibited an engineering school, bootleg engineering centres existed, some of which were sophisticated enough to build complex space experiments in the astrophysics department and advanced prosthetic devices in the biological sciences division.

And the faculty was becoming restless.  They could see the revenues being generated by multiple licenses of the Cohen-Boyer recombinant DNA inventions at Stanford and UCSF.  (This, by the way, was an example of how a key decision by a Stanford technology transfer executive, Nels Reimers, not to license the inventions exclusively to Genentech, avoided an enormous sub-optimisation of revenue for the universities and inventors.  The decision also gave birth to the biotech industry.)  And even though the red blood cell stimulating factor, erythropoietin, which later became AMGEN’s blockbuster drug, Epogen, had first been synthesised at the University of Chicago, it had not been protected.  This turned out to be a remarkably expensive oversight.

All these factors led to a climate of discontent regarding technology transfer at the University of Chicago.  The faculty, trustees and administration came together to try to craft a response.  This unusual consensus led to the invention of ARCH.

ARCH, the Argonne National Laboratory/ University of Chicago Development Corporation, was designed largely by the trustees of the University in the 1984/85 time period when the mandates of the Bayh-Dole and Stevenson-Wydler Acts were fresh in their minds.  The University was the manager of the Argonne National Lab and could take title to its intellectual property.  The president of the University was an active enthusiastic supporter of commercialisation, and the vice president for research, Walter Massey, who was later president of the AAAS and head of the National Science Foundation, was the driving spirit.  The dean of the business school provided a physical as well as an academic home for the nascent organisation.  Consequently, the original staff was almost entirely graduate business school student volunteers.  ARCH had its own dedicated board of directors made up largely of chairmen and CEO’s of Fortune 500 companies.  I give you this much detail to demonstrate how unique and serendipitous the original circumstances were.

We quickly confirmed that both the university and the laboratory were rich with scientific and technological business prospects.  Not really surprising from two institutions that spent more than US$500 million research dollars (much of it basic research) annually.  But we also quickly learned that we could not make progress without some form of early-stage financing.

Some universities have tried to provide this financing from a foundation, from the endowment, or even from operating funds.  I believe this was, and always will be, a mistake because it bypasses the critical discipline of market-based investment review.

So we at ARCH set out to attract venture capital to our midwestern deal flow.  Then, as now, the two great concentrations of venture capital were in northern California and eastern Massachusetts.  We travelled, presented our deals, but were confronted by the gyroscopic tendency of these coastal folks to turn around at the Nevada and Pennsylvania borders.

We decided to try to raise our own fund, the first by a university.  I often reflect with wonder at how naïve we were.

My partners and I – we are still together after 18 years – tend to look back nostalgically at that first fund.  We raised US$9 million, and invested in 12 of our start-up companies.  With unexpected symmetry, four failed utterly, four were sold (one for a spectacular multiple) and four had IPO’s.  Our IRR was 22%.

The university was not prepared for our success.  The containment of a wholly owned profit-making entity tends to put a tax-exempt 501.c3 status at risk.   So the venture portion of our organisation was spun out and became ARCH Venture Partners.  Today we have over US$1 billion under management, have started well over 100 companies, and have recently raised our sixth fund.

Lessons learned

A few comments on how we have learned to work with the university/laboratory community:

  • Our focus on university and laboratory-based science continues to work.  We have relationships with almost all of the major research universities in the country and many of the national labs.
  • We do not have a particular specialty such as life sciences or IT.  Universities are multidisciplinary and so are we.  For 15 years universities have been creating interdisciplinary centers.  Many, if not most, of the ideas emerging from these involve two or more basic disciplines.  We call these convergence opportunities and they represent an increasing proportion of our investments.
  • Partners who first came together in Chicago have emigrated to other locations:  Seattle, Austin, New York (we even have a stealth partner in the Bay area).  At first we considered these to be underserved geographies but today they are hubs of activity.  All partners retain a national focus and we often create companies with pieces of technology from multiple institutions.  We call these scientific roll-ups.  There is risk in pursuing a single institution perspective.
  • Since our origin at the University of Chicago we have avoided contractual arrangements or formal tie-ins with any particular institution.  Our experience is that if we are respectful of the academic culture (for example, we never ask for a restriction on publication), work with those technology transfer offices that are open to cooperative endeavour and establish relationships with local and regional investors, we never need a contractual right of first refusal.  I have often thought that the organic problem of most technology transfer offices was the political necessity of having to spend time and money with every faculty member irrespective of the quality or promise of the particular invention.
  • Our experience is that a small percentage of the investigators at any institution are the true discoverers and they frequently repeat.  There are about two degrees of separation between any of them.  Although it sounds like snobbery, we aim to work with the scientific elite.
  • We believe in strong syndicates constructed from the earliest round of investment.  We raise enough funds to stay through three to four investment rounds.
  • We are very active investors, probably seen as intrusive by some.  We don’t believe you can be passive or reflexive and at the same time be successful as a seed/early-stage investor.
  • We try to avoid those institutions that are feudal in nature and have multiple points of approval in the technology transfer process.  Transaction costs are too high, and the general deal flow in this space is too rich to spend much time with refractory organizations.

The entrepreneurial culture fostered by venture investing is once again spreading.  The industry put US$20 billion into start-ups in 2004.  The number of initial public offerings increased appreciably and for the most part these were of high quality.  And the disproportionate contribution of this small segment of the economy is beginning to be recognised.

A study by DRI and Wharton Economics conducted under the auspices of the National Venture Capital Association reports that at least 7% of the new job creation in the United States is the product of this ferment of entrepreneurial activity largely based on the great research structure and financed by venture capital.  I think the number understates the case but it is a good place to begin.

The future looks extraordinarily promising.  The work going on in the great university research centres and national laboratories may produce outcomes beyond imagination. A small sample of what our portfolio companies are currently working on would include:  resistance-proof antibiotics; electroactive polymer technology; RNAi; high-performance inorganic nanostructures; vision restoration for macular degeneration patients; RFID; and many more.

I am happy to be in a job that brings these discoveries into the community.  Direct descendents of the plough, they are the tools that advance the human condition.


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