Illinois Venture Capital Assocation:
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.
