Changes in High-Technology Research Funding

As a continuation of ideas I picked up in my MST classes, I have been interested in stories about the level of funding of basic research. Yesterday, MIT Technology Review had an article called “Follow the Money” looking into the President's new budget and its effect on basic research funding.

First, the good news.

The appetite of venture capitalists for investing in new technologies is rebounding: in 2004, venture capital financing in the United States was up 8 percent from the year before, following three years of decline.

The resurgence of VC money is an indicator to me that the market is turning around. It is also an indication to me that private funding of basic research is growing in attractiveness. More on that later.

Venture capitalists never entirely stopped investing in companies with technologies just emerging from the lab. But after several years in which high-risk investments were unpopular, many startups developing innovative technologies (especially in such areas as nanotechnology and new genomic approaches to medicine) are starving for capital.

This one I have trouble with. When I was looking into these areas with relation to my coursework we were interested in finding ways to get private firms to leverage the research facilities here in the Pacific Northwest. Much of what we examined was around nanotechnology, especially in relation to microprocessor development. There seemed to be a lot of activity in the firms we examined.

The article goes on to applaud an increase in research funding, even if 80% was targeted at Defense and Homeland Security projects. It did point out that the National Science Foundation had “the first cut in NSF's budget since 1996.” and the National Institutes of Health only had a 1.8% increase. To me, that might encourage the firms that rely on that basic research to fund more of it.

The article does have a point, though. It claims that research funding “has become too skewed toward relatively mature technologies.” That is a serious problem since, to me, funding of basic research makes a lot more sense than funding later stages in the innovation life cycle. ROI from basic research takes decades to quantify, so a broader program to support it makes a lot of sense. ROI for the later stages where technologies are applied and turned into products is easier to calculate because the returns come sooner. Even in the case of defense products, it might be more beneficial to allow private concerns to compete on how efficiently they can create useful solutions rather than funding such activities.

While valuations of later-stage venture-backed startups have begun to bounce back this year, valuations for younger startups have not. In addition, say experts, some venture capitalists are focusing on certain pockets of technology, such as those relevant to homeland security and biodefense, where the focus is more on developing and deploying existing, well-established technologies than on inventing innovative new ones.

So, the VCs have brought more money to the table, but they tend to put it in areas where the risk is lower. That is, if the basic research and even applications of that research are funded by the government, they get to fund the less risky productization of that research. Makes sense to me. The higher the risk factors, the harder it is to identify projects able to adequately cross the hurdle rates demanded by even these less risk-averse investors.

Indeed, the combination of venture capitalists favoring later-stage startups and the continuing trend of large corporations investing less in speculative research is creating an innovation vacuum, according to some experts.

From a Physics perspective, nature (and markets) abhors a vacuum. If there's money to be made in that space and someone can make a good case for it, a firm will arise and VCs will fund them that can take advantage of the need to do this basic work. However, because of the risk, the returns will have to be high. The other factor, in my experience, is that government abhors high realized returns. They tax the snot out of anyone that realizes significant income. A firm that fills this space, therefore, cannot realize income over short periods, but must continually reinvest to incur expenses to bring down its tax liability.

What sort of investor appreciates this sort of capital sink? The long-term one. Are there many of those left?

2004 was a strong year for companies going public; the number of IPOs and the amount of money they raised reached their highest levels since 2000. What’s more, the value of mergers and acquisitions involving venture-backed companies was 76 percent higher than in 2003—all of which means that venture capitalists once again have the prospect of lucrative exit strategies and the motivation to invest in startup companies.

VC's love middle-term projects. Ten years is pretty much their window. So the budget is indeed skewed incorrectly. Let the VCs fund the middle-term Defense and Homeland Security projects that will surely be purchased if threats continue to exist (they will). I agree with this article. The skew of government research grants must be biased towards basic research and away from the shorter-term projects that have caught their interest.

Josh Poulson

Posted Friday, Feb 18 2005 09:58 AM

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Economic Report of the President—2005

Following on the heels of my criticism of the President's budget for basic research on February 18th, 2005 we come across more ripe material in the Economic Report of the President for 2005. Chapter 6 discusses “Innovation and the Information... [Read more]

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