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How Corporate Venture Capital Investing Increases Innovation
Nothing
Ventured, Nothing Learned
New Undergrad Class Explores Venture Capital Investing.
Imagine
you are a venture capitalist, and an entrepreneur approaches you with
a pitch for a new business. He wants to create an online marketplace
for chemicals used by researchers in labs at universities, businesses
and government agencies. The website would operate like Amazon. But
instead of linking buyers and sellers of books, compact discs and other
consumer goods, it would link scientists with sellers of substances
such as proteins and antibodies.
Would you invest?
That's the question that Raffi Amit, a Wharton management professor and academic director of the Goergen Entrepreneurial Management Program, posed to the students in his new class for undergraduates, "Venture Capital and Entrepreneurial Management." The class, modeled on a popular offering that Amit teaches at the MBA-level, aims to prepare students to become either venture capitalists or entrepreneurs.
"For students envisioning an entrepreneurial career, I want them to understand the challenges and opportunities that institutional venture capital creates for them," Amit says. "I believe that entrepreneurs who are familiar with the process will do better at raising money and managing their relationships with venture capitalists. And those students who want to be venture capitalists, I want to give them the tools to be effective analysts on the day they arrive at their jobs."
Which is why he has asked the students to evaluate the online chemical marketplace. The company isn't just a classroom fiction. Rather, it's the very proposal that an entrepreneur named David Perry offered to investors in the mid-'90s. Perry, a veteran of the biotechnology industry, saw scientists wasting lots of time — he estimated several hours a week — flipping through paper catalogs looking for chemicals. He figured that an online marketplace would not only be more efficient, but that computer-savvy scientists would embrace it quickly.
What he needed, of course, was money. He had to build a website and also undertake a massive marketing campaign. He had a classic chicken-and-egg problem: he couldn't attract chemical makers to his site without scientists-shoppers, and he couldn't attract shoppers without lots of vendors.
Perry promised investors riches in exchange for the risk. He estimated that specialty chemicals accounted for $1.5 billion in sales a year and that his company, which he called Chemdex, could carve off $250 million of that. If all went as planned, Chemdex would have a market capitalization of nearly $600 million within five years and would be growing at 15 percent a year. With numbers like that, the company could launch an initial public stock offering and cash out its venture investors.
Faced with
Perry's optimistic projections,
Amit asks his classroom of aspiring investors and entrepreneurs — they're
divided into teams — to offer
up their analyses.
"We liked the management team," says the spokesman for one group. "They're
experienced, and they've got skin in the game."
"Skin in the game — what do you mean?" Amit shoots back.
"Perry is putting up funds, too. If we lose, he loses."
"So you wouldn't invest if he didn't have skin in the game?"
The student shakes his head emphatically to say no.
"But what if the entrepreneur has no cash?" Amit asks. "When Steve Jobs started Apple, he had no money. He was a college dropout working in his parent's garage."
"What about Chemdex's competitive position?" Amit wants to know. "Is this a defensible business?"
Another team offers up its analysis, pointing out that Perry would have a first-mover advantage as the first company to try to fill this niche.
Amit pushes back again. Is being first any real advantage when you have no proprietary technology and you're selling a commodity?
A student volunteers that Chemdex may enjoy network externalities.
"Direct or indirect?" Amit asks.
The student looks stumped.
"A direct network externality is what you have with a fax machine. My fax machine is worth more as others buy fax machines. More faxes mean more value. And there are switching costs. What Chemdex would have is indirect network externalities. The more that buyers go to its site, the more suppliers want to be there. And the more suppliers that are there, the more buyers that will come."
Now it's Amit's turn to share some of his analysis with the students. He urges them to continue to explore the competition that Chemdex will face, pointing out that commodity markets tend to be brutally tough. "They're all about price competition," he points out.
One of the ways that businesses try to escape price competition is through branding, but that seldom works, he says. Few consumers look for a brand on a bushel of wheat or a bale of cotton.
"But what about this," Amit says, picking a bottle of water from a desk in the front row and holding it aloft. "Who would've thought you could brand water. Now some people want Poland Spring. So maybe there are ways to brand commodities. Aren't prescription drugs just branded chemicals?"
Then comes Perry's chicken-and-egg problem. Amit returns to it again and again during the discussion. Big suppliers, he points out, will have no reason to list with Perry until he has lots of traffic on his site. Yet Perry will have trouble covering the whole market without them, and that will make it hard to draw customers. He'll need to recruit a lot of small suppliers and do it fast. How might he do that?
"He could go after the third-party catalogs, the companies that don't make any chemicals but just distribute," one student suggests. "He could offer them a cut of the revenues."
"They'd be kissing their businesses good-bye if they listed with Perry," Amit points out. "That's a downside — a fairly substantial one."
Hands shoot up around the room. One by one, students offer solutions to Perry's problem, and each time, Amit points to a weakness of their argument. Soon, the class seems flummoxed. One young man spins out an elaborate and hard-to-follow plan in which he throws around terms like "big bang" and "go-live date." His classmates look at him blankly.
Amit steps in. "Without solving this chicken-and-egg problem, there's no business," he says. "But there's room for multiple approaches here. There are various ways that you could play this."
"How many of you would invest? Let's see a show of hands," he says. The class is about evenly split, with perhaps a few more opposing an investment.
In this case, the nays have it.
Chemdex, like so many Internet companies, eventually failed. Perry was able to land multiple rounds of venture funding and take the company public. But soon afterwards, its fortunes began to skid. The company changed its name — to Ventro — and its business model — instead of running online marketplaces, it would help other companies build their own. By 2000, it had shuttered the Chemdex site and laid off half of it staff.
Nathaniel Stevens, a Wharton senior, enrolled in the class last fall, the first time Amit taught it to undergraduates. Stevens has founded Natpal.com, an Internet search and advertising company, and wanted to better understand how to raise money and negotiate with venture capitalists.
Amit showed him that he needed more than a clever idea and a flashy business plan to raise money, he says. "I understand now that we have to make sure we've proven ourselves before we go out for funding — we need to begin to develop a customer base," he says. Amit also taught him "all the ways in which the VC can get the entrepreneur," he adds. "They have all of these clauses in the term sheets, and if you don't understand them, you could find yourself in trouble down the road." Stevens, who was selected for the Wharton Venture Initiation Program, says he would recommend the class to anyone considering a career as an entrepreneur or an investor.
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Wharton Entrepreneurial Programs
Wharton Venture Initiation Program