What the computer science revolution did for manipulating data, the nanoscience revolution will do for manipulating matter.[1]

Normally, a claim similar to the one above would have venture capital firms (“VCs” or, singularly, “VC”) salivating and running to board this newest investment train before it leaves the station. Yet VC interest for this journey has recently waned, compared to initial levels. We believe the sources of historical investment in nanotechnology, current market conditions, and lack of apparent disruptive technologies provide insight into this decrease in participation.

What Is Nanotechnology?

Simply put, nanotechnology is tiny technology. More specifically, the United States National Nanotechnology Initiative defines “nanotechnology” as “the understanding and control of matter at dimensions between approximately 1 and 100 nanometers, where unique phenomena enable novel applications.”[2] This umbrella term is used to refer to the products and processes at a nano/micro scale that have resulted from the bringing together of the physical, chemical, and life sciences.[3] Because nanotechnology involves both research and development that strive to create materials, devices, and systems with new molecular properties and functions, it has been referred to by many as the “next industrial revolution.”[4]

As evidence that this revolution is in full swing, the Food and Drug Law Institute maintains that nanotechnology was incorporated into more than $60 billion in manufactured goods in 2008, approximately 20 times the amount in 2006. The National Science Foundation predicts that nanotechnology will represent a $1 trillion market by 2015 and will eventually employ two million workers.[5] The number of products manufactured with nanomaterials, including those made of carbon, silver, zinc, silica, titanium, and gold, is on the rise, increasing from approximately 800 to more than 1,000 over the last few years.[6] Certain commentators predict that by 2014, 15 percent of all goods manufactured globally will contain nanotechnology.[7] Currently, nanotechnology is utilized in everything from consumer products (such as tennis racquets, sunscreen, clothing, and health products) to building products, and from electronics and automotive parts to medical devices. Almost 50 percent of the Dow Jones Industrial Average companies are making or working on products involving nanotechnology.[8]

Overview of Nanotechnology Funding Sources

The majority of funding for nanotechnology products is centered in the United States. In July 2000, then-President Clinton initiated the $422 million National Nanotechnology Initiative (the “NNI”) to encourage research and development in this field.[9] The NNI aims to increase funding for fundamental research, establish nanotechnology research centers, instill a research infrastructure, support workforce education and training, and study the ethical, legal, and societal implications of nanotechnology.[10] A large portion of funds allocated under the NNI is channeled to research universities. Accordingly, most nanotechnology start-ups are spinoffs from university breakthroughs, with the majority of the other spinoffs derived from government laboratories and large corporations.[11]

Through the NNI and similar government and private initiatives, U.S. investment (both public and private) has thus far spearheaded nanotechnology expansion, as other countries have been slower to focus on funding. For example, in 2007, the United States accounted for 90 percent of total VC activity in nanotechnology by value, with New Hampshire alone accounting for more funding ($76.5 million in two companies) than all countries outside the U.S. combined ($70 million). The overall federal budget proposed for 2010 under the National Nanotechnology Initiative is estimated to be $1.6 billion.[12]

Despite this trend, the interest of foreign governments and businesses in nanotechnology is changing. Currently, Russia and Southeast Asia are viewed as key growth regions in terms of research and development investment. In December 2008, Russia formed its first nanotechnology venture capital fund through the Moscow School of Management SKOLKOVO and the Russian Corporation of Nanotechnologies for approximately $70 million.[13] Also in 2008, China specified a desire to catch and eventually pass the United States in nanotechnology development, even though China’s current nanotechnology funding comes largely through the central and regional governments rather than private capital. Finally, a German-based nanotech VC, Nanostart, recently asserted that as investments focus on the emerging sector, Singapore nanotechnology companies will continue to expand.[14]

Top U.S. VCs are themselves becoming more interested in international nanotechnology opportunities, helping to grow the global interest in this field. In the first half of 2010, a delegation of leading U.S. VCs planned to travel to Moscow to learn about Russia’s growing potential in the high-technology and nanotechnology fields. The Russian Corporation of Nanotechnologies, together with the American Business Association of Russian-Speaking Professionals, organized the trip, demonstrating other countries’ willingness and desire to attract foreign investment.

The global activities highlighted above have generated a growing concern that if the United States does not continue to increase its governmental and private spending for nanotechnology commercialization, it could lose its current front-runner position in the race to turn nanotechnology into lucrative and possibly world-changing products. The President’s Council of Advisors on Science and Technology recently published a lengthy report that stated, “U.S. leadership in nanotechnology is threatened by several aggressively investing competitors such as China, South Korea and the European Union.” To help meet this threat, the Council recommended both increasing spending and reforming related federal programs and policies.

Even as concerns rise about the need for increased levels of government spending to support nanotechnology development, U.S. government funding still outpaces private investment. According to a June 2008 report by Houston-based Plunkett Research, Ltd., the combined U.S. government and private investment in nanotechnology research and development is estimated to be more than $3 billion annually. The government portion of such spending, however, far surpasses private investment, as the venture capital nanotechnology investment from 1998 to 2004 was approximately equal to the amount that the government spent on nanotechnology in 2004 alone. Compared to the amount of government resources, the volume of venture capital money flowing into nanotechnology is a minor slice of the entire research and development pie. A number of explanations for this imbalance in funding sources exist.

Barriers to Venture Capital Investment in Nanotechnology

Although the use of nanotechnology in today’s marketplace continues to expand, VC funding for and involvement in these endeavors currently lag behind the pace of scientific advancements. The disparity in government and VC funding of nanotechnology demonstrates the existence of inherent difficulties in obtaining private capital for certain types of developments.[15] These difficulties arise from both global economic and more VC-specific concerns.

The current state of the global economy cannot be viewed as “nano-friendly.” Start-up companies across the board are experiencing difficulty obtaining initial and follow-on VC funding, and nanotechnology start-ups are no exception. VC funding in nanotechnology is likely even more tepid, due in part to wounds still felt from the bursting of the internet bubble. Although the investment environment facing nanotechnology entrepreneurs in 2010 is very different from that which internet entrepreneurs faced in the late 1990s, the dot-com bust has not been forgotten.[16] During the dot-com bust, investors learned hard lessons about the risks of funding companies prematurely, and as a result, they are generally more reluctant to pour large amounts of capital into companies until such companies have defensible, tested technologies; precommercial products; defendable patents; growing target markets; likely profitability; and strong management teams.[17] Consequently, nanotech entrepreneurs will need to conduct more rigorous self-assessments of their strengths and weaknesses and impress potential investors with solid strategic business plans.[18]

The credit crises facing the world’s economy have also contributed to a shortfall of VC funding in nanotechnology. According to Lux Research, an independent research and advisory firm, the heyday for nanotech VC likely was in 2008, when overall investment reached approximately $1.4 billion.[19] In 2009, the sector raised only $792 million, a 42 percent decline from the prior year, and 53 percent of VCs are predicting that their investments will decrease or remain flat in the near term.[20] Thus, current economic pressures will probably continue to impact VC funding of nanotechnology.

Apart from these general economic roadblocks to VC investment in nanoscience, specific barriers unique to VC financing have further reduced VC participation in this field. Several of these barriers are set forth below:

Inability to Capture Margin; Lack of “Disruptive” Applications. Most current applications of nanotechnology are evolutionary in nature and offer incremental improvements to existing products and generally modest economic and societal benefits. Nanomaterials are often embedded deep within a particular product, which product is then utilized in another product, etc. This type of scenario makes it inherently difficult for nanomaterials to capture margin and, consequently, attract VC funding.

Because nanomaterials are often a small piece in the larger product picture, nanotechnology has not created an abundance of “disruptive” applications. New technological inventions are most successful in attracting many VCs when they fully and completely alter a current methodology or create a new product rather than merely improve such methodology or product in an incremental fashion. Successful medical device companies are shying away from acquiring nanotechnology companies, because many see nanotechnology as an “expensive, incremental improvement” and do not yet feel threatened enough by their competition to make changes to their current products.[21] Likewise, biotechnology and pharmaceutical companies currently partner with nanotechnology companies rather than engage in outright acquisitions.[22]

By way of illustration, Nantero, Inc., is a nanotechnology company using carbon nanotubes for the development of next-generation semiconductor devices. According to the Nantero web site, “These devices include memory, logic, and other semiconductor products.” In the memory field, Nantero is currently in the process of developing a product by the name of NRAM®, a “high-density nonvolatile Random Access Memory.” The company’s stated objective is to “deliver a product that will replace all existing forms of memory, such as DRAM, SRAM and flash memory, with NRAM® serving as universal memory.” Although a VC may not be willing to invest money and take on the inherent risks of a new technology to realize only a marginal improvement, a more disruptive invention such as NRAM®, which completely replaces all existing forms of memory, may be more attractive to potential investors. In fact, Nantero has raised more than $31 million from investors thus far.[23]

Need to Build Around Markets Rather Than Nanotechnology Itself. The future of VC investment in nanotechnology lies in industries forming around markets (such as health care or the energy sector), rather than around the technology. Nanotechnology is often viewed by VCs as becoming an ingredient to factor into everything one does, rather than a segment in and of itself. Despite the fact that nanotechnology is increasingly integrated into the products around us, the “nanotechnology” category may actually be disappearing, with companies no longer valued merely for being nanotechnology enterprises.

Uncertainties in Intellectual Property Rights. Uncertainties in intellectual property rights create another barrier to VC involvement in nanotechnology. Early nanotechnology patents may have been granted at a time when the U.S. Patent and Trademark Office (the “USPTO”) was struggling with examination procedures in this rapidly developing field. The USPTO’s examination is traditionally accomplished through subject-matter classes, but nanotechnology, often being interdisciplinary in nature, inherently defies such classification systems. As a result, the USPTO may have granted numerous patents with overlapping and conflicting claims, creating thickets that are perhaps not well understood but need to be navigated.

Valley of Death. Another deterrent to VC investment in nanotechnology—and one that may be seen as a key roadblock in the maturing of the nanotech industry—is the “valley of death.” This term was derived from the recognition that the U.S. government is willing to spend money on basic nanotechnology research and that VCs are willing to invest in nanotechnology products once plausible business strategies and strong management teams are assembled. Nevertheless, the period between these two financing sources creates a gap in the capital available to nanotechnology firms. The government has been unwilling to support the research efforts within this gap, and VCs are hesitant to take on the risk that a precommercialization investment may not become a saleable product. This period between capital financing sources has therefore been referred to as the “valley of death,” as a solid lab nanotechnology discovery may “die” at this stage for lack of the funding needed to bring it to market.

Regulatory and Liability Uncertainty. Nanotechnology is a highly evolving, multidisciplinary technology spanning different industries, a fact that has caused the regulation of nanotechnology to become increasingly difficult. Therefore, substantial uncertainty surrounds the regulation of nanotechnology products and their associated risks. Many VCs view nanoscience as a new wave of technology in which ample opportunity exists to invest in companies that could encounter regulatory or similar hurdles that impair or impede commercial success. For example, the government is still in the process of determining how to regulate nanotechnology products in various markets, including nutraceuticals and foods. The continually developing state of environmental regulations, as government agencies attempt to gauge the possible impact of the manufacturing, use, and disposal of nanomaterials, creates further ambiguities about the potential practical difficulties and liabilities that developers of products incorporating nanotechnology may face.

In addition, although limited research has been conducted to date, nanomaterials are conceived to have certain human health risks that could evolve into costly litigation claims.[24] Two specific health risks are as follows: (1) increased mobility: the minute size of nanomaterials may cause such materials to be more easily taken up by the body and transported across biological membranes; and (2) increased reactivity: nanomaterials’ increased surface area may increase reaction with biological tissues.[25] Such product liability claims are currently evaluated on a case-by-case basis, fostering a lack of foreseeability that hampers private investment. Risks such as these, which are not well understood or defined, cannot be quantified, a fact that makes VCs hesitate to become too heavily involved in nanotechnology endeavors. Until the “rules” are known, it is difficult for VCs and companies alike to budget and plan for these risks and factor them into a company valuation. As this list of potential risks shrinks and the variables become known and quantified, VC funding should correspondingly increase.

Difficult Exit Strategies. Difficult exit strategies and a lack of major success stories have deterred some VC investment in nanotechnology. While the current economic downturn has made delayed exits typical for essentially all start-ups at the present time, past statistics indicate that, even apart from the existing crisis, nanotechnology investment projects often have twice the exit time frame that VCs usually anticipate for investments in technology areas. Most VCs expect to exit their investments in approximately six years. Nanotechnology companies are not hitting this target. Of the 66 nanotechnology start-ups that received their first institutional VC funding in 2001 or earlier, 58 percent continue to operate. Lux Research states that of 171 venture-backed nanotech start-ups funded since 1995, only 18 had reached successful exit through an initial public offering or acquisition by 2006.[26] The extension in the time required for products to reach market may be attributed in part to the regulatory scrutiny for some nanotech-based applications.[27]

The above difficulties have contributed to a downward trend in VC investment in nanotechnology over the last few years. Yet while overall VC backing of nano-initiatives has diminished, it has not disappeared. In fact, investment in nano-driven health care and life sciences increased in 2009 at the same rate that overall nanotech venture capital dropped (i.e., 42 percent).[28] Health care and life sciences attracted $404 million in VC financing in 2009, and those areas are likely to spearhead VC investments in nanotechnology for the near future, while transactions in the manufacturing/materials and energy/environment sectors deteriorated in 2009 by 78 percent and 69 percent, respectively.[29] A gradual reduction in the above-mentioned barriers should aid VC investment in these and other market sectors.

Reducing Barriers to VC Investment in Nanotechnology

Despite the inherent complexities surrounding VC investment in nanotechnology, the downward trend may begin to reverse itself if some of the current barriers are lowered or eliminated. Both nanotechnology start-ups and VCs can take actions that will help break down these barriers.

Cast a Wide Net. Nanotechnology companies should cast a wide and creatively crafted net to secure bridge financing. Seed capital may be available from government-supported private sources, such as organizations that provide capital investments, business expertise, growth services, customized company formation, and other resources to high-potential companies with likelihood for regional economic impact (e.g., Innovation Works, JumpStart Inc., and the Pittsburgh Life Sciences Greenhouse). As nanotechnology companies grow and become successful, the executives and entrepreneurs in those companies will have money to invest and will become natural angel investors. These investors can then work to bridge the gap between government and VC funding.

Create an Attractive Business Plan. Nanotechnology start-ups must also focus on making investment in their companies appear as attractive as possible to prospective funding sources. To accomplish this goal, nanotechnology companies should develop concrete business plans and realistic and advantageous exit strategies (i.e., an eventual sale or public offering) to draw VCs to the negotiating table. When developing business strategies, emphasis should be placed on the technology’s disruptive nature and characteristics, providing a window that helps investors envision the technology’s potential. Companies should focus on why a particular product meets a market’s need, rather than just emphasizing the fact that it employs nanotechnology. Furthermore, companies utilizing nanotechnology should make it a priority to hire individuals experienced in building and growing businesses. Recruitment of a talented and seasoned management team that has a proven history of taking developed technology commercial should be a central objective.

Become as Educated as Possible. In addition to the above recommended actions for nanotechnology start-ups, VCs can take ownership of and responsibility for the removal of the barriers hindering their investment in the world of nanotechnology. First, VCs can focus on continuing to avail themselves of experts in this field by staffing and matching their firms with people who have strong nanotechnology backgrounds. The increased understanding gained by these efforts may make it less likely for VCs to be caught off guard by certain unique characteristics of nanotechnology investment, such as the difficult exit strategies and regulatory uncertainty.

Take a Nano-Company Under Your Wing. Second, if a VC begins discussions regarding investment with a nanotechnology start-up, the firm should consider opportunities for “mentoring” the organization through the financing maze when either foreseen or unforeseen complications arise. Private investors are valuable resources that have the unique ability to partner with a company and a company’s management. For example, if a nanotechnology start-up has produced a solid product but the VC sees weaknesses in either the company’s business strategy or another area, the firm could use its expertise to work with the company’s management to make the necessary modifications to the business strategy and address issues hindering growth.

Support Government Initiatives. Finally, as government regulations become clearer and the market as a whole becomes more accepting of nanotechnology, an understanding of the risks surrounding its uses will bring reassurance to those seeking to invest in its future. In January 2010, two legislators introduced a bill that would create an FDA program to assess the potential health and safety effects of nanotechnology ingredients in various consumer products. Termed the “Nanotechnology Safety Act of 2010” (the “Bill”), the Bill would create a program for the scientific investigation of nanoscale materials included or intended for inclusion in FDA-regulated products. The program would address the potential toxicology of nanomaterials, as well as the effects of nanomaterials on and the interactions of nanomaterials with biological systems. Specifically, the Bill would charge the FDA with assessing scientific literature and data on general nanoscale-material interactions with biological systems and on specific nanoscale materials of concern to the FDA. The FDA would then collect, synthesize, interpret, and disseminate its findings. Legislation like the Bill may eventually assist in alleviating uncertainties inherent in nanoscience.

Conclusion

Despite the barriers facing private investment in nanotechnology, the combined efforts of nanotechnology start-ups, VCs, and government initiatives may begin to break down and eliminate such obstacles. Furthermore, as VCs are more able to quantify and qualify the benefits and risks associated with investment in businesses utilizing nanoscience, private funding for this tiny technology could be enormous.