Radical Innovation Needs Old-School VC

When did risk capital start playing it so safe?

We currently have an abundance of venture capital for projects that are not that risky, such as platforms and apps that promise to make our lives more convenient. These innovations largely disrupt markets and competition — but don’t disrupt the biggest problems facing humanity. We don’t have enough green energy options, and we lack the technology that could suck enough CO₂ out of the atmosphere to restore the climate’s balance. According to the United Nations, more than 800 million people — a tenth of the global population — are undernourished today. We don’t know how to cope with a growing world population or stop overexploiting natural resources.

The problem is that too many truly radical innovators suffer defeat in innovation’s valley of death: what we call that intermediate point where bootstrapping can’t get them any further, yet it’s hard to get the funds that are vital to further development and scaling. That dry stretch, during which the venture works on proving its concept to investors who want evidence they are making a good bet, is often too long for the venture to survive. In essence, this is a case of capital markets failing to support breakthrough innovations and deep technologies.

This has to change fast. While government has a role to play, so does venture capital. It’s high time for the high rollers in VC to shift from financing the easy digital-asset classes to funding more fundamental scientific and technical advancements.

A return to venture capital’s roots might also promise bigger returns for the risk tolerant. Investments in asset-light companies, such as software-as-a-service providers or platforms, are now significantly riskier than they were in the 2010s because of increasing competition and low levels of innovation. Making a sufficient number of bets no longer works when a company’s valuations get so high that there’s no way its earnings will ever justify them, even if the business continues to grow at a healthy rate. At the same time, there’s a lot of excess money sitting around in the VC system that could and should be invested, but investors are waiting for interesting opportunities.

This money is known as dry powder in industry jargon. Management consultancy Boston Consulting Group (BCG) and French deep-tech think tank Hello Tomorrow estimated in a May 2021 report that the dry powder risk capital held by VC and private equity companies had reached $1.9 trillion. That sum has likely increased significantly since then. Despite interest rates having risen in the last couple of years, it faces extreme inflation risk. Rather than being used to fund the next app or digital gadget that will supposedly make our lives a little easier, dry powder can be invested a lot more intelligently to have a far greater impact on the greater good. The good news is that rethinking — and shifting investment positions — has already begun.

According to the BCG/Hello Tomorrow research, VC investments in deep-tech startups quadrupled to more than $60 billion from 2016 to 2020. A significant part of that growth came from large companies’ corporate VC arms, which invested almost $20 billion in deep-tech startups in 2020. Of the total, the lion’s share — about 80% — went to the areas of synthetic biology, AI, and advanced materials.

Naturally, we don’t want to equate deep-tech investment with breakthrough innovations that will significantly help meet the needs of humanity and advance the UN’s Sustainable Development Goals. But in principle, we consider this asset class and the trends in this market to be a good proxy for how sufficient capital can be made available to science-based startups and carry founders through innovation’s valley of death.

However, even if deep-tech capital reaches $200 billion by 2025, as the study above predicts, that’s only a trickle compared with the trillions that flood into digital and asset-light startups worldwide each year. If all of the stakeholders involved in risk capital financing thought bigger and started making the right changes in the right places in the capital system, a lot more disruptive innovation might be possible.

Increase Deep-Tech Competence of VCs and Private Equity

Deep-tech breakthrough innovators have repeated the same basic story when talking to us about their experiences pitching to VCs: The interest was fundamentally there, but the financing ultimately failed because the decision makers lacked the expertise to assess the technology — and they admitted it. Anyone placing technology bets needs to understand the technology and the development risks associated with it. This is especially true early in the investment cycle, before market data is available.

But we’ve found that teams working at VC funds and private equity firms have, as a rule, been weighted too heavily toward generalists to be able to competently take advantage of the tremendous opportunities offered by truly disruptive technologies. To change this, they need to recruit scientists with an interest in finance to join their analyst teams, and open up the partner track for them. And they need to work with external advisers who aren’t the usual suspects from the tech consulting scene but are active researchers in the field in which the fund hopes to invest.

What makes things more difficult for private equity companies is that “deep tech” is too often equated with “early stage” and thus doesn’t fit into the investment patterns of most private equity firms. This view is already outdated. Numerous deep-tech startups are in the second half of the funding cycle right now. In the years to come, tech-savvy private equity firms will take a closer look at this area. Meanwhile, non-tech-savvy firms are going to miss out on major opportunities for their investors.

Venture capitalists have gotten used to quick wins — or to knowing relatively quickly whether they’ve made a bad investment. If they’re successful, it usually takes no more than seven years from seed financing to exit for software-as-a-service applications, e-commerce, or platform business models in B2C markets. With deep-tech startups, investors have to wait more like 10 to 15 years, and sometimes more, before the ventures actually reshape their markets.

As noted above, corporate innovators are showing encouraging signs of increasing risk intelligence: Major chemical, automotive, engineering, medical technology, pharmaceutical, and infrastructure corporations are rapidly increasing their M&A activity in deep-tech startups. When it’s your own market being disrupted, you really need to be part of the action. Likewise, for family offices, long investment horizons are often less of a deterrent because they’re used to thinking in terms of generations.

Another positive development that’s been discernible for some time is that investment decision makers are increasingly focusing on what’s referred to as the potential life-cycle impact of startups. This means that an investor’s decision isn’t primarily based on whether they can realize a profit after the next round of financing (or take their cut on exit at the latest) but on whether they’re investing in a company that might remain in their portfolio for a very long time. Both corporations and family offices have great potential to radically improve the financing of disruptive innovations.

Venture capitalists who want to make an impact on global problems must learn (or relearn) to take risks — and take closer looks at deep-tech investments aligned with serving humankind in significant and even urgent ways. In the long run, it will pay off for them — and for our collective future. First movers in VC have already realized that in times of technological paradigm shifts, the biggest risk lies in not taking any risks and instead relying on the linear continuation of present trends. Financing radical innovation for a healthier, wealthier, and greener world will be better bets for themselves — and for all of us.