An Overview of Venture Capital

Venture capital is financial capital invested into high-potential companies. The role of venture capital is to support the entrepreneurial talent that takes basic science and breakthrough ideas to market by building companies. This risk capital ultimately supports some of the most innovative and promising companies—those that have gone on to change existing industries or create new ones altogether (Thompson Reuters, 2011).

Venture capital is a distinct asset class. Venture capital firms, which are professional, institutional capital managers, make investments by purchasing equity in a company. The stock acquired is an illiquid investment that requires the growth of the company for the investors to ultimately reap any potential return. It is this inability of venture capitalists to rapidly enter and exit investments, or “flip” them, that aligns their goals with those of the entrepreneurs. Venture capital is intrinsically a long-term investment (Thompson Reuters, 2011).

Venture capitalists invest out of a fund, a vehicle that deploys capital on behalf of third-party investors. The investors in these funds, called limited partners, are often pension funds, foundations, corporations, endowments, and wealthy individuals, among others. Given the low liquidity associated with their investment into venture capital funds, limited partners expect large returns—better than those in the stock market—from the funds in which they invest. The funds represent a commitment of capital with a fixed life, typically 10 years. The general partner, a group of partners with fiduciary responsibility for the firm with the legal form of a partnership, manages the capital in the fund. The committed capital is called by the general partner from the limited partners to make a portfolio of investments. Ultimately, when investments mature and become liquid, the profits are shared, with the majority going back to the limited partners and the rest shared by the general partner.

Funding provided by venture capitalists typically takes the form of “rounds,” where a given amount of money is invested into a company at a valuation agreed upon between the management and the investors. Prior to an investment, the equity ownership is divided among the founders, management, and others. The valuation sets a share price against which the venture capital firm buys shares. At each round, the earlier investors and management team strive to increase the valuation for the subsequent round(s) of investment. The higher the valuation of a round, the less dilution (reduction in ownership) the existing shareholders take. While each round contemplates a share price that defines a paper value for an investor’s or an employee’s shares, little actual value is created. Only at a sale event or initial public offering do investors and the management team see a tangible financial return, which can take 5–8 years, if not longer.

Venture capital firms statistically see 100 business plans, take a deep look at 10 of these proposals, and invest in one. This process involves an assessment of the management team, the proposed business, its potential to exclude competition, the market being pursued, and how well the opportunity fits with the firm’s goals.

With an investment, a partner will typically get involved with a company by taking a seat on the board of directors, where he or she works closely with the management team on company strategy and growth. The venture capital industry plays an important role in the economy. Companies supported by early venture capital account for 21 percent of the U.S. gross domestic product by revenue, and 11 percent of private-sector jobs despite the fact that fewer than 1,000 new businesses get venture capital funding any given year (National Venture Capital Association, 2009).

A Brief History of the Venture Capital Industry

Venture capital is said to have originated in 1946 with the founding of the first two firms: American Research and Development Corporation (ARDC) and J. H. Whitney & Company (Wilson, 1985). Georges Doriot, referred to as the “father of venture capitalism,” the former dean of Harvard Business School and founder of INSEAD, founded ARDC along with Karl Compton, the former president of MIT, as well as Ralph Flanders (Ante, 2008). ARDC sought to invest in businesses run by soldiers returning from World War II. The firm is most famous for investing $70,000 in Digital Equipment Corporation in 1957—a company that when it had its initial public offering in 1968 was valued at $355 million for a return to ARDC of over 1,200-fold. Employees of ARDC went on to found leading venture funds including Greylock Partners and Flagship Ventures, among others (Kirsner, 2008).

Two major government changes allowed venture capital to emerge as a fully fledged industry. First, the Small Business Investment Act of 1958 enabled the Small Business Administration to license Small Business Investment Companies to help finance and manage small entrepreneurial businesses. Second, in 1978, the Employee Retirement Income Security Act was altered to allow corporate pension funds to invest in venture capital. These two acts together supported the framework for venture capital and facilitated substantial investment in it.

Successes of the venture capital industry in the 1970s and 1980s, with companies including Digital Equipment Corporation, Apple, and Genentech resulting, led to rapid growth of the industry. With rapid growth came diminished returns. In the early 1990s the numbers of firms and managers shrank in response to declining investment performance. At the same time, the more successful firms retrenched, starting a wave of increased returns that began in 1995 and continued through the Internet bubble in 2000 (Metrick, 2007). Once again, with grossly increased returns, the investment into the sector and the number of funds skyrocketed. Beginning in March 2000, the NASDAQ crashed, and many funds suffered from a second contraction.

After the Internet bubble, the funds raised by venture firms shrank substantially. Amounts of committed capital increased through 2005 to a level much less than in 2000, and they remained flat until the economic meltdown in 2008. During the decade from 2000 to 2010, venture capital returns also fell dramatically to the point that the median 10-year return of all U.S. funds was less than the stock market (Thomson Reuters, 2011). These events resulted in another substantial contraction in the industry. The industry is currently responding to this most recent contraction. The number of funds has decreased as the average fund size has risen. This dynamic has caused venture funds to focus on either earlier-stage investments, later-stage investments (similar to private equity), or a combination. Other funds have started focusing on flipping assets by investing before or to induce specific value-creation events. This has created a new environment where only a small number of funds are focused on the earliest stage—that which venture capital is most associated with and most successful at—with several others focused on a more transactional business. This evolution is still in process, but it has been changing the nature of companies that receive investment as well.

At the earliest stage of investments, venture capitalists have returned to investing in outstanding teams and under the assumption that they can create great companies. A number of approaches have been taken to inspire innovation and support a new era of breakthrough companies. Various firms have taken different approaches. CMEA, for example, invests in proven entrepreneurs “pre-napkin” (before the idea), on the belief that they will come up with ideas. Polaris’ Dogpatch Labs has created an environment where multiple entrepreneurs share a common environment and with light money attempt to prove out their concepts. Y Combinator gives entrepreneurs an education and a small amount of money to try out their ideas. Andreessen Horowitz has similarly created an infrastructure to support the earliest stages of companies and to allow them to focus their capital on the company. “Super Angels” such as Peter Thiel have also emerged to provide important early stage funding. Several companies produced from some of these efforts have emerged as important venture-backed companies. Flagship VentureLabs has created an internal infrastructure of serial entrepreneurs to co-iterate its own innovations and use that as a basis to build companies.

Flagship VentureLabs

Flagship VentureLabs was built with a focus on increasing the efficiencies of innovation and entrepreneurship. In the broadest context, both traditional entrepreneurship and venture capital have intrinsic benefits and inefficiencies. Entrepreneurs, for example, typically perform well when capital constrained, but, by the same token, avoid asking critical questions because if an undesirable answer results, they are unemployed. Venture capital has the advantage of large sample sizes and substantial funding, but it is limited in its investments to only those which it can see, and all of its investments must fundamentally go through a common set of efforts (i.e., financial infrastructure, legal, etc.). Fundamentally, Flagship VentureLabs removes the constraints from the typical elements of traditional ecosystems; that is, by harnessing the key constituents and requirements all under one roof, with the common goal of the betterment of humankind through innovation and entrepreneurship.

The focus of Flagship VentureLabs is to develop breakthrough technologies to match large unmet needs in life sciences and sustainability through the vehicle of startup companies. New companies come from a breakthrough innovation without a set utility or from work within Flagship VentureLabs identifying the intersection between the potential for technology solution and market pull. In the former case, a team is nucleated around the technology, including the inventor, to heavily iterate the concept and pressure test it against markets, intellectual property opportunities, team-building potential, and other features with the attempt at nonrationally identifying the “sweet spot.” In certain cases, this process results in the pseudolinear formation of a company focused on commercializing the technology. In others, however, through a progressive set of explorations, the company may end up far from its origins, potentially not including the base technology. In the latter case, the defined intersection creates a hypothesis. If the hypothesis has already been manifest by others in a company or in academia (either singularly or through a combination of efforts), a simple investment may be warranted. In the absence of such a proof point, the concept then goes through heavy conceptual iteration with the attempt to prove the hypothesis wrong, and in the combination of not being able to make it fail and the generation of significant key stakeholder support (including industry and key opinion leaders), a company will be launched. Ultimately, this approach results in taking new ideas and forming companies several years before such an opportunity is likely to be compelling. The following discusses efforts in three such technology-based companies originating from Flagship VentureLabs covering both life sciences and sustainability.

Seres Therapeutics: Rethinking Drug Development

In an effort to reduce side effects, drug development has focused its efforts on target specificity, particularly on features including affinity, low off-target effects, pharmacokinetics, pharmacodynamics, and others. The Human Genome Project and systematic understandings of the functions of kinases have helped to drive this increasing target specificity. Nonetheless, the biology of diseases is complex and multi-factorial. Focusing drugs to single actors may reduce side effects but it also limits the spectrum of efficacy. The growing recognition of the nature of disease is driving the understanding of more complex biology and the development of drugs focused on the multitude of key factors.

One particular example is with the human microbiome. Microorganisms have long been thought of as independently functioning pathogens. Recently, however, the commensal and mutualistic natures of various microorganisms that inhabit the body have started to be characterized (Dethlefsen, 2011). The interactions between the multitude of organisms, as well as between the organisms and the host, play an important role in normal physiology broadly (Reid et al., 2011). Accordingly, disruptions in the microbiome, whether by antibiotics, diet, infection, or other means, can alter the microbiome and induce or simply increase the likelihood of a wide range of diseases, ranging from Clostridium difficile infection and inflammatory bowel disease to obesity and diabetes (Kau et al., 2011).

The complexity of the microbiome, including not only the interrelation between a number of species and the host but also the physical formation of the communities in specific niches (Rickard et al., 2003), is important to take into account when developing therapeutics aimed at diseases where the microbiome plays an important role. Seres Therapeutics was founded specifically to develop drugs based on the complexity of the microbiome. Probiotics and single biologics affect a limited scope of disease and, thus, have limited efficacy in complex diseases such as those involving the microbiome (Shen et al., 2009). By creating synthetic microbiomes aimed at disrupting pathogenic communities, Seres provides a therapeutics means by which a normal microbiome can be restored. Understanding biology and synthetically recapitulating conditions that can recover from a disease-associated insult enables a new class of therapeutics to be designed and developed that are focused on the etiology of underlying disease.

Sustainability

Persistently high fossil fuel prices, increasing dependency on foreign fuel supplies, and insecurity relating to the sources of petroleum have created substantial market pull for alternative solutions in the $6 trillion petrochemical industry. Outside of government-mandated markets, such as ethanol of late, fuels and chemicals are fungible products driven by price and purity, as well as supply and demand. Markets therefore require products with a known utility that meet certain industrial specifications while doing so at a competitive cost point. Consumers have not shown a willingness to pay for benefits such as greenhouse gas mitigation or domestic sourcing, so products made as alternatives must do so while competing head-to-head with the incumbents using the same metrics.

Fuels have traditionally originated from biology in some form or another. Fossil fuels are thought to ultimately derive from processing of ancient biomass through a process that takes millions to hundreds of millions of years. Historically, humans have also found faster cycle time sources of energy, namely the burning of trees for heat and energy, as well as the removal of spermaceti from whales as a source of wax. All of these resources have limited renewal potential and substantial environmental impact (Tertzakian, 2009). Given the central role biology has had in fossil fuels historically, it stands to reason that biology would be well positioned to be at the forefront of the future of sustainable fuels.

Biological engineering has evolved rapidly over the last 50-plus years. Breakthroughs in genomics research, increased genetic manipulation potential, and more complete knowledge of the inner workings of cells have set a stage for cells to be engineered to achieve desired functionalities. Moreover, the time from conception to proof of concept, and that from proof of concept to commercial viability, has reduced substantially. Historically, these periods have decreased threefold every 10 years. Given the technological potential enabled, the market needs can now drive the technological direction, thus leading toward an intersection between market pull and the potential for technology solution.

LS9: Ultraclean Renewable Diesel

In 2005, the U.S. government had built a robust market demand for ethanol by outlining a replacement timeline for methyl tert-butyl ether (MTBE), a fuel oxygenate that had been associated with groundwater contamination and potential increased cancer risks, with ethanol (U.S. Environmental Protection Agency, 2011a). Twelve billion gallons were mandated by 2012, effectively defining a market growth. This mandate was soon supplemented with the renewable fuel standard (RFS), and subsequently RFS2, ultimately requiring 36 billion gallons produced per year by 2022 (U.S. Environmental Protection Agency, 2011b). Corn ethanol was thus given ample runway to launch, and blenders were incorporating biologically based products into fuel nationwide. The intent of the MTBE replacement with ethanol, however, was replacing an oxygenate, not deeming ethanol a fuel. Nonetheless, outspoken investors were enthusiastically supportive of building the future of American renewable fuel on ethanol, asserting that it could be cheaper than and as efficient as petrochemically derived fuels (Khosla, 2006) despite the disadvantaged domestic cost structure and intrinsic lower energy density. The market was becoming well positioned for a viable alternative.

LS9 originated by asking the question, “If you could make any fuel from biology, what would you make?” The ideal fuel to be produced from biology would be diesel, given its high energy density and its use throughout the world as a primary transportation fuel. A market-acceptable biologically produced diesel must compete in a low-cost commodity market without subsidies, requiring an efficient biological pathway and process. Translating these needs into specific technological tasks required that the cell be engineerable to be feedstock agnostic (i.e., able to use any form of sugar), that the most efficient pathway of producing the product was available, that the product was to be made directly and secreted, and that it entailed both straightforward separations (a feature of the product) and no downstream processing (the final product is made by the cell).

Using the defined market constraints, various pathways to produce a straight-chain hydrocarbon were defined and evaluated. The fatty acid biosynthesis pathway not only has exceptionally high energy efficiency at over 90 percent but also produces a molecule that is chemically identical to diesel, requiring potentially fewer biological steps. Fatty acids are activated with coenzyme A (CoA) or acyl carrier protein (ACP) to make fatty acyl-CoA or fatty acyl-ACP (Zhang and Rock, 2008), which serve as the biological precursor products for fuel synthesis. These products are then modified to make a desired end product. The same pathways can be leveraged to make a series of other petrochemicals including fatty acid methyl esters, olefins, fatty alcohols, and others, in addition to alkanes (diesel) (Rude et al., 2011).

The product itself is insufficient for a commercial host and process. The identified market constraints require that the cell chassis has flexibility in feedstock, be optimized to maximize carbon flux to end product, and secrete the end product. Feedstock costs, driven by sugar prices, have risen dramatically over the past 6 years. Alternatives require the liberation of sugar from cellulosic biomass, which is done through exogenous enzymes at present. The expression of hemicellulases into the host already engineered to produce alkanes or other derivatives can enable consolidated bioprocessing, thereby reducing process costs (Magnuson et al., 1993). This is achievable, for example, with the endogenous production of glycosyl hydrolases such as xylanase (Xsa) from Bacteroides ovatus and an endoxylanase catalytic domain (Xyn10B) from Clostridium stercorarium, which together hydrolyze hemicelluloses to xylose, which is usable in E. coli central metabolism (Adelsberger et al., 2004; Steen et al., 2010; Whitehead and Hespell, 1990). Optimizing the host requires focusing the flux of the sugar input through central metabolism to the product. Specifically, fadD and fadE knockouts block the first two steps of the β-oxidation pathway, increasing end-product production three- to fourfold (Steen et al., 2010). Secreting the end product eliminates end-product inhibition and streamlines bioprocessing, thus increasing flux and reducing operating costs by supporting continuous operations (Berry, 2010). Expressing a leaderless version of TesA eliminates end-product inhibition, drives secretion, and notably also positively affects chain length with a natural preference for C14 fatty acids (Cho and Cronan, 1995; Jiang and Cronan, 1994; Steen et al., 2010).

Through this approach, an industrial chassis has been rationally developed to systematically meet commercial needs. By specifically including features necessary to ensure diverse feedstock utility, drop-in product synthesis, and lowest cost processing, LS9’s technology has been designed specifically to drive market pull.

Joule Unlimited: Renewable Solar Fuels

An intrinsic challenge of using a sugar-based feedstock is the price volatility associated with the commodity. Joule Unlimited was founded to develop a platform that could eliminate dependence on sugar feedstocks while still producing fuels in a way that meets market needs. A systematic exploration of sources of carbon that can be routed into central metabolism rapidly identifies photosynthesis, nature’s solution to carbon dioxide assimilation driven by solar energy, as a compelling, though insufficient, pathway. The Department of Energy’s Aquatic Species program, based on explorations of algal biofuels between 1976 and 1996, concluded that photosynthesis could support viable fuel processes, but it requires a set of key innovations to do so (Sheehan et al., 1998; Weyer et al., 2010; Zhu et al., 2008). At the outset of Joule Unlimited, the fundamental limitations of algal fuels were examined and coupled with market needs to design an entirely new and distinct approach, whose only similarity to algae was the use of photosynthesis.

A thorough exploration of market needs identified that an ideal solution would directly produce secreted fungible fuel directly from sunlight and carbon dioxide without a dependency on arable land, freshwater, or other costly reagents, while having a cost that could meet or beat fossil fuel equivalents in the absence of subsidies and at the same time scale modularly such that smaller-scale plants could be used to validate large-scale deployments. The simultaneous technological solution to meet all of these needs demands a genetically tractable cyanobacteria engineered to not need exogenous factors and to produce secreted fuel grown in a modular bioreactor leveraging the two-dimensional scaling of light and incorporating fundamental process needs including proper mixing. A schematic of the Joule Unlimited approach, Helioculture™, is provided in Figure A1-1.

FIGURE A1-1

Schematic of the Joule Unlimited Helioculture systems approach. Specific cyanobacteria are engineered to convert sunlight, CO₂, and nonfreshwater to diesel (or other fuels and chemicals). The engineered organisms are housed within a Solar Converter, a (more...)

Cyanobacteria had previously been engineered to express recombinant proteins, but it had not been systematically engineered on a genome scale owing primarily to a lack of engineering tools (Alvey et al., 2011). A concerted effort using E. coli engineering over 50 years serves as a roadmap of the needs for genome engineering in cyanobacteria. Using these tools coupled with a systemic genome engineering effort allows one to overcome a theoretical maximum light use and net productivity for algal biofuels of ~2,000 gallons per acre per year by enabling photoautotrophs, for the first time, to function like industrialized heterotrophs, whose phases of growth and production are separated (Berry, 2010; Robertson et al., 2011). Systematic re-regulation of central metabolism directs 95 percent of photosynthetic activity to specific product synthesis versus up to 50 percent in un-engineered organisms, allowing for productivity ~95 percent of the light-exposed time through continuous operations versus substantial down time with batch processes, minimizing maintenance energy requirements, and limiting the energy lost to photorespiration.

At the same time, the engineered cells are grown in a reactor system designed to be low cost and linearly scalable. Low-cost product separation, cell mixing, and proper gas transfer to the cells are all incorporated into the reactor design. Coupled together, this systems approach allows for ~12 percent theoretical maximal photonic energy conversion versus 1.5 percent for traditional algal processes (Figure A1-2), which translates to unprecedented areal productivities of 25,000 gallons of ethanol per acre per year or 15,000 gallons of diesel per acre per year.

FIGURE A1-2

A summation of the accumulated photon losses for algal and direct fuel processes, as well as a theoretical maximum photonic energy conversion. The losses are shown through individual contributions accumulated serially and illustrated on a logarithmic (more...)

The high productivities achieved through the Joule Unlimited approach allow for cost points as low as $20/barrel for fungible diesel. Maximizing solar energy capture, carbon dioxide fixation as a replacement for sugar use, and organism productivity creates a system that can be market competitive while providing for the environmental benefits that have been sought in fossil fuel replacements. Specifically, Joule Unlimited’s technology eliminates the need for arable land, requires no freshwater, and reduces life-cycle greenhouse gases by over 90 percent by using carbon dioxide as a feedstock. By coupling the technical needs for a total solution with a market need, Joule Unlimited has uniquely developed a process that can produce a sugar-independent diesel in a highly scalable manner, overcoming the challenges of alternative approaches.

Conclusions

Systematic changes in venture capital have altered the entrepreneurial ecosystem. Flagship VentureLabs is pioneering a new approach of technology development through companies by building technologies that specifically address the intersection between the potential for technology solution with market pull driving invention and innovation toward market needs. The resultant companies are designed by exploring cutting-edge capabilities and iterating against market needs—not just from an evolutionary standpoint, but additionally identifying the true needs of an industry across multiple facets. Synthetic biology is a new and rapidly developing tool that has particular utility in meeting broad-based and distinct market needs, particularly through its ability to create functional modules in a cell-based system. By leveraging the potential of synthetic biology with market-driven needs, Flagship VentureLabs has been able to spearhead a set of breakthrough innovations in both life sciences and sustainability. This approach now takes market potential before traditional research approaches have made for a compelling and investable technology-driven opportunity and, through heavy iteration, can bring it to bear ahead of time through broad-based collaborations with industry and academia. This approach can be broadly leveraged to develop a series of future breakthrough technologies in a variety of important market sectors.

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1

Affiliation: Flagship VentureLabs, Cambridge, MA, USA.

2

Key words: venture capital, biological engineering, synthetic biology, microbiome, diesel, photosynthesis, genome engineering.