Risky business

Government-funded venture capital firms spark agency innovation

Federal agencies that need innovative solutions to their most vexing technical problems have moved into a field once reserved for industry: venture capital (VC) funding. The trend began with In-Q-Tel, a six-year-old private, nonprofit VC firm sponsored by the CIA.

In-Q-Tel invests CIA funds in promising early-stage companies. Those companies develop products for the CIA that also have commercial value. Based on In-Q-Tel’s success, the Army followed suit by forming its own private equity investment outfit. NASA and the Energy Department are also planning firms patterned after In-Q-Tel.

“Who would have thought the words ‘CIA’ and ‘venture capital’ would be used in the same sentence?” said Amit Yoran, In-Q-Tel’s chief executive officer and former director of the Homeland Security Department’s National Cyber Security Division.

Industry leaders say the government trend gained impetus after the 2001 terrorist attacks. Federal leaders realized that the government lacked technologies that it could have used to thwart the attack or fight back. Now the government is trying to remedy that problem by investing in innovative research and development.

“This is a sea change,” said Mark Heesen, president of the National Venture Capital Association (NVCA). In the past, the government had a stranglehold on new information technologies. The R&D arm of the Defense Department — the Defense Advanced Research Projects Agency — gave birth to the network that would become the Internet. NASA put a man on the moon. In the past two decades, however, the federal government has fallen behind industry in terms of R&D spending and achievements, some industry officials and research analysts say.

The 2001 terrorist attacks put the government on notice that the private sector is also a source of innovation, Heesen said. “The private world is innovating at a faster clip than the federal government.”

Adopting the VC model could strengthen the government’s science and technology leadership, Heesen said. Venture capital is money made available for investment in innovative enterprises, especially in technology. It carries the risk of large losses and a potential for big profits. The cycle is long term and does not guarantee a successful product.

Agency officials who are considering the start-up market “have to look at these things from a 10-year perspective, not a two-year perspective,” Heesen said. Losses at the beginning of a new venture do not indicate bad science or research, he added.

Government venture capital brings unique challenges, opportunities

Smaller companies or entrepreneurs that typically avoid government work are more likely to work with agencies through a venture-funding framework, Heesen said. “An In-Q-Tel can open up doors in the huge federal bureaucracy that your individual VC doesn’t know exists,” he added.

In-Q-Tel, which has offices in Arlington, Va., and Menlo Park, Calif., has maintained a solid reputation with portfolio companies, Heesen said. “From a government perspective, it’s important to be very analytical and basically slow-paced in rolling out these federally sponsored VC firms,” he said. “If they are bureaucratic or mediocre, entrepreneurs and VC firms who work alongside the government-sponsored VC fund are going to walk away quickly.”

NASA and DOE — two agencies that have technology transfer activities — are a natural fit for experiments based on the In-Q-Tel model, Heesen said. NASA’s Innovative Partnerships Program fosters collaborations that pair the agency with private enterprise to support technologies applicable to NASA’s mission and the global marketplace.

The Energy Department is another logical area, Heesen said. “As you see energy [sources] running out, and China and India taking a bite out of oil demand…you see a lot of venture capitalists interested in the entire energy field right now.”

In-Q-Tel officials have shared their experiences with other federal officials who are considering that approach to innovation. Yoran said DOE has expressed interest in building an In-Q-Tel-like program, and he has met with department officials.

In-Q-Tel has made dozens of investments in IT companies developing technologies such as search engines, translation tools and software to visualize large datasets.

In 2003, In-Q-Tel invested in a 3-D geospatial visualization tool created by a start-up company called Keyhole. Keyhole was marketing it as a real estate application that potential buyers could use to scope out properties’ surroundings. Within months, the technology was supporting the Pentagon and National Geospatial-Intelligence Agency in the Iraq war.

In October 2004, Google acquired Keyhole, producing financial returns for the government that In-Q-Tel then reinvested in other new technologies.

Internal structure tough to devise

The concept of a government VC firm is still so novel that In-Q-Tel initially had a hard time working out the details of its financial structure, Yoran said. Officials must understand how to structure deals and how the firm will meet the sponsoring agency’s needs. “Those are all challenging,” Yoran said, “and staying aggressive in the market is a challenge.”

Yoran said companies tend to become conservative after their first market success, but In-Q-Tel has avoided that pitfall by taking calculated risks.

VC companies must also avoid the trap of becoming bureaucratic, he said. How? “The short answer is we are not a government organization,” Yoran said. “We make independent decisions. We pride ourselves on independent thought and being nimble. Part of our mission is to stay largely independent and unencumbered by bureaucracy. We look and act to the world as regular venture capitalists.”

In-Q-Tel’s board members include Charles Vest, president emeritus of the Massachusetts Institute of Technology; Howard Cox, a partner at Greylock Venture Capital; and Norman Augustine, former Lockheed Martin chairman and CEO.

In-Q-Tel does not have to be as clandestine as the CIA. Its technologies are unclassified, and its funding approach satisfies financial and national security interests. Yoran likens it to Motorola Ventures, the equity investment arm of Motorola. The firm invests in developing companies that match Motorola’s business strategy.

NASA counts down to its venture capital firm

NASA is in the early phases of building a VC fund after releasing a request for information in February. The fund will legally, organizationally and operationally follow In-Q-Tel’s template, according to the RFI. Based on responses to the RFI, NASA expects to identify a partner to manage the fund this spring. The fund could be operational by summer and begin making initial investments by the end of fiscal 2006.

The working name for the fund is Red Planet Capital, in homage to the agency’s goal to send a manned mission to Mars. Red Planet will invest in early-stage companies that focus on communications and data systems. NASA is interested in improvements to space suits and technologies that can help astronauts maneuver outside a spacecraft. Its other interests include water recycling, reuse and reduction; technologies that can fix hardware onboard; and biomedical support for exploration missions.

NASA has allocated $11 million for VC investments and operations in fiscal 2006. The fund could grow to about $20 million per year. NASA will help strategically guide the fund and offer its assessment of proposed investments. The fund’s manager, however, will make investment decisions.

NASA officials have met with In-Q-Tel officials on several occasions to understand their approach to private equity investment funding. “The decision-making process has to match private-sector timetables,” NASA spokeswoman Melissa Mathews said.

Government keeps traditional role

Although In-Q-Tel and Red Planet demonstrate new ways for the federal government to sponsor innovation, VC-funded research will not replace traditional federal R&D activities. NASA’s RFI states the importance of other federal programs that promote innovation. “Red Planet Capital is not designed to replace existing technology partnership and technology transfer programs but rather on being another innovative mechanism for promoting the future availability of broad-use technologies that meet NASA mission requirements,” the RFI states.

Analysts agree that federal VC funds will not replace traditional R&D budgets. “For targeted areas, [VC firms] can be effective tools,” said Stan Soloway, president of the Professional Services Council. “But we shouldn’t assume that because they exist they [could] replace the government efforts in R&D.”

The government spends about $135 billion a year on research, including $55 billion in basic and applied research, according to the White House’s Office of Science and Technology Policy. Meanwhile, private-sector VC funding reaches about $21 billion annually, according to NVCA. In contrast, the federal government allocates about $20 million to $50 million a year for such funding.

But industry experts applaud the government for using federal venture funds as a shortcut through the government acquisition process. Agencies “are acknowledging that there is a gap between how technological innovation comes to the surface in the commercial world and how it works through the government procurement process,” said Julia Spicer, executive director of the Mid-Atlantic Venture Association. “The effort to go through and identify approaches to get at the gap between the procurement cycle and commercial to-market process is a good thing.”

Army bets on venture capital

The Army is among a handful of agencies funding venture capital firms to develop new technologies.

After the 2001 terrorist attacks, the Defense Department began a venture capital initiative to support the Army’s research and development efforts. The $60 million fund is managed by OnPoint Technologies, which invests in mobile power and energy technologies for soldiers and consumers.

A practical example of such dual-purpose R&D is PowerPrecise Solutions, one of the companies in OnPoint’s portfolio. Its technology for increasing battery life in portable devices could serve soldiers in combat and office workers on business trips.

Jason Rottenberg, managing director of OnPoint, said the Army began acquiring technologies from OnPoint’s portfolio companies last year. The first solution it deployed was PowerPrecise’s battery-charge indicator. Without reliable indicators, soldiers had no way of knowing how much power was left in their battery packs. They would throw away batteries and get new ones before going on a mission rather than risk losing power at a critical moment. In early 2004, Army arsenals were reportedly short on batteries for everything from handheld radios to shoulder-fired missiles because soldiers were discarding them too soon.

“According to the Army, soldiers were basically throwing out the average battery with 50 percent charge left,” Rottenberg said. “How would you feel if your car had no fuel gauge?”

To help save the Army money, OnPoint invested in PowerPrecise, based in Reston, Va. PowerPrecise crafted a semiconductor that can gauge the battery power left in commercial and Army supplies such as power tools and hybrid electric vehicles.

OnPoint faces challenges in persuading companies to undertake projects, however. Start-up companies like PowerPrecise, which strive to reach the mass market, would not normally spend their limited resources developing technologies that will be used by only a few thousand people. “One of the battery companies works closely with Black & Decker, which will buy far more from them than the Army,” Rottenberg said. “But the Army can use the same technology and provide a great test market.”

— Aliya Sternstein

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