Follow the Money

The appetite of venture capitalists for investing in new technologies is rebounding: in 2004, venture capital financing in the United States was up 8 percent from the year before, following three years of decline. With the success of Google’s initial public offering (IPO) in August 2004, technology again excited the public imagination. Indeed, the window on IPOs opened wide in 2004, with 233 companies going public on U.S. stock exchanges and raising $43 billion, up from 79 companies and $16 billion in 2003. Biotechnology IPOs were particularly successful, raising $2.5 billion, the most since the $8.7 billion raised in 2000. So why are many of those involved in the funding of emerging technologies so worried?

According to some experts, the kind of basic research necessary to create tomorrow’s technologies is under siege – or at the very least, suffering from neglect. Venture capitalists never entirely stopped investing in companies with technologies just emerging from the lab. But after several years in which high-risk investments were unpopular, many startups developing innovative technologies (especially in such areas as nanotechnology and new genomic approaches to medicine) are starving for capital. Even more worrisome, the federal government’s preoccupation with funding homeland security and national defense, and its resulting cutbacks in support for basic research in other areas, has left many wondering where the funding for research on new core technologies will come from.

For many in the technology community, the threat of crisis became much more vivid in early December when President Bush signed off on the fiscal year 2005 U.S. federal budget. While this year’s budget increases spending for research and development by 4.8 percent to $132.2 billion, most of that increase – 80 percent – goes to defense R&D, and most of that to new weapons development, according to the American Association for the Advancement of Science (AAAS). In fact, defense-related R&D reached a record high $75 billion this year. One winner was the U.S. Department of Homeland Security, which gets a 19.9 percent increase in its R&D budget, to $1.2 billion. The big loser is the National Science Foundation (NSF), which had its R&D budget cut by .3 percent, to $4.1 billion; it was the first cut in NSF’s budget since 1996. Meanwhile, R&D funding for the National Institutes of Health (NIH) increased by just 1.8 percent to $27.5 billion; it was NIH’s smallest percentage increase in years, and well below the rate of inflation.

“Defense and homeland security are very important. I can’t criticize funding increases per se in those areas,” says Shirley Ann Jackson, president of Rensselaer Polytechnic Institute in New York and the 2004 AAAS president. “But the bigger issue is sustaining focus and support for funding of basic research across broad fronts. We have to have a robust base of basic research. We’re talking about potentially eroding that base.” Jackson adds, “Other places will innovate. The question is, are we going to be a leader? If we don’t pay attention to the warning signs, 15, 20 years from now, we could find ourselves in a relatively disadvantageous position in terms of global leadership.”

Experts also worry that the federal R&D budget has become too skewed toward relatively mature technologies. “A lot of the federal funding has gotten a little more conservative and risk averse. The government needs to put a bigger percentage in radical innovation and more-exploratory research – technology that’s going to be transformational,” says Deborah Wince-Smith, president of the Council on Competitiveness, a group of industry, university, and labor leaders based in Washington, DC. Amar Bose, professor emeritus at MIT and founder of the Bose audio company in Framingham, MA, puts it more bluntly: “Research funding is going downhill, and I don’t see it turning around. We’re going to have trouble.”

The cutbacks in the federal budget are further exacerbated by the continuing trepidation of many venture capitalists. While valuations of later-stage venture-backed startups have begun to bounce back this year, valuations for younger startups have not. In addition, say experts, some venture capitalists are focusing on certain pockets of technology, such as those relevant to homeland security and biodefense, where the focus is more on developing and deploying existing, well-established technologies than on inventing innovative new ones. All of which could have dire consequences for innovative startup companies.

Indeed, the combination of venture capitalists favoring later-stage startups and the continuing trend of large corporations investing less in speculative research is creating an innovation vacuum, according to some experts. “The effects are pretty ghastly,” says Lita Nelsen, director of MIT’s Technology Licensing Office. “Large corporations have become less and less invested in early-stage research. They buy it from little companies. And if there’s nobody to get the little companies started, we’re getting it at both ends.”

Despite these concerns, however, there are encouraging signs that investment in innovative technologies, at least in the private and public markets, began to regain favor last year. In particular, 2004 was a strong year for companies going public; the number of IPOs and the amount of money they raised reached their highest levels since 2000. What’s more, the value of mergers and acquisitions involving venture-backed companies was 76 percent higher than in 2003 – all of which means that venture capitalists once again have the prospect of lucrative exit strategies and the motivation to invest in startup companies. “Despite the disappointments, venture capital is still a way to make enormous riches,” says Josh Lerner, a professor of investment banking at the Harvard Business School.

Technology Review editors Gregory T. Huang, Corie Lok, and David Rotman contributed to this report.