Nightmares, Delicate Machines & Strange Zoos; Of Keynes, Darwin & Cato

Our new issue comes out next week with exclusive sit-downs with iconic

inventor Dean Kamen, ex-McKinsey veteran and innovation luminary Dick

Foster and Lux Research President Matthew Nordan. Their words are

breadcrumbs. Follow the clues...

Today, we'll follow the rational clues of Keynes, Darwin and Cato. And

then next week stay tuned for I will-unable to resist railing against

the foolhardy futility of prioritizing global warming as direr than

cancer, heart disease, AIDS or alzheimers-share two of the most elegant

and persuasive arguments I've heard yet on why curbing carbon isn't

worth the cost.

First some thoughts on time. The more time until a hoped-for-event

occurs, the more chance it won't happen. Or inversely the more chance

the undesired event does. When a target is in your sight, do everything

you can to seize it, for it can quickly flee your scope. Time is the

marshall of Murphy's Law; it paves detours to the undesired; it's a

bedfellow of uncertainty; an inept shepherd of the sought; an agent of

entropy and an enemy of the anxious.

Now for some soothsaying sages who are unusually un-anxious. Following

Warren Buffett's style, Bill Gates released his first annual letter this

week. Buffett passed Gates a quote from John Maynard Keynes on the

current environment. It said this:

"This is a nightmare, which will pass away with the morning. For the

resources of nature and men's devices are just as fertile and productive

as they were. The rate of our progress towards solving the material

problems of life is not less rapid. We are as capable as before of

affording for everyone a high standard of life-high, I mean, compared

with, say, twenty years ago-and will soon learn to afford a standard

higher still. We were not previously deceived. But today we have

involved ourselves in a colossal muddle, having blundered in the control

of a delicate machine, the working of which we do not understand. The

result is that our possibilities of wealth may run to waste for a

time-perhaps for a long time."

Meanwhile, on a similarly delicate machine-the human mind-and the animal

spirits swirling in us social primates which caused the current crisis,

professor Paul Seabright, says "If Darwin had been around to reflect on

the financial crisis, he might have reminded us, in his diffident way,

to think of human beings not as inadequate calculating machines, but as

remarkably well-adapted apes. As group living primates, they are

intensely competitive, alert to the narcissism of tiny differences in

status, navigating their social life through coalition formation.

The way to get ahead is to join powerful groups. The key to social life

is not unfettered competition, nor universal cooperation, but a subtle

mix of the two: competing fiercely to join up with the most attractive

cooperators. And the cognitive capacities they deploy involve a capacity

for strategic reasoning of the second, third, even the fourth degree.

You have to be impressed how well they have adapted to life in the wild.

The problem is that many primates do not adapt well to life in zoos, and

Wall Street is the biggest and strangest zoo of them all. It presents

our large primate brain with vast challenges, of which the greatest has

been solving strategic reasoning of the thousandth degree.

Faced with evidence that a housing boom can't continue forever, we do

not unravel it back to the beginning but try to ride the boom till the

very end, to do just a little better than the very best of the others.

Those differences in status, you see.....Though Darwin's name is often

wrongly associated with admiration for the outcomes of natural

selection, the man who wrote "what a book a devil's chaplain might write

on the clumsy, wasteful, blundering, low, and horribly cruel work of

nature!" would doubtless have been less than surprised at the kinds of

terrible games Homo sapiens gets up to when he spends too much of his

time in the zoo."

One advocate of avoiding the zoo as much as possible has been Vanguard

fund founder and advocate of indexing, John Bogle. John recently said,

"We can't say that we haven't been warned about the perils of ignoring

the past. More than 2,000 years ago, the Roman orator Cato noted that,

'there must be a vast fund of stupidity in human nature, or else men

would not be caught as they are, a thousand times over, by the same

snares . . . while they yet remember their past misfortunes, they go on

to court and encourage the causes to what they were owing, and which

will again produce them.'"

Have a great weekend and enjoy the Super Bowl.

Dean Kamen, More Adjacently Possible, & More Peter Hebert

Stay tuned for my upcoming interview with all-star inventor Dean Kamen and which two dead inventors he'd love to spend the day with and what he thinks is the single most important problem that needs to be solved today.

Meanwhile: I have a few interesting anecdotes that readers sent in on my column on "the adjacent possible"-when some stuff (whether in nature or business or science) might randomly get invented (either by accident or byproduct of an original intent) and that stuff might have an attribute that has absolutely no apparent use, you can't even predict a use way into the future for it. But then lo and behold, sometime in the future, something happens and suddenly a use for that attribute, by itself or in combination with another thing, gets discovered.

One friend writes: "A wonderful example of this is G.H. Hardy, an early 20th century mathematician. Hardy was concerned about the potentially negative uses of mathematics, so he set out to work only on mathematical problems that were totally useless. He wrote a great little book (really a short essay) called A Mathematician's Apology in about 1940, in which he argued that there are no "noble" professions precisely because of what you noted above: you may think you're doing good, but someone can come along and turn your work to evil purposes. (This was at the start of the Second World War, and Hardy was a pacifist.) So he sought to pursue pure mathematics just for the joy of it (and the book is a wonderful insight into that way of thinking). The irony of his life is that his "useless" work in obscure number theory and random numbers has found application in cryptography and encryption."

Another friend sent me an excerpt from an interview with David Morse, SVP at Corning research:

"....Technology invention and innovation is always successful in that it creates new science and new opportunities, but the value may not be recognized until later. We have technologies that were invented and then "shelved" because the application was not clear, or the initial applications were not yet significant to a particular industry.

One example of such an innovation is our proprietary fusion process for manufacturing liquid crystal display (LCD) glass. Corning originally developed this process in 1964 as a means of making thin glass that did not need to be polished or ground, which was dubbed the "fusion process." It was intended for the making of windshield glass or other flat-glass markets.

Decades later, the fusion process was further developed to yield LCD substrates, first for notebook computers and computer monitors and then for flat-panel LCD televisions everywhere. This originally "shelved" innovation has since made our Display Technologies division one of the largest of Corning's businesses today."

Finally as we go into the weekend, enjoy more from my Lux Capital partner Peter Hébert, asking "Why Don't Innovative VCs Innovate?"

"...For a group priding itself on identifying, nurturing and commercializing innovation, it's ironic that the venture capital industry resides in the relative backcountry of financial innovation.

Considering all of modern finance's experimentation and ingenuity (for better and worse), today's basic VC model has remained untouched for over a quarter century. It's as if 18th century traders swapping shares under a New York buttonwood tree agreed, "This is the future of finance."

Why is it that the same investors obsessed with change and the next best thing haven't applied their considerable talents to their own craft? For decades, this inefficiency was prized by a clubby VC industry as a competitive moat, keeping newcomers out and quietly maintaining a lucrative profession to fund vineyards and Gulfstream jets.

But I need not tell you that all isn't well in venture capital. This isn't another "VC model is broken" story. It is, however, an assertion that "We VCs need to reinvent the model."

Journalists are only now scratching away at the VC veneer to reveal what industry insiders have privately lamented for some time-the asset class has not returned money to its limited partners in nearly a decade. Forbes' recent skewering is just the start of a media BBQ.

Yes, there may be lots of turkeys in venture portfolios, but meager VC returns are the symptom of a systemic issue. Venture investors require alternate paths to interim liquidity for their 10-year fund structure to make rational sense.

The fact that great venture firms operating according to plan-partner with the best entrepreneurs, build great companies-are still finding themselves unable to realize value creation, exposes the critical flaw in the venture model.

The answer isn't passively "waiting for the IPO window to re-open." Rather than pine for the salad days of tech offerings led by Robbie Stephens, Montgomery, H&Q and Alex.Brown, it must be accepted that the world has changed. Surely the collective intellectual horsepower and sheer will of the venture capital industry can develop a systematic solution. Where to start?

VCs are always trying to catch the current-but they missed the wave. The wave of financial innovation over the last 25 years transformed nearly every facet of financial services, from exchanges to student loans. But it entirely bypassed the venture capital industry. It might seem like a peculiar time to extol any virtues of financial engineering. While the current market crisis reveals many of securitization's downsides, it also exposes the detriment of not having a market capable of providing efficient and structural liquidity for its participants.

As an industry, we should work with large capital markets players (with great self-interest of their own) to build a more sophisticated system that addresses the needs of all participants-not just VCs, but entrepreneurs and LPs. A system that incentivizes and rewards early investors and shareholders for risks taken, allows for orderly interim exits and enables different types of investors to participate in the various stages of a company's development.

Secondary funds like Coller, Lexington and W Capital are a valuable part of the ecosystem, but VCs should aim for a more comprehensive solution. Other innovative ideas like the Series FF shares developed by the Founder's Fund, allowing for partial liquidation by early entrepreneurs, is the kind of creative approach that should be embraced. Goldman Sachs' exchange-based effort to modernize private equity-the Goldman Sachs Tradable Unregistered Equity-seems the most intuitive answer, but appears to be more focused on traditional PE rather than VC.

We should not undermine what makes venture capital unique-but instead reimagine the method by which we finance early-stage companies and harvest investments. It's time to put our collective fates back in our own hands, rather than remain at the whim of a fickle and ever-more elusive IPO market."

Peter is a Co-Founder and Managing Partner of Lux Capital, focusing on investments in advanced materials and energy. In 2003, Peter led the spin-off of Lux Research.

Guest Column: Peter Hebert on Cleantech & VC

Proud to have my Lux Capital partner Peter Hébert provide a guest column this week. His insights on cleantech and VC must be heeded. Enjoy!

To paraphrase Warren Buffett: As prices fall, a huge amount of financial folly is exposed. You only learn who's been swimming naked when the tide goes out - and the financial shrinkage we're witnessing is uglier than George Constanza's worst nightmare.

It was in 2007 that adjustable-rate, subprime mortgages issued during the boom years began resetting to higher interest rates. During prior years, cheap capital from no-money-down Option ARMs (adjustable rate mortgages) helped flood the housing market with new buyers and pushed prices vertical. But when rate resets dramatically increased the cost of capital, buyers defaulted and home prices fell or were foreclosed.

I believe 2009 will bring a rate-reset for the cleantech investment sector (albeit, nothing close to the same scale!). When the cost of capital is low, investment dollars abound and valuations skyrocket. Too bad the process works in reverse too. Or as recent analysis from Lux Research (full disclosure: Lux Capital is an investor) summarized it, "The current bonanza in which all players are winners will come to an end."

If resetting the cost of capital pricked the real estate bubble, I expect cleantech's coming 2009 reset in this financing tundra to force scores of flimsy companies out of business, cause investors to realize losses, and significantly reduce unrealized IRRs.

Over the past few years, VCs and angels funded far too many undifferentiated business plans in a race to get "exposure" to cleantech. Solar, Biofuels, Wind. Touting cleantech credibility to their LPs left some VC portfolios with more "plays" than Bill Belichick on Sunday morning. Lux Research counted more than 1,500 start-ups operating in cleantech worldwide. All ventures had one thing in common-the cost of capital was far too low. This enabled turkeys to fly and hundreds of competitive imitators to gain funding, driving down long-term returns for all participants. But 2009 will see many of these companies return to the market for financings, to get to commercial scale or in many cases, just to survive the storm. It won't be pretty.

Value Trap

In my March 2008 post Something's Gotta Give, I said "I do not believe the disconnect between public and private prices can last much longer. Watch for a downturn in valuations for later stage VC deals when new market realities finally sink in."

Throughout 2008, as credit markets rumbled before the coming quake, VC-backed cleantech companies raised billions of dollars at valuations that increasingly departed from public equity comps. While blue chip shares plummeted by upwards of 75%, privately held solar companies with nary a dime of revenue, closed multi-hundred million dollar rounds with valuations pegged in the billions (yes, BILLIONS) of dollars. I know at least 3 private solar companies with post-money valuations over $1B-and dozens of other no/low-revenue solar, biofuel and battery ventures with values pegged in the hundreds of millions. Pity those late stage investors who bought the dream scenario and no margin of safety.

Why is tapping into a cheap cost of capital a bad thing? It's not-until the company seeks its next financing or a liquidity event. Later stage energy companies are capital vacuums. But the project finance well is dry and the cost of capital has surged. The need for money has forced punishing cram-down financings-for those still fortunate to receive fresh money. The resets are not just in price, but expectations. Most business plans I see still quote comps and commodities with pre-September 2008 prices. It's with no small irony that many of the private cleantech valuations now dwarf the prospective buyers mentioned in their pitch decks!

Stuck With You

While a 50% haircut on a subsequent round might still leave some early VCs in the black, it will be a hard pill to swallow for the later stage investors who signed up for what they were told were pre-IPO prices. During the cleantech boom, many early-stage VCs embraced two types of late stage investors willing to price up their earlier rounds by as much as 10x. On the one hand, the ultra-aggressive (and impatient) hedge funds and investment banks who adopted the "your price, my terms" philosophy. And on the other hand, bundler bankers who assembled less sophisticated doctors and dentists-perhaps under their own anesthesia, they were just happy to be there, much less negotiate the price they paid. The goal was seemingly: price the round up, take the company public and everyone wins. But now companies and their VC backers are stuck with both types of venture visitors...with no end in sight. Early investors should consider themselves lucky if the hedge funds or lenders do not take the keys to the company-and remain wary about lawsuits from individual investors who might feel they were sold a bad bill of goods.

The only sure thing: re-pricings will turn back the clock on paper profits (and IRRs) and require funds to choose: ante-up or get washed out.

The Opportunity

The irony: in spite of all of this, I could not be more excited about investing today in energy and environmental technologies.

Sure, the market stinks-but company valuations will at last approach levels at which investors can earn attractive risk-adjusted returns. The thinning of the herd will also separate the serious companies with scalable technologies from the pretenders. Imagine you had just been offered a $1 million house in Bakersfield, CA and just 12 months later, for the same price, you can get beachfront in Malibu.

The opportunity to apply new technologies to solve critical issues with multi-billion dollar addressable markets has never been riper. Breakthroughs in batteries and utility-scale energy storage, more efficient power electronics, and generation technologies like advanced nuclear and clean coal will yield billion dollar companies.

Bubbles get blown from too much trust and lofty expectations. The same forces that stimulate investment in a sector also leave naïve investors holding the bag. When the punch is flowing, judgment is impaired. A more sober environment is often the best time to invest in creative entrepreneurs to use capital judiciously and build extraordinary companies. I'll toast to that.

Peter is a Co-Founder and Managing Partner of Lux Capital, focusing on investments in advanced materials and energy. In 2003, Peter led the spin-off of Lux Research.

Airbrushing Airwaves & The Adjacent Possible

Happy New Year, Welcome Back.

First off: the “adjacent possible”. Then: “airbrushing airwaves”.

For many years in this column I’ve applauded and espoused Nassim Taleb’s philosophy (as put forth in “Fooled by Randomness” and “The Black Swan”) of not only not knowing what we don’t know, but not knowing (or accepting) that it isn’t possible in many instances to know the future. We mistake luck for skill and often mistakenly attribute success to genius when it’s mere luck.

Being pattern-seeking mammals (remember: the non-pattern seekers got eaten by tigers, having sat still when the bushes rustled), we’re uncomfortable processing randomness. We look at puffs of clouds and see faces and animals. We’re hardwired for it. We can’t help ourselves.

Now I bring to you another idea that I consider as important. It’s from complexity theorist and physicist Stuart Kauffman and it’s called “the adjacent possible.” In my words it’s this: Stuff happens. That stuff might be useless. Until it isn’t.

In longer form: Some stuff (whether in nature or business or science) might randomly get invented (either by accident or byproduct of an original intent) and that stuff might have an attribute that has absolutely no apparent use, you can’t even predict a use way into the future for it. But then lo and behold, sometime in the future, something happens and suddenly a use for that attribute, by itself or in combination with another thing, gets discovered.

Some of you immediately are thinking: Ah, it’s evolution! Random mutation and natural selection. And that’s true. But it’s more than that. The idea of the “adjacent possible” is about the possibility space of all the things that might happen as some new biological trait, technology feature, molecule have pathways that might one day be taken.

Here’s Stuart Kauffman in his own words:

“You might look at a heart and ask, what is its function? Darwin would answer that the function of the heart is to pump blood, and that's true—it's the cause for which the heart was selected. However, your heart also makes sounds, which is not the function of your heart. This leads us to the easy but puzzling conclusion that the function of a part of an organism is a subset of its causal consequences, meaning that to analyze the function of a part of an organism you need to know the whole organism and its environment. That's the easy part; there's an inalienable holism about organisms.

“But here's the strange part: Darwin talked about pre-adaptations, by which he meant a causal consequence of a part of an organism that might turn out to be useful in some funny environment and therefore be selected. The story of Gertrude the flying squirrel illustrates this: About 63 million years ago there was an incredibly ugly squirrel that had flaps of skin connecting her wrists to her ankles. She was so ugly that none of her squirrel colleagues would play or mate with her, so one day she was eating lunch all alone in a magnolia tree. There was an owl named Bertha in the neighboring pine tree, and Bertha took a look at Gertrude and thought, "Lunch!" and came flashing down out of the sunlight with her claws extended. Gertrude was very scared and she jumped out of the magnolia tree and, surprised, she flew! She escaped from the befuddled Bertha, landed, and became a heroine to her clan. She was married in a civil ceremony a month later to a very handsome squirrel, and because the gene for the flaps of skin was Mendelian dominant, all of their kids had the same flaps. That's roughly why we now have flying squirrels.

“The question is, could one have said ahead of time that Gertrude's flaps could function as wings? Well, maybe. Could we say that some molecular mutation in a bacterium that allows it to pick up calcium currents, thereby allowing it to detect a paramecium in its vicinity and to escape the paramecium, could function as a paramecium-detector? No. Knowing what a Darwinian pre adaptation is, do you think that we could say ahead of time, what all possible Darwinian pre adaptations are? No, we can't. That means that we don't know what the configuration space of the biosphere is.”

The more tinkering society does, the better the chance that someone else will pick up that tinkered thing and run with it in a way never imagined. Kevin Kelly founder of WIRED has made a persuasive argument that there’s a moral imperative to invent. Consider if the piano hadn’t been invented by the time of Mozart. Consider if organized basketball leagues hadn’t been invented before Michael Jordan. Or what if the PC hadn’t been invented before Bill Gates? The more “instruments” we invent, the better the odds that a genius picks one up, tweaks it or masters it and carries it further, advancing society.

Sometimes the uses of an instrument end up being even more useful in a completely different field. Someone recently shared with me how a geophysicist used sound waves to map oil wells in the 1990s. A singer friend new this geophysicist was an expert with sounds waves and asked him to tune her singing. Not only did it work, it worked so well, the music industry has now been secretly using it for a decade, it’s called “AutoTune”. Cher's hit song "Believe", Madonna's "Music", current rap star T-Pain. The pitch for the technology: correct your pitch, or tweak it. What about hip-hop’s mantra of "Keep it real"--yeah, right. It’s now airbrushing the airwaves.

Viewed through the lens of history, you shouldn’t be surprised by this. The history of technology has been one of displaced labor. New jobs are birthed as old ones die. Talent is embedded in technology. And technology gets further embedded in advanced materials. Where the molecules are the device I’ve long called this “Simplexity”.

Consider Hollywood and videogame developers who use CGI. They are eliminating the need for actors (or at least managing egos of live ones). Olympic athletes are stripped of medals for doping and enhancing. Milli Vanilli were fully mocked (one of them attempted suicide) for lip-synching. Will discovery of digital doping lead to stripping Grammy medals? Unfortunately, it’s probably no more likely than false economic ideas will lead to stripping Nobel medals.

As Tom Clancy said, “The difference between fiction and reality? Fiction has to make sense.” Art imitates life. The science fiction of Blade Runner with Replicants now seems a future possibility.

In the music business I can envision lyrical Luddites leading a cultural revolution against the inauthentic and engineered while demanding the analog, true and slightly out of tune. Where will true talent come from? Statistically speaking: Asia. As a case in point: see Charisse, 15 year old Phillipine phenom discovered by Oprah, promoted by David Foster, already doing duets with her own hero, Celine Dion.

A once obscure girl in Asia, with a once randomly invented technology (webcam) on a once obscure website (YouTube), that gets randomly watched by another once obscure woman, Oprah Winfrey. As I always say, we cannot predict the future, we can only invent it.