Don't Let ImClone Spoil the VC Party

As I wrote in my column on ImClone and medical devices earlier this week, one of the unrecognised stars in medical innovation is venture capital. To be sure, medical innovation happens at big, established, publicly-traded granddaddy firms. But it also, and increasingly, happens when promising scientists break out on their own and start firms with the targeted aim of bringing their little idea to market.

The inventors' partners in this instance are often venture capital firms, which like the short time horizons that the deals offer. They also reckon that small start-up shops are more efficient than the traditional and often highly bureaucratic research and development departments of corporate giants.

And corporations, through their behaviour, tend to validate the venture capitalists' thesis. Rather than restricting their research outlays to projects within their own corporations, many companies nowadays contract out research to venture capital start-ups, or spend a lot on snatching the projects of start-ups.

Juries and the US Congress are now mulling whether Sam Waksal, ImClone's founder, is guilty of illegal insider trading. But going beyond that, it is important to note that Dr Waksal is in many ways typical of the venture capital culture - he's a scientist with a novel idea, he founded ImClone with the help of venture capital, and he even started a venture capital fund, Scientia. In other words, Mr Waksal is part of the trend.

The cost of harming that trend becomes clear in the work of Josh Lerner, Jacob H Schiff professor at Harvard Business School. In a 2000 paper (www.people.hbs.edu/jlerner/VCInnov.pdf, PDF format) published with Samuel Kortum in the Rand Journal of Economics, Prof Lerner looked at the relationship between patent formation and venture capital. He found that venture capital is associated with a disproportionate number of new ideas in the drugs industry. Indeed, the authors conclude that 'a dollar of venture capital appears to be about three times more potent in stimulating patenting than a dollar of traditional corporate R&D.'

In the decade 1983-1992, for example, venture capital investment amounted to the equivalent of less than 3 per cent of corporate R&D spending. Yet it was responsible for about 8 per cent of relevant US patents in the same period.

Do more patents mean more innovation? Apparently so, according to the same paper. The authors looked at the quality of patents generated in Middlesex County, Massachusetts, aka tech centre 'Route 128', America's Silicon Valley of the East. They found that these patents were indeed valuable ones, measured by the amount they were cited by other patents.

Another index of a patent's economic value is how much legal effort its holders make to defend it. By this measure as well, the heavily defended Route 128 patents gave evidence of being valued. 'This shows they are economically relevant and important', says Mr Lerner. So the conclusion is that venture capital is associated with valuable innovation in the pharmaceutical world.

The paper brings out a third useful point: venture capital is highly dependent on a friendly environment. The US pension law, ERISA, used to make it difficult for pension funds to invest in venture capital firms. Then, in 1979, Congress amended the 'prudent man' rule to allow such investments. This change came, felicitously, at the same moment as a large cut in the US capital gains rate.

The result was the decades-long explosion of venture capital investing in the US. In the 1990s, according to a KPMG survey by David Skanderson, venture capital disbursements increased twentyfold, going from $6.4bn to $125.4bn in 2000. This availability of capital led to medical and technology innovation being driven by the US.

As I write, the heat is turning up on the ImClone investigations. That is all well and good. It would be a shame, though, if such investigations resulted in changes in law that deterred venture capital investment. Even investigation without legal change can be bad, insofar as it has a chilling effect. Let's not throw the VC baby out with the bathwater.

© Copyright 2002 Financial Times

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