Tuesday, July 22, 2008

50% of Money Invested in Venture Capital is Lost: The Right Patent Analytics Can Improve These Odds

According to this article by Arlene Jacobius in Pension and Investments Online, 50% of all investment in venture capital is a loss. This article, which is based upon separate research projects by a Chicago Graduate School of Business professor and a former Chief Economist at the SEC, indicates that the actual return on venture capital investment is not much different from the average annualized returns on the smallest NASDAQ stocks. In particular, the return on venture capital investment from 1987 to 2001 in these smallest stocks was 62% as compared to the 59% mean return of venture capital funds. This 59% value certainly does not reflect the investing public's general perception that venture capital return on investment markedly outweighs what one can obtain on the stock market. And, it is this apparently erroneous assumption of perceived higher return that presumably justifies the risks associated with venture capital investment by the public. Investor perception certainly does not match investment reality for venture capital.

Why this disconnect between perception and reality on venture capital returns? Professor Cochrane, the Chicago GSB professor, posits that, in effect, traditional methods of measuring venture capital return do not take into account the fact that ventures that are a total loss disappear and are not measured. Because these losing ventures are not around to be measured for calculation of rate of returns, Professor Cochrane states that this survivor bias significantly skews the rates of return on venture capital. His simple explanation of the effect of these missing numbers is telling (quoting from the Jacobius article): "They collect the returns for everybody that is around," he said. "It is like collecting data from everyone still in the casino: They're not asking the people on the bus … who are on their way home."

From the Jacobius article, it appears that there is much room for improvement in venture capital investment decision-making. As an IP Business Strategist and Consultant (more info here: http://www.jackiehutter.com/), I am a strong advocate of using knowledge and information to reduce risk and improve the rate of return on investment. I have written about such concepts in this blog (link: http://tinyurl.com/supercrunchers) where I discussed the "Super Crunchers" concept. I firmly believe that venture capitalists, and those who include venture capital in their investment portfolios, can improve their the quality of their investment decisions by collecting and analyzing available information available in published patent data.

When one knows how to extract and analyze the right data in patents, significant business insights are effectively "hiding in plain sight." In short, valuable business information is available for the taking by smart investors. And, why wouldn't you seek to gain knowledge that could reduce the strategic uncertainty of your investment decisions to better manage the risk of your decisions? (I have discussed this concept in detail http://ipstrategyformaximumassetvalue).

In particular, before you invest in a new business idea for a new venture, why wouldn't you want to know whether you can own the business idea in the long term or whether you have minimal opportunity to innovate freely in relation to that business idea? Or, why wouldn't you want to know whether another firm has invested $100K or more in patent rights alone in the new business idea that you are investigating? This, and other, valuable business insights and information are embedded in published patent filings.

However, it is not enough to collect and graph published patent data to obtain insights that will improve the odds that you will make the right venture capital investment decisions. Rather, specific business-focused data collection and analysis methodology is necessary for successful utilization of patent data for investment decisions. In my experience as an actual purchaser of patent analytics costing upwards of $20K per business question, I found that those collecting and analyzing the data had no basic understanding of the business question that my company needed answered. As such, the products of these patent analytics providers were effectively useless to answer our business team's investment and innovation questions. I learned an expensive lesson about patent analytics: the data collection must be based upon the right foundation for the results to have any value. Put another way, with patent analytics it is "garbage in, garbage out."

In the context of venture capital investment, information is undoubtedly power that can fuel your decision-making process. But before you spend good money on patent analytics to improve the odds of your venture capital investment decisions, you must ensure that the data and insights you obtain are based upon methodology that extracts business insights from patent filings. Selection of the wrong methodology could be worse than not conducting patent analytics at all because your investment decisions could be influenced by information that provides the wrong business conclusions. Only those methodologies that are founded on methodology that extracts the business purpose from patent filings can provide you with investment-grade insights from patent filings.

For more information on what methodologies will give you the right information, contact me at jackiehutter@gmail.com

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