Rd Partnerships Come Of Age

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Venture capitalist Charles Kokesh, whose Technology Funding Inc. of San Bruno, Calif., has been writing R&D deals for three years, shares the enthusiasm. "The R&D limited partnership is an incredibly powerful and flexible tool. Within the next four or five years," he predicts, "it will become a normal part of the financing tool kit of most high-tech chief executive officers."

But Kokesh sounds the warning that not all developing products should be funded this way. For one thing, if the deal is not carefully entered into by the sponsor company or entrepreneur, the net received might not be so cheap after all. An outside general partner is apt to rake 20% off the top, leaving only 80% for the company to spend, but 100% to pay back to the investors. Moreover, says Kokesh, very few manufactured products can withstand a 10% royalty rate -- not uncommon in today's market. Kokesh insists that if the gross margin of profit isn't at least 45%, it should not be funded through a royalty-based limited partnership. Further, if a product saddled with large royalties and small margins has to compete with another, unfettered, product in the same company for promotion and advertising, it most likely won't get them.

Unless the various provisions of a deal are structured unassailably, a sponsor company can get itself into deep trouble. One such instance involves a medical electronics manufacturer that was inadvertently done in by the SEC. In 1979, the company entered into an R&D deal that provided for stock payout in lieu of royalties. Two years later, when the company filed an S-1 prefatory to new equity financing, the SEC asked for more information about the partnership. After the agency got the details, it ruled that the agreement really constituted a sale of stock, and demanded that it be restated on the company's books. Under the new accounting, its income statement showed a loss. And with a loss on its books, the stock flotation was doomed. Worse yet, when the S-1 offering was postponed, the company's bank withdrew its line of credit, which was contingent on the stock float.

An inventor himself, Boston's John Taplin, the Super Soaper savior, casts a jaundiced eye at some of the big-money R&D deals being executed on the West Coast for high-tech companies. He thinks investors are so mesmerized by the technology mystique that they hand over their money like robotic sheep. "People who put their money into the Trilogy deal to build a supercomputer are taking more of a flyer than the people who invested in the Super Soaper," Taplin asserts. "Just because it's high-tech doesn't mean they'll end up with a marketable product." Indeed, some analysts of big high-tech R&D financing anticipate that such companies might relegate their more questionable product lines to R&D partnerships, while keeping predictably profitable projects for themselves.

Taplin, of the Taplin & Montle Development Fund, finds that certain entrepreneurs don't need the hefty sums that venture capitalists insist they take. Rather than inflate the requirements to take in the half-million dollars that Michael Kennedy, the dog washer's inventor, was initially offered through a venture firm, Kennedy brought Taplin & Montle a 48-page business plan he had prepared. The financiers were impressed, and matched Kennedy with some interested partners. Thus Kennedy proceeded without a hitch -- and without giving away any business ownership. (He since has raised another $50,000 through an equity placement with friends.) Of the 17 area banks that had turned him down, Kennedy only remarks, "The banks in Boston are too conservative."

Taplin & Montle represent what might be called the unglamorous path that some R&D partnership financings have taken. As unlikely as the products they're considering -- a reclosable bag for potato chips, a higher-protein-yielding bean -- may strike technocrats, their trend is definitely up as well. In 1981, Taplin & Montle arranged 2 deals for a total of $350,000. In 1982, they expect to enter into 10 more deals totaling $2.5 million.

While a properly constructed research and development limited partnership can be what statisticians term a win/win situation -- and at the same time foster jobs and productivity in the overall economy -- a carelessly done arrangement can end up with both sides losing. Investors must be alert to possible tax complications even if there is no leveraging involved. The IRS is currently examining 1,800 tax returns claiming R&D partnership deductions. A number of deductions have been disallowed "because it is obvious that the money was not being used to develop anything new," an IRS spokesperson reports. "We call this reinventing the wheel." Tax accountants recommend that the sponsor company keep detailed records so that R&D expenses can be substantiated. And the IRS, as well as the SEC, may look askance on certain prearranged buy-back provisions, and may require that the income realized from them be treated as ordinary income, rather than capital gains. For these and other areas, such as stock option conversion, it's hard to tell how tolerant the IRS will remain. The most sensible precaution for an investor in this regard is that he have a sharp tax adviser.

Most partnership analysts, however, point out that the best investor protection comes from focusing on the merits of the project itself, rather than its taxsheltering aspects. Since R&D deals invariably are more complicated than, say, initial public offerings, an investor should read the prospectus all the more carefully, should thoroughly investigate the risks involved, and should assure him- or herself that the general partner (an independent, rather than sponsor-affiliated, general partner is preferable in this regard) has carefully appraised the prospects for success.

Despite proliferating precautions, the formula for a foolproof R&D deal from either side of the aisle has yet to be discovered. For both, the sagest piece of advice comes from Kokesh: If you don't know what you're doing, don't do it.

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