Everybody Into The Pool
In November 1981, Trilogy Systems Corp., a high-technology start-up in Coopertino, Calif., sold research and development limited partnerships totaling $55 million to develop a super silicon chip. Today, the partnership's coffers are empty, the company is scrambling to stay alive, and investors who had bought shares in the partnership have seen their investments go down the drain.
Investors were, to put it midly, in shock. "It's one thing to say you understand the risks going in. It's quite another to actually incur that kind of a loss," says the accountant of an investor who sank $20,000 into the partnership. Needless to say, he adds, "My client is no longer investing in these deals." Neither, it seems, are a great many others.
Investment bankers in California and New York report a sharp drop in R&D limited partnerships. They now predict that the amount of money invested in 1985 could end up being as much as 25% to 50% below 1983's record $806 million. "I wouldn't be at all surprised," says Stephen Evans-Freke, a senior vice-president of PaineWebber Inc., in New York City, "if no more than $300 million in R&D financing is done in all of this year."
The problems can be traced back to such companies as De Lorean Motor Co. and Storage Technology Corp., which sponsored R&D partnerships and then headed straight to Chapter 11. The result has been to make it more difficult for hundreds of small and medium-size hightech companies to finance their research and product development efforts with limited partnerships. R&D proposals will now have to be as solid as the Rock of Gibraltar -- or they simply won't sell.
Much of the blame for this situation can be placed squarely at the feet of investment bankers. They did a demonstrably poor job of screening proposals, and allowed companies to go on with projects that focused too much on basic research and not enough on product development. They oversold the tax benefits. (Usually 80% to 90% of the cost is written off in the first year, and investors are promised aftertax returns of 30% to 40% or more.) And they steered the wrong kind of investors into deals, catering to people who needed tax deductions, rather than high-rolling risk takers. As Fred A. Middleton, president of Morgan Stanley Ventures, in San Francisco, notes, "A lot of people who bought these things didn't know what they were getting into, because they didn't understand the technologies and, therefore, the risks."
But it is also true that companies themselves contributed to the problem by failing to keep investors informed of what was happening with research projects on a regular basis. Consequently, they now face tough questions from investors who want proof, beforehand, that the project is viable. Lee Benton, a Palo Alto, Calif., attorney who specializes in R&D transactions, says investors are demanding to know the qualifications of he individuals who re doing the research, and raising questions about the sponsor's marketing plans and financing. "Is there," asks Benton, "a good chance [that the company is] going to miss a market window?"
Companies will also find that investment bankers now have much stricter criteria for handling research and development deals. They look for established businesses, not start-ups. "For single-company financings, we want sponsoring companies that are leaders in their respective fields," Evans-Freke says. Basic research is efinitely out. "That's the sort of risk that should be taken by the venture capital firms, not by R&D partnerships," Middleton states. "We only want products that will reach commercialization within three years -- that is, those that will e manufactured, marketed, and generating revenues within that period."
Investment bankers are now requiring that formal internal review procedures be included in companies' partnership contracts. The reviews guarantee investors that the plug will be pulled on a venture once its viability is seriously called into question. Although it is difficult to pinpoint exactly when a project is in doubt, Benton warns that companies could face investor lawsuits if they go on with a venture despite evidence that it is in trouble. Nowadays, investment bankers also insist that companies pay attention to investor relations. Project reports should be mailed to investors at least quarterly, explaining both the venture's failures and its successes. Perhaps the biggest change in R&D deals, though, is the shift away from royalty partnerships (which give investors a percentage of the product's profits) to a combination of royalty and equity partnerships (in which investors get a chunk of the company's stock as well). "It is almost impossible," Evans-Freke says, "to do a transaction on a royalty basis without having some sort of equity kicker." This is an unwelcome development for some companies that might prefer royalty deals, but it is good news for investors. "The interest of the company and the limited partners are closer to 100% aligned than in a typical royalty partnership," says Benton. "In essence, the partners are betting on the whole business . . . not on a single product line."
Another major shift in the R&D partnership market -- and one that may increase a company's chances of selling an R&D deal -- is the appearance of so-called R&D pools (see INC., September 1984, page 33), in which an investor's risk is spread over several ventures, rather than concentrated in a single one. In the past, it was difficult for a corporation to convince an investment banker to handle a partnership valued at less than $5 million, but pool sponsors are interested in almost any size deal, and won't turn them down only because of the dollar amount involved. Some pools, such as Morgan Stanley's, seek out small projects. Others are now attracting substantial interest from institutional investors that have traditionally stayed out of the R&D market.
As a result, companies ma soon find themselves selling more partnerships to R&D pools than to individual investors. The actual transaction, however, won't be much different in terms of the quality of the deal.
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