Josh Wolfe
Managing Director, Lux Capital

"Nanotechnology: The Economics of Matter "

Before I start on nanotech, here are two quick patterns I’ve seen in the conference so far. One is the tangrams. I’m apparently a horse [laughter]. Bill is a dog. Sue is a fox, Bill Gurley was an ostrich, and Michael looks like an 18 th century butler. [laughter] I guess he’s serving up the brain food of all of us animals.

The other pattern that I saw was that the size of the speakers—and this is probably related to Geoffrey West’s scaling law—has decreased and the clock rate or metabolic rate or speed with which we speak has increased. [laughter] I don’t know if that was intentionally planned to synchronize with Geoffrey’s talk or not.

You will get a very high information density of content over the next 45 minutes or so. Some of it will be eye-opening and some might be confusing, so please ask questions at the end.

Our firm looks at venture capital as a series of S-curves over the past four decades from personal computing to biotech to the Internet and now on to nanotech. The past ten years has been predicated on computer science and electrical engineering in innovation. Now, using those tools, there is a reversion to the physical sciences—using computers and combinatorial chemistry—to invent new materials and tune those materials for new properties and hopefully big margins for companies. I’ve brought some of the materials with me and will demonstrate them throughout the talk.

We’re based in New York and San Diego and we did something strategic for a venture group. We started a media business for Forbes magazine. We started a research firm and also a political body to help influence nanotech legislation. There is about $1 billion being spent per year in the field.

I’m going to talk a bit about the portfolio companies so you can understand why we’re putting our money into these companies: the value proposition. The common thread through these four companies is this: we start with a university professor and his work and couple him or her with an industry veteran and go after a large multi-billion dollar market. In the case of each of these, they have very little in common except they have some fundamental level of control at the nano scale. The end markets they’re serving are highly uncorrelated to one another.

Molecular Imprints is a semiconductor, capital equipment company making feature sizes below 50 nanometers, which is a big problem for the industry today from an economic standpoint. Nanosys is like a Genentech of nanotech. It is a platform technology company that now owns about 500 patents exclusively on one sliver of the periodic table of elements: group 4, 3-5 and 2-6—the elements that run our computers, phones, PDAs and wristwatches.

Cambrios is in the earliest stage of our portfolio. The way we make beer and wine and cheese today relies on fermentation processes. We are now using biology to manufacture electronics, thin film transistors, and LCD screens in much the same way. That radically changes the economics of how we manufacture something. We announced Kereos yesterday with Genentech and Philips. The big opportunity here is in the field of oncology—both diagnostics and therapy.

Here’s a bit of history about nanotech. I’ll start with a very quick video. It’s one of a series of advertisements in which many companies are using the term “nano” as a marketing term to indicate that they’re cutting edge or innovative. This one is from HP and it will give you a very broad overview of what nanotech is. Some of it is scientifically inaccurate but I’ll cover that later. [HP commercial]

A lot of those things are never going to materialize. The history of nanotech starts with the sci-fi visionaries from 20-30 years ago, who we completely discount from a capital perspective. Then you have the real physical scientists who are using computer science to make advances. It starts with the brainchild and seed kernel of Richard Feynman. He gave a talk at CalTech in 1959 where he said that principles of physics as he saw them didn’t speak against the possibility of us being able to maneuver things atom by atom—the ability to assemble things precisely on an atomic scale.

A whole slew of discovery occurs in the physical science and chemistry world over the next twenty to thirty years. One of the key breakthroughs was the invention of a tool that would allow you to see things and move them at the nano scale. The wavelength of light is much larger than the nano scale. Visible light is about 400 nanometers, whereas a single nanometer is about one one-hundred-thousandth the width of one of your hairs. To see individual atoms, new tools were invented that actually touch these molecules and create a kind of topographic map that a scientist can use to identify what he’s looking at.

Twenty years later in 1996 a Nobel Prize is won for the discovery of the C60 molecule. It was a new form of carbon. The diamond in your engagement ring or the graphite in your pencil are both the same atomic composition but in a different configuration. Richard Smalley discovered a sphere which he called a fullerene, named after Buckminster Fuller’s geodesic dome structure. Fullerene is one of the strongest materials known to man. It’s ten times stronger than steel though only 1/6 th its weight. It conducts heat better than diamond and electricity better than copper. Before ten years ago, it never existed, and this creation of new materials is one of the highlights of the whole field.

Then the politicians got involved in the latter part of the 1990’s and started allocating tax dollars to the field. That set off a funding bonanza across the world where people are sitting down to a metaphorical poker game anteing up more and more money. This is accelerating the growth of the field with positive feedback.

Here’s a working definition of nanotechnology: “the purposeful engineering of matter at scales of less than 100 nanometers to achieve size-dependent properties and functions.”

Now let me give you a sense of what a nanometer is. The average person is about two billion nanometers tall. A million nanometers is about the size of a pinhead across. Red blood cells are thousands of nanometers across. Individual molecules of DNA are about 2.5 nanometers wide. Ten hydrogen atoms side by side are about one nanometer long.

Nanotech is not just the scaling of things down to smaller sizes. We don’t really care about size for size’s sake. We care about how it changes the economics of manufacturing or how it gives devices properties that never existed before because of the way the physics acts at a certain scale.

Nanotech is the consilience of several fields: material science, life science and electrical engineering. These scientists are all talking together now. Any university that’s engaged in nanotech has a new building in the middle of their engineering quad. It is interfacing all of these disciplines that never spoke to one another before.

Let me invoke an analogy. If you think of the tower of Babel upside down, you have the perfect analogy for nanotechnology because in the Biblical story you have lots of people building up towards the sky where their language is fragmented into many. In this case you have people speaking different scientific languages and they’re building down from that into a common language at the scale of the atom.

There are all kinds of inventions throughout the world that had nano-sized properties but were accidents. Egyptian pottery, stained glass and cat litter are examples. The scale of nanotechnology is important because it’s where classical Newtonian physics meets quantum mechanics which is more probabilistic in nature. Size-dependent means that it’s not just small but small and different.

Carbon nanotube crossbar memory is non-volatile memory, which means it doesn’t require power. It’s competing with flash memory. It uses carbon nanotubes to represent bits of logic. It takes advantage of Van der Waals forces instead of electricity. Quantum dots are made in identical ways—chemistry wet bench instead of intensive manufacturing processes. Using one source of light can produce tens of thousands of different distinguishable colors. Cancer diagnosis is one application. Today we use different fluorescent dyes and correspondingly colored laser light. These nanocrystals remove all of that complexity. Nanosys uses it today for friend-or-foe identification in Iraq on uniforms.

Artificial setae are an example of biomimicry through reverse engineering. The scale at which nature operates is the nanoscale. People used to think that a gecko could climb a wall by secreting something sticky through its toes. But instead it has millions of little hairs called setae. Each one exhibits a weak atomic force but when they all add up it’s so strong that you can’t pull the lizard off the wall. So the U.S. government is looking at putting billions of these wires, grown synthetically, onto pads. Putting the pads on your hands and feet would allow you to scale a wall like Spiderman. The implications for the military are obvious. We can use the same platform of material in cardiothoracic surgery. Instead of having to use clamps on a vein or artery we use this material like a universal velcro.

All of the drivers of nanotechnology growth are exponential. The first one is funding. Nanotechnology funding is twice the size of the Human Genome project, which in the late 1990’s was a doorway for all kinds of companies to access the capital markets. Corporate players are starting to come on board. For example, GE has labeled nanotech as one of its top three priorities. It touches every business they can think of from lighting to imaging to jet engines.

The second driver is the technology itself. Once you have the tools, your ability to discover new things is accelerated. This is followed by patents and the formation of companies around the patents. There has been an exponential increase in the number of filings of patents over the past ten years. Earlier this year we helped the Patent and Trademark Office create a new category for the field. When that happened in biotech, it was followed by an exponential increase in company formation. Everyone now is looking for white space—places where patents don’t yet exist. There’s a land grab mentality.

The media is increasing exponentially. We compare this to the Internet in the 1990’s. In 1994 there was a huge increase in media coverage of the Internet, which coincided with broad public market receptivity, the Netscape IPO and the subsequent boom and bust. We think there will be an equivalent sort of public offering over the next year or two.

We have political support and a $4 billion government stimulus. The U.S. has prompted other countries to ante up. Twenty-five percent of the money globally is coming from our tax dollars. Half the papers are coming from U.S. scientists. Over time, we’ll see the global balance of scientific power shift dramatically. Fifty percent of the scientists in our portfolio companies are Chinese.

Where does the money go? Government spending goes first to the research centers to buy tools from the research equipment providers. This is the old theme from the time of the railroad boom as well. These providers are seeing double digit growth rates and large revenues. The availability of tools drives scientific discovery and that in turn drives patents which are increasing exponentially. Lots of Asian countries are starting companies that are licensing U.S. intellectual property that came from U.S. tax dollars, raising a number of global competitive issues.

We’ve developed a map that shows the white spaces in the field. Across the top are types of nano structures like fullerenes, nanotubes, quantum dots and nanowires. Down the side are different application industries from structured materials to energy to optics and electronics and health care.

Scientific discoveries get a lot of attention in publications and broadcasts. There’s a lot of hype in the field. I heard this tongue-in-cheek story about three scientists. They were driving to a National Science Foundation meeting: a cardiologist, a biologist and a nanotechnologist. The cardiologist is driving and someone taps on the window. It’s a carjacker who yanks them all out of the car. He says, “I’m going to shoot each one of you unless you tell me why I should let you live.” The cardiologist says, “I’m a cardiologist. I save women’s and children’s lives.” The carjacker just laughs and shoots him. Then he looks at the nanotechnologist and says, “tell me why I should let you live.” All of a sudden the biologist jumps in front of him and says, “please shoot me now before I have to hear how nanotech’s going to save the world again.” [laughter]

The capital markets for nanotech will resemble the biotech markets. There will be fits and starts. Today, stocks are driven by retail investors and are very illiquid, small market caps with a few pure plays.

The perception is that nanotech is ten years off. There are a few ideas in the space worth investing in. Accelrys recently spun off their software business from their drug discovery business. FEI Company manufactures the tools and infrastructure for nanotech and they’ve been growing.

In summary, in the capital markets there’s a disconnect between fundamentals and prices. We expect this to change over time with additional companies and more sophisticated investors. Companies with the most to gain right now are not the stocks that are driving the momentum in nanotech but the people who are using their products. There’s a value chain emerging. Institutional investors are making nanotech more of a priority. Lux has a research firm that has produced the first publicly traded index.

This is a quote from an electronics company: “Life usually deals with a combination of fear and greed. In this case, the fear is that nanotechnology is going to kill current cash cows and the greed is that we can use nanotechnology to kill someone else’s cash cow.” There are three ways that nanotech will disrupt the incumbents.

First, it will disrupt the cash cow businesses: chemicals, semiconductors, pharmaceuticals/biotech, energy, and aerospace and defense. It’s a broad, horizontal, enabling technology.

Conventional wisdom about the field is wrong. There is not a nanotech market today. People said the same thing about biotech years ago. However, there is a nanotech value chain. Not all nanotech products are new. But there is emerging nanotechnology. There are old discoveries that people are trying to reclassify to capture some of the buzz. People think that anything associated with nanotech has huge profit margins and that’s also false. Most of these things will be marginally profitable and 90%+ of the companies will fail, as is the case in the entire history of innovation.

The three step value chain starts with materials companies that feed intermediate companies who make products with nanoscale features. These intermediate products are then incorporated into the finished goods by yet other companies. The entire value chain is supported by the infrastructure companies who manufacture the tools.

The nanomaterials companies make nanoscale structures in unprocessed forms. The intermediates embed nanomodules into their existing products without much other change to their existing products in order to realize new performance features. The nano-enabled products are mostly sustaining products like nano-enhanced khaki trousers but there will be some disruptive products as well.

The materials companies are nanotech specialists. They are start-up companies typically with $10-$50 million in revenue. They’re almost all private. They sell to public companies who are the end-use incumbents. Tool providers are a mix of private companies with access to capital and public semi-conductor capital equipment companies that are transitioning into these higher growth markets.

Here’s a recap of the trends:

• Government funding is the largest since the space race.
• Large cap companies are signing deals.
• The technology is starting to migrate into high volume products. VC investment is on the rise.
• IPO’s are expected later this year or next.
• Pharmaceuticals is the one sector that’s really lagging with a few exceptions.
• The governments of Finland, the Netherlands and Portugal among others are starting nanotech funding.
• Singapore is doing an excellent job of recruiting US scientists. They have a very liberal scientific environment, which is not something we have here domestically—increasingly so. We’ll see more of that happening.

There are a number of companies that are spending at least 5% of their R&D on nanotech. It’s a whole spectrum of people from software to consumer products to food to GE. We conducted a number of surveys to find out how much of a priority nanotech is. For pharmaceuticals it was rather low. For materials and manufacturing it was very high because they’re trying to transition out of powders and low margin commodity businesses into higher function products.

In pharma, the R&D is distributed and in electronics and manufacturing it’s more centralized. About 50% of large companies will claim they have an explicit strategy for nanotechnology. R&D is on the rise in terms of people and budgets.

There are many threats to a number of large companies from Motorola to Nike to P&G. There are a number of deals being done between companies and they’re all revenue generating startups. Applications fill a matrix of depth and breadth of impact. Some of the applications can’t be backed by venture capital because they’re marginal improvements to products. Mercedes-Benz is using them for marginal improvements as is Wilson in their tennis balls.

Eddie Bauer has nano-care khakis that repel water. It works with a polymer whose one end sticks to whatever fiber the slacks are made out of. The other end is hydrophobic and repels water. It’s so small that it’s imperceptible to your tactile sense. It feels just like cotton or whatever the material normally feels like. When you pour water on it, it will bead up and roll off. Not only are the slacks not getting dirty, but think downstream behaviorally. The slacks will be washed less frequently, using less detergent. The chemical suppliers will also be impacted. This is a potentially disruptive change that will impact large companies more and more over time. The margins on these products range from 11% on the slacks to 35% on the tennis balls.

We estimate there is $13 billion dollars moving in the nanotech value chain. Ford has been very active in how they integrate nanotechnology. The EU created a nanomobile project among a consortium of European automobile manufacturers which is integrating nanotech into everything from longer lasting tires to stain proof windows and lighter bodies.

Motorola is interested in mobile phones. They are looking at even the paint on the phone and seeing how they can embed function into those molecules instead. For example, the case could be an energy source that picks up and converts heat from my body or the sun into energy—a constant trickle charge. We can also embed a phased array antenna into a clear piece of plastic which means that the entire function of the device can be embedded into the plastic. So in the future, the surface of your house could be a constant radar to sense intrusion. Again, the effects cascade through a number of industries.

There are a few analogies for nanotech investing. The first is plastics, which had an enormous impact on everything from food & beverage bottling to data storage. It had a trillion dollar impact on the economy. Nanotechnology not only lets you have structural control over matter like plastics did, but also adds function. A material can be tuned much like a radio dial to create optical, thermal, magnetic control and so on.

Fixed assets and massive capital expenditures lose but recipes win. Twenty years ago, we made insulin by having a farm of sheep or pigs, which we killed and processed for insulin. There were a lot of steps and capital investment involved. Two scientists decided to take recombinant DNA and mass produce insulin through bacteria at room temperature. That shifted success from one that was based on the scale of operations to one that was based on the creativity of the scientist. The same thing is happening now in nanotechnology. Today Intel manufactures semiconductors in clean rooms but we can do more sophisticated things in some of our companies.

An assembly line analogy may be better. Consider the impact of Ford’s assembly line idea on the cost of goods and its subsequent adoption by other manufacturers. IT is a similar analogy because of its wide horizontal appeal and application.

There’s been a shift in history between processing and properties. The surface area volume effect is one example (which we heard about in Geoffrey West’s presentation). A piece of rock candy placed in a glass of water would take an hour to dissolve. A small particle of sugar dissolves faster. Powdered sugar dissolves instantly. The smaller the particle size, the more reactive it is. We can treat a surface so that it loses its friction with respect to water and the water just balls up and bounces off. Some applications include coatings for buildings and the fact that bacteria can’t grow on surfaces that water can’t adhere to. That leads to huge applications for medical devices.

Simplexity is another example that means taking the complexity out of a manufacturing process and simplifying it with a recipe. The entire active layer of a solar cell can be made of molecules that are manufactured in a bottle of water, poured onto a surface, and then hooked up to an electrically conducted backplate. The resulting cell is less efficient than a normal solar cell, but the cost is so low that it generates electricity at $0.75-$1.00 per watt, a cost competitive with natural fossil fuels. Manufacturing of semiconductors can shift from assembly using expensive equipment to something that looks more like printing a newspaper.

Again, we’re not interested primarily in smaller size, but in new properties that open new markets. The value can be harvested by owning the IP, finding application-focused technologies, or exploiting the changing economics of manufacturing or supply chains (taking a process that has 100 steps and doing it in three for 1/1000 th the cost).

Recipes are fundamental patents. Tollbooths represent the ability to license the patents for non-core capabilities. Moats are barriers to entry.

Of 1,200 startups and $1.1 billion in venture capital financing, the majority went to electronics and life sciences. Until 2004 the amount of venture money had been declining. A few companies will capture the lion’s share of the dollars.

Nanotech is not a Silicon Valley phenomenon. There are clusters of venture companies in California, Texas and Boston. But there is also activity in upstate New York, Virginia and Illinois. A research group may spawn companies all over the country, not just next door.

There are two phases in the venture formation process. The infrastructure side moves to applications. In the scientific and capital markets sense, the transition is from experiment to existence proofs and from speculation to common sense. Speculation will never go away. A picture from fifty years ago shows what they believed a computer might look like in the future and a prominent feature is a steering wheel. [laughter]

Every industry experiences an exponentially increasing number of entrants into the field, followed by a precipitous decline. This happened in PC’s, autos and television manufacturing. But higher ability firms enter earlier and survive longer. For example, the relative strength of nylon firms continued to rise over time.

Designs are more valuable than manufacturing. This is a picture of the iPod and illustrates the value of investing in a company that has the recipes instead of just having all the fixed assets. The iPod sells for $275. It costs $200 to build. The chip costs $12. The largest margins on the iPod went to Apple designers and not to the Chinese assemblers or the chip manufacturers by a margin of ten times or more. Apple sent $1.5 billion to China for assembly but translated the iPod into $20 billion in market capitalization. Recipes and designs will win over time.

Paul Romer says that growth comes from combinations of fixed resources. The periodic table can be looked at as a sort of roulette wheel. We’ve placed a lot of bets on group IV, 3-5, 2-6 semiconductors. Ferrous oxide was a means of storing information in cave paintings thousands of years ago. That same material was used as a medium for data storage on disks and was reconfigured in a more valuable way. Likewise with silicon whose natural state is sand. It was transformed into glass and later into the Pentium chip. The result in these examples is more economic value per unit of material. Given about 100 atoms in the periodic table, they can be combined in groups of four in 94 million ways. Kept in proportions of less than ten atoms, the combinations yield 330 billion recipes, or 1,000 recipes per day over one million years.

We see eight venture investable paths playing out over the next decade or so. The first is decisively improving existing products. The product is basically spiced up with a bit more performance and hitches onto the market glitz. For example, China is using an effect found on lotus leaves that allows rain to clean the surface of buildings.

The second path is powering research with tools. The third is creating new products. The next paradigm shift in computing may be individual molecules in five to ten years. If you can compute with an individual molecule then all of the transistors ever invented would fit into a single drop of water if their capability could be converted to molecular computing.

The fourth path involves disrupting the competition and their cost structures. For example, 20%-50% of the cap-ex that Motorola puts into its display manufacturing facilities could be cut. Quantum dots can be used for solid state lighting, replacing light bulbs. They say, “if you don’t like change, you’re going to like irrelevance even less.”

The fifth path cuts manufacturing costs. Motorola is figuring out how to embed multiple functions into one material to eliminate a number of suppliers. We’ve done a deep analysis on how this all plays out. Our bet is on nano imprint. The seventh path is unexpected ripple effects like the effects of fabric treatments on fabric care products.

The eighth path has to do with large scale platform shifts. I’ll talk about Nanosys and Cambrios. Nanosys’ business model consists of licensing IP from top universities. They own everything from the composition of matter—how you make a new molecule—to integrating it into a new device or end application. It patents every step of the way from how to design the molecule to integrating it into existing devices to its use in existing applications. This includes integrated nano devices like memory, LEDs, transistors and solar cells. These are integrated through flexible assembly into high value modules with partners like flexible solar cells, fuel cells, or memory.

Nanosys deals with all of these uncorrelated sectors. They’ve also received about $40 million in government money. They make nano modules and their partners spend millions of dollars up front and then Nanosys gets royalties based on contribution to end product. Most royalties are in the 3%-5% range, but these range between 20% and 50%. The company has fifty scientists that can take any pathway to come up with different products. One pathway creates a solar cell. Another yields an RFID tag. The different aspects of synthesis, assembly, interface, and formats can be mixed combinatorially to create many different kinds of applications.

Cambrios uses biology to manufacture electronics. The company was started around Angie Belcher’s research. She reverse engineered the abalone’s calcium carbonate shell. In biology, genes make proteins and proteins do things. In this case, the abalone’s genes make proteins that attract sea salts that form the shell. She hypothesized that she could synthesize genes that could manufacture proteins to attract semiconductor material instead of sea salts and deposit it in patterns to assemble electronics. She’s used evolution to create the genetic modifications that produce the variety she needs. She starts with a virus library and figures out which viruses will bind to which semiconductor materials. In this way she determines which genes code for the proteins that stick to different materials. Those gene sequences are used to manufacture precise, repeatable patterns of semiconductors without all the capital equipment.

The last thing I’ll talk about is the big backlash against nanotechnology. Some activists want to suspend all production of nanomaterials until we understand their full safety and efficacy. On the other side, the government says it’s just workplace safety issues. A county in California was very upset and actually banned the molecule dihydrogen monoxide. It corrodes metals, it’s found in chemical warfare and if you inhale it you can die. Unfortunately no one told them that it’s just water. There are always tradeoffs in technologies. We have to show that the benefits outweigh the risks. After all, gasoline that powers cars is highly flammable. Electricity is also very dangerous if not used properly. Cars kill 50,000 people in the United States every year. It’s just the law of large numbers.

There is fortune at the bottom of the pyramid. Companies using nanotechnology will be able to do well while doing good. CK Prahalad created a chart that shows something of the nature of the human condition on the planet. Out of 100 people, 57 live in Asia, 21 in Europe, 14 in the Western hemisphere and 8 in Africa. Eighty live in substandard housing, 70 can’t read, 65 have never made a phone call, 50 suffer from malnutrition, 20 never had a clean drink of water, 15 live on less than $1 and only one has a college education. The purchasing power of the 4 billion people who are in the fourth tier eclipses the spending power of everyone in Germany, the UK, Italy, France and Japan combined.

How do you sell very cheap things to these people in very large volumes? P&G has figured it out. They use a nanomaterial packaged as “pure” and sell it for eight cents per packet. It will coagulate most of the dangerous bacteria and dirt when poured into a jar of water. The coagulant is then wiped away. This helps prevent dysentery, which causes 75,000 deaths per day. HP uses solar powered printers and cameras so that residents in India don’t have to travel to get a national ID card. A byproduct empowers people to use the cameras to start a small business in taking photographs of families and trading them for currency.

When I grew up my mother used to hand me film which I took down to the Fotomat for processing and now today, it’s all personalized and you can do it at home. I used to have to carry around quarters to use in pay phones but now everyone has cell phones. I used to go to video game parlors to play games and now there are portable devices I can use in my house and I can play with people around the world. What kinds of trends will nanotech lead to?

Question: Any thoughts on the application of nanotech to energy?

Josh: Rick Smalley, who won the Nobel prize in 1996, believes that the Apollo challenge for the next generation should be to use nanotechnology for alternative energy. He’s come up with about 12 different ways in which nanotech can affect energy. Some are decades away. We’ve invested in the cheap solar cell. In 2006 Matsushita will roll out a solar cell fabric as well as a polymer embedded in glass that conducts electricity.

We’re also developing materials for fuel cells. I’m pretty bearish about fuel cells because of the amount of energy required to produce and store hydrogen.

Water is also a big problem in the world and nanotech can help here. Penguins have a membrane of proteins that filters salt out of salt water, creating clean, fresh drinking water. Scientists figured out a way to genetically engineer large sheets of this material without needing energy to do it.

The comments, opinions and any forward predictions presented about any particular security, the economy and "the market" are based on the analysis of the speaker. These are not necessarily the opinion of, and should not be construed as a recommendation on the part of Legg Mason Capital Managment or any of its affiliates.