How to turn R&D work for Uncle Sam into a real business

Most VCs consider it a very bad idea to invest in companies doing contract research and development for the government. Government R&D is a specialized business model that’s made even more complicated by the nuances of government accounting and contracting practices. Companies that start out with government contracts have a tough time generating new business and winning proposals. And even if they do win new business, they may find that the government claims the rights to all of the intellectual property they developed while under contract.

But a number of companies have learned to navigate these waters. iRobot is one of the most successful examples we’ve seen of a company moving from government research to a profitable standalone business. Founded in 1990, iRobot spent the first eight years of its existence developing robots under government contracts. But, in 1998, the company raised its first round of venture capital, and, by 2002, it had delivered the first of its highly successful PackBot mobile tactical robots for applications such as bomb disposal and had launched its first commercial robot, the Roomba floor vacuuming robot.

The key to generating high growth and high returns is to transition the technologies developed under government contract into products that can be sold on a repeatable basis to either government or commercial markets, or both.

So, what filters can a venture capitalist or business owner apply to identify the rare growth opportunity in a landscape full of government R&D shops?  Here are four high-level factors to consider.  For me, the absence of any one would be a knock-out punch.

1. Transition markets. Are there markets, either government or commercial, in which a product or service based on the technology can be sold? Many venture capitalists refuse to look at businesses that sell products either entirely, or mostly, to government customers. The standard rationale is that the government is an unpredictable customer, with long sales cycles and sometimes-rapid budget changes. I would contend that the war on terror changes the opportunity, because it is not going away anytime soon, and technology can provide winning advantages when facing the asymmetric threat posed by terrorists. One market area that is very relevant to the war on terror is cyber security. The government has problems that are not solved by the existing commercially available products, and large enterprises face many of the same issues.

Another interesting area is sensor technologies for physical security. Mike Ellenbogen and his team built Reveal Imaging (acquired successfully by SAIC) into a very profitable growth business based on explosives detection for checked luggage at airports. In Reveal’s case, there was really only one government customer (the Transportation Security Administration) and no commercial markets, yet Reveal delivered significant returns to investors.

2. Technology readiness. The technology has to exist outside of PowerPoint. Government contractors often sell R&D services based on what might be, but they tend to talk about technologies in the present tense as if they already exist. The best opportunities are those for which a hardware and/or software solution has already been built and deployed in the field. Many companies make a living doing Phase 1 Small Business Innovation Research (“SBIR”) research, but they never actually build and deploy anything. Investors will want to look for Phase 3 SBIR awards to pinpoint real technologies with the potential for real customers.

3. Solid intellectual property. For technologies developed under government contract, companies generally enjoy strong intellectual property rights for commercial markets, but, lately, it seems that the U.S. government wants more and more unlimited rights for government applications. Companies that are very careful to document the components of a product that are developed using government funds and that segment off the components that are developed using the company’s funds are the best equipped to build a strong business able to serve both commercial and government markets

4. Savvy management. Building and selling products takes a very different set of skills to selling professional services to the government. Savvy management will recognize this and will be receptive to a plan in which new people are added to the team in order to pursue new product initiatives. It also takes a great deal of foresight to build a government R&D business that has the potential for high growth by transitioning technologies into products. Tom Burns, CEO of SET Corporation (acquired by SAIC), is a great example of a manager who pro-actively looked for opportunities to transition technologies into products using the SBIR Phase 3 program. Making sure you have people with the right mindset leading the charge can be the biggest challenge of all.

The move from government contract to high-growth standalone business can be a complicated one, but there’s enormous potential here for companies and investors who get it right. iRobot hit the Daily Double by transitioning R&D technologies into products for both the commercial and government markets. As of 2010, the company had delivered over 3,000 PackBot robots and over 5 million of its consumer robots. The payout for this Daily Double is a market cap pushing $700 million.

Alex Laats is a general partner of Commonwealth Capital Ventures. Alex has over 15 years of experience operating, advising and investing in early stage technology businesses, with a particular expertise in new business creation based on federally-funded research and development. At Commonwealth, he focuses on investments in the software, Internet, defense and security sectors. For more information, please visit www.commonwealthvc.com.