Behind the Prize at the X Prize: A New Model For Venture Capital
At a time when many people are saying the traditional venture capital model is broken, an influential Internet pioneer has developed a fundamentally different concept for investing in innovation.
San Diego resident Lee Stein explained his concept to me in a long conversation last week. He already has given shape to his idea in the form of Prize Capital, an investment firm he founded in 2006 in Del Mar, CA. Last week, the X Prize Foundation identified Prize Capital as the firm that put up the $25,000 award for the “What’s Your Crazy Green Idea?” contest won by a pair of U.C. Irvine students. But Stein says that wasn’t a true test of the Prize Capital model.
“We sponsored the YouTube prize because it gave us the opportunity to formalize our relationship with the X Prize Foundation and YouTube—and to watch and experiment with online marketing of prize ideas,” Stein says. Establishing an incentive for “crazy green ideas” also reflects Stein’s personal passion for using innovation to help the environment. He is particularly alarmed about global deforestation, and says, “We are living in the era of greatest extinction since the time of Noah.” His environmental ideas are evident at Prize Capital, but before detailing those, a bit of backround.
Throughout his career, Stein has shown a knack for seeing the essential nature of a business, and acting on his insights. Trained as an accountant and lawyer, Stein and his wife formed a financial management firm in 1980 for the Hollywood elite. As he once put it, he realized that many rock bands and film stars had the same gross annual income as a medium-size company—without a CFO or corporate finance department. Their clients included film stars Gene Hackman and Matthew Broderick, and rock bands Journey, Rod Stewart, and Men at Work.
In the early 1990s, when many people viewed the Internet as a playground for computer renegades and cowboy poets, Stein helped to develop one of the first Internet payment systems. He says he remembers thinking, “If we don’t bring commerce to the Internet, it will just go the way of CB radio.” He founded San Diego-based First Virtual in 1994 to provide secure online credit card transactions for consumers. Stein says his validation came almost a year later with the Netscape IPO, which fundamentally transformed the way people viewed—and valued—what was happening on the Internet.
First Virtual’s early investors included GE Capital, EDS and First USA, which was then a fast-growing issue of Visa credit cards. The company went public in a successful IPO in 1996 and was sold in 1998 to MessageMedia, which was itself eventually acquired by DoubleClick. First Virtual’s patents are now held by eBay.
Stein says he began to develop his ideas for Prize Capital about three and a half years ago, after PayPal founder Elon Musk invited him to a dinner with the philanthropists behind the X Prize Foundation. Stein wouldn’t tell me who else attended, but he’s well acquainted with such X Prize supporters as Dean Kamen (a Boston Xconomist) and Ariana Huffington. “I thought the concept of using prizes to stimulate innovation was spectacular,” Stein says, “so I started doing my due diligence.”
His research led him to New Mexico for the X Prize Cup, which was conceived as an annual two-day Air & Space Expo. During the trip, he met four aerospace engineering graduate students from Romania who told Stein they had developed a composite rocket engine. “When I asked them if they had filed patents on their design,” Stein recalls, “they said, ‘Patents? We don’t even have enough money for lunch tomorrow.’ ”
Stein says the encounter encouraged him to take on a supporting role in developing future multi-million dollar “mega prizes” that induce technology innovation. Since the 2004 success of SpaceShipOne, which won the $10 million Ansari X Prize for its suborbital spaceflight, the X Prize Foundation has created similar prizes for breakthroughs in genomics, fuel-efficient automobiles, and to develop a robotic lunar lander.
Prize Capital, however, is exploring the idea of creating mega prizes that are more focused on Stein’s passion for the environment—in developing breakthroughs for next-generation biofuels, solar energy, and in energy efficiency. Stein says the kind of breakthroughs sought, however, are too “over-the-horizon” for conventional venture capital funding. “In order to attract capital to something that is extremely early,” he says, “you have to take a completely different approach.”
His approach is to have Prize Capital form a strategic alliance with a non-profit partner, such as the X Prize Foundation, with each taking a different role in a mega-prize competition. The foundation assumes a non-partisan role in setting the rules and in administering the contest. Prize Capital participates as an investor in the technologies being developed by contestants—not by investing in a particular team or competitor—but by investing in all of the contestants.
“So basically, if we can place a bet on every horse in a race, we don’t care who wins,” Stein says. The contest rules will be structured so that Prize Capital charges each entrant a “fee,” which consists of several options. It could be the right for Prize Capital to take a small percentage of the entrant’s technology royalty sales, or it could be the right to join future venture capital investors when they enter the picture to fund technology development. In such deals, Prize Capital would invest only as a passive “tag-along” investor without a board seat. Prize Capital also can provide loans of roughly $100,000 to contestants for various needs, such as filing patents.
Well-funded teams that don’t want to participate in the arrangement can opt out by instead paying a conventional cash entry fee.
By investing in all of the competitors, Stein says Prize Capital substantially reduces the risk that venture capital firms face in seed stage investments, when they back just one firm among many in a given field. That’s because Prize Capital can participate in the returns of any technology development from any of the entrants—regardless of who wins the prize. Stein says the risk mitigation strategy is so novel that he filed a patent application last year entitled “Investment Model for Formation of Capital and Value Creation.”
Stein is especially keen on the idea of developing a biofuels competition. His concern for deforestation also has led him to sign a letter of intent with a large foundation in Brazil to create a series of small prizes to develop what he calls “small-scale, distributed energy systems.” With an environmental X Prize focused on the right kind of technology breakthrough, Stein says the next “Netscape moment” could trigger a 21st Century gold rush that will save our global forests from destruction.