Technological Innovation and Venture Finance in Post-Bin-Laden America
December 30, 2001
The crash of the Internet bubble didn’t do the job fully, but Osama bin Laden and crew took care of that. Post-September-11, the American venture capital scene has been well and truly different from anything in recent history. As Chicago banker Tom Gregory put it, discussing a deal that had been scheduled to close in mid-September, “Well, people aren’t writing a lot of checks right now.” In early 2001, it was mildly embarrassing to be an entrepreneur whose company had gone under. But by this point, one can’t walk into a café in Palo Alto without running into at least 10 others in a similar situation. The connection between cutting-edge sci-tech and capital investment has been, if not quite fully severed, reduced to the merest thread.
Yes, it’s become harder to raise millions of dollars to start a hare-brained retail Internet site. This is bad for nerdy college students and marketing hucksters, but it was bound to happen, and everyone knew it. But the effect of the new VC conservatism on scientific and technological innovation is another matter entirely – more serious, more regrettable, and potentially with dire long-range consequences. The next year, it seems, is going to be a critical one. If things improve by the end of 2002, the current tough times may wind up looking in retrospect like a necessary period of winnowing and strengthening. But if things stay bad or get worse, we may find that the winnowing has gone too far, and that technological progress has been delayed by years, with serious longer-term damage done to American entrepreneurial culture.
Consider the story of one East Coast bioinformatics software company, founded a few years back by a group of professors with an innovative technology. Right from the start, their product was technically better than any of its competitors and they had an enthusiastic initial client base, but they were having trouble competing against larger firms with inferior technology. So a year and a half ago, hit by the tech stock slump, they hired a new CEO with a marketing background to help them cope.
The new guy quickly realized that in order to compete with the big boys in their particular market subsector, the firm would need to drastically expand their sales and marketing budget. He created slick marketing materials, and brought in his own marketing team, experienced in the Internet space. A new business strategy was created, focused on seeking rapid growth through grabbing industry attention, rather than on slowly scraping by with quiet scientific superiority. A lot of hard work went into creating partnerships with hardware companies, convincing them to bundle the firm’s software with their hardware – a time-tested, clever and effective way of getting sales via someone else’s sales channel.
But it can take a good while for marketing and joint-venturing to turn into real customer mind-share. Meanwhile, all this salesmanship was costing serious money; the firm’s finances were suffering. In order to fund the year or two of intensive marketing that was going to be necessary to get to break-even with the new more business-savvy strategy, a round of fund-raising was going to be necessary. This was anathema to the scientist-founders, who had bootstrapped their business themselves, not relying on venture money. They recognized the necessity, in principle. But when it came down to negotiation over price, it became clear that deals weren’t going to happen. Some serious biotech firms were interested in investing, but, not at the price the scientist-founders wanted.
Soon the CEO was out on his ear, and the scientists were running the show again. But the economy plummeted further. Before long even the proudest founders were heading back to their previous suitors, begging for the deals they had previously refused. But the situation was different now; the terms were even worse. Negotiations dragged on and on, debts went unpaid, the situation become uglier and uglier. As I write this words, this particular situation is ongoing – and dozens of other scenes just like it are taking place throughout the country.
The point is not that reams of perfect, faultless firms are being driven out of business. Obviously, in this example, some moderately serious mistakes were made. A CEO was hired who made decisions that were only half-supported by the company founders. They supported his expenditure of money but not his raising of capital. The point is rather that, in better times, absolute perfection was not necessary to avoid absolute disaster. But nowadays, it’s one strike and you’re out – and the dissemination of quality science and technology throughout the world often suffers.
From the entrepreneur’s point of view, the behavior of investors in such situations can seem downright nefarious. Ethics often seem even more absent than usual; in times like these everything boils down to strict, ruthless, short-term financial calculations. For instance, at a certain point, when a company’s situation looks too bad, potential investors may decide it’s not worth bailing the company out, when instead they can wait for the firm to go bankrupt and then buy the intellectual property out of bankruptcy court, for a pittance. To the inventor who knows there are investors waiting like vultures to buy his tech out of bankruptcy, this can seem offensive and outrageous. But from the investor’s point of view, it’s simple arithmetic.
A major California venture capitalist gave some insight into the investor’s side of things, in a recent conversation. For a start-up tech company to succeed in this market, he said, “One of two things are needed. The first is an amazing, already totally complete technological breakthrough…. The other is to really, really know your customer.” He mentioned one opportunity that he thought might be a good one. It was a new machine that could detect and correct errors in a certain kind of biological data that a lot of large companies had spent a lot of money collecting. “Companies would have no choice but to buy it,” he observed with a grin. This example illustrates an important point: even in this economic climate, investors are still looking to make money. There’s just not a heck of a lot of risk tolerance out there. People are looking for, not just a sure thing, but an obvious sure thing, an investment opportunity so awesome that not a single moment’s thought is necessary to evaluate it – and even so, months of careful due diligence will naturally occur before any checks are written. Investors are no longer willing to fund any kind of technological innovation. But they are willing to take a completed innovation and aid with its sales and marketing, so long as the path to business success seems close enough to absolutely certain.
The same investor told of a West Coast software company his firm had been looking at. The CEO of this firm, he said, “built this business with sheer force of will. He wasn’t a businessman. He just went out there with an understanding of the technology, and he really got to know his customers…. It’s always interesting to talk to the first five customers, and then the next five are usually boring, but you always learn just as much from them…. He built this company up and now they have maybe twenty million a year in revenue. They have a great product. If I were young, it’s a place I’d like to work. But even so it’s not clear that it’s the kind of opportunity we’re looking for. It’s not clear that he can build that business into a fifty million a year operation, that will give us the kind of valuation we want to see.”
To me, this story just about said it all. As I listened to him talk, I tried really hard to imagine a big-time California VC making the same speech in, say, early 1999. But my powers of imagination, normally ample, failed in this instance. At that point in time – eons ago, Internet time -- seasoned and war-weary investors were pouring seemingly endless amounts of money into wild ideas and ambitious dreams, championed by enthusiastic entrepreneurs entirely inexperienced in business management. “Let’s sell Product X on the Net” was enough to get a ten million valuation; and “In two years I can productize this research paper I wrote” was enough to get a professor his own company. Now VC’s are thinking really hard about whether to fund a brilliant scientist who has built a business with thousands of customers and twenty million a year in revenue.
Does this mean the much-vaunted marriage of venture capital with innovative science and technology is dead? Not yet, not exactly. But unless something changes within the next year or two, such dire pronouncements won’t be inappropriate. The trend is far from encouraging. We may be seeing the down swing of a cycle, or we may be seeing a down period that will be followed by a transition into something completely different, an economic regime we cannot currently foresee.
If Not Start-Ups, Where, Then?
But if start-up firms are no longer the place for innovative sci-tech, then where? Big company labs are not the answer. A few of these are surviving relatively intact; for instance IBM’s research groups continue to prosper, carrying out top-quality research in hundreds of areas, areas from supercomputing to data mining to bioinformatics to large-scale Java computation…. But IBM is very much the exception. Lucent, for example, which carried the bulk of AT&T’s once-great research group, recently laid off tens of thousands of people in North Jersey. Unfortunately this is much closer to the norm.
Universities are prospering – out-of-work tech employees are returning to graduate school in droves; and more than one academic-turned-entrepreneur has become an entrepreneur-turned-academic. And the “war on terrorism” effort has boosted government research grant funding in some sectors, which is helping both grant-funded university researchers, and, even more so, national labs like Los Alamos and Sandia.
But, there’s a reason that innovation experienced such a boost when scientists and engineers were able to move out of universities and national labs and big corporate research labs into the start-up world. Big stodgy institutions are not the best framework for innovation. At Los Alamos National Labs, for example, computer science researchers are only rarely allowed to hire their own programmers to work with them on their projects. Rather, they must contract out programming work to the lab’s programming division, to programmers whom they do not get to educate or manage. This kind of inefficiency is not exactly ideal for moving ideas quickly from concept to reality.
Great sci-tech work will still get done; innovative and entrepreneurial scientists and engineers are not going to simply disappear from the landscape. And venture money is out there, for projects that are right in every way: this is not the Great Depression. But still, there’s little question that, with the bursting of the tech stock bubble followed by the Sept. 11 tragedy, there’s been a fair bit of the “baby thrown out with the bath water” phenomenon. Investors who fooled themselves into thinking SpandexFormalWear.com was going to be the next billion dollar giant, have now become so risk-averse that only the most obvious financial sure-things can be funded, and high-quality businesses founded on genuine scientific and technological advances are left to their own devices, in some cases to flounder and be picked off by the corporate vultures.
When one hears anecdote after anecdote of great ideas squashed by marginal economics, things can begin to seem rather depressing. But if one takes a big step backwards and takes a system-theoretic view, it’s possible to come to a different conclusion. It’s entirely possible that all this pain and suffering may end up being good for technological innovation, in the long run.
In evolutionary theory there is the notion of an “optimally harsh environment.” If an environment is too benign, then there is no pressure for superior organisms and species to evolve. Necessity is the mother of invention, and a totally kind and loving world leaves no room for necessity. But if an environment is too harsh, on the other hand, there is no room for innovation. Evolution, if it’s lucky, will find something that’s just barely capable of surviving in the difficult conditions, and then no significant variation will occur, because all variants will be immediately squashed. For the evolution of complex and creative forms, for true evolutionary progress, one needs an environment that is harsh but not too harsh.
The same sort of conclusion has been found in human psychology, with a different sort of twist. The childhoods of great artists and scientists, it has been shown through statistical analysis, are rarely trauma and trouble free. Blissful, perfect childhoods don’t tend to yield interesting people, though they may well yield happy people. On the other hand, a childhood that’s too nasty and traumatic is going to lead to an unsettled and unproductive mind, one incapable of the focus required for great works. Again, an intermediately harsh environment turns out to be optimal.
But things get subtler than this still. It may be that, in some cases, a constant level of harshness is less desirable than an oscillation between more and less harsh conditions. William Calvin, the famed neuroscientist, has argued that this is in fact how human intelligence evolved. It was the oscillation between ice ages and warm periods, he believes, that gave rise to human intelligence. The ice ages thinned out the unfit humans, allowing only the most intelligent to survive. But then the warm periods supported innovation, creating a diverse variety of humans, to be winnowed out in the next ice age.
The application of Calvin’s notion to the American hi-tech economy is not too hard to see. Perhaps the oscillation between easy money and hard money is necessary. Good times like the Internet bubble spawn reckless innovation. Bad times like the present, winnow out the weaklings, allowing the truly superior innovations to survive.
The key point, though, is that if an ice age (real or metaphorical) lasts too long, it is no longer serving a positive purpose, it is just killing time. If the last ice age had lasted three times as long, for example, it’s not likely that any greater winnowing would have occurred. Rather, the advent of the next period of innovation would simply have been delayed. Today there would be no complex language, no theater, no mathematics, no newspapers, no technology companies to be sure. The dark times need to be long enough to weed out the unfit, but beyond that, they serve no positive goal and may actually be harmful by leading to narrowness and overspecialization. It may well be that the crash of the Internet bubble was enough harshness for American tech firms – the bin-Laden-induced post-crash crash, an ice age within an ice age, was quite likely more than what the system-theoretic doctor ordered.
While it’s easy to throw around objective-sounding terms like “optimality,” in this sort of socioeconomic context there is really no scientific way to assess something like “how harsh is too harsh.” There is not an adequate ensemble of similar historical situations to make statistical analysis meaningful. One is left with the richness and ambiguity of the real world. One is left with examples like the bioinformatics firm mentioned above, which probably really does not deserve to die. And like Supercompilers LLC, an American-Russian firm creating Java program optimization technology, which ran through its initial investment a year ago and is now proceeding on pure willpower, staff reduced to the original founders. How long will they keep going, unfunded? Who knows. But if they do run out of steam, the world will be worse off, because it will be years before anyone else comes along with similarly powerful technology.
So, what’s going to happen as 2002 unfolds?
Right now, investors are holding onto their money and waiting to get a better sense for the medium-term future. Scientists and engineers are holding their breaths, unwilling to give up hope just yet, the memory of better times still too vivid and recent to forget.
There can be little doubt that, whenever this ice age lifts, and innovation is again economically valued, the human mind and spirit will be ready to rise to the occasion. But in practical terms, if the current situation lasts too much longer, a lot of work is going to be lost, a lot of scientific and technological development will have to be built again by a new generation. Evolution may be inexorable, but it is not efficient and it is frequently messy. All in all, it seems that this next year may be a critical one, in which the momentum of the better aspects of the Internet bubble is either regained or lost for a good long while.