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Where Are All the Bright Ideas?

Perhaps no other industry in the world has produced as many innovations over the past decade as America's high-tech sector. Until 18 months ago, tech innovation -- much of it related to the dot-com boom -- was the engine that powered the rapid expansion of both the technology business and the U.S. economy, plus a surging stock market. So as tech companies struggle to escape the doldrums, the question arises: What happened to the innovation that's supposed to sustain them through good times and bad -- and when will it return?

Undoubtedly, innovation is a powerful potion. For instance, despite the lagging economy, Apple Computer's new flat-screen iMac is back-ordered for three to five weeks even as makers of IBM-style PCs are struggling. And it has been an article of faith for years that a new microprocessor from Intel, often combined with improved software from Microsoft, can spur huge new rounds of PC sales. Moreover, it's easy to forget that as recently as the mid-1990s, most people went online using 2,400-baud connections -- a speed suitable for viewing nothing more than text-only sites.

TAKING A BREAK. The modern Web owes its very existence to rapid innovation in myriad technologies such as servers, communications networks, and Web-browsing software. So, tech companies and the economy would be much better off right now if substantive innovation -- advances that cut costs, improve productivity, or appeal mightily to consumers -- weren't taking a break.

The simplest answer for why it has is that innovation, like all things in business, comes in cycles. It surges when risk-taking is in vogue, as it was during the late 1990s. It slows when caution is in the wind, as has been the case since mid-2000 -- both in corporate research-and-development labs and among venture capitalists.

"Innovation is a state of mind: the willingness to think differently," says Nicholas Negroponte, co-founder and director of the Media Lab at Massachusetts Institute of Technology. "As such, innovation has slowed. In fact, one kind of innovator -- the startup entrepreneur -- has almost become extinct."

Fewer VCs are going boldly where no VC has gone before

That may sound like an overstatement. After all, though venture-capital investment in 2001 dropped 65% from the year before, it still came to $32.1 billion, the third-highest yearly total in history, according to research firm Venture One. Projected investment for this year is expected to fall again but will hit a still-hefty $25 billion. What doesn't show in raw numbers, however, is the degree to which venture capitalists have become more risk-averse -- using the bulk of their money to support existing initiatives, rather than going boldly where no VC has gone before.

To raise money these days, you need to be someone like Stephen Senturia. A graduate of Harvard and MIT, Senturia has been a professor of electrical engineering at MIT for 36 years. In 1982, he founded Micromet Instruments, which developed devices that monitor the hardening of aerospace and structural adhesives. He also served as a consultant for three startups -- one went public, and two were acquired by major telecom equipment providers.

SWINGING PENDULUM. Over the past four years, Senturia has received $8 million from the Defense Dept. to research microelectromechanical devices (MEMS), tiny machines used in everything from automobile air bags to medical diagnostic equipment. Last September, at a time when venture capitalists were more demanding than they had been in years, Senturia raised $7 million for a new company, Polychromix, which is building a device that will allow telecom companies to remotely manage data flows over optical networks. Polychromix expects to release its product by yearend.

Years of research, an established track record, and hefty preinvestment. These are now the characteristics most budding companies must demonstrate to attract additional funding. And while no one recommends going back to the 1990s, when 25-year-old MBAs raised millions by scrawling business plans on napkins, the pendulum has now swung far in the other direction -- too far, some observers argue.

VCs insist that innovation is as hardy as ever

The result? Young entrepreneurs with even deserving projects have become discouraged, and that may now be stifling new innovation. VCs -- who a short time ago were advising their charges to put off making a profit in favor of winning market share -- now mainly want to fund projects that will lead quickly to a viable, commercial product. Nowadays, "entrepreneurs are [encouraged] to do something achievable, where they can show they have a ready market for an idea," says Matthew Littlewood, an analyst who tracks the flow of VC money for PricewaterhouseCoopers in Boston.

Venture capitalists, of course, tell a different story. They insist that innovation is as hardy as ever and point to such examples as Silicon Valley venture firm Draper Fisher Jurvetson, which since September 11 has signed nine new funding deals, including one with integrated-circuits maker Phosistor on Sept. 12. In January, 65 venture firms bid to invest in a second funding round for Boston-based nanotechnology company Nanosys. It raised $15 million from five VCs.

LESS ME-TOOISM. VCs say despite the difficult funding environment -- or perhaps because of it -- the pace of true innovation is increasing. Just because huge numbers of entrepreneurs got money during the dot-com craze, they argue, doesn't mean it added up to real innovation. It was "me-tooism," says Wes Raffel, a technology partner at Advanced Technology Ventures in Palo Alto, Calif. "Everyone saw something someone else had done and thought, 'I can do it a little better than that.'"

Claude Leglise, vice-president of Intel Capital, the semiconductor giant's VC arm, adds that today's entrepreneurs "are much higher-quality people than two years ago. They've thought through their ideas more, and they're aware of the amount of personal sacrifice and effort it will take to launch a company and succeed."

Moreover, the $6.3 billion in VC investments in the fourth quarter, according to VentureOne, suggests that funding now may be stabilizing at levels well above those that preceded the Internet boom. The new hot sectors include MEMs companies such as Polychromix, plus companies in nanotechnology (minuscule devices) and biotech. Products that increase the Internet's efficiency also continue to attract money. "We're investing in truly big innovations rather than incremental ones," asserts Bob Nelsen, a partner at ARCH Ventures in Seattle. "Fundamental innovation always gets funded."

IPO DROUGHT. That may be true anecdotally, but industrywide numbers appear to contradict the trend. According to PricewaterhouseCoopers' quarterly MoneyTree survey, later-stage companies received 64.1% of the venture dollars invested in last year's fourth quarter, up from 56.2% in 2000's fourth quarter -- when the VC market bottomed out. Early-stage investments made up just 15.9% of the total dollars, down from 23.4% in fourth-quarter 2000.

A technologist with a great idea now has little incentive to leave a day job

Moreover, many VCs vow to focus primarily on companies already in their portfolios until at least the beginning of next year. In no small part that's because they don't expect the market for initial public offerings -- the method VCs typically use to cash out their investments in startups -- to rebound in force until 2004. As a result, a technologist with a great idea has little incentive to leave a job at, say, Microsoft to start a new company -- because it probably won't attract enough funding to survive.

Even so, experts believe that innovation from new companies eventually will recover. "I believe the Next Big Thing will grow out of a new idea bumping up against an existing Internet technology, rather than from a breakthrough in quantum computing," says Rudolph Burger, director of MIT Media Lab Europe.

JUSTIFIED ECONOMICALLY. Many such ideas are floating around the battered telecom sector. Take Seattle-based AccessLine. Among other things, its technology allows employees to tap into their corporate phone network from the road, a client office, or from home. Similarly, East Hanover (N.J.)-based dynamicsoft is building instant-messaging capabilities for phones that will make it easy for callers to check ahead with the recipient to see if it's an appropriate time to connect. "A lot of the telecom companies were hype. Here the economics are justified and carriers can make money," predicts Roland Van Der Meer, a partner at Palo Alto (Calif.)-based ComVentures, which invests in dynamicsoft.

Cycles of pauses in innovation followed by renewed momentum have plenty of precedents. During the creation of the steel industry and the rise of railroads in the late 1850s and early 1860s, historians point out, investment outpaced the market's capacity to absorb it. The result was a period of retrenchment and consolidation. The golden era of steel and railroads didn't happen until 10 years later, when demand for these advances had caught up with innovation.

So perhaps the current lapse is really a new beginning -- of an era in which innovation will again deliver the growth tech watchers have come to expect. By Jane Black

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