Sri And Sarnoff: Research Labs Reborn As Spin Off Machines

Bouncing back from bad times, the labs are now a breeding ground for blockbusters

It's 10 p.m., you know where your children are, and you're in the mood for a good movie. But nothing on the usual cable channels strikes your fancy, and you're too tired to go rent a video. No problem--if you live in Delaware County, near Philadelphia. That's where Suburban Cable offers special set-top boxes, called OnSet, that pretend to be VCRs.

Call the OnSet menu to the TV screen, pick the movie you want to rent--$3.95 for new releases, less for oldies--and settle back. A computer at Suburban Cable's parent, Lenfest Communications Inc. in Oaks, Pa., immediately transmits your choice, which will remain accessible for 24 hours. You can watch it as often as you want, using the OnSet remote control to fast-forward past the boring parts or freeze interesting scenes.

The OnSet service was launched last Thanksgiving. The entire package, from the computer "server" to the set-top boxes, is furnished by a startup called Diva Systems Corp., which takes 50% of OnSet's profits. Diva has signed deals with other cable operators to introduce OnSet in Monmouth County, N.J., and certain Atlanta suburbs by spring.

Diva is the product of a curious history that brought together two premiere research labs: SRI International, in Menlo Park, Calif., and Sarnoff Corp., formerly the David Sarnoff Research Center, in Princeton, N.J.

SRI is Silicon Valley's soul. It was there before silicon chips, and its multidisciplinary focus was, and is, the foundation for the Valley's seething climate of innovation. Sarnoff is an equally bright beacon on the East Coast--and has been around even longer. Best known for its seminal work in TV, Sarnoff continues to do groundbreaking research in semiconductors, electronics, and materials.

The story begins in 1946. That's when Sarnoff invented the color-TV tube--four years after the outfit was founded as RCA Laboratories by RCA Corp. to pioneer what was then a revolutionary new medium. After the color tube came a long string of innovations, including the liquid-crystal display (LCD) and the charge-coupled device (CCD), a key element of video cameras.

The same year that Sarnoff brought color to TV, the Stanford Research Institute was established at Stanford University. Among SRI's early credits--before silicon took off--were magnetic inks for credit cards and checks, which led to the first round of banking automation in the 1950s. In 1957, blazing a trail many others would follow, Paul M. Cook left SRI's Radiation Chemistry Lab to found his own company, Raychem Corp.

MOUSE WORK. At SRI, the 1960s saw a whirlwind of innovations, including the modem, the mouse, onscreen windows, and hypertext, the software foundation of today's point-and-click surfing. Most of those came from one prolific researcher, Douglas C. Engelbart.

The next year, after student protests over SRI's involvement in military projects, Stanford spun off SRI as a not-for-profit research center. The military work continued, and the lab grew fat during the '70s. SRI also developed a medicine for malaria and a blood-clot inhibitor for cardiovascular diseases.

Around 1980, with color-TV sales soaring, RCA's factory asked Sarnoff for a fast way to test color tubes. The lab responded in 1985 with a computer that could send hundreds of simultaneous video signals to TV tubes as part of their final quality check. But this technology would be short-lived, at least in its original incarnation.

NEAR DISASTER. That's because General Electric Co.--which had helped create RCA in 1919, then absorbed it 1985--decided in 1986 it wanted no part of the cutthroat TV business. RCA's consumer-electronics operation was sold to Thomson of France in 1987. At the same time, GE reaped a tax credit by donating Sarnoff to SRI, along with $65 million in cash.

So the two R&D heavyweights became one. It was a welcome windfall for SRI, which was starting to feel the pinch of the major defense cutbacks to come. But joining the two powerhouses didn't stave off a near disaster. SRI failed to react promptly to shrinking Pentagon budgets. In the early 1990s, SRI slipped into the red. So did Sarnoff.

After three years of operating losses, Paul Cook decided it was time to intervene. He had joined SRI's board in 1988 and retired in 1990 from his startup, by then a billion-dollar giant. In 1993, at the tender age of 69, he was tapped as chairman. "I thought I could turn SRI around in a year and then take it easy," he recalls. He succeeded on the first count. But not the second.

Cook lost no time installing a new president, William P. Sommers, a former executive with management consultant Booz, Allen & Hamilton Inc. Together, they trimmed staff and pushed through other economies. In 1994, SRI earned a surplus of $6 million on revenues of $312 million, even though Sarnoff remained $3.3 million below breakeven. Sarnoff, which operates as a for-profit subsidiary, posted a net profit of $2.9 million in 1995.

What tripped up Cook's scheme for bowing out was the long-term strategy he and Sommers devised. Sitting in the middle of Silicon Valley, it seemed only fitting that SRI should embrace the surrounding culture. Instead of just doing low-margin, contract-research jobs, SRI would mine its ivory tower for technologies it could spin off, acting as a sort of venture capitalist.

So the two began looking for spin-off candidates. When Cook came across the supercomputer that Sarnoff had created for testing TV tubes, he bolted to attention. Here was a dream machine for video-on-demand systems that cable companies could buy to retaliate against their direct-broadcast satellite rivals--and maybe even grab some of the $16 billion business in videotape sales and rentals. Sarnoff Real Time Corp. was founded in 1993 with $6.5 million in seed capital. But the startup couldn't attract outside investment. Nobody wanted to sell a new supercomputer, says Cook, given the dreary fate of most supercomputer suppliers.

Undaunted, Cook decided to have another go, with himself at the helm, and this time offer cable operators a deal that would be hard to refuse: a "turnkey" service costing practically nothing. He formed Diva Systems in 1995 with $4 million from SRI--and found a warm reception for this strategy. He has raised $98 million in venture funding, with the latest investors pegging Diva's valuation at $250 million. Since SRI still has a 13% stake in Diva, that's a 200% paper return. And Cook says he's "having the time of my life."

Entrepreneurial fervor has rapidly spread throughout SRI and Sarnoff, as the list of selected spin-offs (table) clearly shows. Some of the new ventures promise blockbuster paybacks. Take Delsys Pharmaceutical Corp., spun out by Sarnoff in 1995 and headed by Martyn Greenacre, former head of European operations for SmithKline Beecham PLC. Delsys has a prototype system that uses xerographic principles to print flat "pills" with electrostatically charged, powdered-drug "toners." Greenacre predicts the system will slash drug manufacturing costs by more than 50%. "This is going to make a major impact across the whole pharmaceutical industry," he asserts.

COMFY CUSHION? Sarnoff President James E. Carnes hopes Greenacre is right. Carnes is also weary of relying on contract research. He's counting on spin-offs to provide that cushion. With 1997 revenues tentatively pegged at $130 million, up from $109.7 million, plus stakes in 11 ventures with a paper worth of $64 million, "we're well on our way," Carnes says.

Similarly, SRI's Sommers takes heart from the fast start by Nuance Communications, formed in 1994 to exploit speech-recognition technology developed for the Pentagon. SRI spent $1 million to tailor it for automatic speech transactions via the telephone. Nuance has sold systems to Charles Schwab & Co., United Parcel Service Inc., and others, and Nuance President Ronald A. Croen expects to climb into the black this year. SRI's portfolio in Nuance, Intuitive Surgical, and GeneTrace Systems--three spin-offs that have raised $50 million in outside capital--now tops $16 million.

Both labs still have troves of technology itching to be free. In fact, for every venture given the green light so far, 20 others have been put on hold. Carnes and Sommers are bending over backward to ensure their initial hatchlings are successful to smooth the job of raising outside capital for future spin-offs.

They're also being careful not to whip up an entrepreneurial frenzy that would cause droves of researchers to jump ship. Good people are too hard to find, explains Carnes. SRI has long had a revenue-sharing scheme to help keep its top people. Sommers estimates that one Menlo Park scientist has pocketed $3 million or more from this policy.

Under the spin-off strategy, SRI and Sarnoff are doing the same with stock options. "Both royalty and equity sharing is the way to attract good people," says Sommers, since it means a talented scientist can create his own "mutual fund" of stock options without the risks of joining a startup. At 10 p.m., Sommers feels pretty confident he knows where his researchers are.

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