No Slacking In Silicon Valley

How the crucible of the New Economy churns out one astounding product after another

Jeff Thermond could have happily stayed at 3Com Corp. for the rest of his career. After 8 1/2 years helping build the computer networking company into a giant, he was a top manager with a fortune in stock options. But last summer, Thermond felt the Silicon Valley itch--and jumped ship to become chief executive of Epigram Inc. The Sunnyvale (Calif.) startup is about to unveil technology he hopes will become essential in every home--a way to link together PCs, consumer electronics, and appliances for the smart house. "We can create a market that didn't exist before," effuses Thermond. "We're going for a home run."

Take a look at an amazing phenomenon. After one of the most astounding outpourings of ideas and products in history, Silicon Valley's legendary innovation machine is still in overdrive. If anything, the Valley's stature as the world's high-tech capital is growing. Last year, 3,575 new businesses were launched, and venture capitalists poured a record $3.7 billion into startups--60% more than the year before, according to PriceWaterhouseCoopers. And 1998 is shaping up as another banner year: Venture capitalists dumped $1.87 billion into Valley companies in the first quarter, up slightly from the same period a year ago, says researcher VentureOne Corp. in San Francisco. "Silicon Valley is the single most important center for innovation," says Mitchell L. Moss, a professor at New York University. "Money follows ideas, and money flows to money."

MAGIC MIX. Signs are strong that the region will continue to churn out new ideas and new companies for some time. The reason? The Valley still possesses the combination of ingredients that nurtured Intel, Apple Computer, and Cisco Systems. The key is the sheer density of more than 7,000 tech companies crammed into a 50-mile corridor. That gives startups access to a deep talent pool of smart, experienced engineers, programmers, and managers, as well as the infrastructure--from legal to technical to marketing--that can transform an entrepreneur's idea into a company overnight. Add to that the unmatched availability of venture-capital and funding from larger corporations, and a climate that rewards risk-taking and tolerates failures, and you have the recipe for a technological hothouse.

True, Silicon Valley runs the risk of tripping over its own success. Explosive growth has left the region with a shortage of engineers, a lack of affordable housing, and sky-high business costs that make it ever more expensive to start a company there.

Despite these problems, the Valley is moving into the 21st century at top speed. In the past, innovation focused on producing more powerful hardware and whizzy packaged software. Now, the hot investment fields are ones that aim to reshape entire industries: electronic commerce, digital consumer electronics, and communications. "The game now is structural changes in the economy itself," says John Seely Brown, director of the Xerox Palo Alto Research Center.

And Silicon Valley is playing the new game well. Take E-commerce, where the pace has accelerated to warp speed. Hundreds of startups such as E-Loan and are devising ways to cut out middlemen and speed product cycles by connecting buyers and sellers directly over the Internet.

E-MAILROOM. Not all of these will succeed--but the sheer number of startups is an essential part of the Silicon Valley creative process. In E-commerce, where no one yet knows the best ways of doing things, the advantage of Silicon Valley is that it gives bright ideas a chance to prove themselves.

Nothing shows this better than Palo Alto's Kana Communications Inc., launched in 1996 by Mark Gainey, then 28 years old. Gainey had the idea of making software that categorizes and sorts E-mail. Potential buyers: companies that took the plunge into the Net but couldn't cope with the avalanche of customer E-mail generated by their new Web sites. Kana's software would enable companies to eliminate expensive brick-and-mortar call centers one day and, by having instant E-feedback from customers, quickly modify or customize products.

Gainey, who previously worked at venture-capital firm TA Associates, was able to raise more than $5 million to get started. Today, the startup has customers such as Netscape Communications, online auctioneer eBay, and cable company Cox Communications. "The global 2000 are waking up to the leverage they can get from electronic business," says Gainey. "And we're providing the plumbing."

But good ideas and cash alone are not enough to keep innovation going. Where Silicon Valley also shines is in the availability of talent that's seasoned and willing to take risks. At Epigram, for example, the five-person management team came to the startup with a total of 110 years of experience at such high-tech companies as 3Com, Sun, Rockwell, BBN Communications, and Cisco. Backers are betting that such hands will help the company get a big chunk of the home networking market, expected to reach $1 billion in sales by 2002, according to Forrester Research. Venture capitalists have funneled $13 million into the company, which will ship its technology early next year.

Startups such as Epigram have to find their way in a business dominated by giants. Indeed, one danger to Silicon Valley's innovative vigor is the growth of megacompanies such as Microsoft, Intel, and Cisco. In other industries, the emergence of such behemoths has typically signaled the maturing of the industry and the slowdown of innovation.

That has not turned out to be true in Silicon Valley--at least not yet. Instead, the giants have been a further source of funds backing innovation. They have been pouring money into the Valley for several years, investing in or snapping up more than 200 companies. Intel alone has taken equity stakes in 125 fledgling companies, while Microsoft has poured money into more than 50 deals.

WIDER BETS. Association with the giants gives startups access to huge resources and marketing clout. For big companies, spreading R&D money beyond their walls is a way of stimulating innovation--and upping their chances of not missing the next thing. Intel, for example, has invested in companies doing everything from improving chip design and manufacturing to building Internet communities. "It's our equivalent of a Bell Labs," says Michelangelo A. Volpi, manager of Cisco's investment portfolio. "Instead of betting on one technology, we can place our bets on 10."

More and more, corporate investors are taking the next step and actually buying up startups with promising technology. "We don't invest in companies with the idea of selling," says C. Richard Kramlich, managing partner of venture capitalist New Enterprise Associates in Menlo Park, Calif. "But we've had 10 companies acquired this past year."

Motorola Inc., for example, recently paid an estimated $400 million for Starfish Software Inc. of Scotts Valley, Calif., which was started in 1994 by Philippe Kahn, founder of former software giant Borland International Inc. For Motorola, it was an opportunity to acquire Starfish's TrueSync technology, which reconciles data between handheld computers, PCs, and mobile phones. For Kahn, who together with his wife owned 75% of Starfish, it meant both vindication and riches. "It's almost embarrassing," says the 46-year-old Kahn. "It's more money than we'll need for the rest of our lives."

Often, such a purchase can give a new technology a jump-start. Take WebTV Networks Inc., a Mountain View (Calif.) company that was developing a digital set-top box for viewing the Web via TV. In August, 1997, Microsoft Corp. bought the company for $425 million and quickly brought in research and development funds--in addition to Microsoft's considerable marketing might. Sales of the WebTV box jumped from 50,000 at the time of purchase to 400,000 today. "They got a great exit and a better shot at realizing their dream under Microsoft's umbrella," says Andy Duncan, CEO of E-commerce startup EC Co.

But it's not just the big outfits that are funding new firms: The Valley's abundance of wealthy entrepreneurs continues to be an essential ingredient to the innovation cycle. Even after an entrepreneur is flush with cash, few stray far before returning to the high-tech hunt--to start another company or invest in other hopefuls. "They get the new house, the new wife, the boat, and they don't really like to play golf. So what then?" asks Hans C. Severens, a former investment banker who now backs tech startups. "They have business in their blood. They have money in their pockets. It's about reinvesting."

BAND OF ANGELS. That part of the equation could become more critical in the years ahead. The sheer abundance of startup capital is beginning to have one ironic consequence: Venture funds are bulging to the point where many investors no longer want to be bothered with small-fry opportunities. The average size of deals has climbed 27%, to $5.3 million, in the past two years, according to PriceWaterhouseCoopers.

In typical fashion, the Valley is plugging the hole. To seed deals too small for venture capitalists, private investors are jumping into the fray, including one group of 120 industry execs led by Severens, known as the Band of Angels. Since it was formed in January, 1995, the Band has helped launch 62 startups, pouring an average of $1.1 million a month into the market. This reinvestment is helping the Valley refuel itself--and is apt to continue doing that as even more wealth is spun off. One enterprise that benefited from such funding was EC Co. Duncan started with some of his own money, then brought in a half-dozen angels. Funding from four corporations, including Intel, followed. Only then did venture capitalists add their contributions.

Could anything slow the rate of innovation in Silicon Valley? As dynamic as it is, the Valley isn't immune to larger economic forces. The Asian economic crisis is making a dent: Layoffs have already occurred at Intel, Sun Microsystems, and Applied Materials. Last year also saw a sharp drop in the number of initial public offerings for local companies: There were just 34 IPOs, vs. a record 74 in 1996, according to VentureOne. Just 15 went public in the first half of 1998. Part of the slowdown reflects a return to more tempered conditions after the Internet stock frenzy of 1996.

Another drag is the Valley's physical limits. It's bursting at the seams: Commercial real estate vacancies hit a 10-year low in 1997, and traffic delays on the region's clogged freeways have doubled since 1994. The cost of housing, too, is the highest in the country, making it harder to recruit top talent. That's prompting some companies to expand elsewhere in California or into other states.

RESILIENCE. But the nerve center of the tech world is still firmly planted in the Valley. Even when companies set up shop elsewhere, says Becky Morgan, chief executive of the public/private partnership Joint Venture: Silicon Valley Network, "research and development incubators will still be here." SAP, L.M. Ericsson, and AT&T, for example, have all established R&D centers in the Valley in recent years. Even Microsoft, long rooted in Seattle, plans to build a 32-acre campus in Mountain View.

It's that constant supply of fresh talent that will continue to keep Silicon Valley on the cutting edge. Despite periodic downturns, the region has shown a remarkable ability to catch the latest technical wave. Is it home networking, automating customer service, or connecting buyers and sellers over the Net? Or maybe it's as simple as transforming the lowly TV into a tech-savvy device. That's what 48-year-old Mike Ramsay, a former marketer at Silicon Graphics Inc., thinks. In Sunnyvale, he launched TiVo Inc. to create a smart set-top box that recommends shows to viewers based on their preferences and records programs for later viewing as easily as clicking a remote. "We're dealing with a whole new category," Ramsay says. "We're on the edge."

It's the Valley's siren song. Every day, seasoned managers and fresh-scrubbed MBAs alike throw caution to the wind and try their luck at building the next Yahoo! Inc. or Sun Microsystems Inc. As long as they do, the land of startup dreams, breakthrough technologies, and fast fortunes will keep its innovative verve.

Before it's here, it's on the Bloomberg Terminal.