Innovation Drought

After a few years of mad creativity, it looks like a desert out there

Sixteen months ago, Andy Hertzfeld launched a promising company called Eazel. The idea was to make Linux, the powerful server software, simple enough that consumers could use it in their PCs. And Hertzfeld was no wet-behind-the-ears, freshly-minted MBA: He was one of the key designers of the software that made the original Macintosh easy to use. And he had another startup, General Magic Inc., under his belt. Last year, he raised $13 million from big-name venture investors, including Accel Partners and Dell Computer Corp (DELL ). Today, Eazel is dead. Hertzfeld had to shut it down in May after failing to raise more money. "It was heartbreaking to see our team of talented developers scatter to the winds," says Hertzfeld. "Especially when I'm pretty sure we could have made a really big difference if we had another year or so to work together."

No one will ever know, and that's what's troubling. From one entrepreneurial hotbed to the next are coming tales of technological promise unfulfilled. From networking and e-commerce to software and computer services, the startups that have been fueling innovation around the globe are being snuffed out. Certainly, many of the new companies going belly-up deserve their fate. Did we really need the perpetually whiney Or CD-World, the umpteenth site selling music online? Still, the tech wreck is wreaking havoc on more than just silly ideas. What's getting thrown out these days is the baby, the bathwater, and the basin too. "A couple years ago, even the bad ideas were getting capital," says Bill Joy, chief scientist at Sun Microsystems Inc. "Now, we have gone too far in the other direction, shutting down investment in good ideas."

Just try getting a check for a tech startup these days. After hitting a record $100 billion last year, venture-capital funding plummeted to $11.8 billion in the first quarter, or an annualized rate of $47 billion. Worse, the market for tech initial public offerings is nearly closed: Only 14 companies have gone public so far this year, one-tenth the number for the same period last year. "The environment is the worst I've ever seen and it's not going to get better in the near term," says Frank Bonsal, who helped found venture firm New Enterprise Associates in 1978.

It's not just money that's scarce: The ranks of eager entrepreneurs are dwindling too. Building a tech startup these days looks more like professional suicide than a path to sure riches. Who wants to be the next George Shaheen? It's hard to remember that when Shaheen left the top job at Andersen Consulting (now Accenture) in 1999 for the CEO post at online grocer Webvan Group Inc. (WBVN ), and an options package thought to be worth $100 million, everybody wanted to follow in his footsteps. This year, only 3% of the grads from the Massachusetts Institute of Technology's Sloan School of Management are going to tech startups, vs. 11% last year. "Entrepreneurs won't even waste time trying to find money," says Ron Conway, a Silicon Valley early-stage investor. "Do they want to go out and spend months trying to get money and then maybe have nothing to show for it?"

Less productivity. All of this raises a critical question: How big a toll is this taking on innovation? After a few years of mad creativity, then a market crash, it looks like a desert out there. Is this a temporary drought in novel ideas or a long-term phenomenon? Where will the next tech breakthroughs come from? Who will pay for them? And which people will risk their careers to bring them to market?

The answers aren't encouraging. Interviews with more than 100 venture investors, entrepreneurs, academics, and executives suggest that innovation in several key areas of technology will be compromised for the next three to five years. The consumer market, particularly in broadband services and Internet devices, will be the most troubled, though new technologies for businesses won't escape unscathed. Certainly, some sectors of tech will sidestep the fallout, but many will suffer from a steep drop in funding for 18 months to two years. Once the money starts flowing again, it could take another two years or more to bring new technologies to market. That means the innovation dry spell could last four or five years. "Innovation is going to be stifled," says Conway. The decline in investment, he says, is temporary, "but in high-tech, 18 months is a long time." The last time venture funding slid 50%, in the early 1990s, it took until 1996 before products were innovative enough to prompt corporations to crank up their tech spending.

The impact on the economy could be profound. Heavy investment in new technologies contributed to the productivity gains that created the boom of the 1990s. During the second half of the 1990s, annual productivity growth surged to about 3%, or double the rate of the prior two decades. That pushed economic growth to a torrid 4.3% annual clip, much higher than most economists thought possible. When innovation suffers and productivity growth stalls, it ripples throughout the economy. Already, there are troubling signs: Productivity slipped 1.2% in the first quarter, its worst showing in eight years.

None of this is to say that innovation is dead. Universities and national labs are plowing ahead with mind-boggling research. MIT, for instance, is developing micromachines and has created a rocket engine the size of a button. Mapping the human genome has set the stage for breakthroughs in biotech. At the same time, the few corporations with buckets of cash see this as the perfect time to lap their crippled rivals by increasing their spending on research. Sun Microsystems (SUNW ) is boosting its research and development expenditures 21% this year to $1.9 billion. Chip giant Intel Corp. (INTC ) is hiking its R&D budget 10% to $4.2 billion. And Microsoft Corp. (MSFT ) plans to spend $4.3 billion this year, up 14% from last year. "We've been able to make significant inroads into (our competitors' markets) because of innovations that come out of research," says Rick Rashid, senior vice-president of Microsoft Research. "Our future will depend on the technologies we are developing today."

Even the drop in venture financing, at first glance, doesn't look that bad. After all, at the current pace, venture firms will make investments at a level that's just a smidge below that of 1999--and higher than any year before that. Some tech sectors, including semiconductors and wireless infrastructure, are still getting venture dough. Veteran VC firms, such as New Enterprise Associates and Bessemer Venture Partners, are particularly active. Many think this is the ideal time to invest because they can get more equity in startups for less money than at any time in the recent past. "Some of the best money can be made in the darkest times," says Geoff Y. Yang, a partner at Redpoint Ventures, a Silicon Valley VC firm that has invested in wireless infrastructure and other new technologies this year.

But these times are darker than a first glance reveals. If venture funds continue to drop for another 18 months as many VCs expect, the $47 billion annual rate now could drop to $25 billion. Worse, most of that money won't go into launching new companies. Rather, it'll be used to try to salvage existing startups. In the first quarter, only 28% of the venture money went into companies getting their first round of financing, vs. 33% last year. A prolonged drop in venture investing "will certainly stop good ideas in their tracks, dry up the seed funding that feeds the VC industry, and turn off (investors) for a good long time," says Lewis M. Branscomb, professor emeritus at Harvard University's John F. Kennedy School of Government.

Few people realize how important the venture business has become to innovation in the U.S. While universities, national labs, and corporations continue to develop important new technologies, it's the role of the venture capitalist that has become most crucial. Last year, when venture funding reached $100 billion, it accounted for 55% of the money spent in the U.S. on R&D, according to the National Science Foundation and Venture Economics. By comparison, venture funding made up 4% of the overall research spending in 1990--a period of slow economic growth. What's more, venture firms are extremely effective at bringing innovative ideas to market. Josh Lerner, a professor at Harvard Business School, estimates that venture financing leads to three to five times more innovations than corporate or university funding. "Too many of these research labs are too academic," he says.

What's considered innovative often sparks debate. The classic definition comes from the mid-century economist Joseph Schumpeter, who described innovation as the first commercial use of a product or a process that hadn't previously been exploited. Someone can be a great inventor like Edison but have a hard time commercializing inventions. Ken Kennedy, a professor of computational engineering at Rice University, estimates that product or process development costs are about 10 times that of research. "It's true that a great idea, properly developed will find its way to the market," says Kennedy. "But I would say this environment means some of the ideas that could be quickly developed won't be."

Which areas of technology are suffering most from the innovation drought? It's a big group: application service providers, business exchanges, digital-rights management, e-commerce, consumer devices, consumer wireless software and services, and broadband information providers. These once-promising categories are in critical straits, typically because early financiers got scorched and have no interest in trying their luck again. "VCs are saying, `I lost in that business once, it's a dead business to me now,"' says Roy Sardina, who runs the Silicon Valley VC firm HighBAR Ventures.

Consider application service providers, a gobbledygook name for an important new sector. These companies became popular with venture firms two years ago because of a powerful idea: They would use the Net to let companies outsource their entire tech departments--from personnel and computers to software and storage. Rather than doling out millions to buy and install complicated computer systems, corporations could pay a steady monthly fee to ASPs. The ASPs would run a company's crucial operations out of their own offices, dishing up software as needed over the Internet. Corporations salivated over the prospect of saving big upfront costs and lots of tech headaches. After $1.6 billion was poured into ASPs last year, VCs cut off the money, reducing their investments to $121 million during the first quarter. Now, Gartner Inc. estimates more than half of the 500 ASPs that were funded over the past few years will go under this year.

The decimation is taking a heavy toll on innovative new services. NotifyMe Networks Corp., an 18-month-old startup that raised $14 million and boasted an engineering team out of AT&T and a chief executive that had worked at Microsoft, shut down at the end of May when it ran out of money. Its system allowed corporations to send information from their customer databases to a service run by NotifyMe, which would then zap updates to the company's customers via mobile phones and pagers and e-mail. Travel service Sabre was trialing NotifyMe to let passengers know when flights were delayed or cancelled, and package delivery service NextJet was using the system to let customers track packages. "Their philosophy and strategy made the service so easy to use," says Paul Orsak, chief technology officer at Dallas-based NextJet. "Literally, within a day you could be using their service."

That's not the only place a lack of money is choking off innovation. Last year, venture firms began trying to figure out how to commercialize peer-to-peer technology, which harnesses thousands of computers and huge databases of information to tackle big jobs, such as analyzing climate changes. vcs invested $300 million in 100 P2P companies in 2000, but the flow of cash has declined substantially this year. Already, 10 of the freshly funded companies have bit the dust, sold out, or shifted to a new line of business. For instance, Popular Power, which pulled together the spare processing power of far-flung computers to model influenza vaccines and other similar projects, went out of business in March. "It's really hard right now," says Clay Shirky, a partner at the Accelerator Group, a New York incubator. "It's hard to get people to fund infrastructure companies."

ASPs and P2Ps may sound like alphabet-soup companies that only corporations could love. But consumers, too, could pay for a slowdown in innovation. Several tech sectors had been on the cusp of becoming truly mass markets when the bottom fell out of the capital markets. Internet devices, wireless data, and broadband services seemed ready to make the leap to wide use--much like when television graduated from being an educational tool to a mass-market product in the 1940s.

Remember all the talk of an Internet appliance on your refrigerator to order groceries over the Net? Or how you would download all your music from Napster or some other Web site and then copy it to a player in your car or your wristwatch? Forget about it. Innovations that seemed close a few months ago may not materialize for 5 or 10 years. In Net appliances, for example, the capital crunch has chased hotshot upstarts like Netpliance out of the business. Even more established companies, including 3Com (COMS ), have dumped their Net-device initiatives as they go into survival mode. "I think that everything that was happening around Napster was a sign that [these new digital services] were about to turn consumer just when the market went down," says Harvard's Branscomb.

The hit to broadband may be one of the more damaging ones. Because broadband Net connections have been rolled out more slowly than expected, many investors have been scared away from companies that rely on speedy Internet links that deliver movie-quality video and rich graphics. An entire generation of companies has been wiped out in online entertainment, streaming audio and video technologies, and digital-rights management--the software that's critical in managing how copyright-protected movies or songs zip around the Net. In online entertainment alone, dozens of companies have gone under in the past year, including sports site Quokka Sports and personalized news site Zatso Inc.

The result is a vicious circle: Without broadband, online content is a mere shadow of what it could be. That makes the Web surfer's experience less compelling, which could slow the number of people who flock to the Web. That, in turn, lowers demand for broadband--making it the problem and the solution. "The unfortunate thing is that just as VCs are giving up on these companies is exactly the time when they are critical," says Ford Cavallari, vice-president at the Boston consulting firm Adventis.

Development drag. A similar cycle is putting a drag on the development of wireless devices. Consider Scout Electromedia's wireless service called Modo. The size of a cigarette pack, the Modo device transmitted data using the existing paging network and was targeted at the 22-to-33-year-old crowd that wanted to find the latest hot spot or listen to the coolest band. Thousands of people bought the $99 devices as soon as they went on sale in New York and Los Angeles last fall and the company planned to boost production. But the company needed more dough and its venture backers, idealab! and Flatiron Partners, had big enough financial problems that they wouldn't chip in more cash. Modo shut down in October, three weeks after its launch. "Instead of trying to make a slightly better cell phone or Palm, Scout wanted to change the world," says Kevin Werbach, editor of EDventure Holdings' tech review newsletter Release 1.0. "This was a company building technologies consumers could really use, and tackling the expense and complexity that have caused most wireless information devices to fail."

The impact on innovation goes beyond the failure of a flock of newbie companies. With less pressure from startups, established companies have less incentive to develop new products and services. After several music sites folded and Napster was straitjacketed by the courts, most of the major record labels scaled back their plans for peddling music on the Net. "The studios and the labels don't really have much pressure now," says Frank Biondi, the former CEO of three entertainment companies--Viacom (VIA ), Universal Studios, and HBO--who is now senior managing director at venture fund WaterView Advisors LLC.

Not all the news about innovation is gloomy. Some VCs continue to make high-risk bets that may lead to significant innovations in the future. They tend to be in a handful of areas, including semiconductors, data-storage technology, and optical-networking gear for high-speed telecom networks. Lightbit, headquartered in Mountain View, Calif., is an example of the long-term investments still being made in optical technologies. The company, based on research from Stanford University, is developing all-optical switching capabilities that make telecom networks faster and cheaper to operate by eliminating the need to change optical transmissions into an electrical format as they zip around the country. "The technology may not be applicable for two or three years but we think it makes sense," says Todd Brooks, general partner at Silicon Valley's Mayfield, a financial backer and one of the most active venture firms these days. IBM (IBM ) is pushing the envelope in supercomputers and chips. "A well-run research organization shouldn't go up and down with the economy," says Paul Horn, IBM's research director.

Still, most venture firms are shelving the expensive change-the-world bets of the past few years. Rather, investors are focusing on incremental improvements, particularly in supply chain software, Internet security, and wireless networking software. One example is Tahoe Networks Inc., which raised $38 million in January from Redpoint Ventures and Accel Partners. The San Jose (Calif.) company is developing switching equipment and software to let wireless network operators more easily connect new wireless networks with existing data and Internet networks. "In some ways, the best time to start a great company is in a downturn," says Anthony Alles, the company's CEO.

After the folly of the past couple of years, a return to more careful, measured development of technology does make sense. The danger is that cutbacks will go too fast and too deep. Regis McKenna, the marketing guru who helped put Apple Computer Inc. (AAPL ) and Intel on the map, argues that Silicon Valley is prone to wild swings in funding and innovation because it has not yet learned from the past. "My parents learned from the '29 Crash," he says. "But we haven't developed a community memory, maybe because of the huge influx of entrepreneurs. There aren't enough people who have been around long enough." Maybe this time the Valley and the rest of the tech world will learn from the lessons of the past.

By Heather Green

Contributing: Jim Kerstetter

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