Latest research on high-tech startups

Since 2003, an informal consortium of four (now five) West Coast research universities have been hosting an annual research conference on technology entrepreneurship. The 6th West Coast Research Symposium on Technology Entrepreneurship was held earlier this month at Stanford (engineering not business). The other sponsoring organizations are USC, Oregon, Washingto and UC Irvine.

The conference is no longer just a West Coast affair, but this year drew an national (if not international) contingent of tech entrepreneurship researchers, with presenters from MIT, Wharton, Illinois, Northwestern and INSEAD (among others). Because it’s a small conference — consisting mainly of the paper authors and discussants — there’s not enough room for all the people who want to attend.

In an interesting innovation, Stanford has put MP3 files of all the presentations up on the Stanford Technology Ventures Program website. (Independent of WCRS, the STVP also has an impressive list of talks posted to its own iTunes U site as well as its own website).

Next year’s conference will be back at UW Seattle. Let’s hope that this innovation becomes a regular feature of the program.

IFRS tax increase

The SEC and other leading accounting and regulatory organizations are stampeding to switch US accounting rules from GAAP to IFRS. The question is not if, but when.

The nominal goal is to provide both comparability across nations, and also to simplify the accounting practices of MNCs that operate in multiple markets. (Of course, as with SOx, the shift will provide full employment for accounting firms like PWC and KPMG).

The reaction of engineering entrepreneurs to GAAP or IFRS would be MEGO. Of course, this is about the reaction an accountant would have to a discussion of the relative merits of Si or SiC as semiconductor substrates, or the platform requirements for building a service oriented architecture.

However, when I was a (non-MBA) entrepreneurial software engineer, the second class I could in night school was accounting: I needed to understand how financial performance was measured in my tiny startup and how to talk to my CPA. (The first class I took was strategy, which I thought was the most fun — an opinion I still hold more than 15 years later).

This brings me to a letter to the editor in Wednesday’s Wall Street Journal highlighted the accounting impact that IFRS will have on small businesses:

New Accounting Standard Offers Benefits, Problems
In "Closing the Information GAAP" (Information Age, Sept. 8). Gordon Crovitz has done a public service by informing the business community of the pending consequences of the adoption of the International Financial Reporting Standards. As a member of the Financial Accounting Standards Board's Small Business Advisory Committee, I can relate that IFRS has been a subject of discussion in our past two meetings.

What Mr. Crovitz does not state is the tax implications facing businesses adopting IFRS. Mr. Crovitz is correct in that IFRS does not accept the last-in, first-out method of inventory. IFRS only accepts the first-in, first-out method. Nor does IFRS accept mark-to-market accounting. Businesses changing from the LIFO method to the FIFO method will experience significant tax increases. Only congressional action protecting the entire business community can avert this unwelcome tax increase. According to my sources, the IRS is also currently working on the preparation of guidance materials for the anticipated adoption of IFRS.

The American Institute of Certified Public Accountants has developed a Web site to provide important information (www.ifrs.com). The implications of IFRS will be far and wide regardless of which party controls Congress in the next few years. The time to begin preparing is now. The time to contact our congressional representatives to protect businesses is now.

Leonard Steinberg, E.A.
West Windsor, N.J.

In an inflationary environment LIFO will increase taxes for manufacturing (or retailing) firms — because profits will be recorded against the lower basis of the older inventory rather than the newer basis of the more expensive inventory. (Of course, under GAAP, firms can elect FIFO if they expect the newer inventory to be cheaper).

My sense is that startup firms — particularly small startups run by engineers — are completely ignoring what will happen when GAAP is replaced by IFRS. But this stampede to help large multinationals be more efficient (generally an admirable goal) may crush the smaller, less well-funded small firms. And this doesn’t even count the switching cost of moving over to the new system.

The lighter side of raising money

Raising venture capital is an essential prerequisite to many tech startup business plans. While some companies — usually software or services — can bootstrap off of savings or credit cards, companies with high R&D or manufacturing costs need a sizable cash hoard before they see first revenues (let alone profits).

In teaching about VC, my favorite tool has been the documentary Startup.com. Although about a New York-based startup called GovWorks.com, the presentations and negotiations with Kleiner Perkins, General Atlantic and Highland Capital illustrate the broader issues faced by tech startups raising money.

A friend, serial (i.e. chronic) tech entrepreneur Doug Klein, recommended The VC, a comic strip from the dot-com era. The strip rang true: as an entrepreneur during this period, Doug swears he lived each of these vignettes at some point during their fund-raising efforts.

The comics take the point of view that the actions of VCs are funny. Some of these are painful funny, as in the VC is going to flush us because he can’t buy a clue. Most of them are about laughing at (rather than with) the VCs in some way, shape or form.

All 52 strips from 1997-2000 are online at TheVC.com Business school professors (and public speakers) have been using Dilbert cartoons for a decade to lighten up discussions of project management, managers and (more generally) corporate bureaucracies. This site is a source of illustrations for one aspect of tech startups.

Creating firms and an industry

One of the major goals of our entrepreneurship program at San José State is to identify and re-establish ties with successful alumni entrepreneurs. We have a number of College of Business graduates who achieved success in low-tech startups, most notably Peter Ueberroth, Don Lucas, Gary Sbona and Mike Sinyard.

However, the most visible successes have come from our tech entrepreneurs. A few people know that Gordon Moore spent 2 years at SJSU (where he met his wife) before graduating from Cal, and then Caltech and going on to Shockley Labs, Fairchild and Intel. (Not to mention Moore’s Law).

In addition to semiconductors, two other SJSU alumni helped create the disk drive industry that made PCs possible.

Last April we had as a guest speaker serial entrepreneur Larry Boucher (who has an EE from Cal and both a BS and MBA from SJSU). He worked for Shugart Associates before founding Adaptec, Auspex and Alacritech. He was a technical pioneer that made both SCSI and NAS possible.

An even more compelling story is Finis Conner, who got a 1969 degree in industrial management. Conner founded three major disk drive companies: with Al Shugart, he co-founded both Shugart Associates (1973) and Seagate Technology (1979). Without Al, he created Conner Peripherals in 1986.

Very few people have created both firms and an industry the way that Shugart and Conner did. Certainly Moore and Andy Grove deserve credit for helping to create the semiconductor industry (and Intel), as the two Steves did with PCs and Apple Computer.

What is cool is when an entrepreneur can have success creating an industry, as well as technical success, business/shareholder success, and personal financial rewards. SJSU can be proud of its major successes here, even if they are far fewer than Stanford or Cal (let alone MIT).

Users becoming entrepreneurs

Last week I was at the HBS-MIT User and Open Innovation workshop. The conference is mostly (but not entirely) about user innovation in the footsteps of Eric von Hippel and his 1988 and 2005 books.

One of the major subthemes was on user innovators who become entrepreneurs. I’ve summarized the research I heard on the open innovation blog, but here wanted to comment on its applicability to facillitating engineering entrepreneurship.

One of the examples cited was Medtronic, the $14 billion/year firm founded by an electrical engineer and his brother-in-law to repair medical equipment. They were not user innovators, but to make their first pacemaker they involved doctors (i.e. pacemaker buyers, i.e. users) in the design.

This raises a question of how to best commercialize at the intersection of a highly technical user (in this case, MDs or scientists) and highly technical production processes (e.g. engineering of a human-wearable medical device). In this case, science is the customer — as with say instruments for radioastronomy — as opposed to being the input for the engineering (as with the WW II RadLab physicists enabling microwave radar).

So what if you have a product category that requires a combination of engineering competencies with deep knowledge of science, which belongs on the founding team? Are the engineers — who talk to doctors — more likely to succeed? Or does the advantage lie with a doctor-founder who hires engineers? The first is an example of a lead-user approach, while the second is user entrepreneurship.

My hunch (not immediately provable) is that the most important factor is none of the above. Instead, I suspect the driving force will be the same as with any other tech startup: how much business knowledge does the technical founder have — or, lacking such knowledge, how much is the founder willing to defer/listen to those with such knowledge?

Build or flip?

Once upon a time, tech entrepreneurs were motivated by a desire to build something of lasting value: a better mousetrap, a great company, or to change the world. In 1938, Bill Hewlett and Dave Packard sold eight oscilloscopes to Walt Disney, who was making Fantasia. Seventy years later, the successor business-to-business instrument division is at the core of Agilent.

It always helped to have good timing — either by being lucky or making your own luck. HP was there when Disney (and soon the war effort) needed electronic instruments. Fairchild bet big on silicon just as the military was shifting from tubes to transistors. Intel took the integrated circuit to the next level with its 4004 microprocessor, and bought back the rights from Busicom. Steve Jobs and Steve Wozniak went to the Homebrew Computer Club and saw how the microprocessor would enable personal computing.

In the original waves of tech startups, going public meant generating enough of a track record of revenues and profits that investors could reasonably hope that your stock would go up. Those (relatively rare) IPOs meant a few tech entrepreneurs got to be fabulously wealthy and endow vanity foundations (that today seem likely to do less good for society than their companies did). But the wealth was not the thing, at least until the hippies of Apple Computer created dozens of millionaires with their IPO, and later IPOs from companies like Sun, Oracle and SGI permanently changed the Silicon Valley mentality.

However, a much larger number of companies didn’t change the world, or create large (or even small) fortunes. Instead, they provided value to their customers, income and training to their employees, and a chance to have a vocation of meaningful work. It’s a standard power law distribution: if you buy a lottery ticket, you’re far more likely to win $5 than $50 million.

This more typical path was my own experience. We didn’t have an exit strategy because I hadn’t heard of the term when we started the company in 1987. Every penny that I made off the company came out of positive cash flow which (without the benefit of reduced capital gains taxation) is a much harder to way to throw off profits. But we produced good quality software for 17½ years before closing the doors in 2004.

The dot-com bubble seems to have changed things. Companies went public without profits and sometimes barely with revenues. There was a gold rush mentality and people who weren’t really qualified (either by talent, ethics or disposition) to build a real company were looking for a get rich quick scheme. This has continued into the current Web 2.0 era, as I was reminded when I gave a presentation at USC Thursday on Web 2.0 business modes.

So the new mantra is “flip this company.” As a 2004 Business 2.0 article proclaimed

The New Road to Riches
How To Get Ahead In The Postbubble World
Build A Company Cheap. Flip It Fast. Repeat.

Flipping a company today is about selling out to a big company ina just a few years: the Holy Grail is the $1.8 billion that Google paid for YouTube after only 18 months. However, the philosophy is similar to the dot-bomb (some say dot-con) era, companies built using this philosophy were sold to the public as a naked demonstration of the “greater fool” school of ethics.

This may be the road to riches, but it’s not a way for entrepreneurs to create value or success (more broadly defined). This philosophy was dissected by author Jim Collins in a thoughtful 2000 essay. He illustrated a point using a 1985 medical equipment startup:

The real question, the essential question is this: Is your company built to work? The answer rests on three criteria: excellence, contribution, and meaning. Again, consider Cardiometrics. The company may not have been built to last, but in all of its activities, it adhered to the highest possible standards: Instead of relying on expedient studies and marketing hype, it conducted rigorous, costly clinical trials in order to demonstrate the value of its technology. And the company clearly made a significant contribution -- to the market, to its investors, and to the lives of patients all over the world. Finally, the people of Cardiometrics found their work to be intrinsically meaningful: They worked with colleagues whom they respected and even loved, and they pursued a worthy aim to the best of their ability. Built to Flip? Built to Last? Cardiometrics embodies neither of these models: It was built to work.

Today, I believe that the opportunities for startups to IPO are greatly diminished, for a variety of reasons. IT is mature with a large number of diversified established incumbents. Biotech startups have disappointed investors with both the risk and the payoff. Both types of startups lack the complementary assets such as distribution or economies of scope to fully capitalize on their innovations.

Today startups are being acquired, and sometimes a piddly little company can create a value that they will be unable to unlock on their own, but can be realized by a Google or a Cisco. But in a free economy, every excess eventually self-corrects, so if acquiring companies don’t get value, they will buy fewer companies and pay less for those that they get — or their mistakes will put them out of business.

Either way, assuming that a bad business will be bought at a good price seems like a lousy bet.

Who deserves SBIR funding?

The Wall Street Journal reported this week on an ongoing controversy over eligibility for SBIR funding. This follows up on earlier reporting by the Washington Business Journal.

The Small Business Innovation Research program (established 1982) provides grants of about $200K for Phase I and $1.5 million for Phase II from 12 cabinet departments and agencies. In addition, five of these agencies administer SBTTR (Small Business Technology Transfer) grants — which are similar to an SBIR except they require cooperation with a university or federal research lab. The grants are funded by a Congressional mandated set aside of 2.5% of their research budgets.

An entire industry has developed around SBIR. At the university-industry conference last week at UCI, it is clear that states see integrating with SBIR is one of the easiest and most effective parts of a regional innovation strategy, as with the presentation by Lee Herron of the Georgia Regional Alliance. Drafting off the SBIR screening and legitimation, states can provide matching funds or bridge funds for firms that have won a first SBIR and are awaiting receipt of follow-on funds

The SBIR was created by PL 97-219:

The Congress finds that

1. technological innovation creates jobs, increases productivity, competition, and economic growth, and is a valuable counterforce to inflation and the United States balance-of-payments deficit;
2. while small business is the principal source of significant innovations in the Nation, the vast majority of federally funded research and development is conducted by large businesses, universities, and Government laboratories; and
3. small businesses are among the most cost-effective performers of research and development and are particularly capable of developing research and development results into new products.

Therefore, the purposes of the Act are

1. to stimulate technological innovation;
2. to use small business to meet Federal research and devel- opment needs;
3. to foster and encourage participation by minority and disadvantaged persons in technological innovation; and
4. to increase private sector commercialization innovations derived from Federal research and development.

The SBIR program is the envy of the world — other countries want to copy “the world’s largest seed capital fund.”

Today, however, there is a controversy about SBIR eligibility. In particular, the question is whether VC funded firms are eligible for SBIR funding. The rules were tightened in 2004 after the GAO investigated on behalf of Congress.

Of course, VC funded firms don’t care for this rule. The biotech industry trade association has been lobbying since 2003 to get the rule repealed, because very few biotech firms get started without VC. Their opposition has been far less organized, with people like SBIR consultant Gene Watson of Wyoming  and some bloggers fighting to keep the restrictions.

There are arguments on both sides.

The VCs and their supporters say that the ideas that have already attracted outside capital are better quality ideas than the average submission and thus should be included. Of course, the biotech industry also cite the importance of innovation in their industry to human health and well-being.

While that’s true, there are several possible arguments in favor of the restrictions.

First, the restriction does not prevent VC-funded firms, only those that are 49+% owned by firms or investment funds. If the VCs don’t dilute their entrepreneurs, then biotechs can get funded. Or biotechs can get funded early in their life before heavy dilution. This would be consistent with the use of an SBIR as a seed capital fund.

Second, the SBIR funding is relatively small compared to the VC funding; a quick check suggested the average 2005 Series A was $21 million but today is more like $30 million. So reducing SBIR funding by $500K will just force the VCs to pony up another 1.5%, perhaps diluting the founders another 3% or so. Relaxing the restriction would reduce the amount of money VCs have to put into biotechs — but (economists would predict) not allow biotechs to develop any drugs they would otherwise be unavailable to do.

This leads to the final point. The point of the SBIR would appear to be to make sure that small businesses that don’t have money to fund their innovations have a way to do so. The VC-backed firms have shown they can raise money, so the question is just who’s going to put up the money to fund their innovations — the government or the VCs.

This year, the biotechs are winning handily. A change to explicitly allow VC-funded firms to get SBIR grants is incorporated in the SBIR reauthorization bill H.R. 5819, which has passed the House 368-43 and is heading to the Senate. A quick glance at the votes suggests that won support of all Democrats and all but a few Republicans (not clear if their opposition is from the small business-friendly “Main Street” wing or from the anti-spending Libertarian wing).

Given the SBIR program expires Sept. 30, there will be pressure to pass some sort of reauthorization bill. Given the lopsided House vote, it seems unlikely the Senate will reinstate the restriction. It appears that the WSJ story was prompted by efforts to publicize the fight by the National Small Business Association, but for the average citizen or politician, this would appear to be an esoteric policy fight.