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Sunday, April 17, 2005

VC and Innovation

(Via IEEE Spectrum) Bart Stuck and Michael Weingarten, managing directors of Signal Lake Management have interesting insights into VC funding and innovation. The tech bubble saw an explosion of VC-funded start-ups - and a dearth of original ideas. Venture capital funds can help bring great new ideas to market, some of which go on to disrupt entrenched industries, spawn entirely new ones,and perhaps even permanently change the world. Old established companies rarely do that. They're much better at making incremental innovations, because they generally have more to lose than to gain from disruptive technologies. Yahoo and Google came out of left field, not the R&D labs of Microsoft or IBM. The personal computer as we know it came out of Apple Computer, not Hewlett-Packard, itself the original Silicon Valley start-up. Cryptography was brought to market by new companies like RSA Security and VeriSign, not by AT&T. In theory, then, VC backed start-ups are the best engines of innovation. They are not is what the authors here report. By examining 1303 electronic high-tech initial public offerings for a 10-year period ending in 2002 and sorting out those that were VC-funded and compared them with those that were not, rating them on a scale of 1 to 5, with 1 being the most technically innovative , it was found that overall, the level of innovation during that decade was surprisingly low. Innovation did not correlate well with VC funding: the level of innovation actually dropped sharply after 1996, even as venture funding was going through the roof.
While innovations in e-commerce have created businesses worth billions of dollars, the difference between e-commerce businesses and earlier auction or phone- and mail-order companies is largely one of degree, not kind, and doesn't compare to, say, using lasers for microwave communications or DVD players. In fact, e-commerce business models are almost always grounded in only the slightest bits of incremental innovation. In studying the four years from 1993 to 1996, it is found that there are only 20 highly innovative companies, ones that fell into the two highest levels That's about five per year, only 4.4 percent of the four-year total. For the next six years, though, that already low percentage plunged to 1.4 percent—only five such highly innovative companies in the entire period. That's not even one per year. The number of these midrange companies decreased substantially, from 29 per year during 1993 to 1996 to only 7 during 1997 to 2002. For the first four of the 10 years studied, two-thirds of the 823 companies fell into this No. 4 tier. That proportion rose to 87 percent in the next six years—a further decrease in an already disappointing level of innovation.
The reasons for this failure are complicated and deeply entrenched in the VC way of doing business.But a common thread runs through many of them, and it has to do with risk. VCs really aren't the risk takers they're often made out to be. Venture capital funding increased 12-fold between 1993 and 2002. Perhaps there's just too much money chasing too little innovation. But perhaps the same money, better spent, would encourage more innovation.

My Take:While, I am not an expert in this arena, I think the analysis looks good but somehow I am not able to delink VC and innovation - I think probably its the case that innovation seeded in one entity travels across - as ideas, components, people moving across enterprises and if cumulative innovation appears low in number then it is to be seen as an indicator of larger malaise and not neccessarily link it to venture cap funding. We also need to look at innovation output ratio from small companies without VC backing.I have seen so called promising - mass popular innovative companies listed and run on corprtate lines also doing as bad - so I think we may need to look at extending our review horizin hoping the flowers would bloom with passing time. The internal funding mechanisms of VC may need to be structurally changed to reflect the increase in wait time and faciliate the expectations on returns to settle down at reasonable levels. But in anycase the linkages between VC & Startup funding need to be strengthened and not otherwise.

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