Silicon Valley: Still No. 1
January 30, 2006

Silicon Valley isn’t the only ecosystem of innovation anymore, if it ever was. But it’s still the richest patch of talent, ideas, and money around.

Silicon Valley CEO Max Seybold sits in the passenger seat of a slate-blue 1972 Ferrari 365 GTC/4 and laughs as Edward Holl kicks the V-12 engine up to 4,000 rpms and blows past a Corolla at double the posted speed limit.

“Now we have success—so why can’t we enjoy it?” he shouts over the roar.

Mr. Seybold runs Fox Technologies, an identity and access management startup. His company rented a brace of Ferraris just to let investors and executives have a spin in something fast at a Fox Tech open house. The startup, which raised a $5.3-million round last year, just moved its headquarters from Herndon, Virginia, and from Sweden before that, to Palo Alto, California—the heart of Silicon Valley.

Every high-tech executive has heard how globalization is changing business: off-shoring development to India, or targeting China’s market potential, or tapping into innovation in Eastern Europe or somewhere else. But for all that has changed since the dot-com and tech crash, three things have kept Silicon Valley behind the wheel of innovation and small-company growth.

It’s where the money is, it’s where the people are, and it’s where the laws are written to accelerate innovation. It’s a mix that has defined three big booms and may still power another. Startups still flock to the San Francisco Bay Area to put the pedal to the metal (see The Valley: New Blood).

Still on Top

Start with money. California remains the king in venture capital—the San Francisco Bay Area alone attracted $2.03 billion in VC funding during the third quarter of 2005, according to VentureOne. No other region, no matter what locals elsewhere may do to promote investment, can compare. New York City drew $303.4 million in that time, Israel $311 million, and all of Europe only $890 million (see The Valley: Innovation Envy).

That said, investors now venture outside the Valley, looking to cash in on success stories like Luxembourg’s Skype and China’s Baidu.com.

Granite Global Ventures sent half of its VC team to China and kept half in Silicon Valley, the China half getting behind companies like e-commerce site Alibaba.com and Sino-blogging site Bokee.com. Founded in 2000, Granite is now investing a $225-million second fund and setting aside about 30 percent of it for targeting Chinese technology companies. Director Scott Bonham says the trick to investing globally is in understanding locals. You can’t just take your Internet perspective and ram through another culture, he says.

Draper Fisher Jurvetson has partnered with 17 firms across five different countries—all part of what it calls its “affiliate network” giving Draper access to globally diversified deal flow. Its Beijing-based ePlanet Ventures affiliate helped it capture a quarter stake in Chinese search firm Baidu. Remember how its share price jumped 353 percent on its first day of trading? Draper’s stake is now worth $400 million.

In exchange for deal opportunities, Draper lends its name and Rolodex to affiliates, and it may expand this happy arrangement and extend its network even further. Indeed, Tim Draper has revealed that he’s taking his firm to India with a $200-million fund.

The Syndicated Approach

Some firms employ a variation on the Draper strategy and partner with foreign firms in syndicated deals. Perelgen Sciences’ monster $74-million fourth round earlier this year is an example of such a deal. Perelgen sponged up cash from Biofronteir Partners in Tokyo, Ultreia Capital in Zurich, Vulcan Ventures in Seattle, and Zesiger Capital in New York City.

A4Vision, a biometrics company specializing in facial recognition technology, corralled investors from all over, too: Menlo Ventures, based in Menlo Park, California; MyQube, based in Milan; and Upstream Ventures, based in Singapore.

Global syndication plays an important role even in small, early-stage deals, such as the $5-million first round that Orlando-based business intelligence software startup Pentaho collected from New Enterprise Associates in Menlo Park and Index Ventures in Geneva.

Valley VCs have to think more about partnering with Europeans and Asians on their investments, says Eric Buatois of Sofinnova Ventures. “[But] syndication isn’t something you can do over breakfast at Il Fornaio,” he says, referring to the popular Palo Alto restaurant.

While syndicating is a more complicated, time-consuming process, offshore investors don’t seem to need much convincing these days, eager as many are to partner with valley venture. The trend suggests a new niche for analysts: No one as yet appears to track trans-national VC flows into high-tech startups, be that overseas investors funding U.S. companies or Americans and other nationals investing in Indian companies.

Anders Lindqvist, a VC with Stockholm-based IT Provider who took in the Fox Tech open house, says he really came to Palo Alto to look for VCs to partner with on his next deal. Technological innovation comes easy to Europeans, he says, but capitalizing on it doesn’t. “We have no Larry Ellisons in Sweden” (see The Valley: From Afar).

Local Investments, Global Results

But many investors remain wary of straying far from their home, especially when it comes to backing early-stage startups. Kleiner Perkins Caufield & Byers, for instance, mentions only five foreign investments out of 200 listed on its web site. Explaining why his Woodside Fund has yet to venture into India or China, Managing Director John Occhipinti says simply, “Our model doesn’t scale too well.”

What’s the worry? For one VC, it’s the problem of everyone staying on the same page. Clint Chao of Formative Ventures remembers how, when he worked at San Jose-based semiconductor company C-Cube, development was spread across three buildings. “Communication was tough then,” he says. “Expanding that out across different countries poses a whole new level of complexity.”

That logic would rule out multinationals, or any company with offshore branch offices for that matter—startups included. Consider Fox Technologies, which hired 30 new salespeople in Silicon Valley to handle its U.S. sales, some 50 percent of its business. “People will come to where the customers are,” says M.R. Rangaswami, the head of angel investing firm Sand Hill Group. “And that’s still the U.S.”

Israeli developers know the problem. “If you walk out of your door, and you’re an Israeli tech company, there’s not a market for 1,000 miles,” says Jefferies Broadview Chairman Paul Deninger. The solution that evolved came to be known as the Israeli Model—keeping research at home and putting sales and marketing operations in the United States.

Startups in other countries are following suit. Indian Wi-Fi security developer AirTight Networks started out in 2002 as Wibhu Technology in Pune, a short hop from Mumbai. It moved its corporate headquarters to Mountain View, California, but co-founders Pravin Bhagwat and Kiran Deshpande stayed behind with the research arm, building on technology originally developed at the Indian Institute of Technology.

“VCs wanted a valley-based CEO,” explains Vice President Jai Rawat, the first to staff the startup’s U.S. office. But things changed fast after AirTight hired David King, the former chief executive at networking company Proxim, as CEO. The company quickly raised $10.25 million from VCs. “We immediately got oversubscribed,” says Mr. Rawat. AirTight has since raised another $12 million from Walden International, Trident Capital, Granite Ventures, Siemens Venture Capital, and Blueprint Ventures. It employs 120 people, 90 of them still based in India.

San Francisco-based Soma Networks, on the other hand, sells its wireless devices for delivering broadband Internet into homes, and its biggest markets are in China–yet it chose to stay in California. “The angel investors were from Silicon Valley,” explains Chief Operating Officer Greg Caltabiano. “They understood the technology—if we had started somewhere else in America, it would have been tougher to bootstrap up through this network.”

Facing Overseas Obstacles

Starting overseas wasn’t even worth thinking about. But local VCs found they could take the company only so far. “When it came time to expand, the ones who really understood the market and understood how big it was going to be were investors in Asia,” says Mr. Caltabiano. The company hooked up with Temasek Holdings, the Singapore government’s huge investment company, which made a recent $50-million investment.

Lenovo’s $1.25-billion acquisition of IBM’s PC business last year precipitated a rapid globalization push for startups selling to the computer giant. Take UPEK, a startup that makes a biometric finger scanner for IBM ThinkPads. Originally spun off of STMicroelectronics, a Swiss company, UPEK maintains a third of its work force in the Czech Republic, even though design on its main product is done in Berkeley, California, where another third work. The rest live in Asia, where manufacturing and sales happen—production at the company’s Singapore original equipment manufacturer, and sales in China (Lenovo) and Japan (Sony).

The biggest obstacle overseas was hiring top-notch people, according to Marketing Director Greg Goelz. He wanted to keep the sales team local, but locals weren’t interested in working for an unknown, he says. The solution was to hire recruiters who helped build up recognition for the brand and then got the right people—but they came at a cost.

A startup’s success depends as much on nailing markets as anything else. When it comes to mobile technology or consumer electronics, the U.S.—the Valley, in other words—places last for Jean Schmitt, a managing partner at Paris-based VC firm Sofinnova Partners. “I tell my companies to first go to Asia, then develop Europe and go into the U.S. eventually,” he says.

He cites the success of Esmertec, a Swiss company that makes software for mobile phones and embedded devices, which went public in 2005 with revenues of around $250 million. Two-thirds of its employees are in Asia, the rest are largely split between Switzerland and Britain. One small team is located in the U.S.

Another European, Anne Glover, co-founder and chief executive of Cambridge-based Amadeus Capital Partners, has no doubt about Europe’s lead over everyone in mobile. “We have in this ecosystem all the thought leaders on how this industry is going to evolve,” she says.

Isn’t that what people in the Valley always said about the personal computer and the Internet? Well, irony of ironies, Europe and Asia both lead the U.S. in broadband to the home, the high-speed connections that are supposed to drive PC and Internet use—and subscriptions are growing faster than they are in the U.S. Asia’s consumer markets are also growing like gangbusters, another reason the Valley is starting to look out, instead of in.

Indeed, Esmertec’s success again challenges the notion that Silicon Valley somehow holds an exclusive patent on entrepreneurial networking—or that any ecosystem outside of the Valley is somehow dysfunctional. The company was funded by French, German, and Swiss VCs, its board is entirely European, and when it went public (in Switzerland) its management was entirely European. “This just goes to show that we can create multi-million dollar companies in three years with people from Old Europe,” says Mr. Schmitt. (For a look at Silicon Valley networking, see The Valley: Networking).

Changing Times and Rules

It’s easy to take Silicon Valley’s legal structure for granted. There’s a clear framework for making investments, a mature stock market, and plenty of protection for intellectual property. Countries such as China, on the other hand, are still trying to sort out these basics. Venture capital investment there dropped 16.7 percent in 2005 to a little over $1 billion, according to Zero2IPO. Analysts blame the decline on new regulations hamstringing Chinese partners and companies registering offshore.

There are cultural issues, as well. About 90 percent of VC exits are through acquisitions, trade sales being the lifeblood of the venture industry. Yet Chinese don’t look at a sale as a success, says Brewer Stone, an investment banker with East Peak Advisors, based in Greenbrae, California. “Here if you say your company was bought by Cisco, you hear congratulations,” he says. “That’s probably not what people would say over there.”

But that’s changing, as even Mr. Stone concedes. Yahoo’s acquisition of 3721, for instance, sold at 70 to 120 times its annual revenue. “It was widely considered to be a good deal for the seller,” says Mr. Stone. Then there was Yahoo’s move on Alibaba. No one says the $4-billion payout was a bad deal for CEO Jack Ma.

“Government regulation is the meteor that has hit our economy,” observes VC Gary Morgenthaler. Sarbanes-Oxley reforms tightened the framework for fair disclosure and reporting of U.S. listed companies, cutting into corporate profits and keeping stock prices down. More important from a VC perspective, it raised costs, raising the price of admission to, and trading on, public exchanges. Small public companies might pay $250,000 a year on compliance, large corporations up to $35 million. “The requirements for going public are very clear,” says 3i investor Sandy Miller. “Growing, profitable companies do well in the public market.” Sarbanes-Oxley makes earning a profit a lot harder.

The Federal Policy Factor

Cashing in on effort also got tougher when the U.S. Financial Accounting Standards Board required stock options to be expensed on a company’s income statements, again cutting into earnings.

Silicon Valley lobbied hard against this measure, many firms having relied on the promise of future stock options to keep salaries down and their burn rates low, thus contributing to growth. In July, the U.S. House of Representatives voted to overrule Standards Board on option expensing, but the bill stalled in the Senate.

“Stock option expensing is a disaster and will perhaps harm us irreparably from an economic point of view,” says Jefferies Broadview’s Mr. Deninger. “We’re going the way of Europe,” he adds, letting his brand of raging sarcasm take over. “I got a great idea—let’s let India and China model their economic markets after the U.S. in the ’80s and ’90s, and let’s model our markets on the zero-growth economies of Europe.

“Who came up with that brilliant idea?”

Cuts in federal research grants and science programs are a worry, too—2006 will be the first year that the National Institutes of Health has its budget cut in 36 years, according to the American Association for the Advancement of Science. Tighter immigration quotas are another concern, as foreign engineers educated in the U.S. ship out. Transportation and communications infrastructure are also stretched to the breaking point.

This has some investors panicked. “Mayday!” Carlyle Group’s Bob Grady calls out. “We have a problem.”

Policy makers seem unaware of how their decisions are affecting startups and the innovation economy, he contends. “The venture community needs to sound the alarm.”

Mr. Grady will be doing some alarm ringing in an official capacity beginning in May when he officially moves in as president of the National Venture Capital Association.

Although Silicon Valley isn’t the bed of roses it once seemed to be, it still has the most fertile ground for startups to grow.

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