Will The Four Horsemen Ride Again?

Venture Capital is getting dissed right and left these days...

From WSJ Venture Capital Dispatch
http://blogs.wsj.com/venturecapital/2009/03/03/will-the-four-horsemen-ride-again/

March 3, 2009, 06:57 PM EST
Will The Four Horsemen Ride Again? --> -->

By Scott Denne
The slow pace of initial public offerings has forced venture capitalists to find a solution to their late-stage liquidity woes, funding private exchanges such as InsideVenture Inc. (see our story here) and Web portals that let wealthy individuals in on the action. The drought, which started in early 2008, even spurred the National Venture Capital Association to launch a committee to investigate the issue, with the group’s chairman, Dixon Doll, urging the committee to “move beyond clichés, such as Sarbanes-Oxley bashing.”

Moving beyond clichés is one thing, says Paul Deninger, a vice chairman of middle-market investment bank Jefferies & Co. But, he asks, will venture capitalists own up to the part they have played in the withering of IPOs? As investment banking has become more consolidated over the last decade, Deninger said venture firms have largely stopped listening to the advice from smaller banks like his and tied their interests to those of the brand-name investment banks to their own detriment.

“Venture capital needs to take stock of itself and realize the error of its ways,” Deninger said. “The strategy of a Goldman Sachs is to serve [large companies like International Business Machines], not the VC ecosystem. When things were great, who was leading the charge?”

In the 1990s, four smaller investment banks, dubbed “the four horsemen” - Alex.Brown Inc., Hambrecht & Quist Group, Robertson Stephens & Co., and Montgomery Securities - underwrote a large number of the venture-backed IPOs, which averaged about 130 a year before the dot-com bubble, compared with about 40 a year since, he said. Those full-service boutiques employed a large group of research analysts that offered potential investors insight into the latest technologies being developed, and held conferences where technology companies could present to these investors.

The problem with the large banks, he believes, is they tend to serve only the largest institutions, which must put a more substantial portion of money into an IPO offering to make it worth their while. Smaller banks, meanwhile, cater to the “next tier” of institutional investors for whom $1 million is a meaningful position. By catering to smaller investors, but more of them, banks like Jefferies can get smaller offerings out the door and create demand for the stock after the initial offering, Deninger said.

The silver lining to the current economic climate, Deninger said, is that smaller banks are getting more attention from venture capitalists and institutional investors. “The firms that have gotten in the way of [the IPO] market are the firms that have gotten us into this mess.”

Hitting For Average Vs. Swinging For Fences

another good article from the WSJ - ya gotta love the honesty of our friends at AlphaTech.

March 2, 2009, 11:32 PM EST
Hitting For Average Vs. Swinging For Fences --> -->

By Scott Austin
Baseball enthusiasts often disagree about who’s the more valuable hitter: the slugger who often strikes out but occasionally connects with the big home run or the light-hitting speedster who racks up singles and doubles.

An onstage chat about investment returns at Monday’s Demo 09 conference sparked an analogous disagreement among venture capitalists.

Deep into the talk, which was titled “Venture Capital in the Post Recession” and streamed live on Demo.com, David Hornik, a partner at August Capital, explained that it’s the “wild success stories” that have always driven the venture capital business. Those investors that manage to make the home-run investments “will always drive great returns for their investors,” said Hornik, whose early-stage firm manages more than $1.3 billion in capital.

Christine Herron, a principal at seed-stage investor First Round Capital, which typically invests just a few hundred thousand dollars per investment, politely bit back. “That’s taking a very big-fund mentality,” she said. “For seed stage investors or angel funds that manage $100 million, you can keep hitting a double, double, double, and still have a great fund.” Herron said that a fund she worked at in the early 1990s, Geocapital Partners, was able to yield a respectable 4x to 5x return by stringing together several smaller hits. “We didn’t have the expectations of putting down a check worth $20 million to $30 million.”

Another seed-stage investor, Bryce T. Roberts of O’Reilly AlphaTech Ventures, believes the venture industry needs to scale back expectations. “I think that’s one of the things that’s come out of this downturn is recasting what success looked like,” he said. “When I first got into venture capital in 2001, it was all about trying to build the billion-dollar business….I’m all about swinging for the fences, but that’s the spotlight being cast on the venture industry.

“How many multibillion dollar business have been created in the last seven to 10 years? How sustainable is that as a model versus taking smaller amounts of capital and preserving optionality, and taking a slower path to growth rather taking a ton of dilution and multiple rounds of financings? That’s going to be a really attractive and viable model for entrepreneurs going forward.”

Earlier in the discussion, Roberts said the size of seed rounds are growing because in this environment it may take longer, up to 24 months, before venture capital investors swoop in. “We used to be able to invest $100,000 to kick a ball out for 9 to 12 months, now we’re looking at $1 million to $2 million for a seed round.”

Gov't Bailout for VC's?

Not something I'd imagine we'll be seeing...

http://online.wsj.com/article/SB123595208950605121.html

OPINION: INFORMATION AGE
MARCH 2, 2009
Too Risky for Venture Capitalists
Why proposals for a government bailout were roundly rejected.
By L. GORDON CROVITZ

With industries from autos to banking begging for taxpayer handouts, what would you call an industry that says thanks, but no thanks? Crazy, but like a fox. Even for venture capitalists, some ideas are just too risky.

Hundreds of the country's venture capitalists this past month blogged against or otherwise rejected proposals that the U.S. government fund early-stage investing. They dismissed a recent column by Tom Friedman in the New York Times that urged bailout funds for venture capitalists. "You want to spend $20 billion of taxpayer money creating jobs?" Mr. Friedman wrote. "Fine. Call up the top 20 venture capital firms in America" and invest the money with them.

Venture capitalists certainly agree that innovators and start-up companies, not bailed-out GMs or Chryslers, will create the new jobs. They rightly brag that almost 20% of U.S. gross domestic product is generated by companies built by venture capital, such as Intel, Apple and Google. Still, they almost universally panned the notion of taxpayer support. Their real-time rejection is an excellent example of how social media -- here, the venture community dissecting a proposal online -- can now quickly take down bad ideas.

"The top venture firms don't want, don't need and are never going to take government money. The same is true of the top entrepreneurs," Fred Wilson of New York's Union Square Ventures wrote on his blog. "The worst firms, on the other hand, will gladly accept government money," which would go to investors who can't raise funds privately and to entrepreneurs whose ideas shouldn't be funded. "It's a problem of adverse selection."

Venture firms have had a hard time profitably investing $30 billion each year for the past several years. Even in the paralyzed markets of the last quarter of 2008, more than $5 billion was invested in more than 800 deals. Returns, however, have been low. Some areas, such as clean tech, look especially troubled now that oil no longer costs $145 a barrel. Another $20 billion would be impossible to digest efficiently. Instead of subsidizing the biggest venture firms, Geoff Entress of Rolling Bay Ventures in Seattle posted that tax breaks are needed for seed-stage angel investors, who "are quickly becoming an endangered species."

The idea of direct government funding is also anathema because it would undermine market discipline. Pension funds, endowments and other institutional investors keep a close eye on how their invested money is doing. Venture firms can raise new funds only if their previous performance was good.

Several venture capitalists pointed out the irony that government-funded venture capital could mean trading a credit bubble for another technology bubble. Artificially inflating the venture coffers through a government fund could risk repeating the debacle of 1999-2000, when too much money chased too few good ideas, resulting in the sharp deflation of the Internet bubble. Taxpayer funds would reduce hard-won investment discipline as cheap money backed riskier, less-promising ventures. Valuations assigned to companies would artificially rise, poorly selected start-ups would fail, and taxpayers would be on the hook.

Taxpayer money would bring other unwanted side effects. As Bill Gurley of Benchmark Capital in Silicon Valley put it on his blog, "If American citizens were truly appalled with John Thain's bathroom and the GM executive's private plane, then they should find plenty to abhor in the well-compensated VC community." Congress would no doubt hold hearings on the "obscene profits" earned by the founders of the next Google.

If policy makers want to help entrepreneurs and their investors, there's no mystery about what's needed. Immigration needs to be reopened. Venture capital is still available, but the U.S. is now a laggard in the other half of the equation, which is making sure the entrepreneur's sweat, energy and risk-taking can ultimately pay off. Sarbanes-Oxley helped kill the market for public offerings, which had been a lucrative step for successful start-ups. Income taxes are going up, not down.

And the U.S. capital gains tax rate of 15% contrasts with the 0% rate in Hong Kong, Singapore and even Germany, where there's an understanding that these investments are made with income that's already been taxed once.

This no-bailout-please episode is a wider reminder about the downside of Washington picking winners and losers. Government spending almost always distorts markets. John Maynard Keynes included among his prescriptions a do-no-harm fiscal stimulus of simply paying people to dig and then fill in ditches. Venture capitalists have now reminded us that throwing taxpayer money at an industry is more likely to be a kiss of death than to transform frogs into princes.

Innovations supported by venture capital in technology, health care, education and other promising but risky industries are at the heart of our economy, too important to be dictated by nonmarket forces. Other industries now lobbying for their own bailouts should weigh more carefully the risks that come with taxpayer involvement. The lesson of accepting government involvement often is something ventured, nothing gained.

Write to mailto:%20informationage@wsj.com

Venture Capital and Startups Feel More Pain, Study Says

I hate posting on all the bad news we've been seeing in the Venture Capital world these days, but I thought this article provided the kind of detail that startups are interested in seeing. Not only are the down rounds bad news, but the re-emergence of multiple liquidation preferences doesn't build internal support for startup management and employees. Bad signs here...

http://www.businessweek.com/technology/content/feb2009/tc20090225_653458.htm

Venture Capital and Startups Feel More Pain, Study Says
Startup valuations are falling and venture capitalists are driving harder bargains, according to a survey by California law firm Fenwick & West
By Spencer E. Ante

Like the rest of the economy, the world of venture capital and startups is starting to feel more pain from the deepening global financial crisis.

That's the main takeaway from a new survey detailing trends in venture capital investments during the fourth quarter of 2008 by the California law firm Fenwick & West.

The survey, which analyzed the terms of venture deals for 128 companies headquartered in the San Francisco Bay Area, found that valuations are falling for startups and that venture capitalists are driving harder bargains. The silver lining: The fallout so far is not nearly as bad as it was during the dot-com bust, when hundreds of companies went under and stratospheric valuations came crashing down to earth.

Down Rounds on the Rise
Sure, there were some startups last quarter that secured a higher value on their latest investment round, such as online vacation rental site HomeAway. But, of the 128 companies that received financing, 33% of them experienced so-called down rounds, or an investment that placed a lower valuation on the company than it received in the previous round of investment. More ominous, the percentage of down rounds rose every month at year's end, hitting 45% in December. "Each month things got worse in the fourth quarter," says Barry Kramer, the Fenwick & West partner who runs the survey. The highest percentage of down rounds occurred in the first quarter of 2003, when 73% of the companies surveyed by Fenwick & West suffered down rounds.

With the recession worsening, most financiers and lawyers do not expect the situation to get better anytime soon. They predict valuations will continue to decline until the overall economy begins to improve. "Private values really do lag," says Kate Mitchell, managing director with Scale Venture Partners. "More down rounds will come in 2009."

Overall, the prices venture firms are paying for equity are not rising as much as they have in the recent past. Companies that received venture financing in the fourth quarter saw an average price increase of 25% compared to the previous financing round, a significant decline from the 55% average price increase reported in the third quarter of 2008. One factor that is depressing prices is the continuing lack of an initial public offering market. The prospect of a public offering often helps entrepreneurs to extract higher prices from a venture capitalist. Last year, there were only six public offerings of venture-backed startups, including RackSpace Hosting (RAX), ArcSight (ARST), and IPC The Hospitalist Co. (IPCM).

"Multiple Liquidation" Preferences Gain Favor
As venture capital firms retreat and finance fewer deals, the financiers that do move forward are continuing to extract tough terms from the entrepreneurs they go into business with. Of the companies that received financing, 41% of the deals contained "liquidation preferences," or provisions obligating that the most recent investors get their money back first if the company is sold or acquired. That's about the same rate as the previous two quarters.

However, many more firms that do receive liquidation preference are getting "multiple liquidation" preferences, which state that a venture firm will get back as much as two or three times the amount of capital it invested. In the fourth quarter, 23% of the companies that secured preferences negotiated a multiple preference, up from 16% in the third quarter.

Another painful and little-known practice on the rise is the use of what VCs call "pay-to-play" provisions. When companies can't find new investors to bring into a company, they sometimes will try to corral a new round of financing from existing investors. Some may balk. To force all of the current investors to pony up the money, venture capitalists who are willing to play will create a provision stipulating that if others don't participate, their existing equity, which is usually in preferred stock, will convert into common stock.

Remembering Lessons Learned
Common stock typically has fewer advantages than preferred stock, such as the right to be paid first in the event of a sale. In the fourth quarter, 15% of all financing had pay-to-play provisions, up from 12% in the third quarter and 7% in the second quarter. "Insiders are putting tough terms on each other in order to get them to put money into the company," says Kramer.

About the only good news in the survey is that the venture ecosystem seems to be benefiting from the painful memories of the last bust. Entrepreneurs and financiers say that more firms are likely to survive this crisis since some of them, remembering how hard it was to raise money during the last crisis, brought in money before this downturn. Plus, many startups are getting much more aggressive about cutting costs, which should lower the failure rate. "VCs went through this eight years ago," says Kramer. "The last few years have seen more reasonable valuations. We're not going to fall as much."

The number of startups that are shut down is likely to climb in 2009, and some venture firms may also disappear. But many venture capitalists say that is not such a bad thing. A pruned tree will be healthier, so goes the thinking. "The most healthy thing for this industry would be a clearing out of people who don't have the stomach for it," says Paul Holland, a general partner with Foundation Capital. "It's a very healthy sign for our business."

Ante is an associate editor for BusinessWeek.

Venture Academics - A New Model Emerges

I thought that given the upheaval in today's venture environment, that it was important to note the emergence of some new models for Venture Capital. This is one of them - and I believe there's a lot of potential here.

http://www.forbes.com/forbes/2009/0316/100_venture_academics.html

Venture Academics
Jonathan Fahey, 02.25.09, 06:00 PM EST Forbes Magazine dated March 16, 2009

A new firm thinks it has found a way to turn inventions from the nation's biggest research institutions into cash.

After ten years of research, David Martin, a materials scientist at the University of Michigan, came up with a polymer that could help deaf people hear and blind people see. His poly (3,4-ethylenedioxythiophene), or Pedot, could coat the electrodes used for stimulating and recording from the brain, making them smaller, more sensitive and more effective at treating deafness, blindness and Parkinson's disease, among other conditions. How was Martin to turn Pedot into a commercial product? "I don't have an M.B.A., and I never wanted one," he says. A venture capital firm told him to come back when his invention was further advanced.

Martin had entered what technology transfer officers refer to as the valley of death, the barren gulf between the basic science and a prototype good enough to pique the interest of an established company or a venture capital firm.

But stepping into this void came a new company--half VC, half private equity firm--called Allied Minds, of Quincy, Mass. Allied created a company called Biotectix around Martin's discovery. It put up $750,000 to hire Martin's lab colleagues and run the first animal trials. With promising results Biotectix moved into its own labs and landed its first commercial contract (with the Australian medical device maker Cochlear) to incorporate its invention in cochlear implants. The polymer dramatically increases the sensitivity of the implant, while reducing its size.

In funding the commercialization of academic research, Allied Minds has an ample assortment of targets, given the paucity of bank credit and the preference of VC firms for big, quick investments. But it's a territory littered with failures. Two and a half decades ago University Patents was a glamorous pioneer in this business, with a share price of $24.50. All that's left is a moneylosing firm called Competitive Technologies (amex: CTT - news - people ), which sells for 95 cents a share and is at distinct risk of being delisted from the New York Stock Exchange.

Allied claims it has a new approach, imported from the U.K. The company has agreements with 31 U.S. universities and national labs, including powerhouses Harvard, Yale, the University of Michigan, most of the University of California schools and the national laboratories Lawrence Berkeley and Los Alamos, to periodically survey discoveries and pick a few to develop. The company will initially invest $1 million or so in a project and aims to create six to eight new companies a year.

Instead of operating as a fund, with a specific end date by which it must pay back its investors, Allied Minds is structured like a holding company. It creates subsidiary companies that it owns along with the university and the researcher. Allied Minds, as parent, provides interim management and back-office functions such as legal and payroll to the subsidiary as it "de-risks" the technology on the cheap. As the companies mature, Allied Minds will profit if the companies sell or license products to bigger players, or if the companies go public.

Allied was founded by the British venture capitalist Mark Pritchard and funded largely by Neil Woodford, an investment chief at Invesco, the U.K. asset management firm. Allied Minds won't say how much it has raised, but the number appears to be $50 million. Since its founding in 2005 the company has created 15 subsidiary companies based on technology like magnetoresistive random access memory from New York University and a salt-intake monitoring system from Cornell University. None has made money, but these projects are still in their early years.

"We are in uncharted territory with all of our technologies," Pritchard acknowledges. "But it should not be that hard. There is phenomenal innovation going on in these schools, and the world and companies need innovations."

Pritchard decided to start the company after a 2003 visit to Purdue University on behalf of a British company he was funding. The mechanism for getting technology out of the university was sclerotic. Except for the Massachusetts Institute of Technology and Stanford University, which have developed strong networks of fundraisers, most research institutions, he found, were grasping for help getting technology off their shelves.

"If you look at what comes out of U.S. universities in terms of creation of products and companies, it's a pretty poor return on taxpayer money," says Pritchard.

It's hard to judge that, but according to the Association of University Technology Managers, the biggest research universities in the U.S. received $28.5 billion in federal funding in 2007, along with $3 billion from industry. They received $2 billion in licensing revenue, and 502 companies were started that year to capitalize on academic science. The U.K. has at least two public companies (ip Group and Imperial Innovations) built around university technology development; the only public U.S. company that focuses on very-early-stage university discoveries appears to be the ailing Competitive Technologies.

The little money now being invested in professorial startups comes from state and university grants, angel investors, seed venture capital funds and, occasionally, big traditional venture capital funds. Some schools, like Boston University, have started in-house venture funds.

E. Jonathan Soderstrom, who runs Yale University's technology-transfer office and is the president of the Association of University Technology Managers, says that the problem of raising money has never been as acute as now. "The gap is widening as the market continues to punish risk-taking," he says. "This is a concern of every single tech-transfer office in the world right now. The system is broken, and none of us know how to fix it." Perhaps Allied does.

Finding the Jewels

Recent Graduates
A few of Allied Minds' 15 subsidiary companies, tapped from the nation's universities.

SaltCheck
Based on research from Cornell University, the company is developing a way to monitor salt intake that can be performed at home or in a doctor's office instead of by sending samples to labs.

RF Biocidics
These University of California, Davis researchers have a way to disinfect nuts, grains and other foods, using quick, targeted blasts of heat that kill pathogens but leave food alone.

AXI
An entry in the race for biofuels, AXI is using University of Washington expertise to create algae strains with certain characteristics, like the ability to produce fats or oils.

Illumasonix
A University of Colorado engineering professor is working on a noninvasive system to map blood flow of cardiovascular patients, using ultrasound and microbubbles injected into the bloodstream.

Cephalogics
From a radiology professor at Washington University in St. Louis, a neuroimaging device in the form of a wearable cap. Could be especially useful in monitoring newborns.

ProGDerm
Cancer researchers at Lawrence Berkeley National Laboratory are using a discovery that a certain protein induces fat-cell generation, to develop an antiwrinkle treatment.

Looks like 2009 isn't the year for a return to the tech IPO

Interesing article on a recent Jefferies report. Click through to see the article - there's a good chart on precursors to the return of the IPO market.

http://gigaom.com/2009/01/20/ipo-drought-hides-bigger-tech-woes/


IPO Drought Hides Bigger Tech Woes
Om Malik Tuesday, January 20, 2009 10:30 PM PT 7 comments

A lot has been written about the venture capital industry and how its problems affect Silicon Valley’s (proverbial) innovation machine. And that certainly is true, but the bigger problem for the technology industry has been the IPO market, which mirrors the pitching average of New York Yankees’ closer Mariano Rivera. This lack of public market liquidity is a much more systemic and longer-term problem, one that was brought home by a research report issued by Jeffries & Co, a small investment bank.

Look at some of the numbers: in 2008 there were nine IPOs in the technology, telecom and media (TMT) sector vs. 77 in 2007. In 2008, there were only six VC-backed IPOS and only one from Silicon Valley. (Check out this excellent discussion among the editors of our partner, BusinessWeek.)

What really is most shocking is the sharp increase in the number of IPOs that were withdrawn in 2008, especially in the TMT offerings. And those who did tap the IPO market could get a forward price-to-earnings multiple of 13.2x, down from a multiple of 33.5 in 2007. Only four IPOs were priced in their range and almost all are under water. According to Deutsche Bank, of 98 tech IPOs still public since January 1, 2006, only nine are above issue and the median stock is down 57 percent from offer.

Much like the objects that appear in the rearview mirror of your car, the paucity of public market exits is a much bigger problem. For starters, it really stymies some of the larger startups with sizable revenues and some profits, and limits their options for creating an exit event that brings in much-needed capital but also rewards the employees.

Back in the day — and I mean long before the dot-com bubble totally destroyed technology’s moral and fiscal compass — it was possible for reasonably sized software, network and chip companies to tap the public markets after spending between four and seven years in the trenches. Those type of deals have vanished, just like the smaller investment banks, such as Robertson Stephens.

I think that’s one of the reasons why we’ve seen a sharp decline in pure tech-type investments in companies building next-generation infrastructure or semiconductors, even though we continue to pivot our lives around the network, thereby requiring a more sophisticated underlying infrastructure.

The IPO landscape is going to resemble a dry river bed through much of 2009. Ted Tobiason, a managing director at Deutsche Bank, recently predicted that “There probably won’t be a great deal of volume in 2009 in any circumstance as it takes time to convert a disbelieving market to a believing market (and believing issuers). But 2010 could be a terrific year.” Let’s just hope he is right, for otherwise Silicon Valley’s problems will keep getting compounded.

Interesting article from Biz Week on the future of technology innovation

this recent cover story has some interesting details - most we know about but its a good summary of the broken system that's out there these days.

http://www.businessweek.com/magazine/content/09_02/b4115028730216.htm?campaign_id=rss_tech

Cover Story December 31, 2008, 5:00PM EST text size: TT
Whatever Happened to Silicon Valley Innovation?
Short-term thinking and increasing risk aversion have stifled the tech center's spirit. But innovators still lurk there, if you look for them
By Steve Hamm

Transmeta Corp. (TMTA) once embodied the Silicon Valley dream. Starting in 1995, the company raised more than $300 million in a nervy bid to reinvent the market for chips powering portable computers. Yet Transmeta struggled in recent years, and the grand hopes officially ended on Nov. 17, when the Santa Clara (Calif.) company agreed to be acquired by a little-known rival. In the empty lobby of the company's headquarters shortly before the sale was announced, a note on the reception desk told visitors to call an extension and "ask for Mary Anne." Incoming and outgoing mail bins on the wall were both empty.

Meteoric rises and catastrophic collapses are the norm in Silicon Valley, of course. It's all part of the process of creative destruction that's one of the Valley's strengths. But for some tech industry veterans Transmeta's fall is a lesson in how dramatically things have changed in the information technology capital. Venture firms are shying away from the kind of large and risky bets they made in the 1990s, and some experts say a company like Transmeta could never get off the ground today. "If it takes more than $100 million to get a company started, you probably can't get the returns VCs want," says Navin Chaddha, managing director of Mayfield Fund, which has backed standouts such as Compaq Computer and Genentech. The venture model for capital-intensive companies is "broken," he says.

Venture capitalists' taste for risk has changed for a number of reasons, including the difficulty of taking tech companies public or selling them for lucrative paydays. The result is that venture firms are putting much less money into tech startups than in the past, and the money they do invest goes into less expensive, less risky deals, including social networking startups such as Facebook, Twitter, Yelp, and Digg. These so-called Web 2.0 companies are creating exciting new forms of socialization, information sharing, and entertainment. But some of the Valley's old guard are skeptical they'll grow big and important enough to deliver sizable productivity gains for business and the nation or to produce an upswell in new core technologies. Today's startups "give us refinements, not breakthroughs," says Andy Grove, former chief executive of Intel (INTC).

RESEARCH CUTBACKS
Startups and venture capital are just part of the issue. Federal funding of advanced computer science and electrical engineering research has dropped off sharply since the late 1990s, as has the number of Americans pursuing computer science degrees. And large technology companies are putting less emphasis on basic research in favor of development work with quicker payoffs. "We're off-balance. Everybody is thinking short-term," warns Judy Estrin, former chief technology officer at networking giant Cisco Systems (CSCO). She just came out with a book, Closing the Innovation Gap, that's a call to arms for the U.S. technology sector.

For more than 40 years, Silicon Valley has been the world's most prolific laboratory for information technology innovation. But Estrin, Grove, and others are growing concerned that the vitality of the Valley, and, indeed, that of the entire U.S. tech industry, is at risk. That could have huge consequences for the future of American productivity, job growth, and national competitiveness. These problems have been brewing for years, but they've been amplified by the economic downturn.

Many people in Silicon Valley disagree with the doom-and-gloom assessment. After all, Apple (AAPL) is reinventing the cell phone with its computer-like iPhone, while Google (GOOG) pioneers cloud computing and Intel pushes the envelope in microprocessor design.

But while those concerned about the direction of the nation's tech economy acknowledge those bright spots, they believe an overhaul is needed. They're calling for new tax incentives from government to encourage long-term investments in breakthrough technologies, a renewed commitment by large tech companies to basic science, a shift by venture capitalists to bolder bets, and grander ambitions on the part of entrepreneurs.

So is Silicon Valley losing its magic? Or is there another generation of breakthrough technologies that outsiders just don't know about? To find answers to those questions, I recently motored through the Bay Area. I talked to some of the industry's most prolific inventors and most successful company builders. I got an earful from advocates on all sides.

Andy Grove's modest title of senior adviser to Intel belies the monumental role he has played in the success of the company and Silicon Valley. He rose through the ranks at Intel to become chief executive and chairman. He's widely credited with saving the U.S. chip industry and Intel from the onslaught of the Japanese industrial machine in the 1980s. Grove adopted a motto: "Only the paranoid survive." Now 72 and retired, he thinks the Valley's techies don't worry enough.

Dressed in a gray sweater with a BlackBerry (RIMM) clipped to his belt, Grove greets me at the door of his small office above a travel agency in Los Altos. He launches directly into a diatribe against what he sees as the shortsightedness and shortage of ambition on the part of today's Valley-ites. He regrets that the U.S. ceded the market for computer batteries to Japan in the 1970s. Now it's way behind in the race to invent improved batteries for electric vehicles—something he thinks Silicon Valley companies should be working harder on.

What really infuriates him is the concept of the "exit strategy." That's when leaders of startup companies make plans to sell out to the highest bidder rather than trying to build important companies over a long period. "Intel never had an exit strategy," he tells me. "These days, people cobble something together. No capital. No technology. They measure eyeballs and sell advertising. Then they get rid of it. You can't build an empire out of this kind of concoction. You don't even try."

Grove doesn't name names. But his criticisms raise the question: Can any of today's startups measure up to the giants of the Valley? Can any become the next Intel, Cisco, Hewlett-Packard, Oracle (ORCL), Apple, or Google? It's hard for some to imagine. "These Web 2.0 companies are surfing on the old wave. They're not creating the next one," says analyst Navi Radjou of Forrester Research (FORR), which studies the tech market.

To get a different perspective on the latest crop of startups, I drove up Route 101 to the San Francisco headquarters of Digg, one of the most celebrated Web 2.0 outfits. Started four years ago by Kevin Rose, a University of Nevada at Las Vegas dropout who drifted to San Francisco at the tail end of the dot-com boom, Digg is at the forefront of the concept of crowdsourcing. People who come to its Web site rate the quality of news stories, pictures, and videos collected there. And when "Diggers" find stories they like on other Web sites, they click on a button to add those stories to Digg's lists. The site has more than 22 million users, and it's among the few startups that can still get venture capital funding, raising $27.8 million in October. Rose says the key to Digg's success is staying nimble. "Things change in the shower in the morning," he says.

When I met Rose at Digg's converted industrial building, I didn't recognize him at first. I pictured the kid BusinessWeek put on its cover two years ago—with a baseball hat turned backwards and a goofy grin. Rose still looks young, but he's matured. His hair is clipped, and that day he wore designer glasses. The mood at Digg is a bit more serious these days, too. Growth in the number of monthly visitors to the Digg site has flattened, and Rose and his colleagues are hustling to add new features. While he concedes the company didn't do much technology innovating in its early years, he says that's changing. Digg hired Anton P. Kast, a former assistant professor of mathematics at the University of California at Berkeley, to assemble a small research team. Kast et al have produced software that links people with similar interests and soon will make recommendations to people based on their preferences. "This is not something you can build over a weekend," says Rose.

Companies such as Digg and Facebook are clearly just getting started. They have the potential to let people organize themselves and share information in powerful new ways. But it's hard to imagine Digg coming up with the kind of fundamental technology that changes the way business gets done or the way the economy operates.

There is some serious technology innovation going on in the Valley—just not a lot of it coming from startups. And that fact may prove an obstacle to truly transformative changes. One fountain of innovation, for example, is IBM's Almaden Research Center, perched high in the grassy hills of San Jose. Back in 1954 when the Santa Clara Valley was producing more prunes than microchips, IBM scientists invented a machine that would change the world of computing: the disk drive, a device for storing information electronically. The prototype in one of the hallways at the lab is about the size of a MINI Cooper automobile. It could hold just two digital songs, if there had been such a thing at the time; its modern-day successor, Apple's iPod, can hold 30,000. The march of the miniaturization of electronics is the foundation of Silicon Valley innovation.

And the march goes on. A short walk from the car-size disk drive is the office of Don Eigler, one of IBM's top physicists. Eigler, 55, has white hair, but he wears it in a ponytail and is as energetic as a 25-year-old. Since Eigler joined the lab in 1986, he has produced one advance after another at the intersection of physics and electronics. For example, he was the first person to move a single atom.

THE BLEEDING EDGE
These days, Eigler is working on harnessing the natural spin of electrons to overcome the limitations of the chip technology that has been in use since the 1960s. "My work is on the boundary between fundamental science and applied science. It won't hit the marketplace in a direct way for many years to come," Eigler explains. If and when it does, his work could place IBM at the forefront of the next big advance in microchips.

Exciting, yes. But the fact that much of the most promising tech work is being done at large companies like IBM may actually be a problem. Established companies are usually not the most capable of creating truly disruptive technologies. As management guru Clayton M. Christensen explained in his hallmark Innovator's Dilemma, established companies have a vested interest in selling what they already produce, and they're often reluctant to launch technologies that upset existing businesses. Scrappy upstarts are the ones who usually come up with breakthroughs, and they push established companies to new achievements.

That's certainly been true in the case of Microsoft. For much of the company's three decades in business, it primarily copied, packaged, and improved technologies invented by others. But prodded by Netscape in the mid-1990s and Google in the past few years, Microsoft has been forced to reinvent itself and its software. The company now invests heavily in basic computer science research and employs 1,000 PhDs in labs around the world—including one in Silicon Valley.

Microsoft's glass and stucco Silicon Valley lab is tucked away in Mountain View, just a stone's throw from Highway 101. I stopped in to visit Charles P. Thacker, one of the pioneers of PC computing. As a youngster at Xerox's famed Palo Alto Research Center in the 1970s, Thacker led the team that designed the first true personal computer, the Alto. This machine so impressed Apple's Steve Jobs that he modeled the Macintosh computer on it.

INNOVATION LAG
At 65, Thacker is still a tinkerer at heart. These days he's developing a research computer, called BEE3, to experiment with the newest microprocessor technologies. Microsoft has to rethink its software so it can take full advantage of the way the new chips work. In an annex next to his office, Thacker shows me a BEE3 with the lid off, exposing complex circuits and wiring. He has a small fan mounted on the frame that blows air on the chips. A soldering gun sits nearby.

While Thacker's project could make computers much more productive, it's not a revolutionary concept. Still he says Microsoft researchers are working on a wide array of potential breakthrough technologies. "Don't think about what your computer does for you now," he says. "Think about what it doesn't do. It doesn't drive your car. It doesn't know anything about you. It can't adapt to you. You can't talk to your computer even in the simplest way." These are the capabilities he believes will come with the next advances in computing.

The threat to the U.S. is that these advances may come from overseas. Fundamental innovation is happening in more places than ever before. In 2007, only seven American firms ranked among the top 25 U.S. patent recipients. Europe and Asia continue to lead the way in mobile communications. Japan is surging ahead in display and nanotechnology. And China and India are coming on strong in fundamental computer science research and software, respectively. "India and China are improving exponentially. We're flat. So we're falling behind," says Curtis R. Carlson, chief executive of SRI International, the Silicon Valley research lab-for-hire.

Executives at companies whose investments in basic research appear to be slipping insist they're as committed as ever. Hewlett-Packard's research budget has flattened in recent years, and its rank for patents received fell from No. 5 in 2006 to No. 10 in 2007. But Shane V. Robison, HP's chief technology and strategy officer, says the company is getting more bang for its buck now because it's concentrating on software innovations—which are less expensive to produce than chip advances. "A lot of people think if you're not doing microprocessor design, you're not doing information technology innovation," he says. "That's a goofy way to think about it."

The Valley faithful point out that the region has always gone through cycles of innovation, with lulls before the next big breakthrough. Google looked like just another search engine in its early days; perhaps another startup just getting going has the same potential to change the world. "I'm a Silicon Valley optimist," says John Hagel III, co-chairman of the Deloitte Center for Edge Innovation. "I think there's an incredible amount of opportunity to be created out of the technologies that are already in play."

New technologies may also end up eclipsing the old. Semiconductors, for example, laid the foundation for technology improvements in the past, but there may be more important advancements elsewhere in the future. Ken Lawler, a Valley partner with the venture capital firm Battery Ventures, points to new developments in biotech, solar power, and other green technologies. "Innovation is still alive and well," he says. "It's in new areas."

One day during my journey, I stop into the offices of Numenta, above a bookstore in Menlo Park. The startup has one of the most ambitious goals imaginable: building computers that work like the brain. Numenta represents classic Silicon Valley game-changing ambition—no surprise, perhaps, considering that one of the founders is Jeff Hawkins. He's a serial inventor who produced the first tablet computer, GridPad; the first successful handheld computer, PalmPilot; and the first successful smartphone, Treo.

Hawkins and his Numenta programmers study the inner workings of the brain and then replicate them with some of the most complex mathematical algorithms ever devised. Yet it's not venture capitalists who are funding this effort: Hawkins, a sandy-haired 51-year-old, is financing Numenta largely with his own savings. "The work we're doing is technically very hard. It would be very difficult to get it funded in the typical Silicon Valley way," he tells me.

There's a minitrend emerging in the Valley: Some of yesterday's inventors are resurfacing with bold ideas, which, like Hawkins, they're funding themselves. But there's a limit to how much self-funded entrepreneurs can do.

So, after my journey through the Bay Area and dozens of interviews, I drew several conclusions: Breakthrough innovation is going on at a handful of large companies and a few small ones. But there are also legitimate concerns about the Valley's long-term prospects. IBM and Intel will keep producing important chip advances. Microsoft and Google will race each other to come out with cutting-edge Net technologies. And Apple seems likely to produce more hit products. But unless entrepreneurs and venture capitalists refocus on more ambitious tech projects—even though they take more time and money to incubate—the Valley's and the tech industry's contribution to the national economy is likely to wane.

The world economic meltdown might actually have some positive effects. In times of crisis people sometimes set off in bold new directions. This shock might prompt action on the tech front from the federal government. The America Competes Act, which was passed by Congress in 2007 but was never funded, called for increased money for university research, improvements in math and science education, and corporate R&D tax incentives. Tech leaders say now is the time to act. "We have chosen not to compete," says Intel Chairman Craig R. Barrett. "You cut off your future if you don't invest."