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Making money and jobs with technology: How the successful say they do it

When John Shoch of Palo Alto visited an old friend in Beverly Hills, he discovered they had more in common than Northern and Southern Californians care to admit. His friend took him to breakfast at Il Fornaio; Shoch, a venture capitalist with three Stanford degrees, often starts his day at the chain's Palo Alto restaurant. His friend, in the TV and movie business, proceeded to make an "infrastructure scan" of the tables, taking mental notes of who was eating with whom among the lawyers, writers and agents gathered there.

Amazed at the similarity of the two scenes, Shoch concluded: "This must be a general characteristic of industries."

In the telecommunications age where the world is at your fingertips, how is it that a restaurant ­ or geography at all ­ still matters? Nobel economist Kenneth Arrow asked that question at a recent Stanford conference on "the changing nature of entrepreneurship," which drew some of the Silicon Valley's most respected venture capitalists, technologists and scholars. Hosted by Stanford's Center for Economic Policy Research, the conference was part of a new research effort directed by Stanford economists Paul Romer and Timothy Bresnahan to look at the relationship between national economic growth and the economic well-being of individuals and families.

Geography does not matter, AnnaLee Saxenian of the University of California-Berkeley's urban and regional planning department told Arrow, if you are making widgets that haven't changed much in decades. But "in any environment where speed is essential, face-to-face relations still matter," said the author of an authoritative study of the Silicon Valley and Boston's high-tech ghetto, Route 128. The computer industry now centered in the Silicon Valley and Southern California's entertainment industry both operate on an industrial model that is highly networked, rather than hierarchical, she said. "In a networked system, what matters is relationships."

There is more to getting rich in movies or computers, however, than finding the right place to chew granola. Conference participants discussed in rapid fire such issues as soaring executive compensation packages and sinking executive tenure, the shortcomings of conventional corporate boards of directors, stock options in lieu of salaries for employees, the mounting risks of investing in venture capital and leveraged buyout funds, and concerns over the potential loss of U.S. technical leadership and jobs if the nation doesn't do more to close its growing education gap between rich and poor.

Silicon Valley factors

Beginning at home with a discussion of the Silicon Valley's success, Saxenian and Jim Gibbons, former dean of Stanford's School of Engineering, stressed the importance of a community's technical and social infrastructure to spawning successful new companies. In an informal study, Gibbons said he found that "Stanford startups" were responsible for about half of the revenues of the Silicon Valley's largest 100 firms from 1980 to 1996. He defined a Stanford startup as a company in which both the majority of the founding team and the technology came from Stanford. Hewlett-Packard provides a large chunk of the total, but not one of the valley's semiconductor companies fits his definition.

Gibbons stressed the importance of recognizing that "half of them didn't come from Stanford, or more deeply, the environment is critical." There is no evidence, he said, to suggest Stanford startups thrive in the local environment better than those using technology, graduates or faculty from other universities.

The infrastructure that helped technology in this area includes all of its educational institutions, he said, its relatively cheap commercial space in the postwar period, venture capitalists with management skills and easy access to basic technology through experienced companies that can fabricate chips or write software for new companies, allowing them to concentrate on the part of their idea that is unique.

The supportive social infrastructure includes a general attitude that it is OK for employees to leave one company for another or to start their own, to talk with their competitors about non-strategic business issues, and to fail in their first or even second ventures, Gibbons and Saxenian said.

Vernon Anderson, co-founder and former chief executive officer of Silicon Graphics Inc., said all three of the startups he has been involved with "incubated" at Stanford. He partly credited the Stanford administration for not interfering with faculty who become involved in commercial ventures.

Gordon Moore, chairman of Intel Corp. and a founder before that of Fairchild's semiconductor division, noted that he is a Caltech grad who came to the area because Bill Shockley hired him. Shockley eventually became a Stanford professor but brought his silicon transistor technology from the East Coast to Palo Alto probably "because he grew up here and his mother still lived here," Moore said.

And while a quarter of Hewlett-Packard's engineers have at least one degree from Stanford (many obtained on the job through Stanford's distance learning programs), Moore said Intel rarely hired Stanford grads in the beginning and probably still hires more from Berkeley.

Capital and management

Access to venture capital has been a key to successful U.S. startups in recent years, but it hasn't always been that way, and some conference participants worried that boom times for venture capital could turn into nightmares for some investors.

Mark Wolfson, a professor of accounting and finance at Stanford's Graduate School of Business who has become an investor in leveraged buyouts with Robert Bass, the chairman of Stanford's Board of Trustees, warned other investors that substantially more money is chasing opportunities that may not be expanded so rapidly. Many fund managers are being showered with capital from pension funds and others who find it impossible to resist the lure of 30 to 40 percent returns, the average in recent years for leveraged buyouts and venture capital funds. "The question I have is whether these managers really have been tested," Wolfson said. "The strong stock market has made the racking up of good track records relatively easy."

The venture capitalist who helped Ralph Landau get started after World War II was the U.S. government. With a freshly minted doctorate in chemical engineering from MIT, Landau could find no one to finance his ideas in 1946. Along came the Marshall Plan, which gave him the cash to build a plant in France to make ethylene dioxide, a key ingredient for anti-freeze. Landau and his engineering partners "had never heard of a business plan," he said, and learned management skills on the job.

But if government was a help, it was also a hindrance. Landau said his various companies struggled with high capital gains taxes, foreign violations of their patents and little help from the U.S. government in protecting intellectual property, restrictions on money transfers overseas, price controls, and finally interest rates of 21 percent that forced them to sell out, albeit making millions.

In the 1960s, Gordon Moore and some of his engineering friends got on the wrong side of management at Shockley's transistor and looked around for someone to hire them as a group, he said. No one volunteered but eventually an investment banker friend found Fairchild Instrument and Camera willing to give them $1 million, with an option to buy them out in three years. "So we hired our own boss," Moore said, and Fairchild's semiconductor division grew to 32,000 employees in 11 years. Unable to harness all the opportunities created by the technology, the company spawned many spinoffs, including Moore's Intel, which was founded in 1968 with some of the first venture capital. Intel purposely does not have an independent research and development lab where employees can produce more ideas than Intel can harness, Moore said. That is why he contends the government still needs to finance basic research. Companies like his are more likely to do applied work, he said. Intel also invests in new software companies because it hopes their products will drive greater demand for Intel chips.

In the 1980s, investors like Gordon Cain made millions from older technology by arranging leveraged buyouts of undervalued U.S. companies and restructuring them. Cain, who celebrated his 85th birthday at the Stanford conference, said executives of American companies were so demoralized by the business climate in 1983 when he began his buyouts that they were "almost irrational" in their willingness to sell. He has stopped doing buyouts, he said, because the tax laws are no longer as favorable and no one is offering similarly good deals.

The buyouts were good for America in general, Cain contends in his new book, Everybody Wins ­ A Life in Free Enterprise. He was able to make companies more efficient and more competitive, he said, "partly because workers didn't need all the management they were getting." At one firm, he said, the management he installed raised the productivity per worker sixfold in four years, mostly by reducing overhead employees rather than production jobs.

Cain said he hired as chief executive officers people who had been passed over by Fortune 500 companies, and he insisted they take a significant equity position. "There is nothing that focuses a man's attention like having his own money in the deal," Cain said.

The restructuring of the 1980s and early '90s was prompted by the undervaluation of stock compared to the asset value of firms on their accounting books, said Stanford economist John Shoven. "They were selling at 40 cents on the dollar, so there was billions of dollars to be made if you could figure out how to get the value out."

Those who benefited from the buyouts, spinouts and makeovers, Shoven said, included investment bankers and lawyers but also pension funds and the most productive and talented workers. "The return on a college degree is the highest it's ever been," he said. The losers included low-skilled workers, labor unions and ineffective managers.

Now U.S. stocks are selling well above their book value, suggesting perhaps, he said, that most of the efficiency gains have been made. If so, future economic growth will require more savings to invest, instead of just moving the same money around.

Executive pay, 'free agency'

Nearly every speaker at the conference spoke of difficulties finding and keeping good chief executives. A market similar to free agency in baseball may have developed for the best corporate executives, Shoven suggested. While research has yet to establish that there is greater mobility for top executives, he said that the possibility raises such questions as how much compensation a company needs to pay to keep its leadership and if there are better ways to design incentives.

Research has been hampered by the limited public access to data but Richard Lambert, an accounting professor in Stanford's Graduate School of Business, explained why more companies are using stock options to compensate executives and often even lower-ranked employees.

Stock-option­based compensation packages, which were first common in technology startup companies, are considered to be a good way of aligning management and stockholder objectives, he said. Performance is evaluated not on an individual basis but for the firm as a whole by outsiders who decide what price they are willing to pay for the firm's stock.

Such contracts also save cash because the employees are financing the company, and some owners believe the contracts are effective screening devices ­ attracting those workers who are the most willing to take risks and work hard or who have greater faith in their abilities. Stock options can also offer tax advantages over salary payments depending upon the structure of corporate and individual tax rates, he said, and some people even think they have value in that the cost of them is buried deeper in legally required financial reports.

The contracts are extremely hard to value, however. Lambert said that the formulas used for valuing publicly traded options greatly overvalue options that are tied to employment. This is because individuals view risk differently than businesses, and employees don't have the hedging and diversification abilities of option traders. As time goes on, Lambert said, the downside risk of keeping the option is greater than the potential upside gain to the employee. As a result, employees tend to exercise their stock options as early as possible, with some studies showing 40 percent being executed in the first half of their life.

To keep incentives high over the course of the employment, Lambert suggested companies should stagger stock options, making initial options modest with promises of additional grants in future years.

Chief executive officers need strong owner support if they are to succeed, said George McCown, who has been involved in more than 30 leveraged buyouts of divisions of public companies. Even though his firm, McCown DeLeeuw & Co., has required its chief executive officers to invest some of their own money, he said, "we've had to change 40 percent of them. . . . We decided we have to do a better job of managing ourselves if we are going to help these guys." His company has hired a French firm to help come up with ways to align the needs of stakeholders, including customers. Not everybody is interested only in working for the highest bidder, he contended, and the firm's success has been greater when key people feel they have a "noble goal."

Corporate boards

Weak boards of directors are part of the management problem of many companies. Stanford law Professor Joseph Grundfest, former commissioner of the Securities and Exchange Commission who teaches courses at Stanford Law School for members of boards of directors, said that stockholders and managers of companies should ask themselves what would happen if their board of directors was abducted by aliens. Specific questions to ask, he said, are: "Would you notice? How much would you pay to get your board back? Would you pay in cash or stock? Would your stock price change at all?"

Many companies assume they need boards of directors but can't list any real functions they perform, Grundfest said. Boards of directors began as a way for individual owners to get advice from their friends and associates but have evolved in many Fortune 500 companies into do-nothings.

In Silicon Valley, where venture capitalists do not just give money but take an active role in managing startups before they go public and often afterward as well, "everybody knows why they are on the board," Grundfest said. "The CEO's job is on the line every day. In corporate America, CEOs easily have three years of grace."

Companies should list what roles they expect boards to perform and evaluate members annually on that basis, Grundfest said. In some, board members perform "housekeeping" chores such as monitoring compliance programs relevant to the industry or functioning as ombudspersons who handle complaints such as sexual harassment against officers. In some they are "mudflaps," helping restore public confidence in case a crisis occurs; in others they are experienced coaches to chief executives. Their most important function, he said, usually should be maintaining continuity in the handoff from one CEO to the next.

The education problem

Stanford Business School economist Paul Romer, the author of "new growth theory," which stresses