Task_PostThanks

Entrepreneurship in the Global Economy

Entrepreneurs have long been drivers of innovation in developed countries. They

start companies and create new industries that keep economies strong and pros-

perous. Today, however, in developing nations such as China, state-controlled

economies are building robust industries at stunning speed and siphoning off

jobs from the West. How can entrepreneurs function in the face of this chal-

lenge? Can they continue to create economic value in a globalized business

environment? This book addresses the crucial issue of state planning vs. free

enterprise and examines specific problems surrounding entrepreneurship in the

global economy through nine case histories of entrepreneurial companies. It

also looks at how and why government gets involved in economic growth and

how entrepreneurs contribute to economic value. Based on this analysis, the

authors argue that companies can succeed, even in controlled economies, by

understanding the customs and policies of countries where they do business.

h e n ry k r e s s e l , a senior partner of Warburg Pincus LLC, has been responsi-

ble for investments in technology companies in the US, Europe, and Asia. He

began his career at RCA Laboratories where he pioneered the first practical

semiconductor lasers. He was the founding president of the IEEE Photonics

Society and co-founded the IEEE/OSA Journal of Lightwave Technology. He is

the recipient of many awards and honors, a Fellow of the American Physical

Society and the IEEE, was elected to the US National Academy of Engineering,

and is holder of thirty-one issued US patents for electronic and optoelectronic

devices. He is the co-author of three previous books, Semiconductor lasers and

heterojunction LEDs with J. K. Butler (1977) and Competing for the future:

How digital innovations are changing the world (Cambridge University Press,

2007) and Investing in dynamic markets: Venture capital in the digital age

(Cambridge University Press, 2010), both with Thomas V. Lento. He also edited

Semiconductor devices for optical communications (Springer-Verlag, 1987).

t h o m a s v. l e n t o is founder and President of InterComm, a corporate com-

munications consultancy specializing in technology companies. He has been

a university professor, an ad agency executive, and Director of Communica-

tions for Sarnoff Corporation. In addition to collaborating with Henry Kressel

on three books, he was editor of Inventing the future: 60 years of innovation

at Sarnoff and co-authored Gregory H. Olsen’s By any means necessary: An

entrepreneur’s journey into space (2009).

Other Cambridge University Press books by the same authors

Competing for the future: How digital innovations are changing the world (2007) ISBN 9780521862905 Investing in dynamic markets: Venture capital in the digital age (2010) ISBN 9780521111485

Entrepreneurship in the Global Economy Engine for Economic Growth

H e n ry K r e s s e l

T h o m a s V . L e n t o

C A M B R I D G E U N I V E R S I T Y P R E S S Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo, Delhi, Mexico City

Cambridge University Press The Edinburgh Building, Cambridge CB2 8RU, UK

Published in the United States of America by Cambridge University Press, New York

www.cambridge.org Information on this title: www.cambridge.org/9781107019768

© Henry Kressel and Thomas V. Lento 2012

This publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press.

First published 2012

Printed in the United Kingdom at the University Press, Cambridge

A catalogue record for this publication is available from the British Library

Library of Congress Cataloguing in Publication data Kressel, Henry. Entrepreneurship in the global economy : engine for economic growth / Henry Kressel, Thomas V. Lento. pages cm Includes bibliographical references and index. ISBN 978-1-107-01976-8 1. Entrepreneurship. 2. Economic development. 3. Free trade. 4. Industrial policy. 5. Economic policy. 6. Globalization–Economic aspects. I. Lento, Thomas V. II. Title. HB615.K74 2012 338’.04–dc23 2012013671

ISBN 978-1-107-01976-8 Hardback

Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party Internet websites referred to in this publication, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate.

For

Bertha Kressel

and

Takako Lento

with love

vii

Contents

List of figures page ix

List of tables x

Acknowledgments xi

Introduction 1

1 Government: Boss, financial partner, regulator – Entrepreneurs in mixed economies 11

2 Standing still is not an option: On promoting entrepreneurship and economic growth 35

3 Electronic innovation and the government: David Sarnoff creates the RCA empire 80

4 Global problem, golden opportunity: Ron Stanton profits from market disruption 116

5 Speeding voice and data traffic worldwide: Network microprocessors from RMI 131

6 A world leader emerges: SanDisk and flash memories 149

7 Implementing information technology across the globe 172

Contentsviii

8 Three startups in China: Entrepreneurs in a controlled economy 189

9 Connecting the wireless networks of the world 210

10 Building an economy: Government planning vs. entrepreneurial innovation 227

Select bibliography 257

Index 261

ix

Figures

2.1 GDP of the US with and without new

technology industries between 1990

and 2004 (ref. 4). page 38

2.2 Venture capital investments by US funds

by year, 1985–2011. Source: Based on data

from Thomson Reuters. 69

2.3 Number of companies funded by US venture

capital funds, 1985–2011. Source: Based on data

from Thomson Reuters. 70

2.4 Number of US venture capital-funded companies

that had an IPO and the number of companies that

merged or were acquired since 1982. Source: Based

on data from Thomson Reuters. 72

5.1 Wireless data traffic volume growth by year (figures for

2012 and later are projected). Source: From IBS,

private communications, 2011. 142

6.1 Global flash memory revenues and their

year-over-year revenue growth. Source: Based on

data from SIA and Barclays Capital (ref. 3). 153

6.2a Revenues and net income of SanDisk between

1995 and 2004. 159

6.2b Revenues and net income of SanDisk between

2005 and 2010. (Note: Year 2008 loss was owing

to inventory write-off and other asset revaluations.) 159

9.1 A comparison of combined hardware and

software revenues in the personal computing

and mobile computing industries (ref. 3). 214

x

Tables

7.1 Israeli acquisitions that started

Ness Technologies page 178

xi

Acknowledgments

This book had its genesis in a lecture regarding the future of venture

capital in the global economy that I gave at Columbia University in

2010 at the invitation of Professor Graciela Chichilnisky. However,

this book would not have been possible without the experience I

gained as a senior partner at Warburg Pincus, one of the largest pri-

vate equity and venture capital firms in the world. Since the 1980s,

Warburg Pincus has expanded internationally with offices in London,

Frankfurt, Hong Kong, Beijing, Shanghai, Mumbai, and Tokyo. The

firm has invested over $30 billion in companies located in thirty

countries in a wide range of industries. The companies it has funded

have ranged from startups to some having revenues in the billions

of dollars.

A hallmark of the firm is the outstanding teamwork of its

international professional staff, which brings to bear the required

skills from all parts of the world as needed by its portfolio compan-

ies. As a result, the firm’s partners work as a single entity and with a

common purpose in promoting the success of its investments wher-

ever they are located.

Lionel I. Pincus and John L. Vogelstein led the firm from the

1970s to 2002. Succeeding them in 2002, Co-Presidents Joseph P.

Landy and Charles R. Kaye have continued its record of success. As

Vice-Chairman of the firm, Dr. William Janeway had a major role in

directing the firm’s investment in technology businesses. All three

have been involved, along with other partners, in the companies dis-

cussed here, which were Warburg Pincus investments. The partners

who participated in one or more of these investments include Dr.

Frank Brochin, Julian Cheng, Dr. Nancy Martin, Bilge Ogut, Chang

Q. Sun, Barry Taylor, and Beau Vrolyk.

Ack nowledgmentsxii

In addition, I have also had the pleasure of collaborating over

the years with Scott A. Arenare, Alex Berzofsky, Christopher Brody,

Dr. Harold Brown, Mark M. Colodny, Timothy J. Curt, Cary J. Davis,

Andrew Gaspar, Patrick T. Hackett, Jeffrey A. Harris, Julie Johnson

Staples, Kewsong Lee, James Neary, Dalip Pathak, Dr. Stan Raatz,

Henry Schacht, Steven G. Schneider, Dr. Joseph Schull, Patrick

Severson, Christopher Turner, and Jeremy Young.

Valuable discussions helped in writing this book. We are

indebted to Dr. Bart Stuck, Dr. William Janeway, Dr. Peter Scovell,

Dr. Alexander Magoun, and Paula Parrish, the Commissioning

Editor at Cambridge University Press, for valuable discussions.

Finally, I am very grateful to Tina Nuss for her extraordinary

work in preparing and proofreading the manuscript.

Henry Kressel

1

Innovation is a primary engine of economic growth … The innovation process involves the invention, commercialization, and diffusion of new ideas. At each of these stages, people are spurred to action by the prospect of reaping rewards from their investment. In a free market, innovators vie to lower the cost of goods and services, to improve their quality and usefulness, and – most importantly – to develop new goods and services that promise benefits to customers … Successful innovations blossom, attracting capital and diffusing rapidly through the market, while unsuccessful innovations can wither just as quickly. In this way, markets allow capital to flow to its highest- valued uses.1

President Bush’s 2005 report on the economy (quoted above) identi-

fies innovation as the prime driver of economic development. And

while Democrats and Republicans might disagree on how to promote

it, innovation is officially a bipartisan cause. The Obama adminis-

tration trumpets the need to foster innovation if America is to main-

tain its leading position among the world’s economies.

Joseph Alois Schumpeter would be gratified. The great

twentieth-century Austrian-American economist was the fore-

most theorist of innovation as the source for economic growth in

the industrial world. Schumpeter knew that all technologies even-

tually became obsolete, and according to his theory this presented

an opportunity for change and growth that could only be realized

with innovation. In his view the decline of older technologies makes

room for new ones. Through a process he called “creative destruc-

tion,” innovation enables vibrant new enterprises to replace obsolete

industries.

As the creator of new companies, the entrepreneur is innov-

ation’s true agent of change. By “entrepreneur” we do not mean the

many founders of small businesses with modest ambitions. Such

Introduction

1 Economic report of the President (Washington, DC: United States Government Printing Office, February 2005), p. 135.

Introduction2

entrepreneurs undoubtedly create many valuable jobs, but they do

not individually generate enough industrial growth to be meaning-

ful in a modern economy.

In Schumpeter’s vision, true entrepreneurs are the rare leaders

capable of building revolutionary enterprises and new industries on

the basis of technological innovation.

Schumpeter’s hero … is the creative daring entrepreneur, the

captain of industry who makes the innovations that introduce

new products, embody resource discoveries and technological

improvements, and open new markets, and in the process, build

new industrial empires … The dynamic innovations of the

entrepreneurial class constitute a powerful competitive force in

economic development.2

Every new wave of technology has seen entrepreneurs build

great companies. In the US, in the second half of the twentieth cen-

tury, many of the entrepreneurs who helped lay the foundations for

the new digital age have been venture capital funded. Venture capital

has played a central role in the growth of such trillion-dollar indus-

tries as computers, telecommunications, software, and Internet-

based businesses, which lie at the heart of modern commerce. This

wave of innovative entrepreneurship occurred in a period of dramat-

ically increasing world trade that opened new markets for companies

created in the developed countries, including the US, industrialized

Europe, and later, Japan.

That now feels like ancient history. The world economic order

has shifted since the beginning of the twenty-first century. With the

rapid industrialization of the Asian economies outside of Japan, a

massive amount of industrial diffusion has occurred, and developing

countries are assuming leadership roles.

2 J. E. Elliott in J. A. Schumpeter, The theory of economic development (New Brunswick, NJ: Transaction, 1983), pp. xxxvi–xxxvii.

Introduction 3

Whereas once the US, the EU, and Japan were practically the

only highly industrialized countries, new Asian competitors, not-

ably China, South Korea, and Taiwan, have joined the club. As a con-

sequence the highly successful industrial model of the US, which

encourages open markets and individual entrepreneurship, finds itself

challenged by economic models where the state has a much stronger

influence on industrial development. To varying degrees these emer-

ging countries practice various forms of mercantilism, a policy that

favors the development of their local industries. At the same time,

the developed countries have policies for protecting their industries

as they are increasingly concerned about their health. So every coun-

try works to promote or protect its own industries in various man-

ners, which makes for a world with increasing trade restrictions.

The degree of state intervention in national economies varies

widely from one country to another, and businesses must learn to

deal with it in each country where they operate. They have little

choice, because the biggest growth markets are global. They must

establish international operations in order to grow and stay competi-

tive. What this means is that entrepreneurs with global ambitions

face additional challenges when they start companies. Government

favoritism has a marked effect on all aspects of commerce, and

strongly influences the creation of businesses and the ability of for-

eign companies to operate in local markets. Today’s entrepreneur

must think globally and learn to master new relationships in order

to build a big business. In this book we will see how modern innova-

tors and entrepreneurs have built important new businesses in this

new world economic order.

Many factors have contributed to the alteration of the glo-

bal economic landscape: the fluidity of industrial “know-how,” the

worldwide easing of the movement of capital, and the widespread

industrialization of countries with economic models dominated by

the state. All of them make the task of the ambitious entrepreneur,

in Schumpeter’s sense, harder.

Introduction4

How has the world been transformed so quickly? There are

a number of causes, but the rapid development of technology lies

at the heart of the revolutionary changes this age has witnessed.

Once upon a time industries were protected by proprietary know-

ledge in the hands (and heads) of craftsmen. Today this knowledge

is most often embedded in computer software that travels at the

speed of light. That makes it easier and faster to move jobs than

it was in the days when relocating factories also meant relocating

workers.

So the industrialized countries that emerged as economic lead-

ers in the nineteenth and twentieth centuries are watching their

mature, established industries and associated manufacturing migrate

to China and other developing countries. By sending work overseas,

companies get the advantages of lower costs and plentiful capital

for easing industrial relocation. But such relocations leave behind

unemployed citizens who clamor for new jobs. It takes innovative

new industries to generate such jobs, because the old industries will

not come back.

To put this in a larger perspective, a half-century of cease-

less innovation and global industrial development and diffusion has

irrevocably altered the world’s economic landscape, lifting billions

of people out of poverty and conferring on them the benefits of a

modern society. It has also put the developed world in the uncom-

fortable position of watching former client nations turn into com-

petitors. Developed countries must rely on innovation to create new

industries, while older, commoditized technology migrates to coun-

tries with lower wages and costs.

One can’t blame developing countries for wanting to benefit

from the outsourcing of jobs. These nations have turned to rapid

industrialization as the surest way to foster economic growth and

provide for the wellbeing of their citizens. They are now competing

for the factories that drive jobs and exports. They also want to move

to the forefront of industrial innovation, recognizing that this is

Introduction 5

essential for maintaining their competitive position. Having joined

the industrialized world, developing economies realize that they

must support innovation to create the industries of the future, or

risk falling behind. The result: a race among practically all industri-

alized countries, developed and developing, to encourage innovative

entrepreneurship with varying degrees of state support.

This drive for innovation is especially urgent for the developed

world. It would be comforting to think that innovative entrepreneur-

ship will quickly fill the industrial void in those countries, but skep-

tics say this will not happen fast enough.

“There’s been this assumption that there’s a global hierarchy

of work, that all the high-end service work, knowledge work,

R&D work would stay in the US, and that all the lower-end work

would be transferred to emerging markets,” said Hal Salzman, a

public policy professor at Rutgers and a senior faculty fellow at

Heidrich Center for Workforce Development. “That hierarchy

has been upset, to say the least,” he said. “More and more

innovation is coming out of the emerging markets, as part of this

bottom-up push.”3

With the focus on sustaining economic growth, there are two

diametrically opposed approaches. At one extreme we have pure

“state capitalism,” where the state is the source of capital and pro-

vides competitive protection to major new enterprises. On the other

extreme we have “pure” free-market capitalism, where private capital

finances enterprises and they compete in an unregulated market.

Free-market theorists, such as the people who wrote the report

for President Bush quoted at the start of this Introduction, would say

that the government should not intervene in the market in any way

at all. They would point to incentives from developing nations to

attract factories, for example, as an unfair practice.

3 C. Rampell, “Once a dynamo, the tech sector is slow to hire,” The New York Times, September 6, 2010, p. 1.

Introduction6

However, their call for no government “interference” in the

market is misguided. In fact most countries exercise varying lev-

els of control over the environment in which important businesses

operate. Entrepreneurs need access to resources and markets to suc-

ceed, and this is where national policies play a vital role.

Proponents of the other extreme often base their argument on

China’s policy for most industries, which is the closest approach we

have to “state capitalism.” Since China has demonstrated remarkable

success in rapid industrialization, moving from an agrarian nation

to the world’s second largest economy in less than four decades, its

economic model has a profound influence in shaping industrial pol-

icies around the world. Other fast-growing Asian economies have

largely adopted a model of strong state control, quite contrary to the

pure free-market economic theory beloved of economists.

But China’s leaders seem to understand that ideological purity

never jump-started the creation of a successful national economy.

Although they have adopted the model of state capitalism, they also

encourage entrepreneurs in selected sectors of the economy.

All of this creates a dilemma for developed economies. They

are losing industries to the developing world, and need dynamic new

businesses that can compete in international markets. Unfortunately,

the newcomers are racing to develop the same kind of businesses.

Developed countries have to get there first if they are to maintain

their prosperity.

How can developed countries promote the creation of innova-

tive companies charting new markets? That is the question with

which their leaders are grappling. Politicians and financiers would

love to discover a magic formula that would enable Schumpeter’s

kind of entrepreneurs to appear and create new industries faster than

the old ones can migrate overseas.

Entrepreneurship is essential to a growing economy in large

part because its innovations create demand for new products and ser-

vices that were not previously available. People only know they want

a specific product when someone shows it to them.

Introduction 7

Many economists argue as if the only thing that matters for

a buoyant economy is rising demand from the great mass of

consumers. Nothing can happen until demand increases, we are

told. Well, demand is crucial. But to look only at one side of the

ledger is disturbing. Demand side economists fail to recognize

that supply is critical in the creation of demand. That’s why

restaurants, for example, offer new supply in the form of updated

menus and new dishes and why businesses of all kinds constantly

offer products “new and improved.” What was the market for an

iPad in 1985? Zero: the product didn’t exist. Demand cannot exist

until the supply is brought to market, which is why incentives

to undertake risk are so important … The main goal should

be to create wealth. We’re better off if entrepreneurial risk is

richly rewarded. Every private sector job depended at one time or

another on someone willing to take a risk.4

Promoting entrepreneurship and seeing it succeed are not

the same thing. There are no sure-fire recipes for entrepreneurial

success in a world where increasing government interference is to

be expected as nations struggle to maximize their economic per-

formance – more often than not at the expense of other nations. But

there is much to be learned from the example of successful inno-

vators in key industries. That is what we provide in this book. In

our exploration of their achievements we will focus on the motiv-

ations of ambitious entrepreneurs, factors that have an impact on

their behavior, and the national and international conditions that

can affect their success, including the role of government and the

availability of capital.

We will also discuss how governments affect entrepreneurship.

This is an important topic, because the success of China, a huge

country under tight economic control, is forcing other countries to

4 E. T. McClanahan, “Americans are better off when risk is richly rewarded,” Austin American-Statesman, August 24, 2011, p. A9.

Introduction8

take a much stronger stance on government’s role in their economy

as a defensive move, if nothing else.

This book approaches these complex issues in three sections.

In the first part (Chapters 1 and 2) we set the stage for the exploration

of entrepreneurship in the global economy. We discuss the effects of

national policies and international conditions on industrial devel-

opment, and look at some factors that promote entrepreneurship.

We also discuss regional innovation clusters and the nature of the

Silicon Valley model in promoting entrepreneurial success.

In the second part of the book (Chapters 3 to 9) we present

the stories of entrepreneurs who successfully mastered the complex-

ities of international operations. We draw our examples from vari-

ous industries, and cover businesses created both in the US and in

other countries, including successful startups in China founded by

US-trained entrepreneurs and a startup in Israel. Some are based on

innovative technologies while others involve bringing new services,

enabled by new technologies, to the market. Each of these compan-

ies provides lessons that bear on the success of new companies in the

global market. At the end of each chapter, we offer comments on the

key success factors of the company or companies involved. We hope

these analyses will be helpful to other ambitious entrepreneurs.

Each of the companies we discuss exemplifies Schumpeter’s

definition of the entrepreneur in that it opened a new market. Of

course, the scale and impact of these businesses varied greatly. Some

companies, such as SanDisk and Transammonia, became multibil-

lion-dollar enterprises; others had smaller revenues. However, all

represented businesses that changed the landscape in their market

sector.

We begin with David Sarnoff, an entrepreneur of an earlier

generation who ranks among the first of the great entrepreneurs

of the electronic age. In Chapter 3 we describe how he built RCA

into a dominant electronics company, and created the radio and

television broadcast industry. He also set the pace for managing

intellectual property as a key foundation for corporate success in

the electronic age.

Introduction 9

In Chapter 4 we discuss Ron Stanton and the founding of

Transammonia, a leading international commodity trading com-

pany. He built a big global company on the basis of an innovative

business model rather than a novel technology.

Chapter 5 focuses on RMI, a Silicon Valley startup that pio-

neered a new family of computing processing chips to greatly

improve the data capacity of communication networks. Its initial

success came from developing the market in Asia. This example of

entrepreneurship evolved over two generations of CEOs, starting

with a visionary founder, Atiq Raza, followed by Behrooz Abdi, an

outstanding executive who possessed a remarkable combination of

technological and managerial skills.

The story of SanDisk and its founder Eli Harari, told in

Chapter 6, demonstrates how an outstanding entrepreneur can adapt

truly innovative technology to create a whole new industry segment.

The Silicon Valley company is a world leader in flash memories. It is

equally notable for the exceptional skill with which it developed and

managed intellectual property, and for how it addressed the problem

of low-cost manufacturing in a highly capital-intensive industry by

partnering with Toshiba, a Japanese company.

Chapter 7 discusses Ness Technologies, an information tech-

nology services company that was started up in Israel and became

a successful global provider. It was selected for discussion because

it illustrates the importance of building an international corporate

culture. Raviv Zoller, the entrepreneur who launched the company,

built an organization that was able to operate in many countries, and

could leverage resources from Israel and elsewhere to deliver an out-

standing level of service in all geographies.

By covering three China-based startups, Chapter 8 demon-

strates that there is a role for venture-capital-backed entrepreneur-

ship, even in a huge state-controlled economy. It also shows that there

are ground rules for operating companies in this environment that

entrepreneurs must learn if they are to be successful. Two of these

startups prospered as independent companies and became publicly

traded on NASDAQ. The third was acquired by a local company.

Introduction10

Chapter 9 discusses Aicent, a Silicon Valley company founded

by Lynn Liu, an entrepreneur born in Taiwan and educated in the

US. This company’s success was not built on inventing technol-

ogy but on providing a mission-critical service to the global wire-

less tele communications industry. Aicent also serves as a model for

companies with their origins in the US, but destined from the start

to go global. It was focused on Asia, where it became a dominant

player in its niche market.

As we discuss what it takes for entrepreneurs with global

ambitions to succeed in the current economic and political environ-

ment, it becomes evident that the hurdles they face are higher than

ever. This translates into the requirement for more capital to build

valuable businesses and perhaps lower chances for building big busi-

nesses with private capital. The companies that we selected made

it, but how often will others follow? A fair question is whether pri-

vately funded entrepreneurship can be counted on in the future as an

important engine for growth based on innovations. This would leave

governments as the most important patrons for building innovative

new industries.

This is the subject of our concluding Chapter 10. We believe

that the answer lies in between the views propounded by pure free-

market advocates on one extreme, and by proponents of state control

on the other. History has shown that, while governments are not

equipped to drive innovation into the market, neither can entrepre-

neurs operate in a state-free vacuum. Or, to put it in positive terms,

governments play an important role in industrial development, but

they are no substitute for the ambitious entrepreneur provided with

the right level of resources and a dependable legal environment.

11

Nothing has been more important since the beginning of my reign than increasing the prosperity of my people. The introduction of certain new manufacturing industries … enables thousands of my people to gain their bread honorably, the raw material stays in the country … and my subjects can easily pay their taxes. While previously money left the country, it now stays within, making the country richer and more populated. Leopold I, Emperor of Austria (1640–1705)1

We quote Emperor Leopold here because his touching concern for his

subjects’ welfare (and their ability to pay their taxes) communicates

a clear message: the government needs to play a big role in expanding

his country’s economy. Instead of issuing a proclamation encour-

aging local entrepreneurs to innovate, he instituted an active policy,

backed by state funds, to create important new industries. The idea

of depending solely on local entrepreneurs to build such industries

would not have entered his head.

Leopold was neither the first nor, certainly, the last head of

state to hold such views. Rulers of his era were well aware that build-

ing a country’s economic prosperity had the desirable side-effect

of increasing its power in international affairs, and many acted

on that realization. In the late 1600s Sir Walter Raleigh observed,

“Whosoever commands the sea, commands the trade, whosoever

commands the trade of the world commands the riches of the world

and consequently the world itself.”2 As a result, the competitive race

1 Government: Boss, financial partner, regulator – Entrepreneurs in mixed economies

1 J. Berenger, Histoire de l’empire des Habsbourg 1273 –1918 (Paris: Librairie Arthème Fayard, 1990), p. 331.

2 A. Herman, To rule the waves (New York: HarperCollins, 2004), p. 150.

Gover nment: Boss, fina ncia l pa rtner, r egulator12

to industrialize and sustain national trade advantages was a con-

stant source of international friction, sometimes leading to war.

Statesmen have been involving themselves in their countries’

economies for centuries. They know that building and maintaining

a healthy industrial base is the key to growing national wealth and

sustaining prosperity. They are not about to leave the outcome of

this high-stakes game to chance. Naturally, the economic purists

who advocate totally free markets are perpetually distressed by this

state of affairs.

But these purists ignore the lessons of history. Free enterprise

cannot prosper without the infrastructure, investments, and rule of

law that government provides. Likewise, governments sabotage eco-

nomic growth – and their global influence in the bargain – when

they try to impose too many controls on business, or establish rigid

plans for its direction.

In other words, government and entrepreneurs need each other.

This does not imply that Emperor Leopold’s command-and-control

mode of economic planning is a model for our times. Economies

have evolved toward more open, mixed systems with complex inter-

play between the public and private sectors. Entrepreneurs may

exploit opportunities to build new companies or industries, but gov-

ernments still play a major role in charting the overall course of an

economy and supporting its growth. The only “pure” systems are

failed systems. Plenty of evidence is available to back this up.

Historical antecedents

National economic development programs have historically relied

on several stratagems:

investments in education and infrastructure;• subsidies for exporters;• state funding to help or even create new companies;• erection of trade barriers to limit imports;• establishment of local monopolies or cartels to reduce domestic • competition and increase the ability to export.

Histor ica l a ntecedents 13

This is as true for free-market countries as for nations with con-

trolled economies. A nation’s official commitment to free enterprise

has never stood in the way of a little cheating to help its preferred

industries.

For entrepreneurs, such government involvement – or “med-

dling,” as the purists would have it – is a decidedly mixed blessing.

Government influence over the economy can have a decisive impact

on the success of individual ventures, and decisions made at the

highest levels can foster or stifle entrepreneurial efforts.

Problems usually start for entrepreneurs when political leaders

are looking to jump-start their country’s industrialization process.

Politicians typically believe that national programs to promote rapid

industrial development (and exports) work faster than independ-

ent entrepreneurial enterprises acting in their own perceived best

interests.

It follows that the establishment of state-owned corporations

to address critical industrial needs has been a recurring theme in

countries that are seeking to accelerate their industrialization.

Clearly, the heads of these state-owned enterprises are bureaucrats,

not entrepreneurs, in the context of our discussion.

But real entrepreneurs who build new industries with direct or

indirect state help have also emerged in most industrializing coun-

tries. Entrepreneurs have learned to live with whatever hand the

government deals them and find ways to prosper, which is part of

the definition of being an entrepreneur.

For example, during Leopold’s reign Austria began producing

textiles and arms in privately owned factories. At the start of the

process, the country lacked the knowledge and expertise to build

and operate these industries. So it set about attracting the talent it

needed.

Its appeal was simple. The government promised to grant local

monopolies, place import restrictions on competitive products, and

give business people access to some state capital to establish their

industries. These incentives lured experienced entrepreneurs and

Gover nment: Boss, fina ncia l pa rtner, r egulator14

skilled technicians from elsewhere to set up shop in Austria. If you

were an entrepreneur, seventeenth-century Austria was a good place

to be, not in spite of government meddling, but because of it.

England, the birthplace of the Industrial Revolution, may have led

the way in the race to industrialize in the seventeenth and eighteenth

centuries, but over the next 200 years its increasing prosperity encour-

aged others to follow its example. France, the US, Germany, Russia,

Japan, and other countries industrialized in turn, each at its own pace,

and with varying degrees of government oversight and support.

Since the 1960s it has been the turn of Asian countries to join

the ranks of industrialized nations, and they have done so with a

high level of government involvement. These newcomers have

learned from history, and have no hesitation in using aggressive

national economic strategies to hasten their growth. China, India,

South Korea, and Taiwan have all emerged as industrial powers,

with exports that compete successfully with the most sophisticated

products of the developed world. Their emergence has revolutionized

the world economy and trade patterns.

China has been the most closely watched of all the Asian suc-

cess stories, because of both its size and its extraordinary industrial

progress. It launched its industrial program in earnest only in the

late 1970s, but by 2010 it moved from the back bench to second place

in the world economy, displacing Japan. It now has prospects of sur-

passing even the US.

China’s industrialization process has been a forced march, con-

trolled by an omnipotent Communist Party. Individual entrepreneur-

ship has played a minor role. The term “state capitalism” has been

applied to the current Chinese model because of its combination of

state and private capital. But this policy is actually a modern form of

an old system called mercantilism. It should be seen in that context.

Early mercantilism

Mercantilism has a long history. The term is commonly applied to

national economic policies that encourage exports and discourage

Histor ica l a ntecedents 15

imports. The ultimate goal is to produce a trade surplus. Such pol-

icies were roundly condemned as long ago as 1776 by Adam Smith in

The Wealth of Nations.

Smith advocated free trade of complementary products among

nations. But as we have already noted, very few statesmen are will-

ing to leave economic development hostage to the vagaries of the free

market when vital national interests are at stake.

Mercantilism as a policy was widely practiced from the seven-

teenth to the nineteenth century, particularly as countries with

agrarian economies sought to industrialize. It protected fledgling

domestic industries from being crushed by outside competition.

Governments would provide state support to build locally important

industries where the market risk was very low and the technology

well established. Once these industries had succeeded in replacing

imported products, the state could then promote exports and hope-

fully generate a trade surplus.

Does this sound familiar? It should. Classic mercantilism

bears a striking resemblance to policies being pursued by developing

countries to this day, including China.

Colbert launches modern French industry

Mercantilist policy was first deployed on a large scale by Jean-Baptiste

Colbert (1619–1683), finance minister of France for twenty-two years

under Louis XIV.

Leopold I expressed pride in the growing prosperity of his

Austrian subjects. Whether Colbert worried much about the wel-

fare of his fellow Frenchmen is highly debatable. What is certain is

that Colbert’s big problem was financing the aggressive wars of his

king.3

Four years after Louis XIV personally took over the reins of

government in 1661, he chose Colbert to rescue France from near

3 For a summary of Colbert’s career and influence, see I. Murat, Colbert (Paris: Librairie Arthème Fayard, 1980), pp. 225–263.

Gover nment: Boss, fina ncia l pa rtner, r egulator16

bankruptcy, mostly brought on by previous military adventures. But

this did not stop the “Sun King” from enmeshing France in conflicts

of his own making. In the succeeding fifty years of his reign France

was involved in three major and two minor wars, creating a nearly

constant need for cash.

During this era soldiers and foreign allies had to be paid in

gold and silver. Since France lacked mines for precious metals, the

only way to accumulate bullion was by building a trade surplus, and

the structure of the economy made that impossible. French industry

was underdeveloped and backward, in the hands of small craft enter-

prises that simply could not compete in international markets.

Colbert decided to fix the problem by building industries such

as glass and textile manufacturing. His plan was to restrict com-

petitive imports and promote exports of exceptionally fine products.

In this way he could generate a trade surplus that would bring a net

inflow of foreign gold and silver into France.

Ruthless, determined, able, and in full control of the finances of

France, he poached craftsmen and entrepreneurs from various coun-

tries by offering highly attractive incentives to set up shop in France.

Many of the resulting businesses were granted “Royal Privilege,”

which meant that they received state funding, paid no taxes, and

were guaranteed government orders for their products.

Colbert expected that such new businesses would become inde-

pendent of state support as their products became commercially suc-

cessful. But this was a slow process. He was known to complain of

continuing demands by entrepreneurs for new funds to cover operat-

ing losses. If you were a favored entrepreneur in Colbert’s France, you

did very well. Why not hold onto your perks as long as you could?

The new companies built large factories with over 1,000 work-

ers – something new in France at the time. Their workers lived in

dormitories and were paid minimal wages. The working day was

between fourteen and sixteen hours, and the only days off were reli-

gious holidays. Colbert complained to the Roman Catholic author-

ities that there were simply too many of those.

Histor ica l a ntecedents 17

Labor was cheap because France was blessed, if that is the

word, with a large population and significant unemployment in its

rural economy. Colbert had enough foresight to ensure a continued

supply of cheap labor by encouraging early marriages – women were

expected to marry before the age of twenty.

Having pirated technical expertise from other countries,

Colbert worried about losing what our era calls “intellectual prop-

erty” by the same means. He took draconian steps to prevent it. Once

in France, skilled craftsmen could not leave the country. Severe pun-

ishments awaited those caught fleeing – from a sentence of rowing

in one of the King’s galleys to the death penalty.

For Colbert’s program to succeed, French products had to win

international customers. To ensure that the new industries produced

the highest quality goods, Colbert established a corps of state-funded

industrial inspectors who were tasked with checking the quality of

products. Delinquent producers were penalized and publicly pun-

ished for repeated lapses in quality.

At the same time he made sure that the industries he was build-

ing were protected from outside competition until they were ready

to compete in the international market. For example, the importing

of Venetian glass was forbidden in 1672. And woe to the entrepreneur

who attempted to evade his trade and quality controls. His techno-

crats were said to have had over 15,000 small entrepreneurs executed

for the crime of importing or manufacturing cotton cloth in viola-

tion of French law.

Colbert did not limit his attention to manufacturing. He was

also anxious to compete with the Dutch in international trade,

which they dominated. To that end Colbert promoted the construc-

tion of a merchant navy, and gave preference to its ships for French

trade. To discourage competitive transport, high fees were placed on

foreign vessels visiting French ports.

By most measures Jean-Baptiste Colbert was a thoroughly

nasty man, widely hated within and outside France. But he launched

the country on the path of large-scale industrialization. Under his

Gover nment: Boss, fina ncia l pa rtner, r egulator18

compulsion French industry became renowned for its quality, par-

ticularly in such luxury products as silk fabrics, tapestries, and fine

glass. In these areas French products came to surpass any goods pre-

viously available on the international market.

Many famous company names in France date from this era,

including the tapestry maker Gobelin and the glass maker Saint-

Gobain. In 1688 a Venetian ambassador wrote that “such is the qual-

ity of the French products that they are the best in the world and

attract orders from all countries.” Colbert’s policies were successful

in at least sustaining the finances of France in spite of the country’s

being in an almost continuous state of warfare.

Colbert’s basic approach held sway in France for some time after

his death. In the eighteenth century French industry benefited from

government attempts to attract English technicians and entrepre-

neurs. France sent agents on undercover missions to England to recruit

people and collect commercial secrets, particularly those dealing with

production machinery and metallurgical processes. For example, the

first English steam engines were secretly imported into France.

In 1779 the ice between France and England thawed consider-

ably as the two countries signed agreements allowing the French to

import steam engines openly. Bilateral agreements covering other

products were also negotiated, but true free trade was far in the

future. Entrepreneurs who followed the rules had done well under

tight government control, but free trade was something better to

look forward to.4

In fact, it was in 1846 that England led the way to a national

free-trade policy by removing the restrictive Corn Laws and easing

its control of the export of advanced technology. By the 1860s prac-

tically all restrictions on imports were gone. At that time England

4 This presentation draws on the wealth of historical information found in J.-C. Asselain, Histoire économique de la France du XVIII siècle à nos jours (Paris: Éditions du Seuil, 1985), pp. 77–105; A. Malet and J. Isaac, XVII and XVIII Siècle (Paris: Librairie Hachette, 1923), pp. 190–194; and Murat, Colbert, pp. 249–261.

Moder n merca ntilism 19

had such a huge industrial lead on other countries that it could afford

to be generous and open its market. It did not anticipate that imports

would ever threaten domestic industry. Other countries trying to

catch up continued to play by more restrictive trading rules – and

are doing so still.

Modern mercantilism

You might ask why we are spending so much time on mercantil-

ism and its history in a book on the modern global entrepreneur.

The simple answer is that today’s entrepreneurs operate in a world

where governments increasingly control economies, a defining fea-

ture of mercantilism over the centuries and one that will not dis-

appear quickly.

This reality shapes the economic decisions made by business

people and entrepreneurs as they seek markets and business partners

in countries with diverse economic agendas. To fully understand its

implications, it is necessary to see it in a historical perspective.

For the same reason we must also take some time to discuss

China, by far the most prominent of modern countries with controlled

economies. China has the second largest – and fastest growing – econ-

omy in the world. What happens there, in consumer or industrial mar-

kets, has a huge impact on the direction of all global business.

Industrializing Asia

We are witnessing an economic revolution in Asia, affecting billions

of people. Countries in that region are striving to industrialize as

quickly as possible. Given the pressure to make rapid progress and

the top-down structure of many of their economies, it is not surpris-

ing that Asian countries would adopt mercantilist methods.

Indeed, we are living in the golden age of broadly defined mer-

cantilism. It is currently being practiced in a highly developed form,

on a scale unprecedented in history, by China. The world’s most

populous country has embarked on a path to industrialization that

Gover nment: Boss, fina ncia l pa rtner, r egulator20

in some ways mirrors the journey of France under Colbert, using

some of the same strategies. Its astonishing success has prompted

other countries to learn from its example and shape their trade pol-

icies accordingly.

Long relegated to the ranks of a “third-world” country with a

primarily agrarian economy, China has vaulted into a position of eco-

nomic leadership in just forty years. The ruling Communist Party

still controls the land, much of the economy, the military, foreign

policy, and whatever else is of major importance to the country. But

the highly pragmatic Party has abandoned some communist prac-

tices and embraced a number of capitalist methods without relin-

quishing political control.

Perhaps the biggest difference between China and the devel-

oped West is that the state owns all of the country’s banks, either in

part or in whole. It also controls their activities, and can therefore

channel capital to meet its industrial objectives.5 China’s reluctance

to allow banks to operate outside of government control is as much a

matter of history as it is of ideology. The country suffered through a

long period of weakness and foreign intervention, and its government

is determined to keep it free of foreign economic domination.6

Within China the most obvious sign of the success of these pol-

icies is plain to see. Visitors are frequently amazed at the quality and

quantity of public facilities that have been built in the past couple of

decades. Indeed, the development of a modern infrastructure is a key

element of comprehensive state plans for industrial development.

Of course the government of China had some powerful advan-

tages in its rapid construction of the infrastructure to support a

modern economy. In addition to absolute control of the country’s

5 For an excellent review of the Party’s role, see D. Shambaugh, China’s Communist Party: Atrophy and adaptation (San Francisco, CA: University of California Press, 2010). Also, R. McGregor, The Party: The secret world of China’s Communist rulers (New York: HarperCollins, 2010).

6 H. Jones, Chinamerica: Why the future of America is China (New York: McGraw-Hill, 2010) contains a good overview of Chinese economic practices and policies.

Moder n merca ntilism 21

finances, the government owns all the land. Hence it can develop

roads, airports, railways, and public structures without the legal

restrictions found in countries where land is in private hands. It can

also set arbitrarily low lease rates for land to stimulate the build-

ing of factories and other facilities wherever and by whomever it

chooses.

China’s emergence as an economic power is not accidental. It

is based on long-term development plans drawn up by government

authorities in order to

preserve Chinese control over key domestic industries and the economy;• promote exports and create a trade surplus;• acquire modern technology; and• build a domestic industrial base capable of innovation.•

Developing nations are watching China’s amazing progress very

closely. As more countries adopt various aspects of its approach,

entrepreneurs in the global marketplace will have to make adjust-

ments to economic systems in which mercantilism is flying high

and the government is in the pilot’s seat. It is worth looking more

closely at what they face in China, and may encounter in the other

countries that it influences.

Mixed ownership, tight control

China’s economic policy permits a mix of ownership models: pri-

vately owned businesses, joint ventures with foreign investors and

corporations, and businesses that are fully government owned and

funded. Regardless of ownership, foreign trade by all of these busi-

nesses is controlled by the government. Needless to say in a country

where the currency is tightly regulated, access to foreign exchange

is also strictly controlled.

Some businesses in non-strategic consumer industries,

such as textiles, services, and retail, may be fully owned by for-

eign investors, but restrictions exist on investment and cap-

ital repatriation. Large companies in industries deemed critical,

Gover nment: Boss, fina ncia l pa rtner, r egulator22

including telecommunications services and banking, are either fully

government-owned or have majority government ownership. Even

when these vital companies are publicly traded, the government

maintains significant ownership and ultimate control.

Fifty-four state-owned enterprises, including China Mobile,

Petro China, Sinopec, and China Electronics Corporation (CEC), are

considered “backbone” companies. To get an idea of the scale and

scope of these enterprises, consider the fact that CEC, which was

established only in 1989, today has 70,000 employees.

While control remains with the parent company, CEC owns

fourteen subsidiaries that are publicly listed and have some degree of

public ownership. These businesses cover software, computers and

computer components, and consumer electronics products. Some of

these companies rank among the world leaders in their product cat-

egories. They include joint ventures with foreign companies such

as HP, IBM, and Philips who contribute their technology. With rev-

enues in excess of $10 billion annually, CEC is a big technology con-

glomerate with the resources to address new business areas.

As would be expected in such an economy, exporting for the

purpose of acquiring foreign exchange is a key objective of state plan-

ners. In this they have been markedly successful. Much to the chag-

rin of its trading partners, China runs a large trade surplus. A major

reason for this success is the number of foreign companies that have

moved their production to China. The products from these trans-

planted factories are exported under their original brand names.

Like Colbert’s France, China’s government offers significant

incentives to attract foreign manufacturing: a modern infrastruc-

ture, a disciplined low-cost labor force, and significant financial

inducements for companies that locate factories in areas of the coun-

try designated for development. It is enough to convince many com-

panies that previously manufactured in Europe, Japan, or the US to

move their equipment into Chinese plants.

China benefits from its new status as the world’s factory in

three ways.

Moder n merca ntilism 23

Transplanted manufacturing plants churn out products for which there • is already worldwide demand, building exports at minimum risk.

These plants provide employment for many millions of Chinese workers.• Last but not least, they bring the latest technology into China, helping • it acquire the skills and knowledge to compete on its own in the

international market.

By some estimates as much as 70 percent of the exported products

from China are from such transplanted manufacturing plants.

To take one prominent example, most Apple® products are

assembled in China, using imported and locally manufactured com-

ponents. In some cases the factories where they are produced are joint

ventures with local companies; in other cases the manufacturing is

done by contractors such as Foxconn. Either way, it is estimated that

over 100,000 workers are employed in manufacturing Apple prod-

ucts alone. These wildly popular products are sold worldwide under

the Apple brand, helping boost China’s burgeoning trade surplus.

Foxconn, a huge company ($80 billion of annual revenues in

2009) of Taiwanese origin, exemplifies the importance of transplants

to the development of China’s economy and its workforce. Foxconn

is a contract manufacturer of electronic products not only for Apple,

but for HP and other major international brands.

The company has built virtual dormitory cities for its Chinese

workers. One such location, in Shenzhen, houses over 300,000 work-

ers in a sprawling compound. Since factories draw their low-wage

workers from rural areas, owners have to provide the workers with

access to affordable housing near the plants.

Building domestic industries

Infrastructure, employment, exports: all are prerequisites for a mod-

ern industrial economy. But other bricks are needed to build a stable

industrial base. While transplants contribute to growth, they are no

substitute for home-grown industry.

China’s leaders, anxious to make sure that foreigners do not

control key industries, made the development of domestic industry

Gover nment: Boss, fina ncia l pa rtner, r egulator24

a state policy, as one analyst has noted. “In the late 1990s increas-

ing dependence on foreign companies led Beijing to build strong

national industries in the protected shell of the domestic market.

But then excess capacity and reliance on foreign consumer markets

impelled Beijing to strive to make its national champions truly glo-

bal and to back them with an assertive trade policy.”7

Its success in turning these companies into effective global

competitors was and is helped by the use of foreign-developed tech-

nology from foreign firms seeking access to the potentially large

Chinese market. Since many are restricted from doing business on

their own in industries deemed critical to the state, foreign com-

panies have to participate in joint ventures within China, which

involves a sharing of their expertise.

It works like this. As noted above, China may allow minor-

ity foreign ownership in a China-based company. There is a better

chance of this happening if the local company can acquire state-

of-the-art technology as part of the deal. In this scenario foreigners

benefit economically from the domestic market, but without hav-

ing total control of the venture or of their intellectual property.

For example, GE has made minority investments in local com-

panies that produce wind turbines for power generation – an indus-

try that Chinese authorities deem critical as they seek to build world

leadership in this new technology. GE is expected to contribute its

own technology to the joint venture.8

Chinese authorities have also targeted electric automobiles

as a crucial product for the country’s industrial future. Here, too,

they are looking to foreign firms for technology that could give

them a leadership position. “China’s government is considering

plans that could force foreign auto makers to hand over cutting-edge

electronic-vehicle technology to Chinese companies in exchange for

7 J. Holsiag, “China’s flexing of its muscles is a sign of weakness,” Financial Times, September 28, 2010, p. 13.

8 See P. Glader, “GE in China wind-power venture,” The Wall Street Journal, September 28, 2010, p. B3.

Moder n merca ntilism 25

access to the nation’s huge market, international auto executives

say.”9

But the imported technology does not generate products

strictly for domestic consumption. For example, Japanese and

European companies that pioneered high-speed train technology

and shared it with Chinese companies are now facing competition

from the Chinese products in international markets.10

Overseas companies find access to China’s immense and

increasingly affluent market a powerful argument for sharing their

expertise, but the country needs to develop its own technology if it

is to build a competitive industrial sector. To that end, government

planners are working to generate domestic innovation by funding

research institutes and universities.

In addition, the authorities are pushing local companies to

invest in research and development. This investment rose from 0.5

percent in 2004 to 1.8 percent in 2009. When a new industrial activ-

ity needs to be developed to meet a market need, state funds are

available and every effort is made to build plants for mass produc-

tion. This ensures that new technologies are not neglected.11 China

now ranks among the top four largest generators of patents after the

US, Japan, and Germany.12

The effort is paying off. Some newly created corporations in

technology sectors have already become world leaders. For example,

Huawei Technologies, established in 1988, is now one of the lead-

ing manufacturers of advanced telecommunications and networking

equipment, with over $30 billion in annual sales in 2011. Huawei

successfully competes globally against established vendors such as

Alcatel-Lucent and Ericsson.

9 N. Shirouzu, “China spooks auto makers,” The Wall Street Journal, September 17, 2010, p. A1.

10 N. Shirouzu, “Train makers rail against China’s high-speed designs”, The Wall Street Journal, November 18, 2010, p. A1.

11 J. Dean, A. Browne, and S. Oster, “China’s state capitalism sparks a global back- lash,” The Wall Street Journal, November 16, 2010, p. A1.

12 IEEE Spectrum, July 2011, p. 68.

Gover nment: Boss, fina ncia l pa rtner, r egulator26

Follow the leader

You can debate whether a top-down, controlled economy can con-

tinue to prosper into the indefinite future. It is easy enough to point

to basic weaknesses including a neglect of environmental condi-

tions and overbuilding of certain industries. We can point to plenty

of examples in other countries where bureaucratic incompetence

sooner or later impedes progress.

However, the emergence of China has changed global trade

patterns. It is hard to think of an industry that is not affected by

competitors from China or by the promise of sales of its products to

China. Hence the importance of China to entrepreneurs with ambi-

tions to become global players.

China’s success also encourages other industrializing coun-

tries such as Malaysia, India, Brazil, Thailand, and Vietnam to step

up their own national initiatives to woo manufacturing sites from

the developed countries with subsidies and other incentives.

Vietnam’s case is especially interesting. It too is a country con-

trolled by a monolithic Communist Party but open to foreign capital

and technology importation. Foreigners are investing in the country,

setting up factories that once upon a time would have gone to China.

Two-thirds of the economy is now in private hands (but with state

supervision); the remaining third consists of state-owned corpora-

tions in industries deemed vital by the authorities. In general terms

Vietnam is closely emulating the Chinese model.

However, the government is dealing with the same problem that

has bedeviled other mercantilist countries, starting with Colbert’s

France: state-owned companies can easily become unprofitable, for-

cing taxpayers to cover their losses. This has been the case with the

Vietnam Shipbuilding Industries Group, which ran up multi-billion

dollar debts while its operating losses ballooned.13

13 J. Hookway and P. Barta, “A troubled state flagship makes waves in Vietnam,” The Wall Street Journal, September 22, 2010, p. C1.

Moder n merca ntilism 27

In spite of this risk, the model of combined state and private

ownership is spreading. For example, Brazil is funding the construc-

tion of dams to generate power through such companies. A dam built

to generate 11,200 megawatts, begun in 2010, is 49 percent owned by

the government-controlled Eletrobras. Its total cost will be BRL 20

billion. The rest of the funds came from non-direct state sources and

private investors. The demand for power is stimulating the interest

of investors, with the government coming in when such generating

capacity or transmission needs are not met by private capital.14

Heavy-handed government doctoring of the economy, admin-

istered with an (un)healthy dose of good old-fashioned mercantilism,

can act as a quick tonic for an underdeveloped industrial sector. It

is not only developing countries that are tempted to self-medicate

in this way. In developed countries where jobs are disappearing, dis-

gruntled citizens are alarmed, and political pressure is building to “do

something,” politicians are equally susceptible to the lure of more

government intervention. We return to this subject in Chapter 10.

Among the public, a commitment to free trade is usually the

first victim of the malaise. The call for tariffs to deter low-cost

imports has become ever louder in countries that, like the US, have

suffered a loss of industry. A recent survey shows a marked deterior-

ation in US public opinion regarding free trade agreements, accord-

ing to The Wall Street Journal. In 1999, only about 30 percent of the

people polled believed that free-trade agreements hurt the US econ-

omy, while in 2010 over 50 percent thought such agreements hurt

the country. Even more significant is that only about 15 percent of

the people believed that such agreements were helpful.15

Given this level of disapproval on the part of the public, we

should not wonder if politicians engage in ever louder saber-rattling

over tariffs and trade deficits in the coming years.

14 P. Winterstein, “Brazil power will still see state pressure under Roussseff,” Dow Jones Newswires, September 2010.

15 S. Murray and D. Belkin, “Americans sour on trade: Majority say free trade pacts have hurt the US” The Wall Street Journal, October 4, 2010, p. A1.

Gover nment: Boss, fina ncia l pa rtner, r egulator28

Implications for entrepreneurship

The changing world economic order has enormous implications for

entrepreneurs everywhere. The greater the degree of government

control and willingness to finance and protect industries, the harder

the task is for independent entrepreneurs reliant on private funding.

Such policies affect access to markets and capital. And, most trouble-

some, government-protected competitors can behave irrationally, as

they are not subject to normal market forces.

We live in a world where the fastest-growing economy is the

one where the government has the most control. This has encour-

aged other governments to become more involved in their economies

in the hope of encouraging competitive new industries and defend-

ing established ones. Ours is also a time when trade barriers are

likely to grow.

How do entrepreneurs feel about building their businesses in

this environment? It depends on where they are, and where the best

market for their products is located. We look first of all at the effects

on a Chinese entrepreneur.

While China’s planners are not dependent on domestic entre-

preneurs to build the country’s economic muscle, there is ample

opportunity for entrepreneurship in industrial sectors that don’t

compete head-on with state enterprises. There is even a growing

venture capital industry there to finance such new businesses. Some

of this activity is financed by foreign capital looking for high returns

in a fast-growing economy.

Indeed there are investment opportunities available. A growing

number of independent entrepreneurs, as opposed to state-appointed

managers, are now creating big businesses. For example, the largest

group of Chinese electronics retail stores, Gome, was started by a

private entrepreneur. He was reputed to be the richest man in China

after the company had a public offering of its securities in the Hong

Kong exchange. We will discuss three other Chinese startups in

Chapter 8.

Implications for entr epr eneurship 29

As an independent entrepreneur in China, you would welcome

the government’s financial help. In fact, a survey of entrepreneurs

in China suggests that many count on some kind of government

support for their success.16 But you would have to learn to deal with

state planning policies.

For example, 2010 was the last year of a national Five Year Plan

that called for a 20 percent reduction in energy use per unit of GDP

to reduce pollution. As a result, if you are an entrepreneur running

an energy-intensive manufacturing business, you might find that

the power available to your factory has been reduced or even shut

down by the local power utility. Such cutbacks actually occurred in

2010, reducing the production of materials such as polysilicon used

to manufacture solar cells.

Your only alternative would be to buy diesel-powered electrical

generators. Of course, their exhausts will add to air pollution – dir-

ectly negating the intent of the Five Year Plan. But that is not your

problem.

Now, let us imagine that you are an entrepreneur in the US.

You are likely to wish for freedom from all government interference.

Here is a classic statement of this position from two US entrepre-

neurs, published as a letter to the editor in The Wall Street Journal:

“In our experience [as entrepreneurs] the very last group we would

appeal to for help with a new venture would be a federal bureaucrat.

We thus feel the best way to revive the US economy and revitalize

the past ability to innovate would be to cut government spending,

regulation, and taxation.”17

While such total independence is praiseworthy in principle,

it simply isn’t practical in the real world. Entrepreneurs aiming to

build major enterprises have no choice but to have a global strat-

egy and they cannot do it just on the merits of their products. This

16 R. Steeter, “Asian entrepreneurs are bullish on the future,” The Wall Street Journal, August 6, 2010, p. A13.

17 Letter to the editor by R. Gamblin and K. Borgh, The Wall Street Journal, September 18, 2010, p. A14.

Gover nment: Boss, fina ncia l pa rtner, r egulator30

means they may have to accept from the US government such “help”

as tax rebates, licenses, access to loans, or financial assistance with

exports if they are to succeed.

For example, if you want to sell your products in a country

where government restrictions limit imports, you will certainly

welcome US government help in opening such markets. You will

also be happy to accept its help in protecting your intellectual prop-

erty. And you will also welcome new business opportunities created

by government mandates.

Here is an interesting example of how a US government man-

date helped launch a new business. Telnet was arguably the first

commercial packet switching network service provider. In the mid-

1970s, it started offering dial-up modem access to central packet

switches that provided email and, later, file transfer services.

Telnet subscribers accessed these services through local wire-

line telephone networks, which created a problem. In some states the

telephone rates are flat or fixed, while in other states they are priced

on usage. There were long holding times for data sessions, amount-

ing to tens of minutes or even hours, and customers who paid by

usage complained about their charges. Telnet lobbied for relief with

the Federal Communications Commission (FCC).

Eventually the FCC created what it called Special Access,

which mandates that third-party service providers can pay the local

telephone carrier to provide space in the telephone end office for their

equipment (modems, multiplexers, routers, and management equip-

ment). In return they got local phone numbers at that end office and

a flat rate for these services. AOL was arguably the most successful

of all Internet service providers in exploiting special access, mailing

tens of millions of CDs to potential customers, and signing up mil-

lions of subscribers.

Special access is now offered in over fifty countries around the

globe, with other countries adopting what was arguably a great suc-

cess in the US in stimulating novel data communication services.

Today it is being used increasingly for voice communications via

packet switching, a development unforeseen in the 1970s.

Implications for entr epr eneurship 31

All of the companies that benefit from this cost structure

owe a debt of gratitude to a government agency for creating it. It is

an excellent example of how, instead of crying about government

“interference,” smart entrepreneurs learn to take advantage of such

actions. They adapt in ways that allow them to profit from all oppor-

tunities, including government assistance, which support innova-

tive business models and help pay for new technologies. That is what

they have done throughout history. (We will return to these issues

later in the book.)

Working with the system

Just because countries have restrictive industrial policies does not

mean that there is no market in those countries for innovative prod-

ucts from abroad.

For example, advanced semiconductor devices essential for the

manufacture of electronic products are freely imported into China

and other countries that lack internal competitive resources. This

policy enables new companies from other countries to build their

sales at attractive prices. We will discuss one such entrepreneur-

ial company, RMI (Chapter 5), which became a leading exporter to

China of advanced chips for its communications industry. We will

also discuss Aicent (Chapter 9), a Silicon Valley-based company,

which sells telecommunications services in China.

It is always satisfying to declaim about freedom from govern-

ment intrusion, but it should not be forgotten that, even in the US,

government programs have generated opportunities that spurred

the creation of major new industries. US government policies have

enabled huge investment opportunities in telecommunications, the

Internet, and alternative energy production, to name only the most

important recent examples.18

18 For a fuller discussion of this topic see H. Kressel and T.V. Lento, Investing in dynamic markets: Venture capital in the digital age (Cambridge: Cambridge University Press, 2010), especially chs. 1, 4, and 6.

Gover nment: Boss, fina ncia l pa rtner, r egulator32

In telecommunications, for example, the deregulation of

the US industry in 1996 and the opening to newcomers of what

was once a monopoly field enabled the formation of entrepreneur-

ial companies that eventually grew to be worth many billions of

dollars. Similar deregulatory steps in other countries also led to

the growth of extremely valuable businesses in services and in

advanced hardware and software products. Following deregulation,

the US government played a key role in allocating wireless spec-

trum to companies and regulating its use. This in turn impacted

the development of technology to use this spectrum in wireless

communications.

The growth of the Internet is, if anything, a more striking

instance of beneficial government support. Originally developed

with government funding, its implementation, coupled with

nearly universal access to broadband communications by con-

sumers, enabled an almost infinite number of new businesses

offering products and services on the Web. The opportunities

ranged from commerce (Amazon.com, for example), to auction

sites (eBay), software on demand (Salesforce.com), and social net-

works (Facebook.com).

Our third example of a government initiative in the US (and

many other countries) that holds promise for entrepreneurs is the

fostering of energy generation that uses non-fossil fuels. Hundreds of

new companies have been formed to develop and manufacture solar

energy sources, wind-driven generators, and biomass sources. They

depend on subsidies created by government policies to insure the

commercial viability of these alternative energy sources. Without

government “meddling” many of these new businesses would not

exist. Whether these investment opportunities are good ones depends

on many factors, and we return to this subject in Chapter 10.

Of course government involvement in the economy has a

downside as well as an upside. The bounty of opportunities opened

through government initiative is accompanied by legal challenges

with the potential to kill new businesses.

Summing up 33

Nowhere is this more apparent than in the case of the Internet,

where enormous business potential exists side by side with obstacles

for entrepreneurs to overcome.

To name one such challenge, the issue of Internet privacy pits

new businesses against government regulations. One of the com-

mercial services enabled by the Internet, now being widely exploited

by new entrepreneurial companies, is the ability to track the online

behavior of individual consumers for the purpose of improving the

ability to sell them products.

Its use is being challenged as an intrusion of privacy: “Since

July 2010 at least six suits have been filed in the US District Court

for the Central District of California against websites and compa-

nies that create advertising technology accusing them of installing

online tracking tools that are so surreptitious that they essentially

hack into users’ machines without their knowledge.”19

Summing up

The world order is being fundamentally changed and entrepreneur-

ship must adjust accordingly.

Here is a comment by one observer regarding our new

situation.

Two-thirds of the world’s people live in countries that are

growing fast. Unfortunately, the one-third of the world’s

population living in [relative] stagnation includes the US, Japan,

and Western Europe, which contribute disproportionately to

world GDP – for the time being. The source of the growth is the

great migration from rural poverty to urban prosperity, perhaps

the greatest engine of economic expansion in history. But

this sort of growth implies great disruptions in the economic

life of many countries; it arises from a shift in the world

19 J. Valentines-DeVries and E. Steel, “Cookies cause bitter backlash: Spate of lawsuits shows user discomfort with latest innovations to online tracking tech- nology,” The Wall Street Journal, September 20, 2010, p. B1.

Gover nment: Boss, fina ncia l pa rtner, r egulator34

economic structure, not incremental expansion of the existing

structure.20

Under such conditions, entrepreneurs need to learn to suc-

ceed in international markets, where each government has its own

set of rules. And, rules there will be, as countries intensely com-

pete to defend their industries and nurture new ones on the basis of

innovation.

National industrial policies have historically been condemned

by many people as infringing on their liberties within countries

founded on the principles of “free enterprise,” such as the US. Yet

today political pressure in these same countries is intensifying to

build import barriers, promote exports, and find new ways for gov-

ernments to promote the creation of new, innovative industries to

replace the mature ones that have migrated to countries with lower

labor and capital costs.

This is precisely the situation in which, more than ever, we

need entrepreneurs to stimulate economic growth. Calling for more

entrepreneurship in an era of big government may seem counter-

intuitive, but it is actually the most desirable way to generate eco-

nomic growth in the developed countries of the world.

In short, we need both private entrepreneurial and public ini-

tiatives to advance economic goals. In the next chapter we discuss

the role of entrepreneurship in achieving that objective.

20 D. P. Goldman, The Macro Strategist, from [email protected] – September 19, 2011.

35

The secret to maintaining a robust economy centers on more than efforts to modernize existing plants and equipment. The secret is creativity, allowing new firms with new ideas to rise up, while existing firms work every day to reinvent themselves to compete on a global scale.

D. S. Smick1

Forty years ago China had one of the most strictly controlled econ-

omies in the world, with all major businesses owned by the state.

Now the government permits private ownership of companies, and

seeks a higher level of innovation to keep its economy growing.

In other parts of the world individuals rather than politicians

and strategists are driving the creation of enterprises. One striking

outcome of the Egyptian uprising in early 2011 was the emergence

of young entrepreneurs rushing to form new businesses. It seems

that, in the aftermath of Hosni Mubarak’s overthrow, the new

business registration process had become easier. So these aspiring

businesspeople, with guidance from experienced American entre-

preneurs, took advantage of the opportunity and launched their own

enterprises.2

Before Mubarak’s departure they would have faced forbidding

barriers all too common in the Middle East: copious red tape, bur-

eaucratic foot-dragging, bribery demands from officials, and a protec-

tionist stance that worked in favor of the politically well-connected.

Many of the entrepreneurs-in-waiting would have gone abroad to

2 Standing still is not an option: On promoting entrepreneurship and economic growth

1 The world is curved: Hidden dangers to the global economy (New York: Portfolio/Penguin Group, 2008), p. 81.

2 H. Seligson, “Arab Spring, start-up summer?” The New York Times, July 17, 2011, p. BU1.

Sta nding still is not a n option36

pursue their dreams. Now, with a government that, if not helping,

was at least not hindering, they had a chance to control their eco-

nomic destinies in their home country and help build a new, more

prosperous Egypt.

There is no question that the “Arab Spring” uprisings were

fueled at least in part by public resentment over stalled economies.

Barely a year before the Middle East exploded in revolt, Ahmed

Mohammed Lukman, Director General of the Cairo-based Arab

Labour Organisation and a top labor expert, warned that regional

unemployment, which had been rising for years, had “reached an

alarming level, exceeding 20 million people.”3 This amounted to

a 17 percent unemployment rate. Educated young people made up

26 percent of the total. It is not surprising that when the winds of

freedom began to blow through Cairo’s ancient streets, many of the

protesters who assembled in Tahrir Square to demand regime change

were young people without jobs or prospects. While it is too early to

say if the Arab Spring will produce any lasting effect, it holds out the

promise of more open governments and increased economic oppor-

tunity for the people of the Arab world. It also highlights a couple of

facts about the age we live in.

First, the global economy is moving so fast that standing still

means falling behind. Unfortunately for governments that resist

change, economic stagnation is a sure formula for producing popular

unrest. People won’t tolerate declines in their economic wellbeing

for very long.

Second, no country can afford to ignore the value created by

entrepreneurs. Even in Cairo, hardly a hotbed of pro-American sen-

timent, young Egyptians looked to American-style entrepreneurism

as a remedy for their country’s economic ills. Total government con-

trol of the economy had failed them, and they decided to become

3 Nadim Kawach, “Arab unemployment at alarming levels: ALO,” www. emirates247.com, December 6, 2009.

Entr epr eneurship a nd innovation 37

entrepreneurs, agents of change and innovation who could spur the

creation of dynamic businesses.

Their faith is not misplaced. Entrepreneurs can have signifi-

cant economic impact. In this chapter we will survey the positive

effect entrepreneurial innovations have had on job creation and GDP

growth in the US. Then we will explore the conditions that create

and support an entrepreneurial culture, including funding sources

and regional centers of innovation. We will also discuss intellec-

tual property management and certain government regulations and

activities that affect international business operations.

Entrepreneurship and innovation

Many countries are in a race to build and maintain industries that

can compete successfully in international markets. With the emer-

gence of the Asia-Pacific countries, the race is hotter than ever, and

the stakes are huge.

Asia has taken over industries in which the developed coun-

tries once ruled supreme. As a result, developed countries must cre-

ate the industries of tomorrow and get their economies growing. But

the newcomers are trying to find the same magic formula so that

they can keep their own momentum going. Everybody knows what

is needed. The challenge lies in its execution.

Technology industries help to drive GDP growth

That magic formula has to include a heavy dose of new technol-

ogy, which seeds industrial growth. Sooner or later all technology

becomes either a commodity or obsolete. Commodities don’t spur

growth, and industries built around obsolete technology eventually

have to be replaced – preferably by something developed domestic-

ally. This is the process of “creative destruction” as described by

economist Joseph Schumpeter.

Several studies bear out the economic importance of new tech-

nology. For example, several years ago, in the wake of the “dot-com”

crash of 2000–2001, the consulting group Global Insight analyzed

Sta nding still is not a n option38

the impact of high-technology industry on per capita GDP in the

US between 1990 and 2004.4 As Figure 2.1 shows, in 2004 per cap-

ita GDP would have been about 7 percent lower without the rapid

growth of the technology industries, many of which were funded by

venture capital.

Increased per capita GDP implies the creation of many jobs,

and other figures bear out the importance of new companies in

improving the employment picture. An analysis of US census data

by economists at the Kauffman Foundation shows that new com-

panies have been the major driver for new jobs created in the US

between 1980 and 2005. Nearly all net job creation has been in busi-

nesses that are less than five years old.

In the year 2007, for example, of the 12 million jobs added, 8

million were added by young companies.5 Without these compan-

ies, the US economy would have lost jobs during those years – not a

pleasant prospect, and one with severe political consequences. That

was when massive shifts were occurring in the US manufacturing

4 “Venture impact 2004: Venture capital benefits to the US economy,” www. ihsglobalinsight.com/publicDownload/genericContent/07–20–04_fullstudy.pdf (accessed May 6, 2011).

5 D. Stangler and R. E. Litan, “Where will the jobs come from?” Kauffman Foundation Research Series: Firm foundation and economic growth, November 2009.

38

Without New High-Tech Industries Reported GDP

37

36

35

34

P e r

C a p

it a

G D

P (

T h

o u

s a

n d

s $

)

33

32

31

30

29

28 1990 1992 1994 1996

Year 1998 2000 2002 2004

Figure 2.1 GDP of the US with and without new technology industries between 1990 and 2004 (ref. 4).

Entr epr eneurship a nd innovation 39

base as Asian countries became industrialized. Imagine the outcry if

jobs were not only being shipped overseas, but people were suffering

an overall net decline in employment at the same time.

While this study proved the importance of new companies in

creating jobs, it did not identify how those companies were being

funded. Other evidence shows that the vast majority of new com-

panies start with limited private funding or family loans and remain

small. They generally operate in the service sector and may employ

only a few people; hence their large-scale economic impact is limited

in generating economic growth.6

Among these startups, however, are the future giants that pion-

eer new markets. Although relatively few new companies qualify as

business innovators in the Schumpeter sense, those that do have an

enormous economic impact. They are often initially backed by pri-

vate venture capital, later access public markets for growth capital,

and are headed by the most ambitious class of entrepreneurs. Among

US technology startups that became household names are Intel,

Apple Computer, Microsoft, Yahoo!, eBay, VMware, Cisco Systems,

Amazon, and BEA Systems.

In addition to these giants, thousands of pioneering startups of

the past few decades made major contributions by creating new mar-

kets, yet did not reach the billion-dollar revenue run rate. Many were

acquired by other corporations. VMWare is a recent example. As a

1999 startup it revolutionized the computer industry, but its reve-

nues had only reached $219 million in 2004 when it was acquired

by EMC Corporation for $635 million. (VMWare revenues for 2010

were $2.8 billion.)

The study by Global Insight cited above details the contribu-

tion of venture-capital-backed companies to the US economy.

In the period from 2000 to 2003, venture-capital-supported company • employment increased by 7 percent even though the US economy as a

6 C. Kenny, “Small isn’t beautiful,” Bloomberg Businessweek, October 3, 2011, pp. 10–11.

Sta nding still is not a n option40

whole produced a net loss in US jobs. These data were collected from a

total of 26,494 venture-capital-funded companies.

These companies employed 10,130,807 people and had revenues of $1.769 • trillion in 2003, representing about 15 percent of the total US GDP.

California, the home of Silicon Valley and the biggest source of venture • capital, was by far the largest beneficiary of these dynamic companies:

8,416 were located there, employing 2,470,557 workers, and boasting

combined revenues of $438 billion.

These results would be welcomed by any country and its lead-

ers. The big question is how to replicate the conditions that produced

this outburst of innovation. The US, and developed nations in gen-

eral, continue to search for answers to overcome fears of economic

stagnation. As a recent review of the US economy noted, “Americans’

worries stretch well beyond the next couple of years about stagnating

living standards and a dark future in an economy slow to grow jobs,

saddled with government deficits and under threat from China”.7

Going forward, greater emphasis is needed on fostering the

migration of new technology into the domestic and international

marketplace through entrepreneurial activities. As one recent obser-

ver put it, “Economic success stems from ongoing innovations by

a risk-taking entrepreneurial class that allows an economy to con-

tinually reinvent itself.”8

Technology needs entrepreneurs

In his 2011 State of the Union address, President Barack Obama

described what he saw as the major elements needed for economic

growth: “We need to out-innovate, out-educate and out-build the rest

of the world.”9

Like his predecessor, George W. Bush, the President stressed

innovation as necessary to the nation’s economic health. Both

7 “What’s wrong with America’s economy?” The Economist, April 30, 2011, p. 11. 8 Smick, The world is curved, p. 125. 9 “Hard choices for a soft people: The State of the Union can be stronger if govern-

ment intervenes less in the economy,” Barron’s, January 31, 2011, p. 47.

Entr epr eneurship a nd innovation 41

leaders were correct, as far as they went. New industries cannot be

developed without new technology. But in developed economies the

problem of weak growth is rarely caused by a lack of new technolo-

gies. Governments fund research and development at universities

and in other institutions to develop new technology, and most large

corporations maintain their own product development organizations

to generate the next big success.

To prove the point, consider the fact that the US invests more

in R&D than any other country in the world. The level of this invest-

ment has remained between 2½ and 3 percent of GDP since about

1960. One-quarter of the total is government funded.10

The problem that is limiting the impact of innovations on the

economy is not too little R&D; it is the inability to make more of the

investment in R&D industrially productive. New technologies are

being developed, but they are not making an impact on the market in

the form of commercially successful new products, novel manufac-

turing technologies, or popular services. Competition is what drives

businesses to risk new product introductions and startups play a key

role as instigators for such activities.

It was the rapid migration of new technologies into products

by entrepreneurial new businesses that fueled important past suc-

cesses in industrial development. During the 1950s and 1960s com-

panies in the Boston area received significant US government dollars

to develop defense-related products and services. Once established,

many of these companies then transitioned to commercial markets.

Bose Corporation in the Boston area is a good example. The same

pattern repeated itself in the 1960s and 1970s in Silicon Valley.11

Venture capital financed the entrepreneurs who created the

industries now underpinning the digital age, and it continues to play

10 Figures quoted in “Still full of ideas, but not making jobs,” The Economist, April 30, 2011, p. 32.

11 A. Saxenian, Regional advantage: Culture and competition in Silicon Valley and Route 128 (Cambridge, MA: Harvard University Press, 1996) is an excellent study of the Boston area and Silicon Valley.

Sta nding still is not a n option42

a key role in supporting entrepreneurship. But the task of building

big businesses is becoming harder. Entrepreneurs and venture cap-

ital investors must think more broadly today. For US-based start-

ups, for example, there was a time when just concentrating on the

big US market was enough. That is no longer true. Now, startups

with big ambitions need to focus on global markets in addition to

the more familiar domestic ones. This means that such compan-

ies need to learn to play a much more complex competitive game

in order to grow and thrive. Hence the importance of encouraging

entrepreneurial efforts that are tuned to international opportunities.

All of the companies selected for discussion in this book meet that

criterion.

But before focusing on how to instill the global outlook that is

practically a prerequisite for success, we should consider how entre-

preneurs are created in the first place.

Factors in promoting entrepreneurship

It is not hard to convince skeptics of the economic value created by

ambitious entrepreneurs. It is far more difficult to identify the factors

that drive economically important entrepreneurship. Unfortunately

there is no sure-fire formula. Though government policies and

resources play a big role in encouraging and supporting entrepre-

neurship, they certainly aren’t sufficient to make it an important

economic asset. Programs to “out-innovate, out-educate, and out-

build” other nations may be noble in their ambitions, but they take

time, and they may not produce the desired results.

If entrepreneurial activities cannot be mandated by politicians

or bureaucrats, neither can they be stimulated solely by individual

ambition. Dreams of success are motivators for budding entrepre-

neurs, but on a more practical level they are not enough to generate

broad-based value creation. In fact, there is another major determin-

ant in attracting the most talented people into an entrepreneurial

career: the cultural environment. Here the US experience can serve

as a guide.

Factors in promoting entr epr eneurship 43

Since the 1970s Silicon Valley has been the epicenter of the

entrepreneurial world, the place where some of the most successful

technology companies of modern times were founded and developed.

Similar innovation centers have arisen in the US and other countries

in the past few decades. This is an area where the US has set the pat-

tern and reaped the rewards.

The article from The Economist on worries about the American

economy, cited above, crystallizes one aspect of this cultural advan-

tage: “Are these worries justified? On the plus side, it is hard to think

of any large country with as many inherent long-term advantages as

America: what would China give to have Silicon Valley?”12

Other factors – the presence of educational institutions, the

availability of capital and the level of rewards that entrepreneurs can

expect for their efforts – do have an impact. However, expertise and

money can be found in countries that have not had as much success

as the US in generating industries based on innovative technology as

a result of entrepreneurial efforts.

Cultural orientation in all its aspects seems to be a deciding

factor in entrepreneurial activities. Moreover, that culture is concen-

trated in specific geographic areas. We will look at these so-called

innovation clusters to see how they function.

Silicon Valley: Model innovation cluster

Silicon Valley developed in the 1970s, and became the recognized

center of the digital revolution in the 1990s. Many people have asked

what makes the Valley so special, and whether it can be replicated. I

am familiar with the area because Warburg Pincus has maintained

an office there for many years.13 Several of our most successful tech-

nology companies were headquartered in the area. My personal

experience persuades me that Silicon Valley boasts an unparalleled

combination of talent, industrial relationships, and venture capital

12 “What’s wrong with America’s economy?,” ibid. 13 When the narrative shifts to first person singular (I, me, my, mine) here and

throughout this book, the speaker is Henry Kressel.

Sta nding still is not a n option44

investment professionals that is extremely well adapted to fostering

entrepreneurial innovation. Needless to say, I am not the first person

to come to this conclusion.

We have already said that while technology forms the raw

material for new industries, it is entrepreneurial innovation that

actually creates them. The Valley is the living proof of this observa-

tion. While it has an enviable track record for developing new tech-

nology, it did not invent many of the fundamental breakthroughs

that made its own innovations possible in the first place. Neither

did the great research universities that surround the Valley, though

they did contribute to the deep pool of talent that finds its way into

its industries.

For example, the UNIX operating system and its offshoots and

the software languages C and C++ were developed at Bell Labs in

Murray Hill, New Jersey. Relational databases and reduced instruc-

tion set computers were invented at IBM Yorktown Labs, New

York. Semiconductor devices and integrated circuit manufacturing

were developed at Bell Labs, Western Electric, and RCA Labs (later

Sarnoff Corporation). As for the Internet, while Paul Baran (Palo

Alto, California), Len Kleinrock (University of California at Los

Angeles), Vint Cerf (Stanford University), and Donald Davies (UK)

were instrumental in its development, the project to create it was

funded by DARPA, a US government agency, in 1967–1969, thanks to

Larry Roberts and others of BBN (now Raytheon BBN Technologies)

of Cambridge, Massachusetts, who built the original hardware

platforms.

What makes Silicon Valley and the surrounding area an out-

standing center of industrially valuable innovation, apart from

its deep research capacity? I asked Dr. Curt Carlson, CEO of SRI

International, to define its special mystique. SRI, formerly called the

Stanford Research Institute, located in the heart of Silicon Valley

in Palo Alto, is one of the leading independent research laborator-

ies in the world. “In the San Francisco Bay Area there is an unusual

concentration of technologists able to create compelling commercial

Factors in promoting entr epr eneurship 45

value,” Carlson noted. “These are among the most valuable profes-

sionals anywhere.”

Innovation, business savvy, access to capital

Give such professionals what they need and they become driven

with the ambition to create great companies. A few succeed in creat-

ing businesses that change the world. Unfortunately many more fail,

but, as my partner Dr. William Janeway keeps reminding everyone,

waste is an unavoidable part of the Darwinian process of creating

innovative industries.

Silicon Valley’s fame attracts exceptional people from around

the globe to try their hand at entrepreneurship. We will meet some

of these in the case histories we discuss later in the book. Those who

become successful garner immense prestige in the local culture, and

serve as role models for others.

Everybody there knows someone who has made money in a

startup. Over the years, as the number of companies has grown, so

has the pool of trained people eager to assume the risk and challenge

of working in young companies in anticipation of the rewards to be

gained. Most interestingly, there is no stigma for failure in the Valley,

as there is in most other business centers. People who fail are cred-

ited with having undergone an educational experience, and they get a

second chance. Everybody understands how risky it is to build a new

company, and how important experience is to doing so successfully.

Talented young people are drawn to the region more for what

it promises than for the certainty of employment. I asked a young

MIT-trained engineer why he left the Boston area. “What brings you

to Palo Alto?” I asked. “Did you have a job lined up here?” “No,” he

answered. “I’ve always dreamed of starting my own company and I

believe that the Valley is the best place to get the right training and

build the relationships I will need to get started.” To tide him over

until then, he found a job at Cisco.

It is not just people who relocate to Silicon Valley; some estab-

lished startup companies do it too. One twenty-seven-year-old

Sta nding still is not a n option46

entrepreneur moved his startup software company from Boston to

the Valley because the chance of being acquired there is better than

it is in Boston. “Here it’s happening all the time,” he said, “and it’s

something we’d definitely consider.”14

Another attraction of Silicon Valley is its bias toward action. In

this respect the Valley is following in the footsteps of IBM. Thomas

Watson Jr. said that the single most important idea that IBM tried

to inculcate into its management and culture is to do something,

because if you do something, you learn from it – either success or

failure – but if you do nothing, you learn nothing.15

There is usually no shortage of good business ideas in a region

that can boast of an abundance of talented scientists and engineers.

But the people who combine deep technological knowledge and the

business talent to build a successful company are a scarce commod-

ity. In the Valley, however, you find a significant number of seasoned

managers capable of taking companies from the startup stage to the

global market.

Given the thousands of companies that have emerged in or

migrated into the region, the area around San Francisco has probably

the highest concentration of technology-savvy business talent in

the world. What is also remarkable about the region is its leadership

in developing new industrial ideas. The Internet focus is the most

prominent current example.

Finally, Silicon Valley’s concentration of venture capital firms

has been an essential part of its economic success story from the

start: good ideas get funded. In order to gain access to promising

new deals, hundreds of venture capital firms small and large main-

tain offices in the area. When a new company needs a higher level

of investment, local venture capital firms will often jointly fund it.

Even foreign companies such as Siemens hire local professionals to

develop sources of new technology, build relationships with local

14 M. Helft, “Big tech firms pay top dollar for start-ups, when they just want the bodies,” The Global Edition of The New York Times, May 19, 2011, p. 15.

15 T. Watson Jr., Father, son, and company (New York: Bantam, 2000), p. 77.

Factors in promoting entr epr eneurship 47

companies, and provide investment capital. What is particularly

important is that young companies can get access to substantial

amounts of growth capital from local firms after a successful startup

stage – an essential requirement to build valuable companies.

It all adds up to an environment where good ideas get access to

capital, management talent, and international partners. By contrast,

Boston-based venture capital firms are much fewer in number, with

far fewer assets under management. This situation has forced those

firms to set up operations in Silicon Valley, or simply to move their

whole operation there.

Building an innovation cluster

Given the success of Silicon Valley, it is not surprising that other

regions aspire to replicate it. While no innovation cluster comes close

to it in terms of economic value created, some that have emerged in

the US and overseas have produced a significant number of success-

ful entrepreneurial companies.

How do you build an innovation cluster?16 It takes both infra-

structure, present in abundance around Silicon Valley, and cultural

development. After major efforts, successful innovation clusters

have emerged in the past thirty years in the US, Europe, and Asia,

usually at the initiative of local government authorities.

These locations usually start with excellent universities and

a concentration of specialized industry. They also benefit from sup-

portive state organizations, a modern infrastructure, and ready access

to funding sources. Once past the take-off stage, such regions attract

entrepreneurs and new as well as established companies because of

the ease of recruiting experienced employees and building corporate

partnerships.

Successful clusters all exhibit one overriding virtue: they

are self-sustaining. Competition and collaboration among local

16 A number of studies of regional innovation clusters have been published under the auspices of the Council on Competitiveness, 1500 K Street, NW, Washington, DC, 20005. See www.compete.org.

Sta nding still is not a n option48

organizations in a cluster enables new technologies to reach the

market in the form of successful products. This activity accelerates

as the cluster gets bigger, increasing the cluster’s value to new and

established businesses as it expands.

Relationships with the local universities likewise become

a self-regenerating activity. Typically, professors become consult-

ants. They find outlets for their creative ideas in the form of new

companies or relationships with established ones, making a lot of

money over and above their academic salaries. The universities reap

financial rewards in the form of industry grants and participation

in license income from intellectual property. This allows them to

strengthen their programs, attract more students, and even bring in

more professors.

Prominent long-standing clusters around universities include

the Boston area (Massachusetts Institute of Technology and Harvard

University); North Carolina (Duke University, University of

North Carolina, and North Carolina State University); San Diego

(University of California at San Diego); and Puget Sound (University

of Washington). In Britain, the area around the University of

Cambridge has gained a great deal of prominence.

Cluster success stories

Rochester, New York, is an interesting example of how a small city

that has seen its industrial base collapse has revived its economy

thanks to entrepreneurial endeavors. Rochester lost its major source

of jobs through the restructuring of three major employers in rapid

succession: Kodak, Xerox, and Bausch & Lomb.

In the 1970s, the city’s big three accounted for 60 percent of its

employment. In 2011 they employed only six percent of the work-

force. The rest work for small companies, 97 percent with fewer than

100 employees. These new companies emerged in an unexpected

burst of entrepreneurship, enabled by the presence of a workforce

with technology skills and the participation of the University of

Rochester and the Rochester Institute of Technology. Because of the

Factors in promoting entr epr eneurship 49

turnaround, in 2011 Rochester’s unemployment rate was 7.2 percent,

compared to about 9 percent for the US as a whole.17

Chicago is another example of a region that developed an entre-

preneurial cluster by leveraging its industrial base in manufacturing

and financial services. The city has a long history as a trading center

in commodities. It once boasted many trading organizations with

outstanding communications links with the rest of the world. As

these “floor”-based manual trading exchanges withered away, they

were replaced by computer-based trading facilities. In many cases

these used proprietary technologies developed by startup compan-

ies in the immediate area. These facilities are staffed by local com-

puter science graduates of the University of Illinois, the University

of Chicago, and the Illinois Institute of Technology. These novel

business strategies require massive computer power and clever

algorithms to allow ultra-high-speed trading that takes advantage

of short-lived market discontinuities. Chicago’s 12,000 technology

companies rank it as the third largest concentration of such busi-

nesses in the US. Many of them, though small, are leaders in their

niches.18

Other regions in the US have developed new industrial hubs

that have attracted entrepreneurs and investors. These include the

following: Ogden, Utah, for sports gear; Indianapolis, Indiana, for

life science companies; Albany, New York, for nanotechnology; and

Nashville, Tennessee, for healthcare companies.19 In each case indus-

try specialization is what produces value for startups and investors,

because it creates a concentration of talent and access to established

companies in the industry.

17 “Spotlight on Rochester, NY: Small businesses saved the city. It’s a model for other turnarounds,” Forbes, July 18, 2011, p. 77.

18 H. Weitzman, “High-tech savvy helps Chicago shrug off its rustbelt image: The way to success is letting traditional business strengths converge with technol- ogy,” Financial Times, December 29, 2010, p. 3.

19 E. Maltry, “Where the action is,” The Wall Street Journal, August 22, 2011, pp. R1–R2.

Sta nding still is not a n option50

But, needless to add, there is no shortage of failed attempts. For

example, Las Vegas, Nevada, had a grandiose plan for the Harry Reid

Research and Technology Park. Six years and $2 million in develop-

ment funds later, it remains an empty 122 acre lot.20

The Silicon Valley model has inspired international activity. A

very successful innovation cluster has developed around England’s

renowned Cambridge University. Having served as a consultant to

the Cambridge University Investment Committee, which provides

seed capital to startups based on University innovations, I can claim

some personal familiarity with the area.

Since the 1970s the Cambridge area has attracted many research

laboratories from companies such as Microsoft. It has also been the

site of a large number of startups, which have created 250,000 new

jobs in the local region since 1971. This rate of job creation is sub-

stantially larger than that of the UK as a whole.

Many of these startups were built around technology devel-

oped at the University, and a small local venture capital industry has

helped to fund them.21 Noteworthy are three world-class technology

companies, each with public valuations in excess of one billion dol-

lars, all created as a result of technology spin-offs.

ARM Holdings is the world’s leading developer of intellec-

tual property for integrated circuits. The success of this company is

truly amazing. It shows that there are no permanent monopolies in

the world of technology if entrepreneurial innovations are allowed

to bloom. It is a major challenger to Intel in specialized micropro-

cessor design for wireless handsets, and is beginning to move into

PCs. According to several sources, “rumors are swirling that by the

second half of 2013, Apple will switch to ARM in its MacBook and

MacBook Pro lines, and [at the 2011 Consumer Electronics Show]

20 Bloomberg Businessweek, September 5–11, 2011, p. 87. 21 For an overview see “The Cambridge Phenomenon, Main Report 2003,” pre-

pared by PACEC on behalf of Greater Cambridge Partnership, Cambridgeshire County Council and East of England Development Agency.

Factors in promoting entr epr eneurship 51

Microsoft had a rough, but working version of Windows running

atop ARM processors.”22

The other two major technology companies are also in the

digital space. Cambridge Silicon Radio is one of the world’s biggest

vendors of Bluetooth radio connectivity chips. Autonomy Corporation

is a world-leading search software company with novel data analysis

capabilities (it was acquired by Hewlett-Packard in 2011).

However, many Cambridge companies are small and face lim-

ited growth opportunities, largely because they address niche markets.

Others suffer from inadequate access to new capital or management

resources. For example, business surveys in the area found that

between 25 percent and 35 percent of firms indicated that their growth

was being restricted by the difficulty of recruiting sales and marketing

professionals. This kind of talent is not rare in Silicon Valley, but the

Valley has an abundance of big companies. As Cambridge becomes

home to more sizable companies, perhaps it will overcome both this

limitation and the small pool of entrepreneurial talent.

Other countries anxious to develop entrepreneurial activ-

ity also face a dearth of experienced management willing to join

new companies. People familiar with entrepreneurship in Germany

consider the technical talent pool to be very good, and experienced

people there seem prepared to take the risk of working in a young

company. Their big deficiency is in entrepreneurs with international

experience capable of building major companies – the kind of entre-

preneurs we discussed earlier, many of whom originate in the Silicon

Valley culture.

Cultural factors and entrepreneurship

Some people think that building an entrepreneurial culture is a sim-

ple matter of familiarizing the general population with its attrac-

tions. “Entrepreneurship is infectious,” one writer claims. “The

22 P. Escallier, “Armed and Dangerous?” Maximum PC, September 2011, pp. 42–44.

Sta nding still is not a n option52

more young people are exposed to it, the more they will embrace it

as a lifestyle and philosophy.”23

That may be. But embracing it and doing it are two different

things. Many of those young people will have neither the desire nor

the skills to start a new business. Margaret Thatcher, the former

British prime minister known for her championing of private enter-

prise, noted that “however pervasive an enterprise culture is, most

people are not born entrepreneurs.”24

Thus a central task in building an entrepreneurial culture is

motivating people who are not entrepreneurs themselves to take

professional risks and join innovative companies – or to develop a

commitment to new ideas even if they join big corporations. Yet

we can’t afford to ignore the real entrepreneurs. Recognition that

entrepreneurship needs to be promoted as a societal goal is growing

internationally, but the success of efforts in that direction is hard to

gauge.

In Europe, annual awards are given to successful entrepreneurs

who have taken university-generated technology into the market.

These awards are given by the Science Business Innovation Board

(AISBL), which is sponsored by a Belgian not-for-profit organization.

France, which has a tradition of state industrial planning that

stretches back to Colbert in the eighteenth century, now takes great

pride in the 622,000 new private businesses created in 2010 with the

support and encouragement of private groups. One of those groups,

Entreprendre Paris, maintains regional organizations to promote

new business formation.25

Even in the US, which already has a solid tradition of entrepre-

neurism, there is a growing demand for instruction in the subject.

For example, 90 percent of the engineering majors at North Carolina

23 L. Johnson, “The bug for creating a business is incurable,” Financial Times, March 23, 2011, p. 12.

24 J. Belrau, “The entrepreneur’s process,” The Wall Street Journal, April 28, 2011, p. A19.

25 Y. Le Gales, “Création d’entreprises: Le trou d’air,” Le Figaro, May 19, 2011, p. 21.

Factors in promoting entr epr eneurship 53

State University take a formal three-course entrepreneurship

sequence taught by alumni who have built successful businesses.

Such courses are offered at 90 percent of all accredited US colleges.

This represents a sixteen-fold increase over the past decade.

One reason for this interest might be that students read about

successful startups, and want to learn more. On the other hand,

there are plenty of stories in the media about large, well-established

firms being less willing to hire inexperienced college graduates and

train them to be productive, or about companies laying off older staff

in favor of younger, less experienced workers. Students who are read-

ing these articles could be thinking that sooner or later they may be

working in a small company, so they had better be informed about

what this means!

How have these courses influenced the behavior of students?

Results at North Carolina State University suggest that students

who take the entrepreneurship sequence are 75 percent more likely

to start their own businesses than those who don’t. They are also 59

percent more likely to believe that they can lead a new business and

23 percent more likely to develop new products even if they don’t

start their own business.26

Though few people actually start a new business, even in a

social environment as favorable as Silicon Valley, the exposure to

such an environment does have a direct effect on entrepreneurship.

Talented people are more willing to join startups or young compan-

ies with uncertain futures because there is no stigma attached to

that experience if the business fails. As J. Berenson, editor of Inc.

magazine, has noted, “America, they say, is the land of second

chances. No one knows this better than our readers, many of whom

have started businesses and failed. True entrepreneurs never leave it

at that, however.”27

26 T. K. Miller III, S. J. Walsh, S. Hollar, E. C. Rideout, and B. C. Pittman, “Engineering and innovation: An immersive start-up experience,” Computer, April 2011, pp. 38–46.

27 Inc., April 2011, p. 13.

Sta nding still is not a n option54

Immigrant power

No discussion of the cultural aspects of entrepreneurship can ignore

the role of immigrants. It is no accident that nearly all of the entre-

preneurs we discuss in this book, starting with David Sarnoff in the

next chapter and including some of the Chinese entrepreneurs dis-

cussed in Chapter 8, are immigrants or people who worked or were

educated in a foreign country before they started their companies.

One study suggests that more than half of Silicon Valley companies

were started by immigrants.28

This is not a situation peculiar to the US. An astute observer of

the social scene in the UK finds the same phenomenon there: “The

fact that so many fast-growing companies were built up by immi-

grant families [in Great Britain] confirms the belief that entrepre-

neurship is always most evident among ‘outsiders.’”29

Professor Tibor Barna, the well-known Hungarian-born econo-

mist, thought the reason that more immigrants were attracted to

entrepreneurism was their outsider’s point of view: “The outsider

is likely to be strongly activated by the profit motive; for him the

accumulation of wealth may bring social recognition. He may also

see more clearly the unsatisfied wants of consumers and he may be

more ready to experiment with new products, new techniques and

new forms of organization.”30

Immigrants may have another advantage over native entrepre-

neurs: they are comfortable in international business relationships.

Learning languages and adapting to local conditions is easier if you

have already done so once.

Israel provides further proof that immigration can boost a

nation’s innovation quotient. As the story of Ness Technologies

28 R. T. Herman and R. L. Smith, Immigrants Inc.: Why immigrant entrepreneurs are driving the new economy (Hoboken, NJ: John Wiley & Sons, 2009).

29 A. Sampson, The new anatomy of Britain (New York: Stein & Day, 1972), p. 602. 30 T. Barna, Investment and growth policies in British industrial firms

(Cambridge: Cambridge University Press, 1996), pp. 56–57.

Factors in promoting entr epr eneurship 55

in Chapter 7 illustrates, by any measure it has built one of the

world’s most successful entrepreneurial economies.31 Part of this

achievement must be credited to the country’s several world-class

universities. It is also a prolific producer of technology. It ranks as

fourteenth out of 125 countries in its capacity for innovation. Its

population has an exceptionally high ratio of technologists to non-

technologists, and it generates one of the highest numbers of patents

per capita in the world.

These are great advantages, but the fact that Israel is a country

of immigrants must also be weighed in the equation as a driver for

entrepreneurship. The country has attracted educated immigrants

from all over the world, not least the former Soviet Union, which

has supplied about one million of its most industrious and educated

citizens since the 1970s.

If there is a lesson to be learned from these observations, it

is that a country that welcomes immigrants and offers them edu-

cational opportunities along with integration into its society will

benefit from an addition to its population that can actively promote

its industrial growth.32

Looking for a new direction: Entrepreneurship in Japan

Japan’s amazing rise from postwar devastation to the status of eco-

nomic superpower has long been a model for other Asian nations.

Japan proved that the quality of industrial innovations can provide

the basis for industrial growth. But its economic stagnation since

the 1990s presents a cautionary example of how growth can turn

to stasis. There are many causes cited for this problem, but in the

search for renewed growth the Japanese government is turning to

31 D. Senor and S. Singer, Start-up nation: The story of Israel’s economic miracle (New York: Twelve, Hachette Book Group, 2009).

32 B. Sherwood, “Taking talent across borders: As governments tighten immi- gration rules, businesses fear they might lose out on skills,” Financial Times, Mastering Growth, June 1, 2011, p. 4.

Sta nding still is not a n option56

the promotion of entrepreneurship. This initiative is worthy of dis-

cussion here.

At its height, Japan’s economy was amazingly successful,

with a model that favored big corporations over small entrepreneur-

ial endeavors. Its companies came to dominate industrial sectors

such as consumer electronics, shipbuilding, and semiconductor

memories. Japan accumulated vast foreign reserves as its exports

grew at the expense of the established companies in the Western

world. Japan’s corporate prowess was attributed to magical long-

term planning accomplished through the combination of the bril-

liance of the management of its biggest companies and the wise

guidance of highly competent state bureaucrats. Admirers of the

model ignored the impact of its protective policies, including mak-

ing cheap bank capital available to favored companies and limiting

imports while promoting exports. They also neglected the inevit-

able problem of industrial ossification when industries are protected

from competition.

As a result, Japan never promoted its entrepreneurial culture

on a wide scale. In fact, among those who compared the Japanese

and American ways, the devotion to entrepreneurship was regarded

as a crippling deficiency in the US economic model.

The United States is fertile ground for the start-up of small

entrepreneurial companies. That is where the nation’s economic

dynamism rests … So when it makes the best economic sense

to sell the company and cash in on what you have created,

[you] cash in on what you have, a phenomenon known as the

American Dream. If, however, you grow your company to five

thousand or so employees, everything changes. You face a whole

new set of problems with which as an entrepreneur, you do not

usually have any special expertise … When companies reach this

kind of initial steady state, the leverage of individual decisions

on market value plummets … In Japan, by contrast, the national

soil is much less nourishing for start-ups but much more so

Factors in promoting entr epr eneurship 57

for established, steady-state companies. Once such a company

is in existence both managers and workers know that drastic,

discontinuous changes are not really in the cards.33

This observation sounds quaint today. Try to convince the manage-

ment of “established, steady-state companies” like Apple or Google

that they are not dealing with “discontinuous changes” all the

time.

Meanwhile, some of the giant Japanese companies (such as

Sony) that established global leadership in their glory years have

failed to adapt to new technologies and new market trends. They

seem to be in search of the energy and creativity that brought them

fame. They are still substantial enterprises, but they no longer return

the results they once proudly proclaimed, and the Japanese economy

as a whole has been stuck in low-growth mode since the 1990s.

There is no question that Japan has done, and still does, a lot of

things right. The country invests a great deal of money in the devel-

opment of new technology. In 2008 it spent $149 billion on R&D,

second only to the US, and well ahead of China’s $121 billion (in

currency-adjusted purchasing parity).

However, as most research is done in established companies,

it is mainly focused on incremental improvements to products and

processes. Furthermore, it does not percolate through the industry.

Since engineers in Japan are not as mobile as they are in the US,

ideas don’t move around with their creations. When an idea devel-

oped in the research laboratory doesn’t address a company’s imme-

diate needs, it is often dropped for good, because the lack of staff

turnover means it won’t find a new champion to run with it.

Traditionally the more basic research has been conducted in

universities with government funding. It is of a generally high cali-

ber, but until recently little of it has moved into the marketplace,

in part because there are so few entrepreneurs (and so little venture

33 K. K. Ohmae, The borderless world: Power and strategy in the interlinked econ- omy (New York: Harper Business, 1990), pp. 205–206.

Sta nding still is not a n option58

funding) to build new companies around it, and in part because uni-

versities, especially the state-supported ones, were reluctant to col-

laborate with industry. “Particularly after 1945, [the universities]

harbored strong anti-business sentiment, believing that large busi-

ness had been responsible for driving Japan into the painful Pacific

War … It was only as late as the 1990s that Japanese society became

serious about establishing mutually supportive relations between

the two communities.”34

Japan once benefited from remarkable entrepreneurs. In the tur-

bulent years after World War II, when the country was rebuilding its

industry, daring entrepreneurs contributed mightily to the Japanese

economic miracle by creating great new companies such as Honda,

Sony, Sharp, and Matsushita Electric (Panasonic). They often did so

in the face of disapproval from government officials who thought

they were better at strategizing for the future development of tech-

nology, and usually opted to protect big, established companies.

For example, when Soichiro Honda’s motorcycle company

began producing cars in 1957, “the Japanese government tried to

strong-arm Honda into merging his company with one of the coun-

try’s stronger automakers. He refused and set out to make stylish

vehicles with high quality handling and engineering.”35 Sony’s

founders Akio Morita and Masaru Ibuka, convinced that transis-

tors would transform electronics, “licensed the rights to the tran-

sistor from Bell Laboratories, after overcoming resistance from the

Ministry of International Trade and Industry [MITI].”36

34 R. Nezu, Technology transfer, intellectual property and effective university- industry partnerships: The experience of China, India, Japan, Philippines, the Republic of Korea, Singapore and Thailand (New York: World Intellectual Property Organization, 2007), p. 5. Available at www.wipo.int/freepublications/ en/intproperty/928/wipo_pub_928.pdf, accessed February 12, 2012.

35 M. J. Brewster, “Soichiro Honda: Uniquely driven,” August 17, 2004, http:// businessweek.com/bwdaily/dnflash/aug2004/nf20040817_3267_db078.htm, accessed Februrary 12, 2012.

36 A. Pollack, “Akio Morita, key to Japan’s rise as co-founder of Sony, dies at 78,” October 3, 1999, http://.nytimes.com/1999/10/04/business/ akio-morita-co-founder-of-sony-and-japanese-business-leader-dies-at-78. html?pagewanted=all&src=pm, accessed Februrary 12, 2012.

Factors in promoting entr epr eneurship 59

However, as the country’s economy grew to become the second

largest in the world after the US, the climate for entrepreneurial ven-

tures became less favorable. There are a number of reasons why this

happened.37

Japan’s venture capital industry is very small and averse to risking its • money with unproven management teams.

People who fail in business in Japan lose status, and rarely get a second • chance. This discourages would-be entrepreneurs.

At the national level, the strategy is to support established companies • rather than new ones.

New companies face high regulatory hurdles, so talented people tend • to join and stay with big employers – the bigger the better. Without

vibrant new enterprises to develop and market the good ideas generated

in universities, big companies overwhelmingly control new product

introductions.

Unlike Silicon Valley, Japan does not attract talent from around the • world. Immigration is strictly controlled, and foreign entrepreneurs are

not welcome.

In short, while the Japanese public professes admiration for

successful entrepreneurs, both its political and business establish-

ments favor conventional corporate leaders. Even though the media

often tout entrepreneurial successes, the overall environment is

not favorable to risk takers. This means that talented people tend

to choose lower-risk careers with established companies over risky

new ventures. In a country where the Confucian precept “Harmony

is to be valued” is taken seriously, and group effort is preferred to

individual action, this is an easy choice to make.

To be fair, the bursting of Japan’s real estate bubble and the

subsequent banking crisis had a lot to do with its economic mal-

aise. Unfortunately, it served to exacerbate the weakness of ven-

ture creation there. Since Japanese banks provide most of the

37 See “Japan: Technology and innovation,” Special section, Financial Times, December 9, 2010 for a full analysis.

Sta nding still is not a n option60

funding for startups, the drying up of capital has directly impacted

entrepreneurial endeavors.

In response, the Japanese government has taken a number of

steps to open up the system and encourage new ventures. Several of

its actions affected university/industry collaboration.

To jump-start collaboration between business and both public and • private universities, in 2002 the government proposed that universities

create 1,000 new venture companies in three years. This goal was

exceeded, with Tokyo University alone establishing sixty-four spin-offs.

By 2008 it could boast of 125 sustainable venture businesses. Including

that number, the top ten universities spawned a total of 679 such firms.

In 2004 the government changed the legal status of Japan’s prestigious • national universities to give them the freedom to chart their own course

and to “make them more accountable for creating value in Japanese

society.”38 The mandate freed researchers from regulations that had

prevented them from working with the private sector.

Earlier the universities had demonstrated increasing interest in • protecting their inventions through patent filings as part of a technology

transfer strategy. Their patent filings rose from seventy-six in 1996 to

1,355 in 2002.

The Development Bank of Japan, a government institution formed • in 1951 to finance Japan’s industrial expansion, began a privatization

process in 2008 to separate it from the government. Its new charter will

be to “provide integrated investment and loan services to domestic and

international [emphasis added] clients.”

It remains to be seen whether such steps will help in revitaliz-

ing Japan’s industrial sector, or if they will stimulate the creation

of entrepreneurial companies. However, it might be unwise to bet

against a country that has transformed itself twice in the past 150

years: from a feudal agrarian society in 1868 to a modern industrial

power with a market economy in 1900; and again from a defeated

and impoverished nation in 1945 to the world’s second largest econ-

omy four decades later.

38 Nezu, Technology transfer, p. 14. Information in this and the previous bullet point is drawn from this document.

Factors in promoting entr epr eneurship 61

In the early 1990s Taichi Sakaiya, a leading economic analyst

and former MITI official, made this very point. He published a book39

that was critical of Japan’s exclusive focus on manufacturing, and

the conformist attitudes it produced, which he ascribed to the mili-

tary regime in control before the war. However, he maintained that

its group mindset could help Japan reverse course quickly, because

everyone within a group changes at once.

Indeed there are stirrings of a desire for wholesale change. In

the face of continuing political and economic turmoil, and in the

wake of the disasters of earthquakes, tsunami, and nuclear power

meltdowns, opinion makers and the mass media are calling for a

“return to the spirit of post-WWII.” It has almost become a slogan

for driving Japan forward.

Other nations with highly structured societies, no matter what

their level of economic development, face problems similar to those

of Japan. Challenging the incumbent economic powers in such soci-

eties is difficult at best. South Korea has also been cited as a coun-

try with highly successful, big established companies that is having

major difficulties in developing an entrepreneurial culture.40

Contract R&D for small and mid-sized companies: A key role for government support

I frequently meet heads of small and mid-sized technology product

companies. When asked about their biggest worry, they mention the

difficulty of staying competitive with new international competi-

tors leveraging new technologies in their products.

This is not surprising. Starting a new company is easier than

making it successful over the long term. Companies usually launch

with a single idea, and then concentrate on getting the first prod-

ucts to market while managing cash flow. All attention is focused

39 T. Sakaiya, What Is Japan? Contradictions and transformations (New York: Kodansha America, 1995).

40 “South Korean entrepreneurs: Young, gifted and blocked,” The Economist, May 14, 2011, p. 82.

Sta nding still is not a n option62

on near-term product features. Long-term R&D is relegated to the

future owing to its cost and its delayed payback.

Some entrepreneurs, as we will see in our case studies, do man-

age to get access to enough capital and other resources to grow through

product innovations. But all too many small and mid-sized compan-

ies find themselves unable to adapt to market needs fast enough, both

because they don’t have the money to invest in R&D, and because

their talent needs keep shifting in light of new technologies.

Historically small businesses address this problem by finding

a market niche that is defensible, establishing themselves with solid

products and reference customers, and then moving into adjacent

or bigger market segments. But it is hard to do this successfully, for

two reasons.

First, many startups do not have a disruptive technology that

would allow them to fortify a niche. Second, many do a poor job of

executing on their original strategy and wind up with no resources

to invest in lateral growth. Whatever the cause, their growth, their

profitability, and even their viability are threatened.

There must be a better way of supporting ongoing businesses

that have limited resources. Germany appears to have developed an

approach that works.

German industry has managed to stay competitive in the

world market in spite of having higher costs than the develop-

ing world. The country continues to generate large manufactured

product trade surpluses in the face of new Asian competitors.

Well-managed small and mid-sized companies, many of them

family-owned for several generations, are a source of great strength

for the German economy. It helps that exports are their lifeblood.

But these are not giant conglomerates with infinite resources. In

the face of accelerating technology development, how can such

companies afford the ever-changing development resources needed

to stay in the game?

The solution that Germany has developed to help its indus-

try is centered on the Fraunhofer Gesellschaft. Fraunhofer was

Factors in promoting entr epr eneurship 63

founded in 1949 as a non-profit research institution with the mis-

sion of undertaking applied research to drive economic develop-

ment. This is accomplished through fifty-nine Institutes, mostly

in Germany, which support the innovation needs of major domestic

German industries ranging from solar energy and software to wood

products. The staff of 17,000 consists mostly of engineers and sci-

entists who work with an annual budget of about 1.6 billion euros

(2009).41 In an interesting twist, the Institutes also function as

training grounds for technologists who eventually move into indus-

try. They also act as conduits to academic research of commercial

importance.

The government pays for Fraunhofer’s infrastructure costs

(one-third of the budget). The rest of the revenues come from license

fees and product development contracts from companies or govern-

ment agencies. While companies pay the direct cost of the work

performed on their behalf, and own the results, costs are indirectly

shared with other customers of an Institute in the same industry.

With the government infrastructure subsidy reducing overhead costs

and customers benefiting from independent research, this is a pro-

ductive arrangement.

Two of the biggest advantages that businesses derive from

working with Fraunhofer are access to specialized talent familiar

with their industry and exposure to the latest technology. In effect,

such cooperative work substitutes for a lot of the in-house R&D

that a small or medium-sized business would have to conduct. For

example, the Institute devoted to solar energy development has facil-

ities that are of commercial scale. As a result, device research goes

from concept to production in record time, and companies that con-

tract with the Institute can quickly move the new products to pro-

duction scale and into the market.

The Fraunhofer Institutes are well known for their leading-edge

technology development. Given the breadth of the work they conduct,

41 Data from Fraunhofer Annual Report, 2009.

Sta nding still is not a n option64

it is hard to single out one accomplishment to represent their influ-

ence, but in our media-obsessed culture it is noteworthy that one of

the Institutes is responsible for the MP3 music compression software

technology used by virtually every music player in the world market.

Sources of capital

It is almost too obvious to say: you can’t start a new company without

money. But you also cannot hope to grow beyond the startup phase

without access to capital on favorable terms. Hence, entrepreneurs

need both seed capital and follow-on growth capital to build eco-

nomic value. For that reason one of the basic necessities of a healthy

entrepreneurial environment is the availability of capital to finance

startups and their growth. There are several potential sources for

this kind of funding, and which one(s) you use can depend as much

on what country you’re in as on such factors as your company’s stage

of development and its industry.

Access to public markets has been the preferred way to raise

growth capital. Thousands of companies initially funded with venture

capital, such as Apple, Microsoft, Intel, and Google, raised their capital

that way. Among the companies we discuss later in the book, RCA,

SanDisk, Ness Technologies, RDA, and AsiaInfo were able to access

public markets. But as we note below, public markets are a fickle source

of funding and cannot be relied upon within defined time limits.

In the absence of access to public markets (or other sources of

growth capital including bank financing), business growth becomes

problematic and companies may be forced into mergers with other

companies to access the needed capital. As we will see later, RMI

(Chapter 5) and Harbour Networks (Chapter 8) were in that situation

when their IPO (initial public offering) opportunities temporarily

disappeared in a market crash.

Government grants and bank funding

Because small businesses create jobs, governments regularly provide

direct financial support or encourage other entities to do so. Here are

some examples.

Sources of capita l 65

In the UK, Project Merlin was designed to make bank loans

available to small and medium-sized business. The amount targeted

in 2011 was £19 billion.

In the US, the Small Business Jobs Bill, signed into law in May

2011, includes a $30 billion lending fund that community banks can

use to make loans to small businesses. The bill also increases the

guarantee by the US government through the United States Small

Business Administration of up to 90 percent of the loans extended

by local banks using their own funds. The purpose of the loans is “to

help start-ups and existing small businesses obtain financing when

they might not be eligible for business loans through normal lend-

ing channels.” There are also $12 billion in tax incentives for small

businesses.42

Unfortunately, US government-backed funding carries a sig-

nificant drawback for small businesses. It requires very detailed

reports and accounting documents to be filed on a regular basis to

assure compliance with the law. Small companies are ill-equipped

to do this without taking time away from their regular business

activities or spending money to have someone else handle the fil-

ings. That goes against the reason for seeking the funding in the first

place. Furthermore, many regional banks are not anxious to deal

with small business loans that carry government-mandated require-

ments with them.43

Germany has a program designed to attract venture capital

and promote the movement of innovations from universities into the

market. The Federal Ministries of Economics and Technology and of

Education and Research provide funds to startups, typically about 1

million euros or less, in the form of matching grants – that is, they

match any funds provided by private capital. Another agency, the

KfW Bankengruppe, a Federal and State-owned development finance

organization, also provides either equity or loans to startups on a

42 Source: www/growthink.com/category/blogs/entrepreneurship, May 3, 2011. 43 E. Maltby, “The credit crunch that won’t go away,” The Wall Street Journal,

June 21, 2010, p. R1.

Sta nding still is not a n option66

matching basis. For example, a startup requiring 3 million euros can

get 1 million from private funds, 1 million from the Ministries, and

1 million from KfW.

Singapore is another country striving to achieve a consistently

high economic growth rate. It has a stated policy of attracting lead-

ing-edge industries and helping them acquire the innovations they

need to stay competitive over the long term. To this end, the gov-

ernment funds research that is related to the country’s industrial

activities. In order to move innovations into products, strong ties

exist between government-funded research organizations and local

industry. A strong manufacturing sector is part of the national eco-

nomic strategy.44

Funding to help small businesses export their products

There has been a notable shift in the attention paid in the US to

exports by small companies. This represents a recognition of the

importance of globalization and the fact that the US now represents

a shrinking portion of the world market.

That is a positive development, but it comes with a built-in set

of problems. Once a small business reaches the stage where it has

products to sell in a global market, it faces the problem of financing

not only its regular operations, but its export activities. Lacking the

financial and logistical resources of large corporations, small busi-

nesses often find it difficult to wait for payment from overseas cus-

tomers – or, sometimes, to collect their money at all.

Mindful of the need to help small US businesses go global,

the Export-Import Bank of the United States, an independent Federal

Agency, offers valuable services to bolster their export capabilities.

The Bank is self-funded (i.e. not supported by the taxpayer) and relies

on fees for its services as a source of revenues. Its historic focus has

been on supporting big companies, but small business is now on its

44 C. Day, “Singapore applies itself to science,” Physics Today, June 2011, pp. 20–21.

Sources of capita l 67

radar screen. New programs launched in 2010 provide insurance to

protect exporters and lenders from nonpayment for commercial or

political reasons. They also allow exporters to extend credit to inter-

national customers. Another service guarantees up to 90 percent

of an exporter’s working capital that gets tied up with outstanding

inventory or accounts receivable.

These programs helped relieve the financial strain of building

an export business for 900 small companies in fiscal 2011. During

that year the amount of export financing covered by these initiatives

exceeded $2.4 billion.

Private funding

Before the advent of venture capital firms most entrepreneurs were

funded through banks and private investors – what are now called

angel investors.45 Angel investors are still a large source of capital

in the US, with an estimated $20 billion invested in 2010, but today

professionally managed venture and private equity funds finance

the most ambitious young companies. Furthermore, angel inves-

tors rarely have the capital (or appetite) needed to provide the large

amounts commonly needed to finance the growth of promising

start ups after their initial development phase.

Angel investors continue to be crucial to small business fund-

ing in many countries. Certainly this is true in India and China. But

given how dispersed such funding sources are, there are no reliable

figures on how much money is invested annually by angel investors.

There is clearly a need for such a funding source in the absence of

others.

In China, for example, the number of private companies tripled

between 2000 and 2009, from 120,000 to 340,000. Professional ven-

ture capital was and is relatively scarce there, and it is only avail-

able to businesses in very high growth sectors not dominated by

45 For an excellent review of funding mechanisms see N. R. Lamoreax and K. L. Sokoloff, eds., with a foreword by W. Janeway, Financing innovation in the United States: 1870 to the present (Cambridge, MA: The MIT Press, 2007).

Sta nding still is not a n option68

state-owned companies. Banks are state-controlled too, and their

lending policies are set by government planners who target favored

industries. So how do private companies get financed in this kind of

economy? The answer is that rich individuals in the emerging econ-

omies, who are looking for big profits in fast-growing companies, are

anxious to invest.

This puts small-business funding in the hands of financial

intermediaries who channel investment money from rich individ-

uals. There are also companies that guarantee the loans (with the

blessing of the authorities) to help manage the risk to individual

investors. It remains to be seen how this insurance works out in bad

times, because the amount of money guaranteed is likely to be far in

excess of the capital covering these guarantees.46

The terms of these investments vary with the perceived risk.

Access to capital to finance growth is, however, a big problem for

many small companies because interest rates on loans can be very

high. Press reports suggest that many of the small companies in

China with fewer than 300 employees are operating well below their

potential because capital is so hard to get.47

However, for ambitious entrepreneurs who need many mil-

lions of dollars to build major enterprises, angel investors are not

an adequate source of money. Only access to professional equity

capital and bank financing will meet that need. This level of fund-

ing is now available in many countries around the world, but on a

highly selective basis. In addition to funding US-based companies,

professional investors are moving capital to high-growth emerging

economies like Brazil or certain Asian countries, which have growth

rates sometimes double or triple those in the developed countries.

In the Asia-Pacific market, the number of private equity funds grew

by 60 percent between 2005 and 2010. In 2010 alone $34 billion of

46 H. Sender, “A shadowy presence: Chinese finance,” Financial Times, April 1, 2011, p. 9.

47 Bloomberg Businessweek, August 15–28, 2011, p. 13.

Sources of capita l 69

new capital was committed there.48 The three Chinese companies

discussed in Chapter 8 were funded by Chinese and US venture

capital.

In any period of time, the amount of money available for

investment by private investors depends on their willingness to

commit long-term capital. That willingness depends in turn on

the anticipated rate of return of venture capital compared to other

asset classes, such as public securities. Because the rate of return

of US venture capital (as a group) has lagged since 2000, the total

amount of capital available in US-based funds has declined over the

past several years.49 It is important to note that the best-performing

funds are getting an increasing share of the funding because the top-

performing 25 percent of venture capital funds account for practic-

ally all of the industry’s profits. Poorly performing funds go out of

business. However, the net result is that the total venture capital

funding has declined from its peak years as shown in Figure 2.2.

48 C. Meads, “Opportunities for private equity in a changing world,” Financial Times, April 4, 2011, p. 6.

49 See H. Kressel and T. V. Lento, Investing in dynamic markets: Venture capital in the digital age (Cambridge: Cambridge University Press, 2010), pp. 41–61 for an overview of the world of venture capital.

120,000

100,000

80,000

Follow-on

First

60,000

M il li

o n

s (

$ )

40,000

20,000

0 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98

Year ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11

Figure 2.2 Venture capital investments by US funds by year, 1985–2011. Source: Based on data from Thomson Reuters.

Sta nding still is not a n option70

Clearly, with less money to go around, a smaller number

of companies are getting funded – both in the startup stage and

to finance growth (see Figure 2.3.) As Figure 2.2 shows, follow-

on investments in established companies dwarf startup funding.

Whether the reduced venture capital availability is necessarily det-

rimental is unclear. Investors will clearly be more selective about

where they put their money and hence improve the success rate of

ventures. Note that Figure 2.2 shows that, despite the drop in fund-

ing level from the peak years, the amounts invested are still high by

historical standards, assuming the Internet “bubble” period around

the year 2000 is considered an aberration – which it clearly was.

Given the high failure rate of new companies around the peak

of the Internet-driven investment bubble in 2000, one can specu-

late that not many good new business ideas are being left behind

at current funding levels. There may even be a silver lining: with

venture capital funds being better managed, the profitability of the

venture capital industry is likely to improve, which will stimulate

an increased inflow of capital.

Year

N u

m b

e r

o f

C o

m p

a n

ie s

’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11

Figure 2.3 Number of companies funded by US venture capital funds, 1985–2011. Source: Based on data from Thomson Reuters.

Public m a r kets a nd fina ncia l r ewa r ds 71

Public markets and financial rewar ds for entrepreneurs

Ask any ambitious entrepreneur about his or her dream, and you

will be told that the hallmark for success is an IPO on NASDAQ or

even the New York Stock Exchange. There are two factors that drive

this desired event:

the ability of the management team and investors in the company to sell • some of their stock; and

the ability to raise growth capital at attractive rates – instead of bank • loans, for example.

In fact, US exchanges are viewed by investors as well as entrepre-

neurs as the most desired place for a listing. Of venture capitalists

polled globally in 2011, 87 percent selected NASDAQ as the preferred

market to list.50

The joys of pioneering a new business are stimulating, but the

expectation of big financial returns is still a major driver for entre-

preneurial endeavors. Ultimately, these rewards can come either

from selling the business, selling shares in an IPO, or harvesting

profits over a long period of time. Harvesting profits is how fam-

ily businesses that dominate the small and medium-sized business

environment in many countries are built. Transammonia, covered

in Chapter 4, is a good example of such a business.

In a Silicon Valley-style venture capital mentality the prior-

ities are different. Investors and entrepreneurs are looking at a time

frame that is much shorter than that found in the development

model for a traditional family business. Venture capital funds that

finance companies are generally pools of capital with a ten to twelve

year life. At the end of that period the limited partners expect to get

their money back, with profit. Hence, by definition, their portfolio

companies must somehow return capital. This liquidity can only be

50 M. Davis and S. Ingram, “Getting ready for an IPO window,” XConomy, September 22, 2011.

Sta nding still is not a n option72

generated by a public offering of stock in the company, which then

makes it possible for employees and investors to sell their stock over

time, or by its outright sale.

Taking the IPO route allows a company to continue on its

independent way while rewarding its investors and entrepreneurs.

This obviously requires that young companies be valued for sub-

stantially more than the capital invested in them. On the negative

side of IPOs, public markets are notoriously fickle and unpredictable.

Furthermore, government regulations regarding reporting rules are

enormous and very costly for public companies, so an IPO is not

necessarily the right choice, especially for companies too small to

support such costs.

As Figure 2.4 shows, the number of venture capital-backed

company IPOs in the US has fluctuated over the years, but the activ-

ity in outright sales or mergers of these companies tends to increase

as the number of IPOs decline.

While an IPO is still a cherished objective, regarded as the

gold standard of success for a new company, the reality is that an

acquisition by or merger with another firm can be a better outcome

Figure 2.4 Number of US venture capital-funded companies that had an IPO and the number of companies that merged or were acquired since 1982. Source: Based on data from Thomson Reuters.

Globa l consider ations 73

under the right circumstances. This holds especially true for a com-

pany that is starving for growth capital, and can’t wait for frozen

public markets to once again welcome an IPO. Naturally, it also

includes companies that never get big enough to warrant a public

offering.

A merger or sale under such circumstances can actually

enhance the economic value created. Such an event creates liquidity

to management and investors, thus providing the looked-for return

for risk-taking.

Sales of promising startups benefit buyers as well. By buy-

ing an innovative new company, a larger firm can acquire needed

new products and technologies much faster than if it had to develop

them on its own. This process of absorption is actually healthy for a

national economy. It puts entrepreneurial innovations in the hands

of firms with the resources needed to successfully commercialize

them, rather than allowing them to languish in an under-capitalized

startup.

Global consider ations

Throughout this chapter we have discussed the major conditions

under which entrepreneurship can be effective in building valuable

companies. These include appropriate government support, a culture

of risk-taking, and access to risk capital and markets.

We must remember, however, that this whole process is effect-

ive only in a legal and economic system that supports and rewards

individual initiatives. Entrepreneurship cannot bring out the best

and most creative people in a country where there is no respect for

the rule of law and there is no reliable legal system to protect private

property rights. Corruption, excessive state control, and the inabil-

ity of entrepreneurs and investors to reap the financial rewards of

risk taking are all enemies of entrepreneurial achievement as we

understand it in this book.

As more and more entrepreneurial companies enter the glo-

bal market, they find themselves challenged by unfamiliar, and in

Sta nding still is not a n option74

some cases unfair, policies and practices in certain countries where

they would like to do business. Entrepreneurs also operate under

the constraints of their countries of origin. While none of these are

insurmountable obstacles, they do increase the business risk when

operating in certain geographies.

Here is a summary of some of the issues and pitfalls entrepre-

neurial firms may face as they go global.

Government restrictions on trading technology products

International commerce is rife with limitations imposed by various

governments on the sale of technology products. Keeping track of

them not only keeps companies out of trouble – it can keep entrepre-

neurs out of jail!

For example, the US government places restrictions on the

export of certain products, technology or software, nominally non-

defense in nature, to select countries. The controlled items are in

the category of “dual use,” which means that they can be adapted

to strategic applications as well as commercial ones. These regula-

tions fall under the grouping of Export Administration Regulations,

which are administered by the Department of Commerce. You

need special licenses for the export of such items. For example, one

instance with which I am familiar involved the export of cameras

able to view in the infrared. Such cameras can be used in defense

applications for night vision in addition to being used for commer-

cial security systems.

Having to keep track of which countries are embargoed com-

plicates matters. And sometimes the restrictions seem arbitrary,

since companies in other countries can and do sell similar products

to those very same countries. But the government is very serious

about enforcing these prohibitions. The US is not alone in enforcing

such regulations. The EU has restrictions on trading with certain

countries. Breaching its rules can entail criminal sanctions on the

individuals involved.

Globa l consider ations 75

Needed: Tight financial controls

Every business person understands the need for stringent control

over its company’s finances. This is doubly important in inter-

national business.

Fraud is always a big risk. Examples of questionable business

practices are found everywhere, but newcomers to countries with

weak legal systems should be ready for surprises. Anecdotal stories

circulate of sweetheart arrangements between suppliers and com-

petitors designed to keep out newcomers; bribes paid for government

licenses; and such scams as local managers running their own little

businesses by using corporate personnel as their staff.

Incidents of accounting irregularities are common. There are

documented horror stories about Eastern European countries formerly

part of the Soviet Union.51 Fast-growing markets in any geography

are prime locations for irregularities, as they attract shady business

people.52 Young companies with limited resources are particularly

vulnerable if they have not established strong local business rela-

tionships with trustworthy organizations. Such relationships take

time to develop. They are based on mutual trust established between

senior executives, and sustaining these relationships requires fre-

quent meetings.53

Well-managed international companies implement central-

ized financial controls, so that local controllers report to headquar-

ters as well as to local management. They unify financial systems to

ensure timely reporting and problem discovery. In addition, internal

auditors periodically check local systems and purchasing policies.

Uniform financial reporting is particularly important for companies

hoping to become publicly traded in the US. Accounting standards

51 “From Bolshevism to backhanders,” The Economist, April 16, 2011, p. 57. 52 R. Cookson and H. Sender, “Carlyle suffers China setbacks: Two investments

hit by fiscal allegations,” Financial Times, May 6, 2011, p. 13. 53 G. Colvin, “The biggest problem for developing economies: corruption,”

Fortune, May 2, 2011, p. 48.

Sta nding still is not a n option76

are extremely stringent here, and inaccurate reporting can have

severe legal implications.

Pay a bribe, go to jail

There is no lack of official attempts to eliminate bribery. The

Organization for Economic Cooperation and Development spon-

sored an Anti-Bribery Convention in 1999 to curb bribery of for-

eign officials. Thirty-eight countries subscribed to the Convention,

but a recent report indicates that only thirteen of the signatories

(with the US being most active) have actually imposed sanctions

on individuals or corporations caught in bribery. Of the thirteen,

the most active in applying sanctions has been the US.54 Reports

of bribery of foreign public officials by employees of some big US

corporations surface periodically.55 The consequences are severe.

A recent conviction involved a US company selling products to a

Mexican utility where bribes were paid to officials to enable the

sale.56

Collecting the bill

While you can guard yourself against fraudulent business practices,

timely collection of receivables can be a huge problem. Stories peri-

odically surface of companies totally reliant on a single customer

when a dispute arises. One publicly traded company was unable to

collect from a customer because of a price dispute.57 The incident

affected its public market standing.

To avoid getting local courts involved in settling such disputes,

a common practice is to agree up front to binding arbitration in a

54 P. Hannon, “Few nations punish bribery,” The Wall Street Journal, April 21, 2011, p. A8.

55 E. Byron, “Avon’s stock is hit by widening bribery probe,” The Wall Street Journal, May 6, 2011, p. B4.

56 S. Rubenfeld, “Conviction in foreign bribery case is first in US trial,” The Wall Street Journal, May 11, 2011.

57 E. Crooke and L. Hook, “American Superconductor misses new filing deadline,” Financial Times, June 21, 2011, p. 13.

M a naging intellectua l propert y 77

neutral country. Singapore is a popular location in the Asia-Pacific

region for arbitration proceedings.

Unfortunately, the collection problem is not restricted to exotic

locations. Hard times can make even the most honest customer in

the most law-abiding country look for creative ways to delay pay-

ment and conserve cash. If it happens in the European Union the

problem can be as troublesome as in any other geography. There are

27 different national legal systems in the EU, each with its own pro-

cedures for handling claims and bankruptcies. So it is not surprising

that it is hard for a small foreign company to legally challenge its

customers on payment claims.58

Managing intellectual property

Managing intellectual property is an essential part of technology

business management and the greater the dependence on inter-

national operations, the more challenging this task is. The simple

reason is that laws protecting intellectual property vary widely in

different countries, as do the criteria for patent issuance and protec-

tion. In some countries, little or no legal protection is available as a

practical matter, and doing business in such countries is a risk that

companies can avoid only by going elsewhere.

In a world where few industrial secrets stay secret for long,

protecting a competitive edge is not getting any easier. Bitter patent

fights among corporations in leading-edge technologies are nothing

new (as the history of RCA in Chapter 3 shows), but it does feel like

the amount of litigation has been increasing steadily as companies

jockey for position in fast-growing international markets.59

We should not be surprised by this state of affairs. Product

costs are disappearing as real differentiators around the world for

58 S. Daley and S. Castle, “Slow payers hinder cross-border trade in Europe,” The New York Times, April 19, 2011, p. B1.

59 “LED makers wage patent war,” Photonics Spectra, August 2011, p. 76. “Intellectual property: inventive warfare – Battles over patents are becoming fiercer and more expensive,” The Economist, August 20, 2011, pp. 57–58.

Sta nding still is not a n option78

most technology products, and software is an ever-increasing part of

what differentiates technology products. It is natural that corpora-

tions are looking to their intellectual property as a prime defensive

and offensive tool in their competitive wars.

Ironically, however, a strong IP position can expose a com-

pany to risk of government action. Governments try to help their

domestic champions. If your startup becomes too successful, as in

the cases of Microsoft or Qualcomm, for example, don’t be surprised

if some government brands you a monopolist. The motivation for

such actions is usually to protect or help domestic companies unable

to compete. Such can be the price of building new industries on the

strength of strong patents.

With accelerating technological evolution producing more

innovations all the time, the ferocity with which companies pro-

tect their turf while attacking their competitors has escalated. The

increase in the number of lawsuits has been partly fueled by the

number of questionable patents issued, a side effect of the relatively

recent decision to allow patents on software. It is very difficult to

decide the novelty of conflicting claims on software without a court

fight.

The trouble really starts at the patent offices, where the sheer

volume and specialization of patents overwhelms the staff charged

with deciding the merit of patent claims. But IP battles can also

involve claims that employees have violated patents or used trade

secrets from their former employer at a new company. So protect-

ing intellectual property has two components: retention of pro-

ductive employees, and a vigorous patent filing and legal protection

strategy.

Whoever is not prepared to do legal battle need not bother to

file patents. Unfortunately, while legal protection may be available,

the legal costs can kill a small company because such protracted

battles can last years and cost millions of dollars. The basic prob-

lem is that too many patents are ambiguous and overlapping, leaving

each side of the argument believing that they have the upper hand.

M a naging intellectua l propert y 79

What makes matters more difficult is that the number of patents is

increasing rapidly around the world. Each country has its own way

of dealing with claims of patent infringement, so the global cost of

patent filing and protection continues to rise.

Visions of monetizing intellectual property through licensing

agreements are common among entrepreneurs with a patent port-

folio and badly in need of cash. They are frequently disappointed,

because collecting license fees is never easy, particularly in develop-

ing countries. For example, a US government report surveyed 5,051

companies in various industries regarding their ability to collect

license income.60 Many reported difficulties in fee collection.

Each business needs to develop its own intellectual property

strategy, but looking at some successful examples is worthwhile. We

selected for discussion two companies that can be viewed as “poster

children” of the industrial intellectual property battlefield, RCA and

SanDisk. David Sarnoff at RCA (Chapter 3) was one of the dominant

masters of the art of intellectual property management in the past

century.

SanDisk, the subject of Chapter 6, is a remarkable story of

leveraging patents on an international scale by a smart licensing

strategy, backed by relentless legal action. The company used license

income to fund a great deal of its technology development. In effect,

SanDisk’s competitors financed the innovation engine which fueled

the growing market strength of the company. It is a strategy that

David Sarnoff, the subject of the next chapter, developed and worked

to perfection. There is much to learn from these examples.

60 US International Trade Commission, “China: Effects of intellectual property infringement and indigenous innovation policies on the US economy,” May 2011; reported by M. J. Slaugher, “China, patents and US jobs,” The Wall Street Journal, June 6, 2011, p. A19.

80

I hitched my wagon to an electron rather than the proverbial star.1

David Sarnoff

Introduction

Entrepreneurs, inventors, and innovations have driven the electron-

ics revolution since its chaotic beginnings in the early years of the

twentieth century. Unfortunately, the astonishing advances of the

last thirty years have obscured the contributions of the pioneers of

that era. These men laid the foundation for today’s wired and wire-

less society, but they rarely get the credit they deserve.

Case in point: David Sarnoff of the Radio Corporation of

America (RCA), the company he built and directed for a half- century.

Sarnoff was the Bill Gates or Steve Jobs of his day, a visionary who

pushed his company to develop or adopt new communications tech-

nology, create a market for it, and become the dominant player in

that market.

Under his leadership RCA successfully commercialized both

radio and television, either inventing the technology or licensing

others’ intellectual property (IP) as needed. At Sarnoff’s urging RCA

later invented most of the technology for color television, from the

cameras to the displays. It was also the first company in the world

to successfully commercialize these innovations. He also under-

stood that he couldn’t commercialize major innovations alone, so

he licensed RCA’s IP to competitors. They helped him create market

3 Electronic innovation and the government: David Sarnoff creates the RCA empire

1 The New York Times, April 4, 1958.

Introduction 81

momentum, and the license fees generated a handsome revenue

stream.

Sarnoff combined an ability to foresee commercial applica-

tions for technology with the business savvy to make them econom-

ically viable. More than eighty years ago he created the National

Broadcasting Company (NBC) subsidiary of RCA to build the world’s

first radio and TV broadcasting networks. He financed them with an

innovative advertising-supported business model. Electronic mass

media, including websites and Internet search engines, still use this

model.

His contemporaries stood in awe of his achievements. For much

of his career he was ranked as a colossus of world industry. In 1975,

four years after his death, he was named one of fifteen “Laureates

from Two Centuries” in Fortune magazine’s inaugural Hall of Fame

for Business Leaders. Other nominees included Henry Ford, John D.

Rockefeller, J. P. Morgan, and Andrew Carnegie.

Yet today few people remember who he was or what he did.

He established no foundations to carry on his name, and his fame

and influence began to wane after he officially retired in 1969. RCA,

once one of America’s largest and most powerful corporations, was

acquired by GE in 1987 and sold off in pieces.

Sarnoff deserves better. He was present at the birth of elec-

tronic technology, and maintained a prescient vision of its poten-

tial to the very end of his career. In 1965, at the age of seventy-four,

he gave a speech2 predicting that one day satellites would broadcast

TV directly to homes, and mused about the political and social

consequences.

Telstar, the first satellite to relay TV among broadcasters, had

been launched only three years before. Direct-to-home analog satel-

lites would not be announced for more than a decade, and it took

until 1994, nearly thirty years after his speech, for the launch of the

2 David Sarnoff, Looking ahead: The papers of David Sarnoff (New York: McGraw- Hill, 1968), pp. 184–87.

Electronic innovation a nd the gover nment82

DirecTV digital satellite TV system to presage the fulfillment of his

prophecy.

In many ways Sarnoff was the archetypal globally oriented

entrepreneur, sparking innovation and driving economic growth. For

that reason his career makes a good starting point for our survey of

entrepreneurial ventures in the global economy. But his example is

important for another reason. The history of Sarnoff and RCA dem-

onstrates the delicate balance between entrepreneurship and govern-

ment goals and policies.

This cuts against the romantic view of early entrepreneurs as

swashbuckling builders of industry who didn’t have to worry about

government regulations and interference. But the fact is that there

has always been plenty of government involvement in areas that

affect national security and economic policy. Government agencies

essentially dictated the creation of RCA. They continued to moni-

tor and restrict its business activities, and periodically reshaped

the communications industry through antitrust suits and other

actions against the company they had sponsored. Sarnoff proved to

be as skilled in navigating the uncertain waters of governmental

intervention as he was in grasping the commercial implications of

technology.

As we review his achievements as a global entrepreneur,

however, we must not let his knack for dealing with governmen-

tal concerns obscure the true dimensions of his legacy. His work

was a significant spur to the development of today’s electronics

industry, an industrial sector that continues to create a staggering

amount of economic value. To take just the most recent figures, the

Telecommunications Industry Association reports that telecom-

munications revenues for 2009 were $3.7 trillion worldwide. The

figure for the US alone was $1.2 trillion. A substantial portion of

those revenues comes from mobile phones. These devices are essen-

tially radio receivers/transmitters, making them direct descendants

of RCA’s original products. Another heir to RCA’s legacy, the US

Introduction 83

cable TV industry, also accumulates huge revenues – $93.7 billion in

2010.3 In the same year digital satellite TV had 195 million subscrib-

ers in 73 countries, producing $71 billion in revenues.4

In the area of job creation, a primary concern of all govern-

ments, the numbers are just as impressive. The US Bureau of Labor

Statistics estimates that the telecommunications industry alone

employed 975,000 US workers during 2010.5

Sarnoff’s company also produced innovations that made the

growth of the computer and electronics industries possible. RCA

Laboratories (later Sarnoff Corporation), a monument to his faith in

R&D, invented both the color CRT (cathode ray tube) and the LCD

(liquid crystal display). Originally designed as TV displays, these

devices are also one of the foundations of the computer industry.

RCA made many other fundamental contributions to the

electronics industry. For example, while it did not “invent” the

integrated circuit, it did pioneer the CMOS process used to manu-

facture over 90 percent of today’s processors and memory chips. My

group at RCA Laboratories created the first practical semiconductor

lasers, today enabling fiber-optic communications systems, medical

devices, computer printers, and CD and video disc players.

David Sarnoff was one of those rare entrepreneurs who made

a successful transition to corporate executive. As head of RCA

he displayed remarkable managerial skill in growing a fledgling

company into a world leader. But his major contribution to the glo-

bal economy came from his entrepreneurial activities. Few other

entrepreneurs have helped create industries that have generated so

much economic value, employed so many people, and improved so

many lives.

3 www.ncta.com/StatsGroup/OtherIndustryData.aspx, accessed August 19, 2011. 4 Source: www.digitaltvnews.net/content/?p=19886, accessed August 19, 2011. 5 Figures compiled from original sources by Plunkett Research, accessed June

10, 2011 at www.plunkettresearch.com/telecommunications%20market%20 research/industry%20statistics.

Electronic innovation a nd the gover nment84

Entrepreneur in waiting

We focus on David Sarnoff because in many ways he prefigured

today’s global entrepreneur. It is true that business conditions were

different during his heyday, which extended from 1915 through the

1950s. But our world grew out of his, and as a pioneer in his industry,

he faced challenges that were remarkably similar to what innovators

encounter in today’s internationalized economy.

He was at his most entrepreneurial early in his career. From

1915 to 1932 he shaped RCA and broadcasting to his vision of the

future of electronics and electronic media. In doing so he often had

to spar with government agencies over the ground rules of electronic

communications and industrial practice. During his later career,

with RCA firmly in the ranks of major corporations, Sarnoff became

what we now call an “intrapreneur,” driving internal projects such

as the development of television and the invention of color TV. We

will cover this period in somewhat less detail.

We will start with a brief look at the events of his early life.

This biographical information is crucial to understanding how he

became a major figure in the development and growth of the electron-

ics industry. It also puts his achievements in their proper historical

context.

Struggling immigrant stumbles on a career

David Sarnoff, like so many other American entrepreneurs, was an

immigrant. This accounts in part for his single-minded striving

after success.

Sarnoff was born in 1891 in Uzlian (Uzlyany), a tiny shtetl or

Jewish village in Russia. He arrived in New York with his family

in 1900. We can only imagine the shock he felt at suddenly being

in the middle of a teeming city filled with massive buildings. Carl

Dreher brings the abrupt dislocation into perspective: “In the thou-

sands of villages like Uzlian, such amenities as telephones, the tele-

graph, gas, and electric light were entirely unknown; as fate would

Entr epr eneur in wa iting 85

have it, the foremost entrepreneur in modern communications came

from a place where the only communication was by direct word of

mouth.”6

In America he entered a society where information and com-

munication were open, free, and abundant. He was amazed at this –

and turned it to his advantage. His father’s health was so poor that

he could not work steadily, and so from almost the day he arrived,

David supplemented his family’s meager, often non-existent income

by selling newspapers. He worked morning and evening, before and

after school at the Educational Alliance. There were other odd jobs

as well, including singing as a boy soprano at a local synagogue.

Ultimately his family’s parlous financial situation made it

impossible for David to continue his formal education. In 1906, at

the age of fifteen, he left school for good to look for a full-time job.

Today we marvel at people who drop out of college and start

successful companies. But Sarnoff never attended high school, let

alone college. The man who gained fame for his grasp of technol-

ogy, who became a proficient public speaker and precise writer in

his second language, and who conversed and negotiated with world

leaders and prominent intellectuals on an equal footing, was essen-

tially self-educated.

Undaunted by his youth and lack of formal schooling, Sarnoff

was determined to pursue a career as a reporter. He had sold news-

papers, so why not write them? He went to the New York Herald

building to apply for work. There, by sheer accident, he found his

true vocation: a career in electronic communications. When Sarnoff

entered the Herald building he asked a man he saw behind a window

in the lobby for a job. But the man was not a Herald employee. He

worked for the Commercial Cable Company, an undersea telegraph

business that was renting space in the building. The company had an

opening for a messenger boy, and young David took it.

6 C. Dreher, Sarnoff: An American success (New York: Quadrangle/The New York Times Book Co., 1977), p. 10.

Electronic innovation a nd the gover nment86

Entrepreneurial beginnings

Within a few months Sarnoff would leave Commercial Cable because

the company would not give him (unpaid) time off to sing at a syna-

gogue during the Jewish holidays. But while he was there he had

taught himself Morse code. Another telegrapher, with whom he had

exchanged messages, referred him to the Marconi Wireless Telegraph

Company of America in downtown Manhattan, a subsidiary of the

British firm.

Marconi had no junior operator positions, but it could use an

office boy and file clerk. Sarnoff took the job and used the opportun-

ity to learn all he could about the company and the industry. In six

years he worked his way up to telegraph operator and, eventually,

station manager in such places as Nantucket Island and Sea Gate in

Coney Island, as well as on a Canadian sealing expedition.

In 1912 he was named manager of the American Marconi sta-

tion on the top floor of Wanamaker’s department store in New York.

There he had a brush with history, which he would later inflate to

promote the image of himself as the dauntless executive.

On April 14, 1912, the Titanic famously hit an iceberg and

began to sink. Thanks to its wireless SOS signals, it was able to

attract help from the SS Carpathia, which rescued over 500 survi-

vors hours after the sinking. However, in part because no operators

were on duty on other nearby ships, 1,700 other passengers perished

in the cold Atlantic waters.

Fourteen years later Sarnoff and the publicists at RCA floated

the story that he was the first wireless telegrapher to get the

Carpathia’s message reporting the sinking. They also claimed he

had gotten national recognition for receiving all the names of the

victims and survivors. In fact, the story asserted, President William

Howard Taft had ordered all wireless stations on the East coast off

the air so that the young telegrapher would have clear access to mes-

sages from the site of the tragedy.7

7 See Sarnoff, Looking ahead, pp. 22–23, which reproduces the whole fabricated tale as reported in The Saturday Evening Post for August 7, 1926.

Entr epr eneur in wa iting 87

This PR fairytale was obviously a near-total fabrication, yet it

gained wide acceptance. To this day it is occasionally trotted out by

careless writers. Even historians who dismiss the claim that Sarnoff

was the first to get the news of the Titanic’s sinking have gotten

caught up in the legend. In Carl Dreher’s account, for example,

Sarnoff is depicted as sitting at his receiver for three days straight,

receiving the names of survivors from the Carpathia while VIPs peer

over his shoulder and police restrain crowds of relatives and curios-

ity seekers outside the station.8

In fact David Sarnoff was not even on duty at the time of the

tragedy. He is mentioned in contemporary news accounts as man-

ager of the station, but credit is given to his assistant J. H. Hughes

for picking up “direct communication with Siasconsett, Sagaponack,

Cape Cod, Hatteras, Sable Island and many other stations along the

coast.”9

According to historian Alexander B. Magoun, Sarnoff did

have some involvement in the aftermath of the Titanic sinking.

However, it was limited to “working with two other operators at the

Wanamaker station to obtain the number of survivors and then in

trying to get their names from the Marconi Seagate station before the

Carpathia arrived with the survivors in New York.”10 Nevertheless

the Titanic incident had a powerful effect on his future – and that of

everyone else in wireless.

On July 23, 1914, US President Taft responded to the tragedy

by signing a bill “requiring ships carrying 50 or more persons to

carry at least two radio operators, with one on duty at all times.”11

8 Dreher, Sarnoff, p. 29. 9 From The Boston American, April 16, 1912, p. 4, as quoted by http://earlyradio-

history.us/amwana.htm, accessed August 23, 2011. 10 A. Magoun, “Pushing technology: David Sarnoff and Wireless Communications,

1911–1921,” presented at IEEE 2001 Conference on the History of Telecommunications, St. John’s, Newfoundland, July 26, 2001, p. 3. Available at www.ieeeghn.org/wiki/images/1/1c/Magoun.pdf, accessed February 12, 2012.

11 www.davidsarnoff.org/rca01.html. Davidsarnoff.org was the official website of the recently closed David Sarnoff Library. Still available online as of this writ- ing, it contains useful facts, timelines, and perspectives on Sarnoff and RCA.

Electronic innovation a nd the gover nment88

Wireless had arrived as a necessary technology. The government had

taken an interest, and “American Marconi expanded its business by

a factor of twenty over the next two years.”12 It would not be the last

time a government action determined the future of radio and, later,

of Marconi and RCA.

Thwarted entrepreneur

In 1915 Sarnoff’s talent for recognizing and commercializing prom-

ising new technology was brilliantly demonstrated in the famous

“Radio Music Box Memo” he submitted to American Marconi man-

agement. The recent emergence of continuous wave transmission

technology made it possible for radio stations to transmit voice and

music, not just the dots and dashes of Morse code. In his memo the

young manager proposed that Marconi exploit this capability by

building and selling receivers for a voice and music service, which it

would provide.

Radio transmission of voice and music was not new. It dated

from Reginald Fessenden’s experiments of 1900 and 1906 – the world’s

first “broadcasts.” By May 1914 Frederick M. Sammis, American

Marconi’s chief engineer, had set up a transmitter that could send

voice and music to Marconi-equipped ships.

Lee De Forest, a noted if controversial electronics pioneer,

used the audion amplifying vacuum tube he had invented in 1906

to run an experimental voice-and-music radio station for a while,

then sold the rights to the device to the American Telephone and

Telegraph Company (AT&T) in 1913. Two years later the telephone

giant used it to start transcontinental wired telephony and to send

wireless telephone messages to distant receivers. No one took voice

and music radio seriously.

Poor reception was one reason: static frequently obliterated the

weak radio signals of the day. But in late 1913 Sarnoff got a glimpse

of the future of radio. Edwin H. Armstrong, a major figure in radio

12 Magoun, “Pushing technology,” p. 3.

Entr epr eneur in wa iting 89

and electronic technology, had developed a regenerative receiving

circuit that miraculously captured and clarified weak signals. On

hearing a public demonstration Sarnoff raved about its capabilities to

management. In London, however, Guglielmo Marconi himself read

the memo and decided that the invention was nothing special.

To confirm his initial impressions, Sarnoff had Armstrong

conduct another demonstration at the Marconi receiving station in

Belmar, New Jersey. He reported that the receiver reliably logged sig-

nals from Clifden, Ireland; Honolulu; and Nauen, Germany. His con-

clusion: “The results obtained with Mr. Armstrong’s invention are

sufficiently convincing to warrant our most careful investigation of

his patents and circuits, etc., for … I am of the opinion that it is the

most remarkable receiving system in existence.”13

It was a revelatory demonstration, which he recalled years

later in a letter to Armstrong. “Whatever chills the air produced,”

he said, “were more than extinguished by the warmth of the thrill

which came to me at hearing for the first time signals from across

the Atlantic and across the Pacific.”14 Sarnoff’s reward for his initia-

tive was a reprimand for misuse of Marconi facilities.

Undaunted, Sarnoff experimented with transmitting music

from Wanamaker’s that he received on a ship sixty miles away. And

the next year he returned to the topic in the “Radio Music Box”

memo. Others had previously recognized the technical importance

of continuous wave transmission, but few understood its commer-

cial potential. Only Sarnoff envisioned a new industry based on the

technology.

13 Sarnoff, Looking ahead, pp. 7–8. Years later, when two Supreme Court cases awarded the patent for Armstrong’s regenerative circuit to De Forest, Sarnoff and RCA did not come to Armstrong’s defense, possibly because the company stood to profit from the decisions. However, RCA’s staff was among those who affirmed Armstrong’s priority in the invention when he tried to return the Institute of Radio Engineers (IRE) Medal of Honor he had been awarded for this achievement.

14 Quoted in D. Stashower, The boy genius and the mogul: The untold story of television (New York: Broadway Books, 2002), p. 4.

Electronic innovation a nd the gover nment90

I have in mind a plan of development which would make

radio a “household utility” in the same sense as the piano

or phonograph. The idea is to bring music into the house by

wireless …

The “Radio Music Box” can be supplied with amplifying

tubes and a loudspeaking telephone, all of which can be neatly

mounted in one box…. Within such a [transmission] radius [of 25

to 50 miles] there reside hundreds of thousands of families …

The manufacture of the “Radio Music Box,” including

antenna, in large quantities would make possible their sale at a

moderate figure of perhaps $75 per outfit [around $1,600 in 2011

dollars]. The main revenue to be derived would be from the sale

of “Radio Music Boxes,” which, if manufactured in quantities of

a hundred thousand or so, should yield a handsome profit …

There are about 15 million families in the United States

alone, and if only 1 million, or 7 percent of the total families,

thought well of the idea, it would, at the figure mentioned, mean

a gross business of about $75 million.15

Almost in passing, Sarnoff broached the idea of an industry

that did not yet exist, one that would be called “broadcasting.” It is a

feat of innovative thinking, delivered in an offhand manner.

But he was addressing men who came from the world of tel-

egraphs and telephones. They viewed radio as an extension of these

technologies, limited to sending and receiving messages, point to

point, individual to individual. “Streaming” music and news – to use

an Internet catchphrase – to a large audience seemed a bizarre con-

cept to them. Yet that’s exactly what Sarnoff’s memo presupposed.

It didn’t stop there. Characteristically, Sarnoff also analyzed

the scheme’s business potential. His projected revenues of $75 mil-

lion ($1.6 billion in 2011 dollars) would represent a fabulous windfall

for American Marconi. When the plan was finally implemented in

15 Sarnoff, Looking ahead, pp. 31–33. Some historians have argued that the memo was actually written in 1916.

The US Nav y m a ndates a monopoly 91

a somewhat different form, his figures proved remarkably accurate.

That wouldn’t happen for several years. Marconi officials had no

confidence in his project, and the memo was shelved.

The US Nav y mandates a monopoly

Meanwhile Europe was fast in the grip of World War I. Allies on

both sides of the conflict were finding strategic uses for electronic

communications technologies, while trying to sabotage those of

their enemies. With communications cables especially vulnerable

to attack, wireless began to assume greater importance as a medium

for exchanging military and diplomatic messages.

Even before the US officially entered the war, the government

recognized the strategic significance of radio and took steps to pro-

tect its interest. In 1914 the US Navy, whose need for ship-to-shore

communications made it especially interested in wireless, teamed

with AT&T, the government-sanctioned telephone monopoly, to

expand its capabilities.

In 1916 the Navy assumed control of all radio patents. When

the US declared war on Germany, the Navy was in command of

most transatlantic wireless stations and equipment in the country

as a matter of national security.16 The shockwaves from this action

produced a radical change in the structure of the nascent US radio

industry in the United States, and shaped the development of all

electronic mass media for years to come.

With the Navy Radio Bureau controlling wireless communica-

tions, American Marconi, as a preferred supplier, remained in a dom-

inant position. But everything changed once the war was over. Public

sentiment against foreign domination of radio in the US had been

building for years. The war only reinforced these feelings. Radio had

16 In 1916 Congress considered a bill authorizing the Navy to operate radio stations in competition with private industry even in peacetime. Later bills to similar effect were proposed in 1918 and 1919. Sarnoff, as Secretary of the Institute of Radio Engineers, testified before Congress in opposition to this legislation – his introduction to dealing with government initiatives. See D. Sarnoff, Looking ahead, pp. 10–13, for his testimony.

Electronic innovation a nd the gover nment92

proven valuable in combat and diplomacy, and Washington decided

that it was intolerable to have such a crucial national resource in for-

eign – that is, British – hands.

Government involvement: Creating RCA

British Marconi managed to fan the flames in 1919 by offering to

buy up General Electric’s total output of the Alexanderson alterna-

tor, a key transmitting device. The Navy feared that by cornering

the market on the alternators, Marconi would effectively control US

radio for years to come. Navy chiefs met with GE officials to express

their strong opposition to the sale. They proposed instead that gov-

ernment and business collaborate to establish an American-owned

company that would wrest control of the country’s airwaves from

foreign interests.

Under this mandate GE officials met with Marconi officials in

London and negotiated the purchase of American Marconi, with GE

holding a controlling interest. On December 1, 1919, the patriotically

named Radio Corporation of America was formed. Its board included

a Navy admiral along with executives from GE and officials from the

former American Marconi.

The firm’s incorporation documents specified that the new

corporation had to remain in American hands. David Sarnoff, only

twenty-eight years old but already recognized as a savvy judge of

technology and an aggressive businessman, was its commercial

manager.

The rise of IP pools

It was one thing to found an American radio company. Ensuring its

survival was another. RCA, as it came to be known, faced a structural

problem in the industry. Unlike Edison’s light bulb, the invention of

radio had been a group effort, and several individuals had developed

and patented key technologies. To be successful, RCA needed access

to any intellectual property (IP) that could help it establish a fast,

reliable radio system.

The US Nav y m a ndates a monopoly 93

This IP was scattered among various interests. For example,

Westinghouse owned the rights to Fessenden’s patents. And when

RCA didn’t act on Sarnoff’s recommendation that it buy the rights

to Armstrong’s regenerative circuit for broadcasting and recep-

tion, and the rights to his even more advanced superheterodyne

receiver, Westinghouse acquired them instead. It paid $335,000, plus

a $200,000 contingency (totaling nearly $7 million in 2011 dollars)

should Armstrong lose his then-pending patent infringement suit.17

In addition, AT&T owned the rights to De Forest’s audion tube, and

claimed a monopoly over the idea of sending voices through the air.

Pooling IP from several sources to create complex new prod-

ucts is commonplace in today’s high-technology world. Standards

committees regularly put together specifications that include tech-

nology from various companies, each of which collects royalties for

its use. But in 1919 this was a new concept. It is not too much to

claim that radio set the pattern for every technology that followed.

RCA had powerful help in negotiating the licensing of the IP

it needed. The Navy pressured patent holders, especially AT&T, to

cooperate. In return for their roughly 2,000 patents, the original IP

holders would get large blocks of shares of the new company. Soon

RCA had four owners: GE, AT&T, Westinghouse, and (rather oddly)

the United Fruit Company. The latter not only licensed patents it

held on loop antennas, it agreed to purchase stock in lieu of paying

the new company for Marconi transmitters that it had found unsat-

isfactory. All four companies assented to a cross-licensing agreement

so that RCA could develop practical trans-oceanic and ship-borne

wireless communications without fear of litigation. Sarnoff would

soon use this agreement to pursue his broadcasting vision.

Viewed from a twenty-first-century perspective, the birth of

RCA stands out in two ways. First, if you substitute “venture capital

17 See T. Lewis, Empire of the air: The men who made radio (New York: HarperCollins, 1991), pp. 150–55, for a summary of the patent situation sur- rounding RCA. This chapter draws heavily on Dreher and Lewis for its history of RCA’s early years.

Electronic innovation a nd the gover nment94

firms” for “corporate owners,” the deal is strikingly similar to the

way entrepreneurial companies have been established over the last

thirty years. Decades before the birth of the modern venture cap-

ital industry, GE, AT&T, Westinghouse, and United Fruit acted like

venture capitalists, exchanging value (money, IP, or both) for major

ownership shares in the new entity.

Second, the action of the US government in creating RCA

bears comparison to how other countries, from that era right up to

the present day, have taken an active role in developing telecom-

munications in particular and industrial growth in general. Other

countries defined telecommunications as a national interest and

created state-owned monopolies aligned with their postal systems.

In its determination to create an American wireless company, the

US government created monopolies in radio hardware (GE and

Westinghouse) as well as telephones (AT&T). And today’s mercantil-

ist countries, such as China, are using state-controlled companies to

build their industrial bases.

At the outset, of course, RCA was essentially a radio services

company, focused on receiver sales and marine communications,

and beholden to its owners. But things were about to change. David

Sarnoff, acting as behind-the-scenes advisor to the new company’s

executives, took on the role of entrepreneur in promoting the com-

pany’s entry into a totally new industry. Ultimately this would

transform RCA, and elevate Sarnoff to the executive suite.

The birth of commercial r adio

Although RCA had limited autonomy, it gave Sarnoff the entrepre-

neurial platform he needed. His vision for achieving commercial

success for radio was to turn it into a household necessity by broad-

casting voice and music, and he immediately started promoting that

agenda.

His first move was to preserve RCA’s ability to produce tech-

nical innovations on its own. In 1919 GE had proposed to take over

all of the company’s research and engineering activities. Without

The birth of commercia l r a dio 95

its engineers, RCA would be no more than a service and marketing

organization. Sarnoff lobbied against the idea on the grounds that

the young company needed its own development team, one that

wouldn’t be distracted by the larger corporate priorities at GE. He

won his point.

That done, in 1920 he resurrected his “Radio Music Box” idea.

In a twenty-eight-page memo to Owen D. Young, the GE executive

who sat as chairman of RCA’s board, he expanded his original 1915

proposal with a three-year plan for achieving sales of a million sets.

Young was impressed enough to authorize construction of a proto-

type receiver. All that was needed now to commercialize the new

communications medium was an audience – and a business model.

Finding an audience

Audience-building was a crucial task if radio was to be a commer-

cial success. It was especially urgent for Sarnoff because, to borrow

twenty-first-century parlance, his radio music box idea had gone

viral, and competition was heating up. By 1920 a small but lively

community of amateur radio buffs was experimenting with broad-

casts of news, comment, and music over their own amateur sta-

tions. One of them, Frank Conrad, a Westinghouse engineer based in

Pittsburgh, was broadcasting programs that a local department store

used to promote sales of receivers.

It didn’t take long for Westinghouse to recognize broadcast-

ing’s business potential. It quickly founded KDKA, still a major

radio and TV broadcaster, thus elevating Conrad’s intermittent

broadcasts to the status of a daily occurrence. Soon it was setting up

stations on the roofs of its manufacturing plants in Newark, NJ, East

Springfield, MA, and Chicago, IL (all of which are broadcasting to

this day). Westinghouse also began manufacturing tube and crystal

receivers for sale to the listening public.

Meanwhile RCA was playing catch-up. Plans for mass produc-

tion of its own broadcast receivers were in process, but it needed

the Westinghouse patents to make them marketable. By the end of

Electronic innovation a nd the gover nment96

1920 the two companies were negotiating, and in March of 1921 the

IP-for-stock swap described above was complete.

Events were moving fast. On April 29 Sarnoff was made general

manager of RCA, giving him the power to push forward his broad-

casting concept. He decided to stimulate interest in radio among the

general public, and at the same time establish RCA as a force in

broadcasting, by staging a spectacular broadcasting event that would

attract an audience beyond any previous program.

He chose the biggest audience draw of the time: the heavy-

weight championship boxing match between Jack Dempsey and the

French champion Georges Carpentier on July 2, 1921, in Jersey City,

New Jersey. “In less than three months, he and a group of engineers

assembled from RCA received permission from the federal govern-

ment to establish a station, appropriated a transmitter that General

Electric had built for the Navy, strung broadcasting aerials from tow-

ers at the Lackawanna Railroad yards, and publicized the broadcast

through newspaper articles.”18

Few people owned radio receivers at the time, so RCA devised

a plan to let a significant number of non-owners listen to the event.

It partnered with the National Amateur Wireless Association to

arrange for the installation of loudspeakers in nearly 100 theaters

and other public places between Pennsylvania and Massachusetts.

Then, in an effort to use postwar patriotic sentiment to boost attend-

ance, Sarnoff announced that a portion of the proceeds would go to

two charities: the Navy Club and a fund for rebuilding France.

The announcer for the broadcast, Major J. Andrew White, the

editor of RCA’s magazine Wireless Age, later recalled that few people

thought the event would be a success. “This experiment, frowned

upon as ‘just plain crazy’ by financiers, had been built on the enthu-

siastic dream of young David Sarnoff. To pull it off, Sarnoff and I

had scrounged $1,500 from a special account of the then new Radio

Corporation of America.”19

18 Lewis, Empire of the air, p. 158. 19 Reprinted from Reader’s Digest, December 1955, in Sarnoff, Looking ahead, p. 34.

The birth of commercia l r a dio 97

Sarnoff’s risky promotion paid off. Perhaps 300,000 people paid

to hear the broadcast of the prizefight, and another 100,000 listened

for free through loudspeakers attached to the New York Times build-

ing. The event jump-started the age of mass media: “That night the

scale and potential of the medium were transformed. Suddenly the

size of an audience was no longer constrained by floor space or seat-

ing capacity; it became almost limitless.”20

Dempsey knocked out Carpentier in the fourth round, fortu-

nately for RCA, because the transmitter melted down minutes later.

It had done its job. Sarnoff’s entrepreneurial vision of a new medium

and a new industry had been validated. Radio was on the map as a

growth industry.

Ads and networks: New models for a developing business

Two years later hundreds of stations were on the air across America.

They were established by banks, churches, police departments,

schools, corporations, small businesses, newspapers, and other

organizations.

Over 400,000 households had bought radios, so there was a

sizeable audience for broadcasts. Broadcasting was a playground for

self-expression and self-promotion, much as the early Internet was,

when personal websites were popular. Also like the early Internet,

radio did not have a fully developed business model. Even visionar-

ies like Sarnoff saw broadcasting as a public service, not a business,

conceiving its principal function as “entertaining, informing, and

educating the nation and … therefore … a public service.”21

Set makers, with RCA the largest of all, saw it as a service

that would promote the sale of their radio receivers, not as a busi-

ness in itself. Sarnoff had proposed this model in his 1915 memo. In

1921 RCA founded its own station, WJY in New York, to fulfill this

20 E. Robinson, “Mass mediums: They channeled the modern age (and made it pay),” Fortune, September 6, 1999; accessed August 23, 2011 at http://money. cnn.com/magazines/fortune/fortune_archive/1999/09/06/265282/index.htm

21 Sarnoff, Looking ahead, p. 41.

Electronic innovation a nd the gover nment98

purpose. It later acquired WJZ, the Westinghouse station in Newark,

which it moved to New York. The twinned stations began broadcast-

ing on May 16, 1923.

Sarnoff clung to this flawed model for broadcasting until a

major corporate crisis prompted him to consider another, more entre-

preneurial one. RCA’s New York stations were in direct competition

with WEAF, AT&T’s New York outlet, just when tensions were rising

between the telephone giant and RCA’s two other big shareholders.

Their dispute grew out of the terms of the company’s incorpor-

ation agreement, which had set up a loosely defined division of labor

for the four companies. GE and Westinghouse would manufacture

receivers on a 60/40 split for RCA to sell. AT&T took on the manu-

facture of transmitters. In return it granted RCA rights to build and

maintain one-way wireless transmitting stations, whose purpose

was not clearly identified as broadcasting.

By 1922 GE and Westinghouse were making money on radio,

but AT&T was not, an intolerable situation for its new young presi-

dent, Walter Sherman Gifford. Gifford also saw broadcasting as an

unwarranted expansion of RCA’s business model, and moved to cor-

rect the situation. At his direction

AT&T sold its 200,000 shares of RCA stock and gave up its two board • seats;

his company’s laboratory began to design a radio receiver that skirted • RCA’s patents;

RCA was not allowed to lease telephone lines for broadcast purposes; and• WEAF would sell commercial time (he called the concept “toll • broadcasting”).

It was a challenge to the new company’s very existence. Without

high-quality leased lines RCA would not only have a hard time doing

remote broadcasts, it would be unable to link its stations into a net-

work. And “toll broadcasting” changed the rules of the business.

Network radio as a service

Sarnoff has been credited with inventing the network concept for

electronic media. In fact, AT&T’s two stations in New York and

The birth of commercia l r a dio 99

Washington, DC were the first to be networked, and the telephone

giant used its lines to tie in other, non-AT&T stations as well. “By

early 1926, the ‘WEAF Chain’ had expanded to nineteen cities in

the Northeast and Midwest, as it slowly spread from its base in New

York City.”22

But Sarnoff was certainly the architect of networks as a com-

mercial enterprise. On June 17, 1922, with RCA still in its infancy

and his voice-and-music broadcasting concept just beginning to gain

traction, he had proposed that RCA “organize a separate and dis-

tinct company … to acquire the existing broadcasting stations of

[Westinghouse, GE, and RCA].” The aim was to build broadcasting

“along national rather than local lines.”23

This network was realized four years later with the formation

of the National Broadcasting Company (NBC). At the time of his

proposal, however, Sarnoff was still tied to the concept of broadcast-

ing as a “public service.” He proposed that it be supported by sub-

sidies from radio manufacturers and their distributors and dealers,

and even through philanthropic donations (a foreshadowing of the

support mechanism for today’s public radio and TV stations).

By 1926, when NBC was formed, he had reversed his opinion,

as any savvy entrepreneur must when market conditions and finan-

cial realities demand it. Meanwhile a government action set the

table for the establishment of the network.

Government involvement: Antitrust action

By labeling ads as “toll broadcasting” AT&T put RCA in a bind. Its

nomenclature tied radio to the telephone concept of a “toll call,” an

area where the telephone company had the right to do business and

presumably, under the terms of its incorporation, RCA did not. In

August 1922 WEAF carried its first commercial, or “toll broadcast,”

making it the first national company to do so.

22 http://earlyradiohistory.us/sec019.htm (April 16, 1912). 23 Letter to E. W. Rice, honorary chairman of GE, reproduced in D. Sarnoff,

Looking ahead, pp. 41–43.

Electronic innovation a nd the gover nment100

When negotiations over their dispute failed, all of the compan-

ies involved finally agreed to binding arbitration, which Sarnoff had

been recommending all along. Matters quickly got more complicated

when the government’s Federal Trade Commission (FTC) dropped a

bombshell in early 1924, charging all five companies – AT&T, GE,

Westinghouse, United Fruit, and RCA – with conspiring to restrain

trade and create a monopoly in every aspect of radio device manufac-

ture and sales. RCA was under siege from inside and outside.

Before the FTC’s charge was acted on, the results of the arbi-

tration were announced. They went RCA’s way on every substan-

tial point, including the right to collect “tolls” for broadcasts. AT&T

countered by pointing out that if the cross-licensing agreement of

1921 stood, it was proof of the government’s claim of a conspiracy

to restrain trade. RCA’s patent structure was in danger – and so was

AT&T’s.

Sarnoff’s entrepreneurial skills came to the fore. In negoti-

ations sanctioned by RCA’s Young and AT&T’s Gifford, he proposed

a business-based solution: get AT&T out of broadcasting, with RCA

buying WEAF and taking over its Washington outlet, in return for

AT&T providing nationwide landline and microwave linkages for

RCA’s proposed network. AT&T got an upfront payment and a hand-

some continuing revenue stream, while RCA got control over its

patent pool and the freedom to seek its destiny.

This was not the last assault by the government on RCA’s patent

policies, but for the moment the point was moot. Sarnoff turned his

attention to finalizing the NBC network, which was announced in

late 1926. He had also come to the realization that broadcasting had

to develop a source of revenues, and advertising was the obvious way

to do it. A new era had begun.

In those days the pioneers were figuring out the rules as they

went along, with the government looking over their shoulders. It

is not surprising, then, that RCA unwittingly structured NBC in

a way that eventually invited government oversight. A few months

after NBC’s launch it divided the stations into the more commer-

cial “Red” network built around WEAF, and a “Blue” network that

The birth of commercia l r a dio 101

emphasized news and cultural programs, with WJZ as its flagship.

Twelve years later the government would decide that this looked like

a monopoly, too.

Sarnoff continued his entrepreneurial activities through the

rest of the decade. In 1928 he joined forces with Joseph Kennedy, the

Boston financier, diplomat, and scion of the Kennedy political dyn-

asty, to build a movie studio around RCA’s sound system for motion

pictures. Radio Keith Orpheum (RKO) produced mostly B pictures,

but was moderately successful.

His most daring business innovation of the 1920s, after

RCA and NBC, was the acquisition of the Victor Talking Machine

Company of Camden, New Jersey. Victor needed radio chassis for

combination radio/phonograph sets if it was to survive the onslaught

of the radio craze. It had been buying them from RCA since 1925,

but sales continued to decline. In 1928 it agreed to negotiate with

RCA to be acquired. For RCA the deal was a strategic masterstroke.

Victor’s manufacturing facility promised to free the company from

its dependence on GE and Westinghouse, and Victor’s recording busi-

ness allowed it to earn profits from content as well as broadcasting.

Initially the terms of the contract, negotiated while Sarnoff

was in Europe on a diplomatic mission, were unsatisfactory. The

new entity was set up as a separate manufacturing company, and GE

and Westinghouse had the same 60/40 split of this manufacturing

firm as they did in making receivers for RCA. Sarnoff renegotiated

the terms so that RCA owned 50 percent of the new company. The

deal was ratified in December 1929. It put considerable strain on the

company’s finances, as upgrading Victor’s facilities proved costly,

but Sarnoff – and RCA – was now the dominant force in electronic

media and technology.

Television: Intrapreneurial beginnings

On January 3, 1930, David Sarnoff became President of RCA. He

had arrived in America as a nine-year-old boy in a desperately poor

immigrant family just thirty years before. Now he was at the top of a

burgeoning industry he had helped to create. Between 1919 and 1929

Electronic innovation a nd the gover nment102

RCA’s revenues had grown from $2 million to $182 million ($2.3 bil-

lion in 2011 dollars).

From this point on he sought to consolidate and grow the cor-

porate empire he had been instrumental in building. But he did not

abandon his entrepreneurial approach. Instead he became an intra-

preneur, constantly pushing RCA to create the next big technological

breakthrough.

As an entrepreneur Sarnoff’s history goes right to the heart

of the major topic of this book. He is an outstanding example of

how innovators can work within or around externally imposed con-

straints to build companies – or whole industries – that create sig-

nificant economic value. As an intrapreneur he continued this work,

indeed enlarged on it, but this period of his life is less central to

our theme. Nevertheless it deserves to be summarized, not just in

homage to a giant of innovation, but to demonstrate how even estab-

lished companies have to concern themselves with the opinions and

actions of government.

Adding sight to sound

RCA was successful beyond its founders’ wildest imaginings,

thanks to its move into broadcast radio equipment, stations, and

networks. Yet Sarnoff saw bigger things ahead. As early as 1923,

when radio was still in its infancy, he advised the RCA Board of

Directors that

television, which is the technical name for seeing instead of

hearing, will come to pass in due course … Thus, it may well

be expected that radio development will provide a situation

whereby we shall be able actually to see as well as read in New

York, within an hour or so, the event taking place in London,

Buenos Aires, or Tokyo.

I also believe that transmission and reception of motion

pictures by radio will be worked out within the next decade.24

24 Sarnoff, Looking ahead, p. 88.

A dding sight to sound 103

Sarnoff was not a prophet, at least not in the sense of seeing things

that did not yet exist. Television experimentation had begun in 1873,

a half-century before his memo. Speculation about the future of tele-

vision had begun to appear in newspapers and in hobbyist magazines

such as Wireless World and Radio Review in England and Radio

Times in the US.

In the early 1920s there had been some successful experi-

ments by British inventor John Logie Baird and American Charles

F. Jenkins at sending moving pictures over a wire. They used crude

electromechanical apparatus to capture the images. In 1927 General

Electric succeeded in broadcasting a moving picture from such an

electromechanical system. Its inventor, Ernst Alexanderson, who

had developed the Alexanderson alternator, predicted that every

American home would have a TV set within ten years.25

While Sarnoff was not a prophet, he was a visionary. Although

he publicly supported Alexanderson’s efforts as part of the GE team,

privately he was not convinced by what he saw, and even less certain

that Alexanderson’s system was practical.26 In January 1929, a year

before he became RCA’s president, he met with the engineer who

would help him realize his vision: Vladimir K. Zworykin, a Russian

émigré then working at Westinghouse.

Zworykin had taken out patents on what he dubbed an “icono-

scope,” an early vacuum tube-based TV camera. He had also adopted

a promising approach to displays from French inventor Edouard Belin.

Westinghouse was not interested – but Sarnoff was. An electronic

camera and display opened the door to all-electronic television. An

electronic system promised better pictures and less cumbersome

receivers. That was something Sarnoff could sell to the public.

25 For a thorough and balanced history of the development of TV, see A. B. Magoun, Television: The life story of a technology (Baltimore, MD: The Johns Hopkins University Press, 2007). It is the source for many of the facts and dates in this section.

26 D. Stashower, The boy genius and the mogul: The untold story of television (New York: Broadway Books, 2002), pp. 122–23.

Electronic innovation a nd the gover nment104

Over the next quarter-century David Sarnoff focused a large

portion of RCA’s resources on the development and commercial-

ization of television. Throughout the same period he found himself

dealing with repeated attempts by the US government to control

RCA’s expansion and curb its business practices. He also faced the

task of assuring that the government would set the standards for TV

signals, so that any receiver could capture transmissions.

We will briefly survey RCA’s progress in developing the tech-

nology and the IP portfolio for television. Then we will look at the

accommodations the company had to make to satisfy government

demands.

Television decade

At his meeting with Zworykin Sarnoff famously asked how much

it would cost to realize the electronic system he was proposing.

Zworykin estimated it would require $100,000 and two years of

work. Equally famously, Sarnoff later claimed the project ultimately

cost RCA ten years and $50 million.

The actual figure over that first decade seems to have been

closer to $10 million, but Sarnoff may have been referring to the

investment up to 1950, when RCA made its first profit on television.

Whatever the amount, it was a lot of money. Most of it was spent

on RCA’s own research, but the company (contrary to myth) also

acquired IP from other inventors, as it had during the development

of radio.

One holder of IP, however, proved difficult: Philo Farnsworth, a

brilliant if erratic inventor and a loner to the core. In 1922, at the age

of fifteen, he had developed the concept of “creating an image from a

photoelectric surface and scan[ning] it back and forth, before a single

aperture that led to the amplifier and transmitter.”27 He didn’t have

the money to patent this “image dissector,” but four years later his

27 Magoun, Television, pp. 23–24.

A dding sight to sound 105

ideas for a working electronic television system convinced an angel

investor and eventually a bank. His initial estimate of the cost to

build a system around this invention was $5,000. It was about as

accurate as Zworykin’s.

In 1927 Farnsworth filed a patent for his electronic televi-

sion system. In 1929 he built the first all-electronic TV system

in the world. Although the system was far from being ready for

manufacture, his patents later threatened to derail RCA’s whole

television endeavor. The patents on the image dissector camera

were to prove especially troublesome. Zworykin had filed pat-

ents for the iconoscope earlier than Farnsworth did for his cam-

era, but Zworykin’s filings were flawed. A contest ensued over

whose patents had priority. In 1935 a patent examiner held that

Farnsworth’s image dissector patents were valid and vacated many

of Zworykin’s claims.

Ironically, it was the iconoscope, not Farnsworth’s invention,

that served as the basis for all early TV cameras. The image dis-

sector ultimately proved impractical. It had no way to store elec-

trons, resulting in a light sensitivity so low that it could not generate

a usable image except under bright direct sunlight or powerful (and

hot) studio lamps. Instead of abandoning his design, Farnsworth

tried to remedy the flaw through improvements in the circuitry that

followed the imager. In the process he produced valuable work (and

patents) in other areas of TV, but his dissector was a commercial

failure.

However, its design included some fundamental imaging tech-

nology. During the 1930s “it became clear to RCA’s technical staff

[that they] would have to draw on Farnsworth’s electronic image and

low-velocity scanning”28 to improve their own cameras. In 1939 RCA

finally agreed to license Farnsworth’s patents for a million dollars

plus royalties.

28 Ibid., p. 62. See the following pages of this book for a more detailed account of the progress of television during the decade summarized here.

Electronic innovation a nd the gover nment106

Throughout the 1930s, Sarnoff made sure that corporate

funding was available to support the television research and devel-

opment effort at RCA despite the Great Depression. The company’s

engineers responded by discovering that VHF frequencies (40 to 80

MHz) were adequate for broadcasting; that a frame rate of 30 frames

per second (fps) would avoid flicker on brighter displays; and that a

resolution of 400 lines was needed to give viewers the equivalent

of a home-movie experience. They also developed a system of inter-

lacing that showed two half-images at 60 fps.

Other companies pursuing the dream of future home televi-

sion sales, including Farnsworth, Philco, Zenith, DuMont, and GE,

were concerned that RCA would dominate the market. RCA tried

to allay their fears by partnering with all of them but DuMont and

Farnsworth. It shared its research, tested their equipment, consulted

with them on design issues, and more.

Starting an industry

By 1938 Sarnoff felt the technology was ready. He decided to force the

hand of the Federal Communications Commission (FCC) to finalize

broadcasting standards so he and his competitors could begin sell-

ing receivers and other equipment that were compatible with each

other.

As he did with the Dempsey-Carpentier broadcast that

launched radio, he chose a big event to dramatize the new technol-

ogy. Ten days before the opening of the 1939 New York World’s Fair

in Queens, New York, he stood in front of the RCA pavilion and read

his now-famous announcement of the birth of television. An NBC

camera captured the moment for viewers at the RCA Building in

New York City.

On April 30th, the National Broadcasting Company will

begin the first regular public television-program service in

the history of our country; and television receiving sets will

be in the hands of merchants in the New York area for public

A dding sight to sound 107

purchase. A new art and a new industry, which eventually will

provide entertainment and information for millions and new

employment for large numbers of men and women, are here …

And now we add radio sight to sound.29

Twice during the speech he stressed the economic benefits of

the new industry. As a chief executive he knew this argument would

serve him well in disputes with the government, which were sure to

come. He also arranged it so that when Franklin Delano Roosevelt

opened the Fair, FDR became the first president ever to appear on

television. Thousands of fair-goers saw RCA’s live demonstration of

television at its pavilion.

There was still no television standard. With the television roll-

out in jeopardy, Sarnoff bore the brunt of ridicule from the media and

attacks by RCA’s competitors Zenith, Philco, and DuMont. When the

FCC met in January 1940 under new chairman James Fly it declined

to set a standard, and in a caution obviously targeted at RCA warned

industry members against trying to set a de facto standard.

Soon the media changed their minds and accused the FCC of

obstructing progress and interfering with business. Sarnoff and Fly

were called in to testify before the Interstate Commerce Committee.

Even FDR got involved, asking Sarnoff to have lunch with Fly to

resolve their dispute. Finally Fly turned to an industry expert to

form the National Television Systems Committee (NTSC) to resolve

the impasse. After much testing of systems and arguments over dif-

ferent approaches, in May 1941 the NTSC recommended a standard

of 525 lines at 30 fps interlaced, in most respects similar to the RCA

system.

Television was a reality at last. Sarnoff’s vision was achieved.

But commercialization would have to wait. On December 7, 1941,

the day of the attack on Pearl Harbor, David Sarnoff sent FDR a tele-

gram saying, “All our facilities are ready and at your instant service.

29 Sarnoff, Looking ahead, pp. 100–101.

Electronic innovation a nd the gover nment108

We await your commands.” TV manufacturing was put on hold for

the duration of World War II.

Postwar television boom

It wasn’t until September 1946 that RCA began building TV sets

again. During the war RCA had put its research and manufacturing

resources to work for Allied military efforts. David Sarnoff, always

a proud patriot, had attained the rank of brigadier general through

his personal involvement in military communications and media

management. His biggest achievement was setting up the commu-

nications structure for D-Day and later, under personal orders from

General (later President) Eisenhower.

During the war engineers at RCA Laboratories in Princeton

(founded in 1941 to centralize the company’s research activities) and

at RCA Victor had made significant advances in cameras and receiv-

ers, for use in guided bombs and aerial reconnaissance. They now

adapted this new technology to commercial products.

But the market for receivers in particular promised to be so

large that RCA would not be able to meet the demand on its own.

To promote the manufacture of TV sets, in 1947 RCA invited its

patent licensees to tour the RCA Victor factory in Camden and con-

sult with its engineers. Its technical bulletins helped competitors

build versions of RCA’s flagship television set for sale under their

own names.

On the transmission side, Sarnoff urged affiliates of the NBC

radio network to take out television licenses, and threatened to can-

cel their affiliation if they didn’t. NBC began programming a heavy

schedule of sports to attract viewers, and Milton Berle’s weekly

comedy show was TV’s first hit program. Pooled coverage of the

Democratic and Republican national conventions by the NBC, CBS,

ABC, and DuMont networks in 1948 created even more buzz around

the new medium.

It was a comprehensive strategy to promote commercial TV,

and it was a huge success. According to Carl Dreher, there were

A dding sight to sound 109

175,000 receivers in use by the end of 1947, and seven million in

1950. “About half of this bonanza accrued to RCA. Sarnoff soon had

his $50 million back, and then some.”30

Adding color to black-and-white

Instead of accepting the “bonanza” and shifting his focus to maxi-

mizing profits, Sarnoff followed his entrepreneurial instincts, much

to the dismay of Wall Street. He poured even more money into a new

R&D project: the development of an all-electronic color television.

His motivation came from his vision of the future of TV – and the

threat of competition from CBS, his chief rival.

This drama played out as a repeat of the debate over electro-

mechanical vs. electronic systems from the early days of TV. CBS

engineer Peter Goldmark, who was convinced that monochrome

television was a blind alley, had campaigned for a delay in the FCC’s

1941 march toward a television standard until color was feasible.

He wanted to hold out for a color system, and was exploring electro-

mechanical systems to realize color broadcasting and reception.

Having failed to block implementation of the NTSC standard

in 1945 and again in 1946, he proposed a color system he had devel-

oped for CBS as the next television standard. It drew on color experi-

ments from the 1920s, and used spinning color wheels at the camera

and the receiver to capture and reproduce color information. CBS

conducted hundreds of demonstrations of its system for advertisers

and the public.

Sarnoff was just as interested in color. In 1930 he had foreseen a

day when television would advance “to the stage when color as well as

shadow would be faithfully transmitted.”31 But he and his engineers,

who experimented with color and 3D television using color wheels

and drums as late as 1945, rejected the electromechanical approach

30 Dreher, Sarnoff, p. 162. 31 Sarnoff, Looking ahead, p. 130. The quote comes from an article in The New

York Times, July 1, 1930.

Electronic innovation a nd the gover nment110

as too limited and too complex. Instead they raced to develop an

all-electronic system, which they announced and demonstrated in

1946.

The story of RCA’s battle with CBS for FCC approval of its

color television system has become a legend in the annals of corpor-

ate/government interaction. In 1947 Wayne Coy became the chair-

person of the FCC. Coy “became a partisan supporter of the CBS

color system. He disliked RCA’s monopolistic position in broadcast

technologies.”32 In July 1949 he called for proposals for color tele-

vision systems that would be compatible with the booming NTSC

monochrome system. The deck was stacked against RCA.

By the time of the first hearings in September, CBS had a

single-tube electromechanical system that worked, but required

three inches of spinning color wheel for every inch of screen size.

A 17-inch screen would require a 51-inch spinning wheel. RCA

had a bulky electronic system with three picture tubes projecting

onto a screen that failed more than it worked. Electronic color TV

needed a single-tube display.

RCA’s Princeton laboratory actually delivered that tube, the

world’s first integrated color video display, only six months later in

March 1950. It worked, and it was monochrome-compatible, but it

produced an unrefined picture with inaccurate colors. In spite of

these faults the NTSC, in its second incarnation, began to support

the early-stage RCA system. By then, however, it was too late. At the

FCC hearings in May, Sarnoff said the choice was, “Shall American

television move forward or backward?”33 In spite of his testimony

the FCC declared the CBS system as the US standard for color TV.

It was a disaster for television – and for CBS. The network’s

manufacturing partner was never able to produce receivers in vol-

ume with adequate quality. CBS was forced to subsidize each of the

32 Magoun, Television, p. 98. 33 Sarnoff, Looking ahead, pp. 135–41 reproduces the relevant sections of his

testimony.

Look ing back 111

sets it sold. When the Korean War started, and parts became hard to

obtain, the network had an excuse to cease production.

Meanwhile RCA and NBC had been steadily improving their

electronic system. On December 17, 1953, Coy and other FCC mem-

bers having stepped down, the commission approved it as the new

standard.

RCA did not reap the fruits of its victory quickly. Color TV

cost the company $130 million over ten years,34 and it only began

to show a profit in 1962, eight years after commercialization, when

Sarnoff ordered NBC to broadcast all its prime time shows in color.

Eventually, however, sales of color sets and license fees from its pat-

ents in the field provided the company with another bonanza. It had

been well worth the intrapreneurial risk.

Looking back

David Sarnoff proved to be an uncommonly gifted corporate execu-

tive, and maintained an intrapreneurial drive that pushed his organ-

ization to continue its innovations. There are valuable lessons to be

learned from analyzing his strategies. The short summary:

owning and controlling intellectual property is a key to long-term • success in dynamic technology industries;

having internal innovation resources is vital to continued success;• the government can be both friend and foe – the trick is to manage • relationships; and

the wisdom to know when to do battle and when to concede can • determine the future of a business in the public eye.

In the present era, Qualcomm, under the direction of its founder

Irwin Jacobs, is a close analog to RCA and Sarnoff. Both compan-

ies pioneered advanced wireless technologies, both built busi-

ness strategies around IP, and both faced charges of monopolistic

practices. The astute reader will be able to come up with other

examples of contemporary leaders and their companies that com-

pare to these two.

34 Dreher, Looking ahead, p. 215.

Electronic innovation a nd the gover nment112

Sarnoff’s career was not without controversy, of course. Critics

have bemoaned his aggressive business tactics, his later treatment of

his old friend Edwin Armstrong, and some of the hawkish political

stances he took in the 1950s and 1960s. But on balance he did more

for his industry – and the American economy – than any other busi-

ness leader of his time.

He would not have succeeded without his remarkable ability to

manage intellectual property and, especially, his company’s relation-

ship with the government. In spite of his influence with Washington

politicians, his policies at RCA led to battles with the FCC and other

governmental agencies that can stand as cautionary tales for entre-

preneurs of our time. It is an unfortunate fact of life that creators of

new industries often find themselves painted as monopolists. Google

and Microsoft are recent examples.

Here are some of the major challenges that Sarnoff faced and

managed to survive.

1930: Electronics monopoly action. Five months after Sarnoff

became president of RCA, the company was hit with an antitrust

action over the patent pool among itself and GE, Westinghouse, and

AT&T, its major shareholders. Sarnoff had helped establish a roy-

alty structure with high licensing fees, a requirement that radio set

makers use RCA vacuum tubes, and other constraints, and the set

makers complained. The government charged that the patent pool

and the ownership structure under which RCA was operating were

monopolistic and illegal – even though the government had helped

create that structure.

Outcome. After two years of negotiations, the Department of

Justice approved a consent decree in which Sarnoff got most of what

he wanted: total independence and the unification of RCA. GE and

Westinghouse left RCA’s board, distributed their RCA stock among

their shareholders, and agreed not to compete with the newly inde-

pendent company for two years. This also solved the patent pool ques-

tion, as all parties were free to compete with each other. The company

also lowered its royalty terms to silence set-maker complaints.

Look ing back 113

1939: FCC radio network action. Networks made radio com-

mercially viable, but the FCC was concerned about their monop-

olistic effects. Commission chairman Fly “championed increased

regulation of the networks and used his power to force the National

Broadcasting Company to divest itself of the blue network.”35 His

grounds were that the Red and Blue networks used their wholly

owned stations to dominate audiences, affiliates, and advertising.

Outcome. NBC divided the networks into two companies in

case RCA’s appeal of the decision failed. In 1943, after the Supreme

Court ruled against RCA, the company sold the Blue Network and

its stations for $8 million. In 1945 it was renamed the American

Broadcasting Company (ABC). This spinoff ultimately became the

third major US radio and TV network after NBC and CBS, and

branched out into music and other media as well. Acquired by the

Walt Disney Company in 1996, it is a major player in broadcast and

cable television, with a particular strength in sports thanks to cable

sports network ESPN, its corporate partner. Although Sarnoff was

forced to divest ABC, it should still be taken into account when

calculating the economic value that resulted from his business

innovations.

1954: Package licensing antitrust suit. RCA’s patent licensing

policies came under scrutiny again nearly a quarter-century after the

patent pool action. In 1946 Zenith Radio had stopped paying royalties

on patents licensed by RCA and brought triple-damage suits against

RCA, GE, and Westinghouse, starting “a jungle growth of litiga-

tion”36 among licensees and codefendants. The Justice Department

joined in with a civil antitrust complaint in 1954.

Outcome. The core of the complaints was the practice of “pack-

aging” patents for license, which forced licensees to pay royalties on

several patents even if they only needed one. RCA defended its pol-

icies by saying it granted “patent licenses to competitors and others

35 Lewis, Empire of the air, p. 302. 36 E. Lyons, David Sarnoff: A biography (New York: Harper & Row, 1966), p. 287.

Electronic innovation a nd the gover nment114

on reasonable and non-discriminatory terms and without restric-

tion.”37 RCA lost the suit in what was then the largest antitrust

recovery in history, and had to modify its licensing structure. In

1957 RCA signed a consent decree on patent licensing, granting free

licenses on all broadcast technology to US companies, finally put-

ting to rest an issue that had been pursued by the FCC, the Federal

Trade Commission, and the Department of Justice since 1925.

Sarnoff and RCA’s example demonstrate that entrepreneurs

and corporations may be the darlings of the government in some

areas while serving as the target of its displeasure in others. RCA

was a government creation, and Sarnoff was influential in the halls

and committee rooms of Washington. But he was also operating in

a highly charged antitrust environment, and the government could

and did step in to block operations that appeared to challenge that

stance.

As RCA’s encounters with crusading agencies show, it is pos-

sible to turn government actions to your advantage, but you must be

willing to compromise. And you must also accept the fact that there

are times you will have to accept a negative result. Here are a few

additional lessons that today’s entrepreneur or would-be corporate

executive can draw from David Sarnoff’s career.

Growth comes with continued innovation. Sarnoff under-

stood better than his peers that technology businesses must innov-

ate to thrive. Indeed, he took a personal interest in new technologies.

Every year RCA Laboratories prepared new inventions, “Christmas

presents,” as he liked to call them, in anticipation of his visits. He

had the vision to create RCA Labs, where I spent many years, which

became one of the foremost electronics research laboratories in the

world. RCA Labs developed and commercialized innovative prod-

ucts and services for as long as Sarnoff was in charge, in fields as

diverse as electronic materials and devices, electron microscopes,

and microwave drying of penicillin.

37 “RCA asks court to dismiss government anti-trust suit,” Radio Age, vol. 14, no. 2, April, 1955, p. 12.

Look ing back 115

IP builds businesses and markets. RCA acquired IP through

its own aggressive R&D effort and by licensing crucial patents from

others. Its massive patent portfolio allowed the company to build

innovative products before anyone else, and to dominate markets.

But it also recognized that by licensing IP to others, even competi-

tors, it not only generated cash flow, it helped grow the markets it

dominated. The patent licensing strategy of RCA was managed by

a dedicated licensing organization with the mission to maximize

revenues from this source, consistent with the product strategies of

the company. Some patents were off limits to licensing because they

were too closely linked to current products. This strategy was so suc-

cessful that the revenues paid for the operations of RCA Laboratories.

In effect, the company got its innovations at no cost.

You can’t commercialize an innovation overnight. Sarnoff

was the undisputed boss of RCA and was able to continue product

investments for many years – even if their prospects were unclear to

others. None of the world-changing products developed by the com-

pany came fast. Radio took over a decade to find its market, and

voice-and-music broadcasting took another half-decade to achieve

commercial success. Electronic television was under development

for fifteen years, and after World War II took another five years to

become a major industry. Color TV didn’t produce a profit for eight

years after commercial introduction. In some cases such things take

much less time today – products and services can build their markets

in as little as three years – but you still need patience and resources

to wait for the results.

In these and many other ways David Sarnoff’s extraordinary

career is a touchstone for all entrepreneurs. We now turn to more

contemporary figures whose successes and failures mirror, extend,

or counter his example.

116

I suppose I could have worked for someone else, but that wouldn’t have been fun.

Ron Stanton

Unlike the other entrepreneurs and innovative companies in this

book, Ronald Stanton and Transammonia Inc. are not involved in a

high-technology industry. While David Sarnoff, for example, built

his electronics empire by envisioning markets that did not yet exist

for technology still under development, Stanton achieved success

by setting up an innovative but non-technical service company in a

commodity industry.

Without doubt his business innovation has had a huge impact.

Stanton started Transammonia, a company that trades in anhyd-

rous ammonia, in 1965 with only $2,000 of equity capital. In 2008

it became the twenty-eighth largest private corporation in the US,

with over $11 billion in revenues. It is the world leader in its sector,

and has branched out into other commodity chemicals and liquid

natural gas.

That is a remarkable achievement. But why do we include a

commodity trading business in our study of global entrepreneurship

when all our other cases focus on the high-technology electronics,

computer, and communications companies that seem to define our

age? In a word, the reason is clarity. It is easy to be distracted by the

glamour of the latest technology from appreciating the fundamen-

tals of building an innovative business that creates lasting economic

value. With Transammonia, there is no danger of that. Its history

and well-defined business model embody the essentials of innov-

ation and entrepreneurship.

4 Global problem, golden opportunity: Ron Stanton profits from market disruption

Tr a ding in r ea l commodities 117

Indeed, the story of Transammonia reinforces a basic fact about

entrepreneurship: it is mostly about finding a dislocation in the mar-

ket and building a business to address it. It does not matter whether

the dislocation is created by disruptive technology, new government

regulations, or an unexpected demand for services. It is the vision of

the entrepreneur in finding a solution that makes the difference.

In Transammonia’s case the market disruption was precipi-

tated by an industry changeover to a troubled technology for pro-

ducing ammonia. Stanton realized that this crisis grew out of a

logistics problem, not a technical one. The temporary technical

glitch had simply exposed the fundamental shortcoming in the com-

modities market. His response was to introduce a business model

that addressed the underlying cause.

Instead of patentable inventions and a portfolio of valuable

IP, Transammonia was built on an idea for a new kind of business.

Success did not come easily, and the early years were not always

“fun.” But Stanton exhibited one of the defining traits of the entre-

preneur: tenacity. In May 2009, talking about the startup years of his

business, he told me: “In the early days I alternated between exhil-

aration and dejection. It was very tough … I know from experience

that no matter how secure you think you might be, complacency

is dangerous. Everything you own, everything you’ve worked for or

ever cared about, can vanish in an instant.”

As we shall see, his success was not solely a result of his busi-

ness acumen. It grew in large part from his courage in maintaining

the highest level of business integrity, even in the face of possible

financial ruin.

In order to understand the challenges he faced, we will begin

by looking at the nature of his business and how it diverged from

standard industry practice.

Tr ading in real commodities

Stanton’s business is specialty commodity trading. Mention com-

modity trading to most people and they immediately think of

Globa l problem, golden opportunit y118

financial speculation, which bets on the future prices of commod-

ities such as oil, copper, wheat, or corn.

In normal practice traders in commodity futures never handle

the physical materials. They make their profit by correctly antici-

pating price movements, the way that stock traders make money by

buying company stocks low and selling them high.

Transammonia is different. It actually trades and transfers the

physical products. It started by trading ammonia, which is one of the

most important chemicals in the world, but is also very difficult to

handle because of its unpleasant chemical properties.

The entry wedge exploited by Stanton was transitory, but he

seized on it to build an enduring company. Stanton understood from

the start that key operating factors such as geopolitics, communica-

tions, logistics, weather patterns, agricultural policies, and financial

strategies were all closely interwoven with the success of the com-

modity trading business. His mastery of these difficult interrelation-

ships allowed Transammonia to thrive in an intensely competitive

market.

Ammonia’s importance in a modern economy

Ammonia, which consists of nitrogen and hydrogen (NH3) mole-

cules, is the second most important chemical in the world economy

after sulfuric acid. It is an indispensable feed stock used to make fer-

tilizers, pharmaceuticals, explosives, and other industrial products,

including cleaning solutions. Its impact on agriculture is enormous:

85 percent of all ammonia is used to make fertilizers.

About 120 million tons of ammonia are produced globally

every year. The process for making it is so energy-intensive that

ammonia production consumes 2 percent of the man-made energy

generated in the world.

It has a curious history. Most of the nitrogen needed to prod-

uce ammonia was originally derived from bird droppings, which

had accumulated as a nitrate-rich organic material called guano.

Guano deposits, found mainly in Peru and Chile, are the result of

Tr a ding in r ea l commodities 119

millennia of droppings. At the end of the nineteenth century, with

easily accessible guano deposits rapidly being exhausted, the world

was facing a potential deficiency in low-cost nitrates. This would

have been disastrous for agriculture.

Fortunately, science and technology soon supplied an alter-

native to guano. In 1913 the commercialization of the Haber-Bosch

process for ammonia production freed the world’s fertilizer indus-

try from its reliance on a diminishing natural resource. The novelty

of the process is that nitrogen for ammonia production is extracted

from the air. It is then combined with hydrogen under high pressure

(as high as 1,000 atmospheres) and high temperature (between 450

and 600 degrees C) in the presence of a catalyst.1

While the Haber-Bosch process solved the raw materials prob-

lem, producers and users still had to deal with ammonia’s chemical

properties. Unlike other widely traded commodities such as oil, cop-

per, and wheat, ammonia is a difficult material to ship and store. The

form that has the most commercial value is anhydrous (water-free)

ammonia, which is used in fertilizer production. This is a liquid that

must be kept either at high pressure or low temperature because of

its low boiling point.

Given the problem of shipping such an unstable compound,

it is not surprising that ammonia is commonly produced and used

by vertically integrated companies that need it for the end products

they also make. As a result, only about 10 percent of the world’s

ammonia production is traded on the open market.

Ammonia plants are complex, requiring the highest level of

mechanical and chemical engineering for reliable operation. New

1 Fritz Haber invented the basic technology, while Carl Bosch developed the com- mercial production process. Both received a Nobel prize for their contributions, Haber in 1918 and Bosch in 1931. An unanticipated side-effect of their technol- ogy is that it allowed Germany to produce explosives (and fertilizers) during World War I (1914–1918) despite a British naval blockade which blocked the importation of guano. If Germany had not possessed its own source of ammonia, it might not have entered the war in the first place, averting World War I and its many consequences.

Globa l problem, golden opportunit y120

plants come on stream periodically when innovations in technol-

ogy promise lower production costs. The 1960s was a time when the

introduction of better technology spurred the construction of many

new plants, creating turmoil in the market. Stanton was perfectly

prepared to take advantage of it.

Learning the peculiarities of international trading

Dealing with change came naturally to Ronald Stanton. He arrived

in New York City from Germany with his mother in 1937, at the age

of eleven. Just over a decade later, in 1948, he had adapted so well to

his new environment that he was able to earn a degree in economics

from the City College of New York.

His education in the so-called “dismal science” had not given

him any skills that were marketable in the job market of the day.

This actually worked to his advantage. He wound up taking part-

time sales jobs, and found the idea of trading commodities appealing.

A friend of the family, who owned a small commodity trading com-

pany called Interore (International Ore and Fertilizer Corporation),

hired Stanton as a trainee.

One of the commodities traded by Interore was fertilizers, and

Stanton eventually became an international fertilizer trading spe-

cialist. In this role he developed two skills that were to prove crucial

to his future success: a mastery of low-cost logistics for transport-

ing the actual commodities, and an understanding of international

trade.

Stanton’s education in international commodity trading

started in the 1960s, when he was learning the fertilizer business.

With Korea as his major customer, he quickly saw how government

pressure can work to the advantage or disadvantage of a business.

At that time the US government had established the USAID

program to provide developing Asian countries with economic

assistance. USAID had a policy of favoring American suppliers for

export, leaving Japanese fertilizer vendors to complain of unfair

competition from American suppliers. Stanton found himself facing

a difficult situation.

From oil to a mmonia 121

Under pressure from the Japanese, eventually USAID decided

to make the tenders to South Korea 50 percent competitive (i.e.

non-US) and 50 percent non-competitive. Now I had already

bought the product and loaded all these ships.

In a panic, I went to Washington and started walking into

the offices of US Senators and Congressmen and meeting with

their staff members, complaining that making life easier for

Japan went against the campaign to Buy American. I raised hell

that the stupid bureaucrats are buying from Japan that was until

recently our bitter enemy.

USAID was forced to reverse their policy because I went to

Congress and USAID was dependent on Congress for allocations.

I swung Congress my way. We sold the product and made a

healthy profit.2

His skill in dealing with government officials would later

prove just as valuable as his commodities expertise and international

outlook.

From oil to ammonia

Stanton was not destined to remain a company man all his life, but it

took a push to get him to start his own company. In 1963 Interore was

sold to Occidental Petroleum, one of the world’s largest oil and gas

exploration companies. Occidental was headed by Armand Hammer,

a flamboyant CEO who loved the spotlight and had a decidedly high

opinion of himself.

This was not a happy event for Stanton. Because he owned

no equity in Interore, he derived no financial benefit from its sale.

More worrisome was the fact that, besides being a notorious char-

acter, Hammer was a terrible boss. But with no other job options

and a family to support, Stanton decided to stay with Occidental

Petroleum. He didn’t last long.

2 R. P. Stanton, Recollections and reflections: A trader’s life (Privately published, New York, 2009), p. 71.

Globa l problem, golden opportunit y122

After years of trading fertilizers, Stanton thought he had iden-

tified a highly attractive opportunity in trading ammonia, a related

commodity, very little of which was openly traded at the time. When

he approached Hammer with this idea he was rewarded with a verbal

explosion. Hammer took pains to tell him that this was a stupid idea

that would bankrupt the company.

After this rebuff, Stanton knew that his days at Occidental

Petroleum were over. And anyway, he was tired of answering to

bosses. So in 1965, at the age of thirty-nine, he decided to open his

own business. He got a commitment for the aforementioned $2000

equity capital from a small investment banking firm. His ownership

stake was only 24 percent, but, with no money of his own to invest,

that was the best he could do.

If you talk with Stanton for any length of time you realize that

this is a man who is averse to taking any risks that are not absolutely

essential. Starting a company was thus a big step for him. But while

he was uncertain of the outcome of his venture, he had one con-

soling thought. He told himself that, if his venture failed, he could

always get a job working as a trader in a big company.

Now he laughs at the idea, saying, “Little did I know that once

you have your own business you never want to work for someone

else again.” So despite a difficult first few years, he never looked

back.

When he told Hammer that he was leaving, he was offered the

equivalent of eighteen months’ salary on condition that he agree

not to compete with Occidental in trading any commodity except

ammonia. He immediately accepted. Ammonia trading was going

to be his focus. He remained convinced that he had spotted a new

opportunity that would let a newcomer with little capital build an

enormously lucrative business.

Leveraging change

As mentioned earlier, a huge wave of new ammonia plants had

come on stream in the 1960s. They were built to take advantage

From oil to a mmonia 123

of innovations in production technology that cut ammonia costs by

50 percent compared to existing processes. But there was a catch:

the new plants proved unreliable. They were built around newly

designed compressors, which kept breaking down.

With the old plants shuttered and the new plants underper-

forming, the world supply of ammonia became unpredictable. Many

users found themselves unable to get ammonia supplies from nor-

mal sources because their plants were not producing. This caused

major disruptions in the production of fertilizers and other vital

products.

Stanton believed that a third party could smooth out the mar-

ket dislocations and make a profit by matching producers with users

and managing the supply chain. His idea was to use the global rela-

tionships he had formed while trading in fertilizers to establish his

new company, Transammonia, as the preferred supply hub in the

ammonia market. The key to success was twofold. He had to know

the producers and the state of their plants. He also had to understand

the requirements of the users.

Stanton positioned Transammonia as a trusted intermediary

between producers and users, offering guaranteed delivery at agreed-

upon prices. Transammonia handled the logistics of shipping the

product, and assumed the financial risk that the market price might

change as the product moved from ammonia sellers to buyers.

The company’s profit came from the fees it charged for logis-

tics services, and from leveraging price movements when the com-

pany took inventory risks. Fixed costs were minimized by leasing

transport and storage facilities. Bank financing was the key to the

operations of the company, and Stanton became very skilled at man-

aging his banking relationships.

The cost of integrity

It was quite a change from trading in stable, predictable products on

someone else’s behalf, and all did not go smoothly. Early in the life

of the company, in the late 1960s, Stanton faced his first major crisis,

Globa l problem, golden opportunit y124

one that tested his financial solvency and personal integrity. It ended

up determining the future of the company.

He had negotiated a deal with Imperial Chemical Industries

(ICI), then one of the world’s biggest chemical companies, to deliver

a million tons of ammonia at a fixed price. This opportunity came

about because ICI had built three new ammonia plants, none of

which had proven reliable. The company was in desperate need of

ammonia.

Stanton signed a multiyear contract based on his knowledge

of ammonia sources and their prices. He was certain the terms of

the contract would produce a profit for him. Unfortunately, he bet

on the wrong suppliers. Just when deliveries were due, their plants

broke down too, leaving Stanton with a massive problem. Unable

to deliver the contracted amount to ICI from his planned sources,

he was forced to turn to other suppliers. Their prices were so much

higher that he would incur a huge loss if he honored the terms of his

contract.

Stanton had three choices, all equally unattractive: walk away

from the contract; offer to deliver at a higher price; or ship at the

agreed time and price and absorb a $1.8 million loss. He did not have

the capital to absorb such a loss without finding a new source of

money outside of the banks. He chose to honor his contract, take the

loss, and find creative ways to finance the deficit. “Doing otherwise

would have doomed Transammonia. I needed to build a business with

100 percent integrity,” he says. “My word was my only asset in devel-

oping the trust of sellers and buyers and growing my company.”

This is a story with a happy ending. It not only solidified

Transammonia’s reputation in the industry – it consolidated Stanton’s

ownership of the company. When his investors saw how much his

decision had cost the company in trading losses, they wanted out. He

took the opportunity to negotiate a very favorable leveraged buyout

scheme with them.

Their despair, it turned out, was ill-timed, because the busi-

ness turned profitable in the 1970s. Meanwhile, in 1971, five years

Inter nationa l pr esence 125

after starting Transammonia, Ronald Stanton acquired all of the

outstanding stock and became the sole owner of the company. He

was now truly his own boss.

Eventually the reliability of the new ammonia plants improved.

By then his niche ammonia trading strategy had evolved into a more

consistently profitable mainstream operation. Stanton had built the

infrastructure for a global ammonia trading system, and it contin-

ued to be a valuable platform for smoothing out world demand. Its

opportunities continued to grow as rapid agricultural expansion in

Asia and Eastern Europe created huge global demand for ammonia.

Today Transammonia continues to model itself as a supply

chain manager dealing in commodities, but it is also equipped to

take advantage of special opportunities. It has evolved a set of cap-

abilities that combine trading, storage, and shipping. To manage its

logistics economically, the company owns or leases its own marine

terminals. It also charters specialized cargo ships and has rail cars

built to its specifications on long-term leases.

Transammonia is now the largest independent ammonia trader

in the world, and it has expanded into fertilizers, potash, sulfuric

acid, and olefins. It is also the largest importer of LPG (liquid pet-

roleum gas) in the northeastern US. Ronald Stanton has become an

expert in building partnerships in various markets to ensure favor-

able pricing and low logistics costs.

International presence

Transammonia’s development as an international trader serves as a

model for entrepreneurs with global ambitions. International trading

is the reason for Transammonia’s existence, and Stanton is always

focused on new market opportunities around the world.

While China and India have both become important markets,

the opening of the former Soviet Union provided the most oppor-

tunities for high drama. In the course of developing the post-Soviet

market, Stanton learned that bringing a little capitalism to former

communist states is far from straightforward. For Transammonia,

Globa l problem, golden opportunit y126

it meant engaging in activities far beyond its normal scope of

business.

The company had to finance a railroad link in Grodno (Belarus) to allow • the shipment of fertilizer from a local plant to the nearest port facility.

It assumed partial, though temporary, ownership of a fertilizer plant in • a town called Nevinnomysk. That investment ended badly when the

local Russian manager ran afoul of corrupt local authorities who were in

cahoots with gangsters.

There was the huge problem of trading with various entities and factories • whose ownership was in dispute. Settling who really owned assets

involved less than fair legal maneuvers.

Ultimately the company’s adventures ended well anyway. By

dint of enormous persistence, Transammonia got its money back

without hurting its trading opportunities in Russia and the former

Soviet republics.

Part of the reason, of course, was Ronald Stanton’s hard-won

savvy in international commerce and its pitfalls. Way back in the

1960s, when he was trading fertilizer to South Korea, Stanton had

figured out that the officials of foreign states and local entities would

be working with operating principles very different from those used

in the US. He had to take these differences into account as the owner

of an international business. Since fertilizers – and ammonia, of

course – were considered essential commodities, they would be sub-

ject to rules and regulations that varied from country to country.

In many of those countries people in authority were inclined

to treat essential commodities as cash cows for the benefit of them-

selves and their friends. Making money in such environments called

for ingenuity, patience, and building the right local relationships. One

popular way to establish business relationships was the joint venture,

and Transammonia became a master of that business format. It has

put in place over 127 different companies and joint ventures over the

years, in practically every significant country in the world.

The running of a profitable business under alien conditions

also requires unusually talented people, and Stanton has a knack for

Look ing back 127

recruiting them. He provides them with the financial incentives to

do their jobs well, and gives them enough independence to permit

them to succeed on the local level. When it comes to any major deci-

sion, however, he has final say. This requires him to have an extra-

ordinary understanding of his business and its market. To make this

possible he restricts his trading to a few commodities in which the

company has a mastery of the market and supply chain.

There is also a broader advantage to be gained from

Transammonia’s specialization. It allows the company to compete

effectively with larger but more diversified firms, which do not have

its detailed knowledge of commodity trading and international

relationships.

Stanton’s company has been consistently profitable since 1971,

despite the periodic business cycles that afflict all commodities

markets. Its success is based on low operating costs, smart man-

agement of the financial risks associated with pricing moves, and

control of key physical assets. Transammonia has competitors, but

none of them match its full scale of service capabilities. That’s what

makes it a unique business.

Because of the way it manages its physical asset requirements,

the company operates with only about 380 employees. This is a remark-

ably small staff for a business that operates in thirty locations around

the globe. I asked Stanton how he managed with so few people.

“It’s simple,” he said. “We can’t afford to spend more in this

thin-margin business and still make good money. We sell the same

products as others do, so our competitive edge lies in inventory man-

agement, pricing risk control, efficiency, integrity, and outstanding

customer service. We do these things better than others and this is

why we continue to thrive.”

Looking back

When I asked Stanton why he thought he has been so successful for

so long in a notoriously risky business, he dwelt on the flawless exe-

cution of a narrowly defined, well-focused business model.

Globa l problem, golden opportunit y128

As a matter of strategy we don’t make anything within the

company, although I confess I was occasionally tempted to go

into the production business on a long-term basis. So we buy the

same products with the same specifications as everybody else

and somehow we have to add enough value to make a profit.

How do you add value? We do it by adding financing,

adding logistics, adding knowledge and a feel for what is

happening in the market. Our internal communications are a

key to our success. Our traders know they are in the middle of

a fast-moving international market and they talk to each other

before any significant deal is done. This ensures that we bring

the best knowledge and judgment to bear on every decision.

Finally, we always ask ourselves how we can do better.

This is a complex, worldwide business and timing is critical. We

really pay attention to every detail and in the long run it pays off

in success and profitability.

Stanton’s answer spells out a business approach that every

entrepreneur would do well to emulate. It is all too easy to be caught

up in the excitement of a new opportunity and neglect the basic prin-

ciples of running a disciplined, responsive company.

But his explanation of his success does not account for the ori-

gins of the business. Where did the opportunity come from? How

was he able to recognize it? How did his approach match the condi-

tions at hand? A review of Transammonia’s history reveals several

factors crucial to the establishment and long-term success of a new

business.

Other people’s pain can be a business opportunity. The cre-

ation of Transammonia is a classic example of an entrepreneur per-

ceiving an opportunity created by a market dislocation. Why did

he perceive this opportunity? Call it a prepared mind – Stanton had

traded fertilizer for over ten years on a global scale. He recognized

that an erratic supply of ammonia was causing a market disloca-

tion in fertilizers. He knew the business opportunity did not lie in

Look ing back 129

solving the problems with the new production technology that had

caused the dislocation. It lay in addressing the market problem.

Market dislocations get fixed. What follows? A wedge into the

market is a start, but nothing more. This must be followed with a

more enduring business model. In commodities a business is not

built around product differentiation, but on service and cost. Once

it pioneered the market in ammonia, Transammonia’s success was

based on a creative supply chain solution. The company built a net-

work of producers and users, and exploited its unmatched capabil-

ities in storage and transportation. Because of its scale, focus, and

proprietary market information, Transammonia became a leader in

its commodity trading markets.

Understand your business focus. In order to expand businesses

rapidly, entrepreneurs are often tempted to diversify beyond the

areas where they have adequate talent or business judgment. I asked

Stanton whether he ever considered entering into the manufactur-

ing of any commodity that he understood well, such as fertilizers or

even ammonia. “We understand how to trade commodities and the

associated logistics, and are undisputed masters at it,” he answered.

“Manufacturing is an entirely different discipline and I never felt the

need to diversify in that direction.” However, he did enter into long-

term partnerships with manufacturers, focusing on the distribution

of their products in order to ensure a more secure supply chain for

his business.

There is no substitute for business integrity. This may be the

most important lesson of all. Stanton’s willingness to honor a con-

tract in the face of serious losses helped establish his reputation. In

his words: “We don’t have a proprietary advantage. So why do people

want to work with us? We stick to our word. If a deal turns sour, we

don’t run away. We’ve built a reputation for integrity and reliability,

doing what we say we’re going to do.” Integrity is the key ingredient

in any business, not just commodity trading. It is an attitude that

starts at the top. Commodity trading has more than its fair share of

shady operators. Transammonia under Stanton always stressed that

Globa l problem, golden opportunit y130

his employees act in a manner that is fair and honorable in order to

build the reputation of the company as a valuable partner.

Learn to operate seamlessly around the globe. When asked

how his company manages to operate successfully in so many coun-

tries while dealing with a wide range of organizations (private and

public), his answer was simple: “We are worldly chameleons who

learn to integrate into the environment as needed to conduct our

business. Folks need our products and we need them as customers.”

Entrepreneurial businesses come in all types, sizes, and areas

of specialization, but the fundamentals of success are similar for

every one of them. Transammonia’s history stands as a monument

to the basics. In the next chapter we’ll encounter a company that

operates in the hyperspeed world of high technology and built its

success on innovative microprocessor technology.

Nothing could be further removed from commodity trading.

Yet RMI, our next subject, also reached its goals by following many

of the basic principles of global business so clearly demonstrated by

Transammonia.

131

The network will truly be the computer.1

If you happen to make a wireless phone call to China, it may

be routed through a microprocessor chip produced by Raza

Microelectronics Inc. Although RMI (later merged with NetLogic

Microsystems) only began supplying integrated circuits in mid-

2005, its microprocessors now power some of the most advanced

communications network equipment in the world, and it counts

the leading Chinese equipment suppliers among its customers.

It has become the acknowledged technology leader in its chosen

market.

How a Silicon Valley startup developed the world’s most

sophisticated network microprocessor is a remarkable story. It is also

especially relevant to our theme of global entrepreneurship, because

RMI’s success hinged as much on its understanding of international

markets as on its technical expertise.

RMI’s management realized early on that overseas markets

were more open to network chip innovations from a startup than the

domestic US equipment manufacturers, who had well-established

chip suppliers with long-standing reputations. So the company

decided that its primary sales target should be China, the world’s

fastest-growing network equipment maker.

This may seem like an odd choice. China has become the

world’s factory. Its trade surplus with the US has risen from $202

billion in 2005 ($243 billion in exports vs. $41 billion in imports) to

5 Speeding voice and data traffic worldwide: Network microprocessors from RMI

1 http://googlesystemblogspot.com/2006/11/network-will-truly-be-compter.html, accessed November 4, 2011.

Speeding voice a nd data tr a ffic wor ldw ide132

$273 billion in 2010 ($365 billion vs. $92 billion).2 American busi-

nesspeople and government officials routinely complain that, while

China floods the US with manufactured goods, the Chinese market

is closed to American products. But RMI’s success in China proves

that its market is very open to innovative products no matter where

they originate.

RMI also embodies another common characteristic of the suc-

cessful technology startups surveyed in this book: it was built by

immigrants. Its founder and first CEO, Atiq Raza, was born in Pakistan,

while his successor, Behrooz Abdi, is a native of Iran. The drive to suc-

ceed, tolerance for risk, and comfort with international dealings that

marks the educated immigrant community must be counted as an

important element in the company’s growth and success.

However, while global perspective and immigrant origins cer-

tainly help, they aren’t the whole story. Ultimately every success-

ful startup enterprise is built on the same foundation: recognizing

and filling an unmet market need. In RMI’s case, it was an urgent

demand for ever-higher speeds in network communications. This is

the story of how the company met that need through technical break-

throughs, business savvy, and the flexibility to adapt to changes in

the business environment.

Information autobahn

The demand for more speed in communications networks has been

building for decades, and shows no sign of abating. It really started

to ramp up about thirty years ago, when the Internet was just getting

started. At that time only large corporations could afford digital net-

work connections, and they ran over dedicated lines that were closed

to everyone else.

Smaller organizations and individuals had to make do

with analog telephone lines, using devices called modems (for

2 www.census.gov/foreign-trade/balance/c5700.html#2010, accessed September 9, 2011.

Infor m ation autoba hn 133

modulation/demodulation) to convert digital data to and from ana-

log transport modes. Early modems could handle a maximum of 300

bps (bits per second) of data. Eventually modems reached top speeds

of 56 kbps (thousands of bits per second). This was the equivalent of

about three typewritten pages per second.3

Today’s data networks are end-to-end digital. Comparing ana-

log modem speeds to what can be achieved in the digital realm is

like matching a slow stroll on a suburban sidewalk to a Grand Prix

race car on the autobahn. Broadband wired Internet connections

can deliver data at up to 100 Mbps (millions of bits per second) –

or 120 copies of the complete works of Shakespeare every minute.

Wireless is slower, but even the latest cell phones are capable of up

to 10 Mbps.

Digital data networks emerged on a global scale in the 1990s,

fueled by the rise of the Internet and its enormous data-handling and

security requirements. As people demanded ever more data-inten-

sive digital applications on their personal computers and wireless

handsets, the pressure to provide faster transmission speeds showed

no sign of lessening.

RMI was founded precisely to meet this demand for faster data

traffic. But providing higher data speeds isn’t as simple as stepping on

an accelerator. In order to appreciate the magnitude of the achieve-

ment, it is necessary to understand the basics of modern networks

and the hardware that runs them.

Routing bits and packets

The speed, flexibility, and reliability of digital communications,

from the simplest text email to video on the Web, are a direct out-

come of their “packetized” network structure.

Analog networks carry a continuous stream of information

that must be kept intact from origin to end-point. Digital networks

3 See www2.sims.berkeley.edu/research/projects/how-much-info/datapowers.html (accessed September 9, 2011) for a handy table by Roy Williams that matches various quantities of digital data with everyday forms of information.

Speeding voice a nd data tr a ffic wor ldw ide134

are built on the radical concept that you can break up information

into smaller units, called packets, and send them as separate com-

ponents, to be reassembled into a single communication at their

destination.

This structure has two main benefits: the network can carry

many individual communications at the same time; and individual

portions of each message (the packets) can travel different routes to

their destination without destroying message integrity.

It may take millions of packets to contain the content of a

single data transmission. Each packet has two parts: the payload, or

data that has to delivered, and a header that identifies the packet’s

origin, contents, and destination.

The header is the crucial part of the message from the net-

work’s point of view – the payload is not so important. In fact, header

instructions can account for as much as half of a packet’s total bits.

Headers contain more than simple routing information – much

more. They identify the order in which packets are to be reassem-

bled, and ensure the packets are treated properly as they travel to

their destination. When the message includes voice and video, for

example, headers tell the network to treat the packets in such a way

that the contents play back smoothly at their destination.

When packets in a single transmission travel along different

routes to their destination, they may arrive out of sequence. This

is because the computers that direct the data traffic along the way,

appropriately called routers, are independent engines, giving the net-

work built-in redundancy. If one segment goes down, or a router is

busy, packets can be rerouted to their destination through alternate

paths.

At the end of the journey, a router must reassemble the mes-

sage in the proper sequence. Since data travels over an optical fiber

cable at the speed of light, the biggest limiting factor in network

speed is clearly the routers that analyze headers and move the pack-

ets to their destination. In order to speed up the network, faster rout-

ers must be created.

Infor m ation autoba hn 135

Microprocessors: Breaking the router bottleneck

That’s where RMI’s focus on faster microprocessors comes into play.

A router is simply a special-purpose computer, and microprocessor

chips are the brains of computing systems. To make routers work

faster, the speed of their microprocessors must be increased.

Anyone familiar with electronic products tends to talk about

microprocessors as if they always existed. In fact, it was only in the

1970s that a single microprocessor began to replace the cluster of

integrated circuit chips on a circuit board that formed the central

processing units (CPUs) of previous computers.

The concept of a single chip designed to perform the core com-

puting operations originated at Intel. Its first commercial micro-

processor chip, dubbed the 4004, was introduced in 1971. The 4004

contained only 2100 transistors, but it had the same computing power

as the ENIAC computer of World War II vintage, which weighed 30

tons, occupied 3,000 cubic feet and used 18,000 vacuum tubes.4 (Of

course, this was before the invention of transistors.)

Gordon Moore, co-founder of Intel, saw the microprocessor as

an alternative to building custom chips for each computing system.

He described the device as “a broadly applicable, complex integrated

logic circuit that can be produced in huge volume, and hence [at] low

cost, and that utilizes the technology advantageously.”5

Moore’s idea was that all computing could be handled by soft-

ware running on a general-purpose microprocessor. Instead of hav-

ing custom hardware (chips) for each application, the microprocessor

would carry out all basic computational operations, with software

supplying application-specific functions. This would result in com-

puting systems that were both faster and cheaper, because these ver-

satile chips would be mass produced.

4 M. White, “25th anniversary for microprocessor,” Toronto Star, November 17, 1996.

5 G. E. Moore, “Microprocessors and integrated electronics technology,” Proceedings of the IEEE, vol.64 (1976), pp. 837–841.

Speeding voice a nd data tr a ffic wor ldw ide136

Moore’s vision of huge production volumes has been fulfilled

beyond anything he could have predicted. Today microprocessors are

everywhere, at all levels of performance. There are hundreds at work

for each human being in the world. As the speed and performance

of microprocessors have improved, and their cost has dropped, they

have found their way into everything from toys to washing machines

to large computers and communications systems.

In his famous “Moore’s Law,” the Intel founder also predicted

that the processing power of chips would double every two years

with no increase in price. This was based on the rate at which tran-

sistors were being shrunk in size, permitting more logic gates (and

higher performance) on each chip. Making transistors smaller thus

meant getting more speed for less money. But gate dimensions could

shrink only so far before they began to bump up against physical

constraints on performance. In particular, the power dissipated by

very-high-performance chips became excessive, and cooling them

increased the size and cost of the systems.

Fortunately, another path forward had emerged: multiple proc-

essors on a single chip working in parallel to process data. In these

configurations each processor core has its own resources, but shares

access to centralized control functions, including instructions and

data storage. Since the individual processors have significant auton-

omy in the execution of instructions, this arrangement achieves

much higher processing speeds even if the speeds of the individual

cores do not increase.

Parallel processing is not a new idea. It was the architecture of

choice in powerful mainframe computers that combined many dis-

crete processor chips. Designing a microprocessor chip containing a

group of suitably interconnected processor cores, however, is new. To

make such a device work called for not only extraordinary engineer-

ing skills but also the invention of new technology.

Multicore processors were just beginning to appear in the mar-

ket in 2002, the year RMI was founded. It was the challenge of design-

ing such devices to greatly speed up data networks that attracted

R ea dy for innovation 137

the company’s founding engineers. Their idea was to create a whole

new family of multicore microprocessors that would dramatically

increase the capacity of networks to meet the ever-growing demand

for higher-speed communications.

To do so, they had to design chips that processed the routing

information in packet headers in parallel rather than in the serial

manner of then-current single-core processors. This required the

invention of a novel chip architecture where multiple individual

processors were synchronized and shared timely access to infor-

mation needed to complete a computing task. This rapid access to

common information would enable a remarkable increase in packet

processing speed, eliminating the major bottleneck in data network

operation.

Designing the new chips was only the beginning. RMI’s cus-

tomers, the companies that built the routers, would have to learn

how to program the chips to meet their equipment objectives. For

this reason the microprocessors would have to be designed for versa-

tile programming. This opened the way for RMI’s customers to write

software that differentiated their network products by lower cost,

improved performance, and a superior ability to incorporate secur-

ity control. RMI’s founders were uniquely qualified to achieve these

goals.

Ready for innovation

Atiq Raza, the Pakistan-born founder of RMI, earned his degree in

physics and philosophy at the University of the Punjab, and then

moved to the US. He founded his first startup, NexGen, in 1988,

where he developed a general-purpose microprocessor designed to

compete with Intel’s top-of-the-line products. It was the first com-

pany to challenge Intel in the high-end microprocessor market.

Developing such a highly sophisticated product involved extra-

ordinary effort. NexGen had to avoid infringing Intel patents or copy-

rights, yet deliver products that were interoperable with Intel chips. It

took until 1995 for the company to develop a marketable product.

Speeding voice a nd data tr a ffic wor ldw ide138

At the same time AMD, a big chip manufacturer with a

license to serve as a second source for Intel processors, was also

committed to breaking the Intel monopoly. It attempted to design

its own microprocessors, but failed to come up with a competitive

product.

For AMD the obvious next move was to acquire NexGen.

AMD paid $850 million in AMD stock for the company, laying the

foundation for AMD to launch a series of successful chips to com-

pete with Intel. Raza joined AMD where, as president and chief oper-

ating officer, he led the microprocessor product line as it established

itself against Intel.

But not for long: always looking for the next challenge, Raza

left AMD in 1999 to become a venture capital investor. His idea was

to incubate new technology companies, and manage their growth

to the point where they would become attractive acquisition candi-

dates. Raza launched a number of companies but, when financing

startups proved difficult after the public market crash of 2000–2001,

he decided to refocus his efforts on building a single company tar-

geting specially designed microprocessor chips to improve data

traffic on networks. With the explosive growth of Internet traffic,

the amount of data carried was believed to be doubling every three

months, so better equipment, powered by faster microprocessors,

was urgently needed.

Raza founded RMI in 2002 specifically to launch a new gen-

eration of microprocessors that were designed to deliver a dramatic

increase in data network performance. This was clearly a growing

market that would be targeted by others, so RMI was off to a race to

be first with the best. In a first for the industry, these new products

would incorporate eight powerful, closely linked processor cores on

the same chip.

In addition to novel ideas, his competitive edge in starting

the company was a team of exceptional managers who had worked

with him before. These included Waqar Shah (head of operations),

Dr. Nazar Zaidi (head of product development), Dave Hass (product

R ea dy for innovation 139

architect), and Dr. Kai-Yeung (Sunny) Siu (head of sales and market-

ing for Asia).

Silicon Valley is the kind of place where talented engineers are

always willing to leave big companies to join a promising startup.

Raza’s reputation in Silicon Valley constituted a very high level of

promise. Everybody knew he had led the only successful challenge

to Intel’s monopoly in high-end microprocessors.

In a remarkably short period of time he assembled sixty of the

best microprocessor design engineers in the world. Their mission

was to produce the industry’s best single-chip data network micro-

processor. That’s the kind of challenge that gets the juices flowing

in that part of California. All that remained to be done was raising

enough venture capital to get to the finish line.

This is where Warburg Pincus came in. Our team was intro-

duced to Raza and his startup in 2002. Whether the proposed prod-

uct would find a ready market was not at issue. It was evident that

the rapidly increasing demand for data network traffic was spurring

a corresponding need for equipment to meet the demand.

What was startling was the ambition of the plan. There was no

precedent for the proposed product family in terms of performance

and value. Only a world-class talent had a hope of succeeding. What

convinced us to help fund the company (along with Benchmark

Capital) was Raza’s reputation and the quality of the team that he

had assembled. If any group could succeed, we concluded, it was

this one.

RMI had talent in the realms of both software and chip design.

It created and refined a set of specifications for the new product in

the process of consulting with potential customers. Production of

the actual chips was contracted to TSMC in Taiwan, the world’s

leading contract chip manufacturer.

This class of semiconductor products is not sold simply as a

chip but as part of a total solution, including the software needed

to integrate the processor into network equipment. Therefore, RMI

started a software development organization in India under the

Speeding voice a nd data tr a ffic wor ldw ide140

leadership of an Indian engineering manager who had returned home

after a ten-year career in the US.

RMI was an international company from the start. In 2009, out

of about 300 employees, about 40 percent were in India and Asia.

The core chip development team stayed in the US, but a large num-

ber of the managers and engineers in the US were born outside the

country.

Furthermore, recognizing that China was likely to be an

important market, RMI had Dr. Sunny Siu build a customer engin-

eering support organization in China. Born in China, Dr. Siu had

earned a Ph.D. from Stanford University in electrical engineering

and had served as assistant professor at MIT – another example of

the phenomenon of Chinese-born technologists moving back to

China and serving as “bridges” between US companies and Chinese

customers.

So, before actually having products to ship in volume, RMI

had prepared the ground to deal with Asian customers to smooth the

sales process.

Product launch

The first of RMI’s new generation of multi-core microprocessors was

completed for customer sampling in 2004, and released for produc-

tion in 2005. It took three years from start to finish. Given the com-

plexity and novelty of the technology, this is record time for getting

a product to market.

Its reception was outstanding. “A new MIPS powerhouse

arrives,” was the headline of the lead article in Microprocessor

Design, the respected industry newsletter, on May 17, 2005. The

article detailed how RMI’s product had outclassed the competition

and was opening new markets. To start with, it delivered a ten-

fold increase in packet processing speed compared to other devices

doing the same job. The article quoted Raza as saying, “The XLR

processor design is my greatest accomplishment to date. It is the

first architecture in my experience that met every architectural

Product launch 141

goal set for it. Today, this is the highest throughput machine on

the planet.”6

Once RMI’s new product was available, there were some inter-

esting market developments around it. You would have thought that

the first serious customers would be in the US. In fact, they were

in China and Israel. Why? After the failure of a number of US chip

startups in the period following the 2000 market crash, US network

equipment manufacturers became apprehensive of committing new

generations of their equipment to products from private companies

with uncertain economic futures.

At the time RMI was not yet profitable. As a result, although

Juniper in the US and a small network equipment company in Israel

designed the RMI microprocessor into their products, the company’s

success was built on its overseas customers. Sales outside of the US

grew rapidly because new equipment manufacturers in emerging

economies were willing to take a chance on buying from a startup.

The advanced performance of RMI’s new microprocessor gave them

a competitive edge against the dominant vendors in the market, such

as Alcatel and Cisco Systems.

China was home to the most important early customers. These

included Huawei and ZTE, the fast-growing national telecommu-

nications equipment vendors that dominated the Chinese market.

RMI benefited from the explosive growth not only of Internet traffic

but also of wireless traffic, as shown in Figure 5.1. In addition, both

Huawei and ZTE were developing overseas markets for their prod-

ucts. The number of wireless subscribers in China was booming and

local service providers needed equipment to keep up with service

demand. RMI’s microprocessor became the technological underpin-

ning of a new generation of equipment for the local Chinese carriers

such as China Mobile.

As a result of its early focus on Asian customers, RMI had the

right organization on the ground to take advantage of the opportunities

6 K. Krewell, “A new MIPS powerhouse arrives,” Microprocessor Design, May 17, 2005, pp. 1–7.

Speeding voice a nd data tr a ffic wor ldw ide142

created by the booming Asian telecommunications market. In 2007

sales in the Asia-Pacific region were $52 million. Sales in the US were

$8 million, and in the rest of the world only $4.6 million.

Transition

In mid-2007 Atiq Raza resigned from the company he had created

and guided to success to return to venture capital management. He

was replaced as CEO by Behrooz Abdi.

Though born in Iran, Abdi received his B.S. degree from

Montana State University and an M.S. degree in electrical engin-

eering from the Georgia Institute of Technology. He joined RMI

from Qualcomm Inc., where he had been Senior Vice President and

General Manager of the chip division. Prior to Qualcomm he had

been at Motorola, where he headed the Radio Products Division.

Abdi joined RMI at just the right time to take it to the next

level as a market leader. His experience with wireless technology

at Qualcomm and Motorola was an enormous asset in this effort

because wireless networks were exactly the market where RMI had

the most to gain. In choosing Abdi, RMI had positioned itself to

adapt to new market realities.

Figure 5.1 Wireless data traffic volume growth by year (figures for 2012 and later are projected). Source: From IBS, private communications, 2011.

Product launch 143

With over 100 patents either issued or pending, the com-

pany had an impressive portfolio of intellectual property to support

expansion into new markets. But it faced a challenge common to all

startup enterprises: the need for more revenue to solidify and extend

its early success. Although its first generation of products had been

launched to great acclaim, RMI had to gain widespread customer

acceptance and build revenues rapidly if it wanted to head off the

competitive pressures it would inevitably face from later entrants

into its market segment.

Abdi’s approach to this challenge was to turn the complex

nature of RMI’s network products into a competitive advantage by

helping its customers design their equipment. In effect, RMI set out

to deliver not only chips but also the software to integrate them into

its customers’ extremely complex communications equipment. This

was particularly important for new Asian equipment builders, who

lacked some of the established engineering skills that US companies

such as Cisco, Juniper, or Lucent had accumulated over the years.

As a result, RMI found itself increasingly in the position of a

system enabler. In addition to expanding its internal chip design and

support organizations, it had to develop a cadre of collaborative soft-

ware vendors if it was to win new customers. It needed these indus-

try partners to provide the enabling software for its customers.

Drawing on his extensive background in communications sys-

tems, Abdi built an ecosystem of over one hundred corporate part-

ners. These organizations developed and sold complementary chips

and software that allowed the company’s customers to build their

products in record time around RMI chips.

By 2008 RMI had over 200 customers and revenues of $79 mil-

lion, an increase of 25 percent from the prior year. It had proven that

it understood the network equipment market, had the technology to

meet its needs, and could work in a global environment. It was in a

good position for future growth – but it needed an infusion of new

capital to fund its expansion. Though successful, it was not yet prof-

itable due to its heavy investment in product development.

Speeding voice a nd data tr a ffic wor ldw ide144

Under normal circumstances, the right place to raise this cap-

ital would be the public market. Accordingly Goldman Sachs was

selected to underwrite an IPO on NASDAQ in mid-2008 – just before

the US mortgage crisis triggered a stock market debacle and the deep-

est recession since 1929.

After the 2008 market crash an IPO was clearly impossible.

The company’s board of directors was faced with the task of plan-

ning a different future for RMI.

Weighing options

Deprived of the ability to raise capital in the public markets, RMI’s

directors had two strategic choices.

Keep the company independent; reduce product development costs to • maintain profitability.

Merge RMI with a public company with complementary products and a • similar customer base, in the expectation that the combined companies

would have enough resources to continue their growth.

Staying independent posed the bigger risk. If RMI chose that

course, it would have to cut back on new product development, pos-

sibly mortgaging its future. In a highly competitive industry like

microprocessors, inadequate investment in product development

could be fatal. There were already a number of bigger competitors

racing to overtake RMI’s lead.

If, on the other hand, the company chose the merger route, it

would obviously have to find the right partner. As it happened, in the

course of building RMI’s industry ecosystem, Behrooz Abdi had run

across a compatible company.

RMI merges with NetLogic

NetLogic Microsystems was the world leader in a specialized cat-

egory of semiconductor chips called knowledge-based processors

(KBP). These chips incorporate massive parallel signal processing

with content-addressable memories (CAM), which store the data

R MI merges w ith NetLogic 145

needed to move data packets to their destinations. Such specialized

memories can greatly increase a router’s processing speed.

We have already seen that the headers on data packets carry

information to identify packet contents, origin, and ultimate destin-

ation. When the microprocessor in a router analyzes each packet’s

header to determine its destination, it must then look up informa-

tion in its own routing tables to decide how to send the packet on the

next leg of its journey through the network.

CAMs are specially designed to increase the efficiency of the

process of matching a packet’s address information with its destin-

ation path, while meeting network security requirements at the same

time. You can think of the operation as similar to the mail-sorting

procedure in an old-fashioned post office, where the routing informa-

tion for each letter is stored within easy reach of the sorting clerk.

After extensive meetings between the investors and the

managements of RMI and NetLogic, we mutually concluded that

by combining the two companies we would produce a technology

leader with a market position superior to what either company could

achieve on its own.

One avenue of potential growth opened up by this merger,

for example, was the combined company’s ability to develop prod-

ucts that more closely integrated packet processing with NetLogic’s

chips. This would allow customers to increase network performance

while reducing chip costs. In addition, the merger would realize sub-

stantial financial benefits by combining two sales, marketing, and

product development organizations into one, thus reducing admin-

istrative overhead.

We agreed that RMI would exchange its shares for new NetLogic

shares so that shareholders in both companies could benefit from

the new value created by the merger. The merger was completed in

October 2009. RMI’s shareholders ended up with about 20 percent of

the shares of the combined company.

Behrooz Abdi joined NetLogic as executive vice-president

and general manager. In 2010 NetLogic introduced a new family of

Speeding voice a nd data tr a ffic wor ldw ide146

microprocessors that had been in development at RMI. These prod-

ucts extended the market leadership of RMI’s previous offerings,

delivering over four times the processing power at the same price as

its nearest competitors, including entries by Intel. Needless to say,

they were very well received.7

They also required a heavy investment in engineering expert-

ise. You get an idea of the engineering requirements for this kind of

company from its manpower: out of a total staff of 650 at the end of

2010, over 60 percent were engineers.

Despite this technology investment, NetLogic’s financial

performance after the merger did not disappoint its shareholders.

Revenues in 2010 reached $382 million (38 percent in China). Its

market capitalization was about $3 billion in March 2011. This

meant that the shareholders of RMI were credited with a value of

about $600 million for their part of the ownership.

Looking back

RMI successfully challenged the biggest companies in its business

with products that required a unique set of skills. In fact, when the

company was started in 2002, there were only two companies in the

world with the technical skills to design such products. One was

Intel, the industry pioneer and leader in microprocessors. The other

was AMD, whose ability to compete in the market was largely the

result of the initiatives of Atiq Raza, the founder of RMI. However,

neither of these big companies addressed the market that RMI

identified.

But there is a sobering message in this story. Despite having

performed an extraordinary feat of product engineering, its ultimate

destiny as a business was not as a standalone company. The reason is

that an enterprise committed to RMI’s class of highly sophisticated

products requires an enormous investment of resources for continued

7 T. R. Halfhill, “NetLogic broadens XLP family,” Microprocessor Design, July 2010, pp. 1–11.

Look ing back 147

success in the international market. Most startups simply don’t have

the resources to sustain that level of investment unless they have

access to the kind of capital available from public markets.

Still, the story of pre-merger RMI is valuable for what it tells us

about the way entrepreneurs and investors have to think in a global

market. Here are some of the most important points to consider.

Management changes can be healthy. A large part of RMI’s

success must be credited to two outstanding entrepreneurs: Atiq

Raza and Behrooz Abdi. Raza was the visionary leader who got the

breakthrough product designed and launched. Abdi took the com-

pany to the next stage, launching the second-generation product

family while ensuring revenues from the first. His work in build-

ing an ecosystem of complementary software and hardware products

to win customer acceptance was critical to the company’s growth

strategy.

There is no substitute for access to international talent. RMI

attracted outstanding talent from around the world right from the

start. Engineers from India, Pakistan, and China were prominent

both in the Silicon Valley location and in the overseas location.

Their geographical dispersion and their understanding of different

markets, to say nothing of their talent, played a large role in the

penetration of the Asian market.

Startups are often viewed with suspicion by big customers in

the developed economies. The more strategic the component, the

more difficult it is to convince big customers to bet their new prod-

uct lines on an offering from a startup. This was the case with big

companies whose concern about the financial stability of RMI pre-

cluded their purchase of its microprocessors.

A global outlook can lead to willing buyers. RMI’s ability to

address the needs of Asian customers saved the company. Equipment

manufacturers in Asia were more focused on using the most advanced

chips than on the financial viability of their vendors. They wisely

concluded that companies with winning products get financed, and

that their support would make that happen. The company’s ultimate

Speeding voice a nd data tr a ffic wor ldw ide148

success in selling in China and the Asia-Pacific region, however, was

no accident. Right from the start RMI had outstanding marketing and

customer support management located there, and it actively engaged

with potential customers while the products were being designed. It

takes years of effort and very talented people on the ground to gain

the respect of new customers. RMI was prepared.

Industry consolidation is a fact of life. The best products in

the world are no substitute for business scale. This is especially true

for technology companies, which require costly and ongoing invest-

ments in product development. Despite high gross profit margins of

60 percent, RMI was never profitable as an independent company. It

was constantly pouring money into new products, a necessity in an

industry where products are obsolete in less than three years. Under

these circumstances any company with the ambition to remain

independent needs access to large amounts of capital at attractive

valuations.

In the 1990s public markets were very open to financing com-

panies such as RMI. The crashes of 2000 and 2008, however, made

the timing of IPOs problematic. The investors’ decision to merge

RMI with NetLogic recognized that the combined companies would

create more value for their shareholders than if they were independ-

ent. This turned out to be the case – NetLogic remained profitable

after the RMI merger and was valued as a very high performance

growth company – over six times annual revenues. It also spends

nearly 40 percent of its revenues on product development. This is

what it takes to stay a winner in the microprocessor game. NetLogic

was in turn acquired by Broadcom in 2012.

In the next chapter we’ll look at a very different approach

to a similar situation: a company that leveraged IP and partner-

ships, instead of mergers, to reach a scale where it could remain

independent.

149

Technologies emerge from the coming together of existing technologies into wholes that are greater than the sum of their parts.1

Imagine having to re-program your smartphone, digital camera,

music player, tablet computer, e-book reader, or similar device with

phone numbers, photos, songs, or other crucial information every

time you turned it on. Or think how much bigger its battery would

be, and how often you would have to recharge it, if you decided to

keep it powered up all the time so it would remember that data.

Fortunately, that’s one dilemma we don’t have to face. Our

electronic devices keep all our information in memory, ready for

use, even when we turn them off. They store the data in semicon-

ductor chips called “flash memory,” either in the devices or on handy,

removable memory cards and USB thumb drives. Their convenience

and functionality are owing in large part to the flash memory inno-

vations of Dr. Eli Harari.

Dr. Harari did not invent flash memory. Credit for that goes

to Toshiba, the giant Japanese electrical and electronics company,

which developed the semiconductor chips in the mid-1980s. But he

did find ways to improve their reliability. Even more important, he

developed flash memory systems. He developed and commercialized

these systems through SanDisk, an amazingly successful startup,

which he founded in 1988 in Silicon Valley.

Today SanDisk is the world’s leading producer of flash memory

cards. In 2011 the company had revenues of $4.8 billion, net income

6 A world leader emerges: SanDisk and flash memories

1 M. Ridley, The rational optimist: How prosperity evolves (New York: HarperCollins, 2010), p. 271.

A wor ld lea der emerges150

of $1.3 billion, and a NASDAQ-traded enterprise value of $12 billion.

It produced over 50 percent of the flash memory cards used in the

world.

How a Silicon Valley startup in one of the most competitive

industries in the world reached these lofty heights is a remarkable

example of global entrepreneurship. SanDisk achieved its success

through a combination of cutting-edge innovation, leadership in

establishing industry standards, marketing flexibility, and the con-

struction of a unique international manufacturing relationship.

None of this would have been possible, of course, without an

entrepreneurial instinct for market needs. When asked why his com-

pany succeeded, Harari, who was CEO until his retirement in 2010,

answered “Total focus. Over the years our tactics changed, but never

our objective.” That objective was to allow people to store and move

their personal data from device to device, for convenient sharing of

information with friends and relatives.

For a better understanding of SanDisk’s story, we’ll start with

some background on pre-existing solutions for storing and sharing

information on PCs, and indicate why flash memory cards displaced

them.

Memory and disks get flashed

Flash memory is relatively new. In the 1980s, when work on the tech-

nology was just getting under way and PCs were in their infancy,

the dominant memory type in computers was (and still is) random-

access memory, or RAM.

The only competition for RAM was read-only memory (ROM),

the predecessor of flash memory, and it was no contest. While ROM

also retains information while in an unpowered state, it cannot be

easily erased or rewritten. As a result ROM was relegated to storing

firmware or other permanent data.

By contrast, RAM can be erased and rewritten countless times

at very high speeds. This makes it the memory of choice for storing

working data. Every digital device, from the mainframe computer

Memory a nd disks get flashed 151

to the wireless handset or the humble pocket calculator, uses RAM

chips to store digital data for recall or processing.

Unfortunately, RAM only stores information when it is con-

nected to a source of electrical power. If you turn off your computer,

or run down the batteries in your portable device to zero, all of that

information will vanish. Most computer users can tell stories of

power outages that wiped out work they hadn’t “saved” to a more

permanent storage medium.

Mechanical solutions

Permanent storage for digital information has long been the province

of the spinning magnetic disk. Most computers today use hard disk

drives for this purpose. These are rigid platters coated with magnetic

material, spinning in hermetically sealed enclosures to prevent dust

from ruining their surfaces. They allow easy erasure and rewriting

of information, and they retain data indefinitely even when discon-

nected from power.

They also boast huge capacities and by far the lowest cost per

byte of storage of any non-volatile memory device. In 2011 a two-

terabyte hard drive for a desktop computer cost around $100.

Of course hard disks have their drawbacks. They draw sub-

stantial power when reading and writing information. Since they

are electromechanical devices, they are orders of magnitude

bulkier and heavier than semiconductor memory. They are sub-

ject to damage from physical shock, especially during operation.

And their access time is much slower than that of semiconductor

memories.

Clearly the hard disk was not designed as a portable data stor-

age device. For many years that role was filled, however inadequately,

by the now-obsolete “floppy” disk. This was a disk of magnetically

coated film, 3.5 to 8 inches (89 to 200 mm) in diameter, packaged in

a protective plastic sleeve or rigid case, and with limited data cap-

acity. In its most popular form it held only 1.44 megabytes of data.

A wor ld lea der emerges152

Floppy disks were also easily damaged. Although the disks

were readily portable, the devices required to access their data were

not. Floppy drives were similar in size, weight, and power require-

ments to hard drives.

Toward flash memory

Getting rid of mechanical disks in favor of all-electronic systems

was an attractive concept. It would make devices much more port-

able, reduce their power requirements, and increase their rugged-

ness and reliability. It would also make information exchange a lot

easier.

When electrically erasable programmable ROMs (EEPROMs)

appeared in 1980, people began talking of them as replacements for

rotating disks. While it was not difficult to imagine the potential of

these memories, there were enormous technological hurdles to be

overcome. They had limited data capacity, and their cost was high.

Reliability was an issue too – the early programmable transistors on

the chips would fail after a few cycles.2

The term “flash” came into vogue in the late 1980s, when

EEPROMs appeared that could be programmed and erased at much

higher speeds than previously achieved. It took more than fifteen

years for flash memories to realize their potential, but their ultim-

ate impact has been enormous, enabling whole new generations of

consumer products.

Figure 6.1 shows the spectacular growth of the flash memory

market between 1995 and 2011. The $27 billion in global revenues

in 2011 represents over 43 percent of all semiconductor memories

produced.3

The latest flash memories offer enormous data capacities. Up

to 64 GB of storage is readily available on a single SD card, with the

2 W. S. Johnson, G. Perlegos, A. Renninger, G. Kuhn, and T. Ranganath, “A 16kbit electrically erasable nonvolatile memory,” ISSCC, Technical Digest, 1980, p. 152. For a detailed discussion of memory technology, see B. Prince, Semiconductor memories (New York: John Wiley & Sons, 1991), pp. 529–605.

3 T. Luke, “Semiconductor handbook 2010,” Barclays capital equity research (June 10, 2010), pp. 302–303.

Memory a nd disks get flashed 153

potential for 2 TB.4 The chip that provides this level of storage packs

billions of transistors into an area the size of your thumbnail.

Flash memories are now inexpensive, fast, and reliable. They

enable portable devices including digital cameras, USB “thumb”

drives, MP3 players, and cell phones. Even GPS navigation devices

use flash memories for non-volatile storage.

In the computer arena, flash memory-based thumb drives long

ago consigned floppy disks to oblivion. They are now replacing hard

disks in PCs, especially portable units, where their inherent rug-

gedness, light weight, superior speed, and lower demand for battery

power outweigh their somewhat higher cost and significantly lower

capacities.

Given the course of their development, it is not hard to imagine

that eventually they may surpass hard disks in capacity and under-

cut them in price. Whether or not that happens, the success of flash

memories thus far owes a great deal to SanDisk’s initiatives and

Harari’s inventions.

Figure 6.1 Global flash memory revenues and their year-over-year rev- enue growth. Source: Based on data from SIA and Barclays Capital (ref. 3).

4 Capacity information comes from www.sdcard.org/consumers/cards, accessed July 13, 2011.

A wor ld lea der emerges154

According to Harari himself, however, a large part of his

achievement should be credited to lessons he learned from his first

startup, Wafer Scale Integration (WSI). He kept making this point

when we discussed the history of SanDisk and flash memories.

Towar d SanDisk: Wafer Scale Integr ation

As it happened, my own interest in what became flash memory

began in 1980. While at RCA Labs I became intrigued by the poten-

tial of non-volatile semiconductor memories, and started a program

to develop a commercial product based on this technology. Investing

in a company that developed new products exploiting this promis-

ing technology became one of my objectives when I joined Warburg

Pincus in 1983.

The opportunity to help build such a company came in 1984. I

was introduced to Dr. Harari, who had earned a Ph.D. in Solid State

Sciences from Princeton University and had held management posi-

tions at Intel, Honeywell, and Hughes Aircraft Microelectronics.

He and his colleagues were planning the start of a new com-

pany, Wafer Scale Integration (WSI), to commercialize novel non-

volatile memories. Impressed with his ideas and the technology

roadmap, Warburg Pincus financed the start of the company along

with several other investors. It was headed by Harari.

From the beginning, everyone involved recognized that cost-

effective manufacturing was going to be essential to the success of

the company. WSI would use new process technology to manufac-

ture its chips. This posed a problem, even though the technology

shared many elements with the generic CMOS process then gaining

ground in the industry. Whatever the manufacturing process, it was

certain that it would have to constantly evolve over time to reduce

chip cost and improve functionality.

Implementing manufacturing innovations requires a focused

engineering production staff working closely with development

engineers. Ideally, WSI would have liked to build its own factory,

but this required an investment in excess of $100 million. A capital

Towa r d Sa nDisk: Wa fer Sca le Integr ation 155

commitment that large was beyond the means of venture capital

investors of that period. Nor were investors inclined to bet such

huge sums (at the time) on a risky new venture.

So the WSI team proposed the next best thing: contract with a

semiconductor company willing to accommodate “guest” products

on its production line. Harari convinced the Sharp Corporation in

Japan to share the use of one of its production plants in return for a

license to the WSI technology.

Manufacturing impacts competitiveness

The company’s first products were called programmable system

devices (PSDs). These provided non-volatile memory for microproc-

essors from Intel, Motorola, and others. The products found custom-

ers, but the market was limited.

WSI’s high production costs proved to be its Achilles heel.

While the semiconductor industry as a whole was reducing its

costs by producing ever-denser chips, WSI did not follow suit. It

could not implement similar process improvements fast enough.

Since developing more complex devices would require significant

production changes, that route to lower cost was closed to it as

well.

In the final analysis, the basic reason for WSI’s limited success

was not lack of innovation, but the difficulty of actually implement-

ing change. Sharp’s management was reluctant to allow WSI to alter

their facility’s production process for fear of affecting Sharp’s own

products. As a result, WSI’s new products reached the market too

slowly, and carried too high a price.

Limited to a narrow market niche, the company did not grow

beyond annual revenues of $40 million. In 2000 it was acquired by

ST Microelectronics, which saw value in its memory technology.

WSI had entered the new non-volatile memory field in its early

stages. But without the right kind of production facility it was impos-

sible to take advantage of the many opportunities created as applica-

tions proliferated and the basic technology matured.

A wor ld lea der emerges156

It has become fashionable to believe that owning production

plants is a bad idea for a corporation. Why burden a company with

the capital costs of manufacturing plants if better alternatives exist,

such as outsourcing?

It is too easy to ignore the fact that control of its own manufac-

turing process can give a company an edge in responding to market

changes, or that manufacturing can be a great source of competi-

tive innovation in certain markets. Better alternatives do exist, as

SanDisk eventually showed when it created a very successful manu-

facturing partnership with Toshiba. But no matter which path is

chosen, you must control your own destiny.

SanDisk pioneers flash memory systems

Unhappy with the progress of WSI, Harari left the company in

1988, to found a new company, SunDisk. He was joined by Sanjay

Mehrotra and Jack Yuan as co-founders. The company was later

renamed SanDisk.

Their business plan was extremely ambitious. Its strategy was

very different from that of WSI and other companies in the mar-

ket. Instead of component memory chips, SunDisk was going to offer

self-contained flash memory systems for auxiliary (removable) com-

puter data storage.

Harari’s vision was to deliver a convenient memory system

that would enable data portability between computers. This would

make it simple for consumers to transfer their personal data. The

easiest way of visualizing such a product is as a less cumbersome

replacement for floppy disks, with the ability to carry much larger

amounts of data.5

Since computers were designed to work with magnetic disk

memories, these new flash memory systems had to emulate the

operation of disk drives if they were to work properly. They had to

5 Eli Harari, “2008 Analyst Day” (Transcription). Available on SanDisk website.

Sa nDisk pioneers flash memory systems 157

be reliable, cheap enough to attract consumers, and with sufficient

capacity to store meaningful amounts of data. And they had to meet

industrial interface standards to allow interoperability among com-

puters made by different manufacturers.

Devices like this did not yet exist. Harari and his colleagues

had to invent them, and SanDisk’s future was based on turning

Harari’s inventions into successful products. Starting with US

patent 5,095,344, “Highly compact EPROM and flash EEPROM

devices,” filed June 8, 1988, Harari described a series of inventions

that addressed key technological hurdles:

a new and superior chip architecture, allowing much denser transistor • arrays;

new ways to manufacture such chips; and• novel algorithms for programming and erasing the information stored on • the transistors, which increased their reliability.

His algorithms made it possible for flash memories to emulate

disk storage operations.

The SanDisk system products that eventually emerged con-

sisted of two parts – flash memory chips and a proprietary control-

ler. The flash memory chip stored the bits, while the controller chip

contained the “secret sauce,” providing system-level management of

the stored data when interfaced with its host computer.

SanDisk’s system developers also faced the problem of partial

failures. In the course of use, some of the memory chip’s data storage

transistors could “wear out.” To make flash memory systems prac-

tical, they had to find a way around the failed components, analo-

gous to the process of taking areas on a hard disk that generate errors

out of use.

To solve that problem, SanDisk’s controller software detects

the presence of failed storage elements and reroutes the data flow

around these failed elements to allow unimpeded operation. The

controller also executes software that emulates the operation of a

floppy disk, so that the computer sees the flash memory chips as a

normal magnetic disk.

A wor ld lea der emerges158

From startup to the big leagues

It took three years for the company to complete its first products.

SanDisk did not become profitable until 1995, seven years after its

start. Its revenues that year were $62 million, with a net income

of $9 million. IBM and Hewlett-Packard were the major customers,

selling the flash memory systems as removable accessories for their

personal computer lines.

Capital to keep the company going was a constant problem

while it was building its revenues. The company had raised capital

from various equity sources. These included Seagate, a leading mag-

netic disk manufacturer clearly interested in a potentially competi-

tive technology.

As the company progressed, it became possible to raise money

in the public market. To take advantage of a hot public market,

SanDisk launched its IPO on NASDAQ on November 7, 1995, rais-

ing $37 million at a valuation of $210 million.

The company has come a long way since its IPO. Figures

6.2a and 6.2b show its revenues and net income from 1995 to 2010.

Revenues passed $1 billion in 2003 and $4.5 billion in 2010. The

company has been consistently profitable with the exception of 2008,

when inventory write-off and other asset revaluations led to a loss.

You will note in Figures 6.2a and 6.2b that revenues are broken

into two parts: product revenues and license income from patents.

We will discuss the reason for this later.

Success factors

As we noted earlier, after a slow start SanDisk became a very suc-

cessful company. Why did that happen when so many other com-

panies failed to succeed in this market? There are several significant

reasons.

SanDisk leveraged its record of seminal inventions into both profitable • products and licensing income.

It led the way in establishing industry standards for interfacing memory • systems to devices; without such standards its products could not be sold

into large markets.

Sa nDisk pioneers flash memory systems 159

The company benefited from serendipity: generations of battery-driven • consumer products that emerged in the 1990s were enabled by flash

memories.

It was able to offer leading-edge products while dramatically reducing • costs over a period of years because of manufacturing joint ventures with

Toshiba.

SanDisk succeeded in building a consumer brand around its peripheral • memories – a rare feat for a chip company.

We will examine these elements of SanDisk’s success in turn.

Figure 6.2a Revenues and net income of SanDisk between 1995 and 2004.

Figure 6.2b Revenues and net income of SanDisk between 2005 and 2010. (Note: Year 2008 loss was owing to inventory write-off and other asset revaluations.)

A wor ld lea der emerges160

Patents and a clever licensing strategy

Inventions were crucial to the company’s success. Over the years,

Harari himself authored or co-authored 119 patents. In 2010, the

company had over 1,500 patents and was filing new ones at the rate

of 300 a year.

Protecting all this intellectual property was a daily battle. The

growth and profitability of the flash market was no secret, and lots of

companies were infringing key SanDisk patents to get a share of the

profits. The company’s annual public filings contain extensive lists

of legal battles with companies big and small over its IP.

These legal processes are part of a larger strategy. They show

that SanDisk will defend its IP in the courts when necessary. But

knowing that legal fights in and of themselves are not product-

ive, in 1997 the company started to cross-license its patents with

competitors.

This sounds counter-intuitive, but actually proved to be a very

wise policy. The reality was that the flash industry was growing very

rapidly and patent infringement was rife. While SanDisk’s patents

were basic to creating a new market, without more entrants it was

unlikely that the industry would adopt the new standards essential

for flash memory’s widespread acceptance. By licensing its patents

the company helped expand the flash system market.

The decision to license its patents brought SanDisk a number

of other benefits.

Because SanDisk led the industry in innovation, it collected substantial • royalty fees from licensing, amounting to between 10 and 20 percent of

total revenues depending on the year (see Figures 6.2a and 6.2b).

Through the trading of suitable IP, it gained access to patents from other • companies that were essential for its own products.

Cross-licensing made it easier to establish industry standards, under • which participants made their patents available in return for royalty

payments.

From a financial perspective the strategy was a boon to the

company’s bottom line. In 2008, for example, licensing income

Sa nDisk pioneers flash memory systems 161

amounted to $508 million. It is interesting to note that Samsung,

SanDisk’s major competitor with a 40 percent share of the flash

memory market, is also its biggest source of license fees.

In essence, SanDisk’s licensing strategy allowed it to fund a

great deal of its product development with money from its competi-

tors. It is an updated version of the approach David Sarnoff used to

underwrite R&D at RCA.

Leadership in setting industry standards

Flash memory systems were originally designed as computer periph-

erals, not as built-in data storage like RAM. Their purpose was to

transfer data from one machine to another. If they could not be eas-

ily moved from computer to computer, regardless of maker, there

would be no market for them.

Clearly the concept of transferrable storage products would

work only if the electronics industry adopted standards to enable

interoperability among equipment sold by all vendors. This would

take the form of a standard interface that would allow flash mem-

ories (and other peripherals) to plug into any PC. So right from the

start, SanDisk focused on creating and leading industry standards-

setting bodies.

PCMCIA standard. SanDisk was a founding member of

the Personal Computer Memory Card International Association

(PCMCIA) in 1989. Just one year later, in 1990, this organization

set the first international standard for removable peripheral cards,

covering memory storage, network communications, and other

functions.

The PCMCIA standard benefited both computer and peripheral

makers. It made computing equipment more versatile by providing a

seamless interface to peripherals that added capacity and functional-

ity. Peripheral manufacturers who adhered to the PCMCIA standard

could make cards with the assurance that they would work with any

computer regardless of maker.

With PCMCIA in place, SanDisk’s data storage cards could

transfer information among all computers, and even among different

A wor ld lea der emerges162

types of devices, as long as they adhered to the standard. For example,

the PCMCIA standard allowed the transfer of photos from a digital

camera to a computer.

SanDisk’s main product at the time was the FlashDisk, a card

designed to replace floppy disks in handheld wireless terminals,

personal computers, and audio recorders. It weighed only half an

ounce (14g), used very little power to operate, and was the size of a

matchbox. As the technology improved FlashDisk peripherals got

smaller and thinner while providing more storage capacity.

Hewlett-Packard used the product in the 1990s to provide

outboard storage for its small 200LX personal computer. IBM,

which was still in the personal computer business, was also a major

customer for a similar application, as were makers of hand-held

computers.

Though a big step forward in portability, the PCMCIA card

(later PC card) was still fairly large. It measured 3.37 × 2.125 inches

(85.6 × 54 mm), exactly the size of a credit card, and had a thick-

ness of between 0.13 and 0.4 inches (3.3 and 10.5 mm), depending on

its type. Its primary market was owners of laptop computers, who

wanted to add storage capacity or additional functions to their some-

what limited portable machines.

USB standard. PCMCIA cards were later superseded by the

smaller, faster, more versatile Universal Serial Bus (USB), which

is now routinely built into desktop and laptop computers, smart-

phones, digital cameras, and many other electronic devices. Right

from the beginning the USB standard defined the requirements for

the now ubiquitous USB flash memory drives.

First offered by IBM for their PCs in 2000, flash drives (called

drives because they could replace both floppy disks and their drives)

are small and inexpensive, yet hold massive amounts of data. A typ-

ical flash drive in 2011 weighed less than an ounce (30 g) and stored

as much as 16 gigabytes at a cost of about $5 per gigabyte.

Smaller-capacity USB drives are now so inexpensive that many

companies give them away as advertising premiums. They are also

Sa nDisk pioneers flash memory systems 163

extremely reliable. Some allow one million write/erase cycles and

have a ten-year retention cycle.

With the introduction of its USB flash drive SanDisk found

itself with a true consumer product. While PCMCIA cards were

sold mostly through computer specialty stores, flash drives quickly

found their way into general merchandise outlets, from office supply

stores to Walmart. Yet the company’s biggest market success was

yet to come.

Flash card standard. As the capacity of flash memory chips

increased, it became possible to consider even smaller form factors

for memory cards. In 1999 SanDisk, working with Matsushita and

Toshiba, led the standard-setting initiative for the Secure Digital

(SD) memory card, which is still in use at this time of writing.

These thin (0.08 inch, 2.1 mm) flash cards immediately found

a ready market as removable storage for digital cameras. The three

companies cross-licensed their patents, but competitors have to pay

license fees to the group members to make cards according to the

standard.

SanDisk then worked with manufacturers of wireless hand-

sets to develop standards for much smaller memory cards, called

miniSD, to bring removable storage to top-quality cell phones. By

allowing transfer of data between phones and personal computers,

miniSD cards made it possible to use the handsets as multi-pur-

pose devices. For example, users can move pictures taken with the

phone’s built-in camera directly to a PC for viewing and editing,

or load the card with music from the PC and use the phone as a

music player.

Standardization was a necessity for SanDisk’s survival, as

it helped grow the market for flash memory past critical mass. Its

downside is that it commoditized the company’s core technology.

But by helping to set the standards for popular products and being

an owner of the associated technology, SanDisk was in a position

to collect huge royalties, which continue to fund its technology

development.

A wor ld lea der emerges164

New portable consumer electronic devices hit the market

Throughout the 1990s one new generation of battery-powered con-

sumer products after another emerged, all of which were built around

flash memory storage. SanDisk reaped the benefits of the growing

demand for its memory devices.

Why did these products emerge and why did flash memories

become essential? It was partly serendipity.

As computing chip performance doubled every two years (following • Moore’s law), and chips shrunk in size, cost, and power requirements, it

became possible to design tiny portable consumer products such as audio

and video players along with ever smaller personal computers.

Makers of these devices relied on flash memory to store information • because magnetic disk storage was too large, too prone to failure, and

required too much power.

Digital cameras were completely impractical without flash memory • cards. To help people understand why they needed the cards, one maker

branded its products “digital film.” Consumers needed an easy way

to add storage and transfer photos to PCs or printers for editing and

viewing.

Cellular phone service became affordable for an ever-expanding portion • of the population worldwide. Handsets grew in sophistication while

shrinking in size; flash memories were essential for non-volatile data

storage.

The fact is, however, that SanDisk created a lot of its own luck.

Management kept up with the advances in semiconductor technol-

ogy that made these devices possible, and had a clear understanding

of the place of flash memories in the big picture. They drove the mar-

ket as much as followed it.

As the flash memory market grew, so did competition. Capital-

rich companies with excellent manufacturing technology, such as

Samsung and Toshiba, increased their production efficiency and

drove costs – and prices – down. For SanDisk the moment of truth

had arrived. Its manufacturing had to stay competitive in order to

survive. As a result of an innovative and prescient manufacturing

strategy, it was ready.

Sa nDisk’s joint m a nufactur ing engine 165

SanDisk’s joint manufacturing engine

To get some idea of the pressure SanDisk was facing, consider the

fact that over the life of the company production costs per bit for

flash memory declined by the astounding factor of 25,000. Single

chips with 64 GB of memory capacity were in volume production in

2011 at prices that mass market consumers could easily afford.

The pace of development in the technology is unrelenting.

Storage capacity on a given size of chip doubles every twelve months,

because new ways of increasing the density keep getting invented.

As a result, flash chip costs are declining at a rate of better than

50 percent a year, producing cheaper consumer prices, a growing

market, and headaches for companies trying to keep up. It took quite

a few years for the company to develop the capabilities it needed to

compete in this environment.

SanDisk’s biggest challenge, as it had been for Harari’s first

company, WSI, was where to manufacture its products. SanDisk’s

venture capital investors, like WSI’s, could not finance a factory.

So early on, in the absence of other alternatives, the new company

adopted the same strategy as the old one: sign contracts with manu-

facturing companies for access to their plants. The outcome was just

as unsatisfactory.

Its first major manufacturing site, at a Matsushita plant, was

in use between 1990 and 1996. But that relationship left much to be

desired, as did agreements it signed with four other companies dur-

ing that time. Delays in ramping up new processes were common.

Yields were not predictable, either, because of the continuous tuning

of processes to increase chip performance.

For manufacturing changes to be implemented as rapidly as

possible, the plant had to be more responsive to SanDisk’s constant

need for process improvements. Only a dedicated facility would meet

these requirements.

Building one was out of the question. It would have cost

SanDisk over $1 billion and involved significant risk, to say nothing

A wor ld lea der emerges166

of the time needed to make it functional. So rather than go it alone,

the company decided to partner with Toshiba, the third largest chip

manufacturer in the world.

Joint venture with Toshiba

The Japanese electronics giant seemed a highly unlikely choice to

deal with a Silicon Valley startup on an equal footing. But deal it

did, because it was also committed to the flash memory market, and

SanDisk had unusual technological assets that it needed to succeed

in the business.

In June 2000 SanDisk and Toshiba signed a deal to create a flash

memory manufacturing partnership named FlashVision. SanDisk

initially committed about $400 million of the capital cost for joint

ownership of a new facility in the US dedicated to flash memory pro-

duction. SanDisk also committed itself to buying, at cost, 50 percent

of the plant output, and to paying its share of the operating costs.

This is how SanDisk gained access to a factory where its technology

could be implemented and controlled.

Manufacturing was eventually consolidated in Toshiba’s

Yokkaichi chip factory complex in Japan. Each company continued

to fund its own product development. In effect, SanDisk and Toshiba

became production partners but market competitors. Further part-

nership deals were signed in 2004 to fund expanded production

requirements, committing SanDisk to further capital funding.

Teaming up with a competitor to create a manufacturing facil-

ity for your respective products sounds just as counterintuitive as

licensing your technology to companies who are trying to beat you

in the marketplace. But like SanDisk’s licensing strategy, this manu-

facturing partnership paid big dividends, even ignoring what it saved

by not building its own factory.

First, by sharing technology with Toshiba, SanDisk was rap-

idly able to increase its production capabilities. The production line

was located in Toshiba’s first-class manufacturing complex and

benefited from its excellent infrastructure. Toshiba also contributed

Sa nDisk’s joint m a nufactur ing engine 167

technology of its own to the joint venture, which complemented that

of SanDisk.

Second, with a high-volume facility dedicated to manufactur-

ing one product, there were bound to be reductions in production

costs over time.

Third, by owning their facility the partners were in a better

position to protect proprietary process technologies. For example,

SanDisk implemented a proprietary technology that stores three bits

instead of only one in a transistor cell. Multilevel bit storage enabled

SanDisk (and Toshiba) to sell much denser memory chips than their

competitors at a lower cost per bit stored.

Of course, these advantages came with a price tag. Through

2010 SanDisk borrowed about $7 billion to finance its part of the

partnership. However, considering the cost savings reaped by shar-

ing infrastructure and technology with Toshiba, this was undoubt-

edly less than what SanDisk would have had to invest if it attempted

to build its own factory.

This deal made sense for Toshiba too, because they not only

gained a partner who paid its fair share of the plant cost, they got

access to the most innovative flash memory skills in the world.

Their partnership allowed Toshiba to remain a leading flash chip

vendor. Most other manufacturers had to exit the business because

they could not muster the technology to compete. In 2011, the joint

Toshiba-SanDisk factories produce about 30 percent of the world’s

flash products.

It is true that the partnership calls for an unusual level of

cooperation between companies that are basically competitors once

the chips leave the factory. It also requires that SanDisk engineers

work closely with Toshiba engineers in the manufacturing plants.

This is not something that is easy for a big company jealous of

its technology and management control. There were issues and

misunderstandings, but amazingly enough, this unique partner-

ship has worked very well. It has been renewed a number of times

since 2000.

A wor ld lea der emerges168

SanDisk builds a consumer brand

Finally, after twenty-five years of development, flash drives are low

enough in price to allow their substitution for magnetic memory disks

as permanent storage in small personal computers. The emergence

of tablet computers is accelerating the rate at which flash memories

are finding their way into personal computing devices. Consumers

love small computing devices and only flash memories make these

practical.

As we have seen in Figure 6.1, global flash product shipments

increased from $2 billion in 1995 to $27 billion in 2011. With mem-

ory densities increasing and costs dropping at a rate of 50–60 percent

a year, the flash memory industry has become mainstream. Product

prices declined from $19 per gigabyte in 2006 to $1.2 per gigabyte in

2011.

As its manufacturing capabilities and cost structure became

competitive, SanDisk was faced with strategic issues. How could it

build unique market value in a business that was increasingly com-

moditized by big producers? Should it remain a supplier of chips to

original equipment manufacturers (OEMs) to package in their own

branded products? Or should the company build its own consumer

brand in some consumer categories?

SanDisk decided to build a consumer brand. This strategy was

designed to overcome the commoditization process, which inevit-

ably follows when industry standards are open to all comers for the

price of a license fee.

It was a bold choice: no chip company had ever developed a suc-

cessful consumer brand for itself. Even Intel, with its famous “Intel

inside” ad campaign, was not trying to sell branded computers. It

was establishing a preference for PCs, which Intel did not build, that

used Intel microprocessors.

It is tempting for a company to go up the product chain and

sell a complete product rather than the component that enables it.

SanDisk succumbed to the temptation and introduced a consumer

product, an MP3 music player called the Sansa, which ended up as a

very distant second to Apple’s iPod in the market.

Look ing back 169

“You can’t out-iPod the iPod,” Harari concluded in 2009. It is

not obvious that this product idea produced any long-term value to

SanDisk, except to reinforce the need to focus on areas of expertise.

That area of expertise was, of course, peripheral memory products.6

Over the past decade or so, SanDisk has succeeded in building con-

sumer preference for its branded memory peripherals for digital cam-

eras, personal computers, and wireless handsets.

USB flash drives and SD cards are the two auxiliary storage

products that consumers see most often with a SanDisk brand.

Neither of these is a unique product. SanDisk’s competitive advan-

tage comes from better reliability and higher capacity storage on a

given chip. Its premium brand reputation results in a higher retail

price and better profit margins.

Overall the company sells 50 percent of its chips to OEMs,

with the other half used in its own consumer products, sold in retail

stores under the SanDisk brand. SanDisk is now the world’s leading

producer of flash cards with an estimated 50 percent of the global

market. It makes 1 million cards a day and is the dominant brand

in tens of thousands of retail outlets, including Best Buy, the largest

consumer electronics store chain in the world.

Looking back

The story of SanDisk holds a number of valuable lessons for the ambi-

tious entrepreneur who is targeting opportunities in the big, inter-

national electronics market. Chief among them: in a market likely

to attract major international competitors, ambitious plans require

meticulous execution on many fronts. Invention is not enough.

I cannot think of another example of an entrepreneur suc-

ceeding in the semiconductor business against greater odds than Eli

Harari. He is the source of seminal inventions that helped to launch

flash storage systems. He also built a great company that competes

on an equal footing with the largest corporations in the world.

6 Quoted on www.CNNMoney.com, June 3, 2009.

A wor ld lea der emerges170

But his inventions were always a means to an end. From the

very start he had the vision to realize that non-volatile semicon-

ductor technology would make the storage and exchange of informa-

tion so easy that consumers would make it an integral part of their

lives. But he didn’t stop with vision. He developed a strategy that

turned his vision into reality. Today SanDisk branded flash cards

and USB flash drives are ubiquitous in popular consumer products.

The methods he and his team used to achieve their success

show that entrepreneurs can get ahead by combining a flexible

approach to business, a global mindset, and unwavering focus on

their target market. The most interesting lessons from the SanDisk

story are that working with selected competitors for mutual advan-

tage is an avenue worth exploring, and that creative answers to the

manufacturing innovation process are an imperative.

We will review the most important factors in SanDisk’s

success.

International standards are important in promoting a new

technology. While the inventions of Harari and other technologists

on his team removed the key roadblocks to realizing useful flash

products, it was their pioneering work in setting industry stand-

ards that made it possible for these products to reach their intended

markets.

For an emerging company, industry standards pose challenges

and dilemmas. Promoting industry standards for removable flash

memories opened the market to competitors. But SanDisk had no

other choice, because without standards computer manufactur-

ers had no incentive to build products accepting interchangeable

memories.

Licensing patents can be very productive. SanDisk’s strategy

of leadership in standard setting was the right way to go, but only if

the company continued to lead the industry in innovation. Its licens-

ing of patents, paradoxically, helped in this effort. The licensing fees

were high enough to generate considerable revenue. This revenue, in

essence pure profit, allowed SanDisk to continue to invest heavily in

innovations that kept it ahead of the pack.

Look ing back 171

There is no place to hide when your production costs are too

high. Harari’s most challenging business issue came down to con-

trolling costs. In the semiconductor memory industry a manufac-

turer’s success hinges on its ability to reduce aggressively the cost

of its products over time. To do this it must produce memory chips

in high volume in its own factories. Those factories require huge

capital investments.

To avoid head-on competition in this market, Harari focused

his startup on building a new market around removable storage sys-

tems enabled by his controller invention. This allowed SanDisk to

compete on its own terms. But ultimately it could not hope to stay

in the business by relying on contract manufacturing.

Harari’s innovative solution was to create SanDisk’s manufac-

turing partnership with Toshiba. This lowered the cost barrier to

building a chip plant and gave it control of its manufacturing, with-

out which the company would not have survived to benefit from its

vision.

When moving to branded products, pick the right ones.

SanDisk’s experience in building its consumer brand has implica-

tions for every component vendor hoping to move up the food chain.

While the attempt to compete with Apple in a consumer music

player failed, it was never a fair contest. Apple’s success with the

iPod was not based solely on its technical merits but on the remark-

able infrastructure it built to make attractive music content avail-

able to its customers. This was not an arena in which SanDisk, a

chip company, could compete.

On the other hand, SanDisk’s marketing of branded periph-

eral memory products did succeed, precisely because the end prod-

ucts leveraged its technical and cost leadership in chips. Once the

distribution infrastructure was built, allowing it to capitalize on

having the lowest cost structure in the industry, the company was

positioned for success.

172

Technology companies and global investors are beating a path to Israel and finding unique combinations of audacity, creativity and drive everywhere they look.1

If you mention a successful startup called Ness Technologies, there

is a good chance that a US listener will assume it is one of those

high-technology Silicon Valley companies. That listener would be

mistaken. Ness Technologies is a multinational information tech-

nology (IT) services corporation, created in Israel in 1999. It is also

the first company in this book that does not have its headquarters

in the US.

This chapter will examine how the Israeli entrepreneurs who

founded Ness dealt with the challenges of a global marketplace.

Within five years of its founding, this Israeli startup became a lead-

ing company in its field with operations in Asia, Europe, and the

Americas. Its rapid rise to prominence has fully justified its name,

which means “miracle” in Hebrew. It did so by melding subsidiaries

in countries with cultures as diverse as Bulgaria and Thailand into

a global corporate culture, with a common set of goals and expecta-

tions that was held across national boundaries.

Demand for IT services resh apes the world

Ness Technologies is a provider of IT services to other compan-

ies. As such it didn’t “invent” any basic technology. Like Ronald

Stanton’s Transammonia, its innovations took the form of a new

7 Implementing information technology across the globe

1 D. Senor and S. Singer, Start-up nation: The story of Israel’s economic miracle (New York: Twelve, Hachette Book Group, 2009), p. 11. This book contains a wealth of information about the Israeli environment for new business building.

Dem a nd for IT serv ices r esh apes the wor ld 173

business model and new approaches to international service. Unlike

Transammonia, however, Ness operated in an industry character-

ized by the most rapidly advancing technology in history. Even those

who lived through the rise of the computer can hardly believe how

quickly and profoundly digital data processing has changed the way

the world does business.

In just twenty years, between 1980 and 2000, corporations

replaced the river of paper that had carried business forward for cen-

turies with a stream of digital information flowing through wires.

Computers and associated software flooded into offices to handle

all aspects of business, including payrolls, supply management, cus-

tomer billing, and everything in between. This transformation, from

a paper-trail business model to a digitally wired one, required enor-

mous investments in successive generations of hardware. Processors

evolved from big, centrally located machines, accessed with “dumb”

terminals, to networked business computers. When low-cost PCs

became available most employees got their own.

As computers proliferated in every aspect of business, enter-

prises faced an urgent need to implement and manage their software

and communications infrastructure. To satisfy this need companies

began hiring IT specialists to configure and operate their systems.

They soon faced a classic supply-and-demand problem. Because of

the rapid growth in demand, skilled IT engineers were suddenly

in short supply. Predictably, a proliferation of enterprising startups

quickly emerged, offering contracted IT services to help companies

meet the needs of their computer users.

Corporate IT infrastructures continued to grow in complexity

as the technology advanced. Companies found they needed special-

ists to write software, install security systems to control access to

data, and install and configure data networks, to name just a few

areas of expertise. The arrival of the Internet in the mid-1990s greatly

increased the demand for highly skilled IT specialists.

IBM was certainly the giant in the IT services industry

throughout this period, but it was not alone. Many other companies,

Implementing IT across the globe174

both large and small, provided expertise to enterprises that lacked

the internal skills to design, build, or maintain their IT infrastruc-

ture. Yet demand for IT specialists kept rising – as did the amount of

concern about their cost.

Companies went looking for other sources of supply. They

came to the realization that it was possible to have enterprise soft-

ware developed and configured at lower cost by skilled engineers in

countries with lower wages, such as India. Thus was born the off-

shore IT service model, with India at its center. Of course, the out-

sourcing of jobs from countries like the US and Britain to what used

to be thought of as “third-world” countries attracted a lot of negative

attention. But India’s ascendancy as a nexus of outsourced IT services

revealed a striking new truth about the developing world: countries

that were once considered economic and technological backwaters

were rapidly catching up to Europe and the US, especially where IT

was concerned. They too had IT infrastructure problems that needed

solutions – and they had skilled engineers who could provide those

solutions. In fact, in every part of the world where demand existed,

an army of startups was emerging to provide IT services. Most of

them were satisfied to remain small regional companies focused on

industry sectors important in their geographies.

Some Indian startups, however, built technical teams in India

and sales organizations in the US and Europe to solicit business. A

few startups there and elsewhere ultimately emerged as large multi-

national companies. Ness Technologies was one of these.

Israel: Technology company incubator

Ness, of course, was different. It was an Israeli company, which

prompts the question, why start such an ambitious venture in Israel?

Israel is a small country with a population to match: only 7.5 million

people in 2011. That is quite a contrast to India, which has a popula-

tion of 1.2 billion. And it is a relatively new player in technology. Not

so long ago oranges and flowers were key Israeli exports, not soft-

ware or medical products. Today the country can boast a remarkable

Dem a nd for IT serv ices r esh apes the wor ld 175

record of technical innovation and entrepreneurship. It was ranked

fourteenth out of 125 countries in the 2011 Global Innovation Index,

published by INSEAD.2 Its economic clout extends far beyond what

its small size would predict. In 2009 Israel exported goods and ser-

vices valued at 35 percent of GDP, ranking it above Germany (34

percent), China (24 percent), and India (13 percent).

Israel developed as a technology powerhouse largely due to the

need to ensure its national survival. It took a sudden French boycott

of defense sales during the 1967 war, after years of close collabor-

ation with French industry, to wake the country up to its vulner-

ability. Because of the boycott, the government decided that it could

no longer rely on the importation of strategic defense products. It

launched a massive program to foster internal industrial develop-

ment and build a technology-based economy.

Trained engineers and scientists are the basis for any tech-

nology sector, and Israel was fortunate in having the resources to

develop engineering talent.

There are several outstanding universities, plus many private colleges.• The country has benefited from the immigration of many engineers and • scientists, particularly from the former Soviet Union.

Young engineers can gain practical experience in technical organizations • run by the Israel Defense Forces, which employ young people during

their mandatory military service.

It is worth expanding on this last point. Israel Defense Forces

draftees take rigorous tests for the opportunity to work on defense-

related product development. When those who are selected leave the

service they are well qualified for an industrial career. Many either

start companies of their own or join existing startups.

Israel’s focus on education and training has produced an

unusually talented and experienced pool of software and hard-

ware engineers. Their presence has attracted many major foreign

2 www.globalinnovationindex.org/gii/main/analysis/rankings.cfm, accessed September 16, 2011.

Implementing IT across the globe176

corporations to open engineering centers and product development

facilities in Israel, among them, Intel, Motorola, and Siemens.

In addition to its support of technical education and training,

the government has taken an active role in encouraging the creation

of innovative new companies. The Office of the Chief Scientist of

Israel provides modest amounts of seed capital to technology start-

ups that are deemed to be promising. Companies that survive the

seed stage then seek funding from venture capital funds or large cor-

porations. There is a healthy venture capital industry in Israel. In

2009 Israel ranked first in venture capital investment as a percentage

of GDP at 0.43 percent. This compares, for example, to 0.08 percent

in China and 0.2 percent in the US.3

Most Israeli startups eventually get acquired, but some remain

independent and become publicly traded companies. Over 100

Israeli-originated firms are listed on US stock exchanges, the largest

number of any foreign country. Many others are listed on the Tel

Aviv exchange.

With a deep pool of engineering talent, an abundance of entre-

preneurial spirit, a solid legal system, and a history of intellectual

property protection, Israel is a good place to build innovative busi-

nesses or develop products for the global marketplace. So when

Warburg Pincus encountered an opportunity to invest in an Israeli

company, we paid attention.

How Ness Technologies began

Our opportunity to invest in Ness Technologies came through

Morris Wolfson, an experienced American investor in Israeli busi-

nesses, who had acquired a small Israeli IT services company in

1997. He realized that he needed an experienced, professional invest-

ing partner to build it into a major company. We were introduced to

Wolfson through a mutual friend, and began to discuss the idea of

3 Data from NVCA and EVCA, quoted in C. Dickson and O. Shenkar, The great deleveraging: Economic growth and investing strategies for the future (Saddle River, NJ: FT Press, 2011), p. 181.

How Ness Technologies bega n 177

acquiring several IT services companies in Israel and merging them

to create the foundation for a global business. We had been investing

extensively in IT businesses in a number of countries. Given what

we had heard of the business climate in Israel, we thought this was

an idea worth exploring. So we went on a fact-finding trip there.

Our first step was to meet Raviv Zoller. A former officer in

the Israeli Navy, Zoller was a certified public accountant and the

founder of an investment bank focused on technology businesses. He

was familiar with the IT industry and was working with Wolfson.

He would be the driving entrepreneur of the new venture, morph-

ing from investment banker to CFO of Ness and finally to its CEO.

Zoller had identified five companies with outstanding technology

and established market positions, one of which had already been

acquired. He believed that these firms, consolidated under a unified

management, would provide the core of a leading IT services com-

pany in Israel. Once a solid local base was established, international

expansion would be a real possibility.

We visited each of the candidate companies, met their man-

agements, and reviewed their projects, capabilities, and finances.

Their combined revenues in 1999 were $94 million with a profit of

$7.5 million. They were selected because, taken together, they cov-

ered many of the most important and valuable IT services, includ-

ing enterprise networks, custom software development for defense

systems, and IT system integration for banks, telecommunications

carriers, hospitals, and utilities. Table 7.1 summarizes their size and

areas of practice.

We then talked to their major customers, who confirmed our

favorable impression of the quality of their work and the productiv-

ity of their engineering staffs. We were sufficiently impressed that

we decided to participate in funding Ness Technologies.

Assembling a senior management team was the first step. Over

a period of six months we recruited three senior-level executives to

launch the company. Aaron Fogel, former Director General of the

Israel Ministry of Finance, became the chairman of the board. Yaron

Implementing IT across the globe178

Polak, a seasoned and highly respected executive who had built a

software company that had gone public on NASDAQ, became CEO.

Raviv Zoller became CFO and Chief Operating Officer.

Putting the pieces together

Merging companies is never easy, but merging five entrepreneurial

companies at one time is best qualified as “Mission: Impossible.”

The fact that it was done successfully is a tribute to the skills of the

management team we had recruited.

We felt it was essential to establish a common culture for the

new company. That would be difficult to do with employees scat-

tered among five facilities. Hence, the initial step in the integration

process was to move most of the 1,690 employees to a single loca-

tion. Fortunately, attractive office space became available in a new

Tel Aviv industrial park, and everybody moved to that facility prac-

tically overnight.

Moving to nice new quarters was the easy part of integration. It

was much harder to decide which managers to retain so we could cre-

ate a coherent business organization to unify the original companies.

As central functions such as finance, personnel, and marketing were

Table 7.1 Israeli acquisitions that started Ness Technologies

Year

acquired Company name Business type

No. of

employees

1999 Gilad Software development and system integration

340

1999 Conthal Information technology services

310

1999 Advanced Technology

Software develop- ment and system integration

650

1999 IPEX System integration 350 1999 IPEX ISI Software development 40

How Ness Technologies bega n 179

staffed and business units were defined, some managers lost their

jobs, while others were promoted to greater levels of responsibility.

Making such wrenching personnel decisions is always difficult and

disheartening. Israeli culture made it more stressful than usual.

Israel is a close-knit society. As people’s jobs were either threat-

ened or eliminated, their friends and relatives anxiously sought to

talk to me about the situation. They waited for me in the hotel lobby

during my frequent visits to Israel. They told me that the people los-

ing their jobs were actually the best people there, and that Ness was

starting down a ruinous path. Would I not reverse management’s

decision and keep those talented folks in the company?

Of course I could do no such thing. The process of integra-

tion would work only if the company’s investors backed its manage-

ment’s decisions. The subsequent progress of the company suggests

that they picked the right people. It took just over a year to complete

the major consolidation process, after which Yaron Polak left Ness

to become a venture capitalist.

Raviv Zoller became CEO in mid-2001, just in time to tackle

the next phase of the project: leveraging the assembled resources to

grow the company’s market share in Israel, in preparation for inter-

national expansion. Zoller put new service initiatives in place, built

relationships with the biggest potential customers in Israel, and built

the Ness brand – all while making the company profitable.

Ness had a roster of established customers, but it needed to

acquire new ones. It faced fierce competition not just from small

companies, but from big multinationals such as IBM and Accenture.

It won business on the basis of both quality and price against these

formidable opponents, rapidly earning a reputation as a quality

vendor. Soon it had emerged as the leader in the domestic market.

Zoller also demonstrated considerable promotional talent. He

picked former US president Bill Clinton to be the featured speaker

at the Ness annual customer meeting, which he had instituted as a

brand-building opportunity. Clinton was very popular in Israel, and

this event won Ness a great deal of national press coverage.

Implementing IT across the globe180

By 2002 Ness could count many leading Israeli banking,

industrial, and defense firms among its customers for IT software

and solutions. It had annual revenues of $167 million and a 13 per-

cent market share in Israel, slightly ahead of IBM. It was time to look

overseas for growth opportunities.

International expansion

Ness Technologies was conceived from the start as a global company.

Now it had to execute on that vision. Its strategy was to develop an

innovative business model for international expansion, particularly

into India, that maintained the integrity of regional operations, yet

integrated them into a worldwide resource for IT services.

There were several ways to penetrate foreign markets. One

approach was to establish sales offices in various countries, have

them solicit projects locally, and execute the work in Israel. This

strategy was rejected. It would take too long for an unknown new-

comer like Ness to gain credibility in a new country. Instead, we

decided that Ness’s expansion strategy had to be based on the acqui-

sition of well-established IT service companies in our geographies of

interest. As known quantities, these companies would make initial

market entry easier. We would then enhance their competitive pos-

ition with technology transferred from Israel.

All business is local

Given this approach, it was clear that retaining senior management

in each of these companies was the key to successful mergers. We

knew that acquisition by Ness could hurt a company’s relationships

with local industry, utilities, and government agencies. These cus-

tomers would be concerned about contracting mission-critical IT

services to a foreign provider.

Therefore, the operating paradigm for the acquired companies

was to continue to “look local” while offering, wherever appropri-

ate, Israeli technology as a competitive edge. Each company would

continue to have local management, and we would keep the folks

Inter nationa l expa nsion 181

who had relationships with customers in place on sales and service

teams. Since these local companies would be Ness Technologies

business units, however, we would standardize operating practices

across all of them as much as possible. This included, among other

things, training and technology implementation. In addition, each

local Ness unit would be able to access resources at other locations

to meet customer needs.

In short, the success of Ness Technologies was to be built on a

network of companies that offered the consistent business practices

and technical resources of a multinational, yet maintained a local

presence with local management in the countries where they oper-

ated. These basic principles drove the company’s later spectacular

growth. Its biggest innovations, however, came about when putting

its principles into practice.

Ness goes global

When the word got out through investment bankers that Ness was

looking to expand beyond Israel, a large number of companies in

various countries around the world quickly identified themselves

as candidates for acquisition. The entrepreneurs who had started

these small companies realized that they were too small to com-

pete against larger rivals over the long term. At this point the only

issue was selecting appropriate acquisitions. Ness narrowed the field

by looking at GDP growth in the countries under consideration to

assess the economic opportunities there.

One of the regions that appeared attractive was Eastern Europe.

This region had developed a number of rapidly growing economies

after the fall of the Iron Curtain. Having analyzed local competition,

the nature of the potential customer base, and the availability of

native talent, Ness focused on APP Group, a company in the Czech

Republic. A startup with 180 employees, APP had received Warburg

Pincus funding when it started in 1990. In the interim it had estab-

lished itself as a quality provider of IT services to the local util-

ities, government agencies, and manufacturing enterprises. It was

Implementing IT across the globe182

a perfect fit. Through its relationship with Warburg Pincus, Ness

kicked off its expansion program by acquiring the APP Group in

September 2002.

In line with the overall Ness strategy, APP’s senior man-

agement continued to run the business after the acquisition. APP

provided Ness an entry into the whole East European region. It

eventually grew to nearly 1,000 engineers providing IT services in

Slovakia and Romania as well as the Czech Republic.

Off-shore challenges

By 2003 the IT services industry was facing the acceleration of the

trend noted above: using engineers from countries with lower wages,

such as India, to reduce IT support costs. With the cost of local

engineers on the rise, thanks to a growing demand for IT talent in

the developed economies, this had obvious appeal.

At Ness Technologies, responding to increasing customer

demand for cost control became a subject of strategic discussion. Its

opportunity to develop an innovative solution to the problem came

about through another major acquisition, this time of Apar Holdings in

India, another Warburg Pincus investment. Apar was started by Indian

entrepreneurs in 1998. Its business model was quite different from that

of Ness. Instead of having intellectual property of its own, Apar sold IT

engineering services to enterprises on a daily or annual contract basis.

Indian engineers worked for its customers either in India or on location

in the US, Singapore, and the UK. The company had 1,200 engineers,

with a core group of 300 located in India. The others were deployed in

other countries and moved to meet customer demand.

A merger with Apar represented a change from the existing

Ness business model, but added management and engineering talent

in India, and promised access to new customers. We decided that

combining the companies was appropriate, and completed the mer-

ger of Ness and Apar in 2003.

At the time of the merger we recognized that Apar’s business

model had to change. It suffered from a basic problem: when Apar

Inter nationa l expa nsion 183

engineers were involved in software development, customers had no

assurance of the continuity of staff assigned to their projects. And

since there were a lot of comings and goings of engineers on the

assigned projects, there was little assurance that intellectual prop-

erty would be protected either.

Shashank Samant, a software engineer trained in India but

with extensive international experience, joined Ness as a manager

during the Apar acquisition. He came up with an idea for a totally

different business model: the “managed laboratory.” His idea was to

offer corporate customers their own “managed laboratories” for soft-

ware development, consisting of a team of engineers contracted on a

long-term basis, all located in India. Working together in a dedicated

facility, they would function as part of the customer’s IT organiza-

tion, even though they were actually Ness employees. The customer

would define the software projects, and the head of the managed

lab would report to the customer’s IT department head. Ness was

responsible for training, recruiting, and all employee personal mat-

ters. Customers would get the continuity they needed, and with a

dedicated team reporting directly to the customer’s IT group there

would be more control over IP.

Ness embraced this idea. Samant became head of the managed

lab business, splitting his time among India, the US, and Israel. He

molded the organization and developed the management structure

that made the business successful. The managed lab model proved

attractive to medium-sized software companies in the US and Europe

who wanted the benefit of low-cost software engineering but could

not afford to build their own facilities in India. Ness provided them

with a dedicated staff that operated as part of their organization in

terms of project oversight. To make the service more attractive to

companies who might be interested in eventually operating their

own facilities, Ness also offered an option under which it would

transfer its managed lab staff to the customer.

This model offered clear benefits to Ness, too. First, the cus-

tomer paid staff costs plus a fee for the service, assuring profitability.

Implementing IT across the globe184

Second, the contractual nature of the IT services made the busi-

ness more predictable. Instead of hiring engineers in anticipation of

potential future projects, the company could plan manpower utiliza-

tion consistent with its current billings.

As a clear “win-win” situation for buyer and seller, the man-

aged lab model was quickly embraced by customers across the US

and in Europe. Ness’s first managed lab customer contracted for 200

engineers in 2003. By 2006 Ness was operating fifty such facilities,

employing a total of 3,000 people and generating $120 million of

profitable revenues annually.

Although the first managed lab was in India, the concept

worked wherever wages for engineers were lower than those in the

developed countries. Ness also used engineers in Eastern Europe to

provide this service to clients in Western Europe.

Cultural considerations

Building the India operation was a lesson in cultural adaptation. As

our Israeli management team did not have an easy time managing

the rapidly growing Indian operation; management talent had to be

recruited locally. It became evident that the key to success was hav-

ing Indian senior management with prior experience in the US, an

appreciation of the local culture, and an understanding of modern IT

technology.

Staffing problems posed another serious challenge. Local com-

petition for talent was (and is) intense. At Ness and similar com-

panies, turnover of engineers in Bangalore, the technology capital of

India, was between 20 percent and 30 percent annually, compared

to less than 10 percent in Israel or Eastern Europe. Such turnover

rates put great stress on the efficiency of an engineering organization

and make training an ongoing headache. In fact, recruiting quali-

fied engineers, even in an increasingly competitive Indian market,

was the easy part. It was much harder to retain the talented ones

in a market where wages were rising at a rate of about 10 percent a

year (much faster than elsewhere) and employers were beginning to

Going public a nd a fter 185

compete on the basis of fringe benefits, the offer of exciting projects,

and opportunities for personal development. Once good engineers

were on staff, their enthusiasm had to be kept high to retain them

by offering opportunities for professional growth.

The staff stayed young, and increasingly included women with

young children, so special provisions had to be made for them. Ness

became used to providing benefits such as meals, transportation, and

even visits by doctors to the Ness facilities to discuss family medical

needs and provide access to treatment as needed.

Going public and after

After APP and Apar, Ness made a number of smaller acquisitions

to increase its global footprint. International sales and marketing

for all these units was conducted by a staff of 200 professionals.

The strategy of leveraging technology skills globally was showing

results. For example, Ness developed and delivered a novel IT sys-

tem to a pharmaceutical company in Switzerland using engineering

teams from Europe and Israel. Similarly, a global delivery service for

an international law firm was implemented by teams from Israel,

the UK, and India. The service was made possible by a proprietary

information management system, developed by Ness engineers, that

allowed users around the world to share information and work col-

laboratively on projects.

At the end of 2003, Ness had a total staff of 4,300 employees

serving over 500 customers, including Lockheed Martin, Coca Cola,

Citibank, AT&T, Israel Aircraft Industries, the Israel Defense Forces,

Pfizer, American Express, and Czech Telecom. No single customer

represented more than 5 percent of revenues. There was a high level

of customer satisfaction, indicated by the fact that, at the end of the

year, 80 percent of the following year’s business was with the same

customer base as the prior year. Clearly the company’s management

was doing a lot of things right, and it was on a solid footing to con-

tinue its global success.

Implementing IT across the globe186

By the end of 2003 the company had accomplished a great deal

of what we had hoped to see. Revenues had grown 23 percent annu-

ally since inception, to $226 million. The company was profitable

and doing business in fourteen countries. It was time to consider an

IPO. In September of the following year, the company had its IPO on

NASDAQ, selling $140 million of its shares.

At the end of 2006, Raviv Zoller decided to leave the company

to resume an investment banking career. He was replaced by Sachi

Gerlitz, an executive with extensive international business experi-

ence. By then the company had 8,900 employees and was on a clear

growth path. It was ranked among the top thirty IT service compan-

ies globally by the Brown-Wilson Group, a respected industry con-

sulting firm. Its revenues had increased from $474 million in 2006

to $563 million in 2007. Israeli revenues accounted for 48 percent of

the total.

A business of this type is affected by business cycles. As a

result of the global recession of 2008, revenues declined in 2009,

stabilized in 2010, and resumed growth in 2011 to $620 million. In

2011, the company was taken private by the private equity group of

Citigroup Inc.

Looking back

Building a successful multinational services company is perhaps the

most difficult management task entrepreneurs can face – especially

starting from a small country. Such a business succeeds only if it

learns how to share resources globally while maintaining a common

internal culture and uniform operating principles. It must also adapt

to the cultures of the places it does business without compromis-

ing common corporate goals. Internal regional politics also pose a

threat if management interests are not aligned. Without a common

operating methodology, each region can easily become a fiefdom that

optimizes its business results at the expense of the company as a

whole. An employee reward system must be put in place across the

Look ing back 187

entire organization that encourages collaboration among disciplines

and geographies.

How the management at Ness was able to avoid the pitfalls

and build a successful organization will reward consideration by any

entrepreneur with global ambitions. Their approach can be summed

up as follows.

Careful selection of acquisitions to meet strategic objectives: adding • desired geographical coverage and skills to the company.

Retention of the most talented senior managers in acquired firms to • help build the local business. There was no attempt to import Israeli

management into overseas locations.

Immediate installation of financial management and control systems in • acquired companies, to integrate them into the corporation and allow

timely and accurate reporting of business activity.

Frequent, prolonged visits by senior Ness management in the various • regions to work with the local staff. In a remarkably short time this

interaction developed a common culture in which international

collaboration was accepted as the best means of generating business.

This effort was greatly helped by an annual meeting where the fifty

top company managers met to review the annual plan. The location

changed each year – Bangkok, London, New York, Bangalore, Prague – so

that local employees had the opportunity to meet company managers

from various countries. Such meetings are a valuable venue for building

personal relationships – over twenty nationalities were typically

represented among the managers.

Leveraging the company’s diverse skills to serve the needs of • international customers in different locations. To further this effort

the company developed proprietary information-sharing technology

that allowed resources throughout the company’s operating regions to

address customer needs.

Rigorous enforcement of a code of conduct – a necessity when operating • in some countries where bribery is a common method of acquiring

business.

Ness Technologies blazed a new path from its very beginning

because its founders designed the company from the ground up to be

Implementing IT across the globe188

an international enterprise. They used acquisitions to give it a global

reach, and created an innovative business model to attract custom-

ers. The strategy for leveraging Indian talent is particularly note-

worthy in this regard. They also developed approaches to unifying

the company’s operations, creating a common corporate culture, and

leveraging its worldwide resources to serve major corporations.

In the next chapter we will look at how three Chinese telecom-

munications startups, operating only in China, dealt with entirely

different problems.

189

China’s entrepreneurs provide valuable lessons in managing effectively in an unpredictable context … Besides the usual challenges, Chinese companies face extremely high levels of uncertainty across multiple dimensions … Executives in China must anticipate and react quickly to a constantly changing environment.1

China’s influence on the global economy has been a recurring topic

of discussion in this book – and in the world at large. How could it

be otherwise? It is literally changing the balance of economic and

political power among nations.

Just thirty-five years ago this would have seemed impos-

sible. The country was in social and economic turmoil following

Mao Zedong’s Great Proletariat Cultural Revolution. In a resolution

issued on June 30, 1981 the Chinese Communist Party said that this

initiative, “which lasted from May 1966 to October 1976, was respon-

sible for the most severe setback and heaviest losses suffered by the

party, the state and the people since the founding of the People’s

Republic.”2

Today China has recovered from this low point to become the

world’s second largest economy. Its factories churn out consumer goods

and industrial products for export to every part of the globe. Its balance-

of-trade surplus is the envy and despair of its trading partners. The

Chinese people are increasingly affluent, buying modern conveniences

and luxury goods that many never dared to dream of possessing.

8 Three startups in China: Entrepreneurs in a controlled economy

1 D. N. Sull with Y. Wang, Made in China: What Western managers can learn from trailblazing Chinese entrepreneurs (Boston, MA: Harvard Business School Press, 2005), p. 3.

2 J. P. Sterba, “Peking assessment asserts Mao made errors as leader,” The New York Times, July 1, 1981, pp. A1 and A12.

Thr ee sta rtups in China190

Despite this astonishing progress, the country’s potential for

development remains enormous. In 2010 about half of its 1.3 billion

people were still in the agricultural sector. Millions of them move

to cities every year, and state planners talk of building fifty new cit-

ies to accommodate them. It is hard to think of a product or service

familiar to people in the developed countries that would not find a

growing market in China as it continues to evolve.

It is no wonder that China has been a magnet for foreign cor-

porate investment since the 1980s. Big companies from overseas have

funded local production plants to gain access to local markets and

low-cost labor. In addition to creating local jobs, these transplanted

factories have helped to fuel China’s export boom. According to gov-

ernment figures, $112.5 billion of China’s $170.4 billion trade sur-

plus in the first eleven months of 2010 came from foreign-funded

enterprises.3

Another reason Chinese authorities have encouraged con-

trolled investment by foreign corporations is to attract sources of

leading-edge industrial technology in addition to capital. Attracting

foreign investors is still a priority. Li Keqiang, deputy premier,

“promised to ‘enlarge [the country’s] openness’ to foreign investment

in an attempt to keep Western companies committed to China and

complete its industrialization by 2020.”4 Few doubt that this ambi-

tious goal will be achieved. China really has little choice but to try.

It must greatly expand its industrial base just to satisfy the projected

growth in local demand, to say nothing of increasing its exports.

China is not relying solely on Western money and technology

to build its economy. Several of its state-owned or controlled com-

panies have emerged as fierce challengers to the leadership of estab-

lished multinational corporations, not just in commodity products,

3 “Chinese manufacturers increase trade figures, but multinationals enjoy most margins,” China Daily, updated March 1, 2011, www.chinadaily.com.cn/ bizchina/2011–01/03/content_11787895.htm, accessed July 19, 2011.

4 G. Wiesmann and V. Mallet, “Li vows China will become more open to inves- tors,” Financial Times, January 7, 2011, p. 2.

Opportunit y a nd constr a ints 191

but in such high-technology areas as communications equipment,

mobile phones, and personal computers.

Yet there is more to the Chinese economic miracle than for-

eign corporate investments, mercantilist methods, and state control

of industry. We will look at three entrepreneurial startups, all in

telecommunications – arguably the most competitive technology

industry in the Chinese economy.

Opportunity and constr aints

One would not think that a state-controlled economy like China’s

would have room for classic entrepreneurs funded by private cap-

ital. But it does. While major sectors of the economy are controlled

by big state-owned or state-controlled corporations, in certain

areas an increasing number of privately funded businesses manage

to thrive.5 Recently the scale of foreign private equity investments

has been growing – about $50 billion was invested between 2007

and 2010.

Common magnets for private investment are companies pro-

viding consumer products or services over the Internet, such as

retail stores, housing, and information services. Private equity has

also gone into minority investments in companies controlled by

the state, which also controls their senior management appoint-

ments. Here the private investor expects to realize his profit by

either the ultimate sale of the business with state blessing, or by

an initial public offering, in which the state sells all or part of its

holdings.

Remarkably, more companies originating in China had public

offerings in 2010 than those of any other country, including the US.6

In 2010, forty-three Chinese companies have had IPOs in mainland

5 Lenovo is one of the successful private companies worth noting. It acquired IBM’s personal computer business. See Sull with Wang, Made in China, pp. 75–83.

6 Source: Dialogic as quoted in L. Cowan, “IPOs, the recovery: Starring China,” The Wall Street Journal, January 3, 2011, p. R6.

Thr ee sta rtups in China192

China (Shenzhen and Shanghai) and Hong Kong. Another nineteen

were listed in the US.7

Concerns for private equity

Private equity investors from the West, realizing they cannot ignore

what is now the second largest economy in the world, have joined

the wave of China investment. This can be a challenging environ-

ment for investors used to US or Western business practices. The

questions asked by private equity investors looking to put money to

work in China can be summarized as follows.

How does state control affect independent entrepreneurial companies?• How difficult is it to recruit experienced management people?• Are Chinese technology companies that are not state-controlled and • are focused on the local market somehow protected from foreign

competition?

How important are state-provided financial incentives such as loans and • tax reductions?

Western companies rely on patents for protecting intellectual property. • How relevant is that situation for companies operating in China?

How do investors and entrepreneurs realize a return from their • investment?

Directly or indirectly, state authorities and their regulations

are everywhere in China, so knowing the rules (which can change

in unpredictable ways) matters a great deal. At the end of the day,

what investors really want to know is whether the risk of funding

companies will be rewarded in a manner comparable to that in the

US and other developed countries.

Three companies, different approaches

To help the reader gain a broader appreciation of what invest-

ing in high-technology Chinese startups is like, we have chosen

examples that illustrate the impact of local conditions across three

7 H. Sender, “US private equity favors China,” Financial Times, December 17, 2010, p. 16.

Opportunit y a nd constr a ints 193

very different business contexts. The first company, AsiaInfo, was

launched in close collaboration with a government ministry. The

second, Harbour Networks, entered a market where it ended up in

direct competition with big local and foreign companies. The third,

RDA Microelectronics, was a neutral player that benefited from the

proliferation of new wireless handset manufacturing companies

interested in buying from a local company instead of dealing with

imported products.

Although they targeted different sectors of the telecommuni-

cations industry, all three primarily addressed the Chinese market.

That did not make matters easy for them. China is far from being a

backwater – if a local company’s technology lags behind world stand-

ards, even state-controlled companies have no compunction about

buying foreign.

The companies were all funded between 1996 and 2004

with the participation of Warburg Pincus. These investments were

arranged by Warburg Pincus partners responsible for Asian invest-

ments, headed by Sun Q. Chang. Julian Cheng led the investment in

RDA Microelectronics. Other Warburg Pincus partners participated

in assisting these investments at appropriate times.

Telecommunications in China

Our three entrepreneurial companies found their business oppor-

tunities in the fastest-growing communications market in the

world. State investment in telecommunications services dramatic-

ally increased from the 1980s, and continues to this day. Fiber optic

network construction, begun in the late 1990s, enabled high data

rate services on a national basis. The market for equipment and asso-

ciated software and services grew 30 percent a year, making China a

desirable destination for equipment vendors from all over the world.

When Warburg Pincus started to invest in this sector in China

in 2000, there were seven nationwide licensed carriers serving 160

million telephone subscribers. State authorities later decided to

consolidate these entities into three giant state-controlled carriers

Thr ee sta rtups in China194

covering the whole country: China Telecom, China Mobile, and

China Unicom. China Mobile and China Unicom are wireless ser-

vice providers, while China Telecom provides wireline service.

Adding national cellular wireless service became a high priority and

spectacular growth in wireless later proved the wisdom of this ini-

tiative. The number of wireless subscribers grew from 180,000 in

1992 to 7 million in 1996 and 950 million in 2011, giving China the

world’s largest population of wireless users.

Many local manufacturers emerged to supply handsets to the

ballooning numbers of subscribers, offering lower-cost products to

compete with phones from the likes of Motorola and Nokia. In 2010,

551 million handsets were produced in China, of which 421 mil-

lion were exported. One of the startups that we will discuss, RDA

Microelectronics, provides key semiconductor chips for wireless

handsets.

Equipment for the country’s telecommunications infrastruc-

ture was initially provided by foreign companies, but state planners

had a strategy to develop a domestic state-owned industry capable of

building world-class equipment. Huawei Technologies emerged as

the national champion, along with a smaller company, ZTE. A num-

ber of privately funded companies also entered the market, including

Harbour Networks.

In addition to equipment, telecommunications systems

require operation support services, billing software, and experts to

manage system integration. AsiaInfo provided such software and

services.

AsiaInfo: Enabling China’s Internet

AsiaInfo was founded in 1993 in Dallas, Texas, by Edward Tian

and James Ding, two entrepreneurs in their thirties. Tian was born

in China, and earned a master’s degree from the graduate school

of the Chinese Academy of Sciences and a Ph.D. from Texas Tech

University. Ding, also born in China, earned a bachelor’s degree from

Beijing University and a master’s degree from UCLA. Their business

Asia Info: Ena bling China’s Inter net 195

provided online information about China to Western news agencies.

It was not a very exciting niche, so the founders looked for other

opportunities. They found them across the Pacific.

New location, new model

Having tracked developments in their birthplace, Tian and Ding

saw the growing telecommunications industry and the rise of the

Internet as opportunities to be exploited.

So in 1995 the founders, exemplifying the flexibility of true

entrepreneurs, decided to move their business to Beijing and totally

change their business model. It was at that point that they were

introduced to the Warburg Pincus investing team and we provided

some of the funding to launch their Chinese venture.

Thanks to their familiarity with local business customs and

conditions, they knew that a newcomer trying to serve a growing

industry owned or controlled by the government would need the

right local relationships. At that time the key governmental agency

was the Ministry of Post and Telecommunications (MPT), which

regulated the telecommunications industry and was also a near-

monopoly wireline service operator. (The MPT was a predecessor

to the Ministry of Information Industries, which now oversees tele-

communications services.) AsiaInfo’s founders were able to estab-

lish two joint ventures with a subsidiary of the MPT. One focused

on selling telecommunications and Internet infrastructure software;

the other sold system integration services. AsiaInfo came on the

scene just as the Internet emerged as a serious service in China. Its

timing was perfect.

The numbers tell the story. In 1993 China had only 2,000

Internet subscribers. There were 330,000 in 1996 when the com-

pany started doing business. Just five years later, in 2011, the num-

ber of Internet subscribers in China exceeded 500 million. AsiaInfo

became the first and largest Chinese information technology com-

pany to provide infrastructure software and services for the Internet

and related fields.

Thr ee sta rtups in China196

It established de facto standards for Internet infrastructure in China in • collaboration with the MPT.

In its first year of operation, the company gained a 70 percent market • share of Internet integration services.

AsiaInfo built the infrastructure for ChinaNet, the first national • commercial Internet backbone company, covering the 31 capital cities of

all the provinces of mainland China.

The company became profitable in 1997, one year after full

operations began, generating $19 million in revenues and a profit of

$6 million.

As Internet technology evolved, the requirements of the Chinese

telecommunications infrastructure grew more sophisticated. To meet

this need and maintain its market position, the company licensed

foreign products for sale in China and developed its own proprietary

products. It also turned to acquisition activities. By that time small

software companies had begun to emerge – some started by Chinese

technologists returning from the US. Following a pattern familiar

from Silicon Valley, AsiaInfo acquired some of these startups for their

advanced technology. Between 1998 and 2002, AsiaInfo absorbed

three local companies to bolster its portfolio of software products for

the wireless industry, which had emerged as the fastest-growing sec-

tor of telecommunications. It acquired other companies later.

AsiaInfo’s growth was impressive. Revenues grew from $60

million in 1999 to $176 million in 2000. It was time to consider an

IPO in the US – something very new at the time for a China-based

company.

Going public across the Pacific

Internet companies were the darlings of the public markets in 2000,

and China was seen as a great growth market. AsiaInfo’s NASDAQ

offering was very successful, selling shares that valued the company

at a very rich $800 million.

The company’s stock price has fluctuated in the years since, along

with its growth rate and profitability. To this day, all of the customers

H a r bour Networ ks: Aga inst the tide 197

of the company are either state owned or directly or indirectly state

controlled. When a company is dependent on a small customer base

its revenues will be tied to the ups and downs of capital investment

cycles. Yet throughout these vagaries AsiaInfo has remained a domin-

ant vendor of software products to the three telecommunications car-

riers in China. This complex software, which now enables service to

hundreds of millions of subscribers, was developed in China. Experts

consider these products to be of outstanding quality.

The company merged with Linkage, another telecommunica-

tions software company, in 2010. The combined company is called

AsiaInfo-Linkage. The merger consolidated the company as the

leader in its field in China. In 2010, its revenues were $350 million

and its market value on NASDAQ reached $1.3 billion.

H arbour Networks: Against the tide

“Harbour Networks is quite capable of designing and developing

switch-routers to compete with the same level of products offered by

US vendors today … at a much lower cost.” So wrote a well-known

consultant after visiting the new company in Beijing in 2001, shortly

after Yinan Li founded it with $4 million of seed capital from local

investors.

Yinan Li combines a strong technology background with

industry knowledge and senior management experience – just the

sort of résumé that one values in entrepreneurs in a dynamic indus-

try. He had been vice-chairman of Huawei Technologies, where he

ranked among the three top leaders of the largest telecommunica-

tions equipment company in China. Huawei was very successful.

Starting from scratch, it developed a growing portfolio of products to

compete with various imported equipment. Huawei’s revenues grew

to reach $2 billion in 2000, only seven years after it was founded. Of

course, Huawei also enjoyed advantages over the foreign firms. It had

access to state-targeted bank funding, plus a strong vendor position

when selling to the big carriers that came to dominate the Chinese

service market.

Thr ee sta rtups in China198

Leaving a major company to found a competing firm is a dar-

ing move for a senior executive, regardless of country. Departing

from a national champion like Huawei carries an even higher level

of risk. It does not compare with leaving Intel or HP in California,

where Yinan Li would have been viewed as a bold entrepreneur. In

China’s business culture he might have been regarded as disloyal, to

both the organization and his mentors. Yinan Li was well aware of

the other risks a new company such as Harbour Networks faced. It

was entering a highly competitive international business where big

buyers, which dominate the service industry, liked the safety of the

big, established vendors. It faced formidable, well-managed foreign

competitors such as Cisco Systems, Alcatel, Lucent, and Ericsson.

And Huawei was a growing force in the market.

Yet he believed Harbour Networks could build a competitive

edge with early offerings of leading-edge products. Switches and

routers derive a great deal of their performance capabilities from

proprietary chips, and he intended to build a very strong chip design

team. Once he had a competitive product, his status as a domestic

vendor would enable him to win sales by adapting his offerings to

local needs, including time-to-market, price, and service. This was

clearly an ambitious program, but investors familiar with similar

startups in the US knew that highly successful equipment compan-

ies were often launched by outstanding managers even in very com-

petitive markets. Yinan Li certainly qualified on that score.

In 2001, on the strength of his vision and reputation and the

quality of his team, Harbour Networks was funded by three sources:

Warburg Pincus; a venture capital group sponsored by the Shanghai

city government; and another Chinese private venture capital group.

To gain marketing experience while developing its own products,

the company started by reselling Huawei equipment. But this was

only a temporary effort because it was developing its own competi-

tive products.

Harbour Networks made remarkable progress in complet-

ing its own products. The company’s pool of skilled chip designers

H a r bour Networ ks: Aga inst the tide 199

completed custom chip designs in about two-thirds of the time I

would estimate to be needed by US-based companies. But just as the

company began to offer its own products, it came face-to-face with

the twin realities of today’s telecommunications equipment mar-

ket: the rapid pace of innovation required, and its crushing capital

requirements. Designing a clever chip was no longer enough to vault

a company over the competition. To continue to grow and compete

with the big vendors, Harbour had to offer ever more complex state-

of-the art equipment to the major carriers. This required growth

capital – lots of it. The company was innovative. Its engineers filed

over 100 patents to protect the intellectual property they were devel-

oping. But Harbour’s profit margins were too thin to support the

expanded product development needed to become a major provider of

equipment in a league with the big established companies.

One way to raise equity capital was to do what similar US

equipment companies had done in the past – sell shares through a

public offering in the US. But the public market for telecommuni-

cations equipment companies in the US was still suffering with a

hangover from the bursting of the “dot-com and telecom” bubble in

2000–2001.

Then, in 2005, Huawei, impressed with the quality of the

company’s technology, offered to buy Harbour Networks. Its bid was

accepted. As it turned out, this was a timely move. The telecommu-

nications equipment market continued to consolidate, and resources

required to compete soon grew even more enormous. Huawei cer-

tainly has those resources. In 2010 it employed over 50,000 engin-

eers and had more than 49,000 patents filed or issued around the

world. It also has the capital to match its global ambitions. Its $30

billion in revenues was second only to Ericsson in the industry, and

it had access to $30 billion in funding from the China Development

Bank.8

8 M. Dalton, “EU finds China banks aid Huawei and ZTE,” The Wall Street Journal, February 3, 2011, p. B3.

Thr ee sta rtups in China200

Yinan Li went on to become the chief technology officer of one

of the largest Internet companies in China.

R DA Microelectronics: Local alliances

By 2003 over 40 percent of the chips produced in the world were

being shipped to Asia-Pacific countries, and China had become a

global hub of electronics assembly. But very few of the chips used

in China’s factories were produced there. Seven years later China’s

supremacy in assembly had not changed the situation. In 2010, 96

percent of the chips used there came from non-Chinese companies.9

The Warburg Pincus team viewed this as an opportunity to

build one or more valuable chip businesses in China to serve the

local market. Given the growth of China’s wireless industry, the

team believed that devices that enabled wireless functionality were

interesting products for a startup.

In 2003 the team was introduced by mutual friends to two

entrepreneurs who were ideally suited to start such a company.

Vincent Tai had been the founder of a company making wireless

application chips in Silicon Valley. He then went on to found an elec-

tronics distribution company in Hong Kong. Born in China, he had

earned a bachelor’s degree in electrical engineering at the Georgia

Institute of Technology in Atlanta and an MBA from the University

of Chicago. His co-founder, Shuran Wei, had earlier co-founded a chip

company in Silicon Valley. He had extensive wireless chip experi-

ence at other companies in the US. He had a bachelor’s degree in

electrical engineering from Beijing University and a master’s degree

from the University of Minnesota.

In 2004, Warburg Pincus funded RDA Microelectronics with

Vincent Tai as CEO and Shuran Wei as chief technology officer.

Company headquarters were in Shanghai, with satellite facilities in

Beijing. The two founders had complementary technical, marketing,

and managerial skills and experience. Since the government wanted

9 IBS Report, private communication, March 2011.

R DA Microelectronics: Loca l a llia nces 201

to encourage the development of a domestic chip industry, RDA

was promised (and received) preferential tax treatment from local

authorities.

Tai and Wei selected products whose technology they were

familiar with for their market entry, in categories where competi-

tion was manageable. RDA’s chips convert real-world analog signals

such as sound and radio waves into digital form. Their chips fall

under the categories of RF (radio frequency) and mixed signal (i.e.

analog and digital) processing devices and are used in all wireless

equipment. Designing them requires highly specialized and rela-

tively rare engineering talent. RDA would be competing largely with

mid-sized US companies, not industry giants like Texas Instruments

or Intel. They were also avoiding competition with favored Chinese

firms: there was no domestic competition.

The two founders believed that a local company would have

a major advantage in selling to the rapidly proliferating number of

Chinese wireless handset manufacturers. These manufacturers all

shared two common traits – limited engineering resources and a

tight focus on low-cost manufacturing. Chips were crucial to their

success, and they counted on the expertise of the chip vendors’ appli-

cation engineers to help design their products. Given the short prod-

uct cycles in the wireless industry (as little as six months in the case

of handsets), such support presupposes a very close working relation-

ship with chip vendors to make sure that the products meet indus-

try standards. If the supplier is local, collaboration becomes much

easier.

RDA was able to hit the ground running because of its business

model, which is that of a fabrication-less chip vendor, focused exclu-

sively on product design and marketing. It did not have to build its

own chip manufacturing facility. Production of the actual chips is

outsourced to factories in Taiwan and the US. As chip factories with

the right technology were built in China, RDA used them as well.

Tai and Wei’s major challenge was to build an engineering team

that could execute their product strategy. Their personal reputations

Thr ee sta rtups in China202

were a great help in attracting talent. So was RDA’s focus on leading-

edge technology. This attribute drew top engineering graduates from

the best Chinese schools, many of them with advanced degrees. With

a team of innovative engineers in place, product development went

forward at a remarkable pace. Although RDA has licensed foreign

technology as needed and available, it also quickly developed pro-

prietary technology for its own use. Throughout this process it has

been scrupulous in managing its intellectual property. It had over

100 Chinese patents either issued or filed in 2010.

As a result of its leading-edge products and a marketing strat-

egy concentrated on Chinese handset manufacturers, RDA has expe-

rienced very fast growth. Its revenues have increased at a compound

annual rate of 197 percent, from $4.5 million in 2006 to $191 million

in 2010.

Its customers mirrored its success, quickly making their mark

in the world’s handset industry. There were 1.2 billion handsets pro-

duced worldwide in 2009. Of these, 31.1 percent came from Chinese

vendors, most of whom bought chips from RDA. The company has

over 500 customers, almost all in China, including all of that coun-

try’s top manufacturers of handsets. It offers dozens of products. By

2009 it was the second largest producer of RF and mixed-signal semi-

conductor devices in the Asia-Pacific region in terms of revenues.

The fact that such a world-class organization was put together in just

five years is testimony not only to the talent of its founders but to the

fact that world-class engineering talent is now available in China.

The company has used its expertise in mixed-signal tech-

nology products and its rapid development capabilities to diversify

into areas outside of wireless applications, such as cable television

equipment. In 2010, RDA was the third largest independent Chinese

chip company.10 RDA began generating profits after 2007. In 2010 the

company executed an IPO on NASDAQ. Of the various reasons for

RDA’s success, four deserve special mention:

10 The largest is part of the Huawei group of companies. IBS Report, March 2011.

Look ing back 203

its ability to develop and deliver products faster than its competitors;• its outstanding customer service to meet the continuing needs of its • customers;

an aggressive product pricing strategy; and• the ability to lower prices while maintaining profitability.•

RDA is not the only company that can boast of these achieve-

ments. In fact, they are basic requirements for all vendors in this

industry no matter where they are located. But RDA has the extra-

ordinary discipline and engineering skills to be better at them than

its competition.

Looking back

AsiaInfo, Harbour Networks, and RDA were created with the express

intent of focusing on China’s telecommunications market. Their

stories underscore how important it is for entrepreneurs to combine

knowledge of international industry with a familiarity with local

business practices in order to to succeed in the global economy. It

is instructive to review how each of these companies addressed the

circumstances that influenced their success.

The human factor

Foreign credentials. RDA and AsiaInfo were started by Chinese

entrepreneurs who combined local savvy and education with add-

itional education and startup experience in the US. For both com-

panies their founders’ US education and management experience

proved to be an important asset. Their public reports made a point of

these attributes. For example, the 2000 IPO offering memorandum

of AsiaInfo stated: “Our senior management team, the majority of

whom have been educated in the United States or have worked with

leading multinational companies in or outside China, have an in-

depth understanding of the China market combined with knowledge

of best management practices gained from some of the world’s lead-

ing information technology companies.”

Thr ee sta rtups in China204

Similarly, the 2010 IPO offering memorandum of RDA stated:

“We recruit engineers from China’s top educational institutions,

which graduate a large number of engineers with advanced degrees

each year, creating a pool of motivated and qualified candidates for

the semiconductor design industry. Our engineering team is led by

[four executives] who together have over 60 years of experience in

the high-tech industry in Silicon Valley and China.”

Cultural adaptability. Fluent in Mandarin and English, and

comfortable in the cultures of China and the US, the entrepreneurs

who founded RDA and AsiaInfo were able to build business relation-

ships on both sides of the Pacific. Their multicultural backgrounds

proved valuable in dealing with foreign competition, negotiating

licensing deals, and recruiting engineers who were returning to

China from the US. It also proved useful in dealing with investors at

the time when an IPO was planned.

Technical talent. When asked what his biggest challenge

was in building RDA, Vincent Tai responded, “finding experienced

engineers with the level of skill needed to compete with the glo-

bal players.” This is why his company treats training as such an

important element of its success. However, this task is eased by

the outstanding quality of the graduates from the best engineering

schools. The educational system in China continues to improve,

with a number of world-class universities turning out well-trained

people in all disciplines, including science and engineering. As we

noted in the case of RDA, there is an abundant pool of talented

graduates available who quickly become very productive under the

right management. That is another reason why foreign training and

experience in managing new companies is so important in building

successful businesses.

State issues

Businesses everywhere are hostage to state regulations. But in a

state-controlled economy, regulatory changes come more frequently,

particularly in industries like telecommunications. Nimbleness and

Look ing back 205

flexibility in managing such uncertainties is a prerequisite for doing

business in China.

For example, regulators influence the pace of deployment of

new telecommunications infrastructure, essentially dictating the

timing of product availability. Government-mandated changes in

timing or technology can be unpredictable. This affects the profit-

ability of vendors to the industry, who can be stuck with an inven-

tory of products that have uncertain market prospects.

As a vendor to the handset industry, then, RDA has to adapt

quickly to changing standards so its customers can meet highly

fluid handset availability requirements. For example, major hand-

set vendors may begin with fifteen to twenty handset designs. Over

the next six to eight quarters they may winnow this number down

to perhaps five or six that they will actually produce. But if a small

company picks a design that does not make it to market, it has noth-

ing to sell.

Then there are the non-technological quirks. In 2010, for

example, RDA’s sales took a temporary hit when state authorities

cracked down on Chinese handset manufacturers who were not

installing the correct software in their handsets or who dodged pay-

ing the appropriate taxes.

We should note that situations like these are hardly unique to

China. The reality is that selling products to the telecommunica-

tions industry has its challenges everywhere. In each country a few

dominant service providers establish the rules of the business and

the pace at which technology is introduced. In the US, for example,

Verizon and AT&T are the dominant service companies, and their

rules affect their vendors’ ability to sell their products. That is the

nature of this market.

No place to hide with inferior products

There are no protected markets for inferior technology in China or

any other important developing country, including India. All three

of the companies we have covered in this chapter were competing

Thr ee sta rtups in China206

directly or indirectly with global suppliers selling world-class prod-

ucts. Low product quality at a low price is not a winning combin-

ation and never formed a part of their strategy. Of course, anyone

doing business in China is acutely aware of the intense price com-

petition there. Price is a competitive advantage – if you can deliver

competitive products and services at lower prices than others, you

have a good chance of success. But industrial customers and con-

sumers alike don’t have to settle for inferior products just because

they are cheaper. They know that sooner rather than later they will

have access to the same high-quality items being sold in the devel-

oped countries.

Harbour Networks’ telecommunications equipment was in the same • league as what such world-class companies as Juniper Networks or Cisco

Systems produced.

AsiaInfo competition came from multinationals such as IBM and • smaller local companies. While it benefited from its partnership with the

MPT in the early days, its success over the following years came from

delivering high-quality, profitable software and services at a lower price

than its competitors.

RDA’s success was due to its ability to serve the local wireless industry • better, and at lower cost, than its foreign competitors. Its continued

success will require a similar performance not only in its current sector

of the market, but in new markets that emerge and can be served by its

evolving technology skills.

Pick your competitors carefully

Harbour’s original strategy was to serve a highly diverse customer

base of enterprises and regional telecommunications carriers. But

when, as a result of state policy, its carrier customer base was con-

solidated into three big companies, it found itself in direct compe-

tition not only with Huawei but with the big international vendors

selling in China. Lots of capital was needed. This was not a winning

situation for a young company with limited resources.

When AsiaInfo entered the market, on the other hand, it was

bolstered by joint ventures with the Ministry that regulated the

Look ing back 207

industry. It wasn’t fighting the establishment; it was partnering with

the establishment. As long as its level of technology, service, and

price matched or bettered what others were offering, AsiaInfo was

able to compete against all comers.

Finally, RDA entered a market where it competed only with

foreign companies. As hundreds of handset manufacturers emerged,

a local company with highly competitive products – and better

prices – had an opportunity to establish itself as a major vendor.

State subsidies and tax preferences

As mentioned above, China is actively seeking to build innovative

industries. National and regional authorities alike offer various

financial incentives for companies to locate facilities within the

country. Available incentives run the gamut from low-cost loans for

the construction and equipping of factories to reduced taxes on prof-

its. These financial inducements are most significant in financing

plant construction. They are of much less importance in businesses

such as the three companies discussed here, where intellectual

property is the key value creator. Of course, lower taxes help com-

panies to retain cash for expansion – but only once a business is

profitable.

Patent filing in China and the legal system

Protection of IP is a constant concern anywhere. Chinese authorities

are quite sensitive about foreign criticism of their perceived deficien-

cies in IP protection. The China Patent Office and related organi-

zations have proven very effective in working with participants in

such disputes to resolve them.

However, software patents are difficult to obtain, although

one can copyright software. Foreign companies doing business in

China need to take into account the difficulty of protecting soft-

ware through the patent system. Disputes over IP where the patents

involved are not filed in China are much more difficult to resolve

because of the country’s complex court system. However, the local

Thr ee sta rtups in China208

courts are very much aware of the need to protect the intellectual

property of important companies in their regions. As a result, cases

of intellectual theft, such as copying products by competitors, are

likely to be vigorously prosecuted in regional courts, with severe

penalties imposed on infringing parties.

Exits

In developed countries the most common investment exits are

through a company sale or a public offering of securities. The buy-

ing and selling of companies within China is common (AsiaInfo

acquired a number of companies), but selling a Chinese company

to a foreign entity is not easy. Such a transaction is covered by

regulations from no fewer than six government agencies. The sale

requires the permission of the Ministry of Commerce, and the pro-

cedure can be long and complex. This means that selling compan-

ies created in China to foreigners may prove to be a problematic

exit path.

IPOs, however, are an increasingly attractive exit strategy for

Chinese businesses that have reached a significant level of matur-

ity. Of course there are rules you must follow. If the company is

majority-owned and controlled by Chinese investors, it can be

listed locally. Foreign-owned companies cannot be listed in either

Shanghai or Shenzhen, but may be listed in Hong Kong and the US.

Both AsiaInfo and RDA are listed on NASDAQ. Both companies

have excellent financial systems, enabling them to meet the stiff

accounting requirements for US-listed companies with minimal

investment.

In summary

One overriding conclusion can be drawn from the history of these

three Chinese startups: it is possible for entrepreneurs to build suc-

cessful high technology companies in China using private equity,

even when much of the funding is foreign. Major sectors that state

Look ing back 209

authorities consider strategic are off limits to startups. But the

20 percent to 30 percent of the economy that remains still provides

huge market opportunities.11

All three of our companies developed world-class products with

local engineering talent and with the additional help of licensed for-

eign technology in some cases. In spite of some key differentiators

unique to China, such as the shifting regulatory environment, the

ingredients for success there are not all that different from those

in the US or other Western countries. Companies that are mindful

of the local competitive and regulatory climate can succeed on the

basis of competitive products, services, and cost structures.

In the next chapter we will examine an entrepreneurial startup

that took a very different approach to doing business in China.

11 Because of the mixed ownership in many enterprises, it is difficult to define the private sector with precision. See R. McGregor, The Party: The secret world of China’s Communist rulers (New York: HarperCollins, 2010), pp. 194–228.

210

The money from hauling data, things like video and texts instead of calls, is now 35.9 percent of total service revenue [in the US] … The phone networks carried 341.2 billion megabits of traffic in the first half of 2011, according to the survey, up 111 percent from a year earlier … Talk, meantime, may be falling slightly out of fashion … The average length of a call was 1.83 minutes … As recently as 2007, the average call was near or above three minutes. Who’s got time to talk, when there’s all that video to watch?1

Mobile data service is more than a booming business; it is a global

phenomenon. Teenagers text each other on their Droids as obses-

sively as business people check email and corporate data on their

iPhone® or BlackBerry® smartphones. TV stations show video

clips of everything from cute babies to the rebellion in Libya, cap-

tured and sent by people on cell phones. We take it all for granted.

Yet none of these capabilities was available as little as a dozen years

ago.

Just as remarkably, Aicent, a Silicon Valley startup founded in

2000 by an entrepreneur born in Taiwan, is a world leader in provid-

ing the data interconnections among the international wireless car-

riers that enable these functions across their networks. For example,

if you are visiting China or Indonesia and access your emails on your

BlackBerry, the chances are that you are using a network connection

managed by Aicent.

Aicent holds interest for reasons beyond its growth and suc-

cess. It provides an interesting case study of a new model for a

startup business: a company that was constructed from the start to

meet the challenges of operating globally even as a small enterprise.

9 Connecting the wireless networks of the world

1 Q. Hardy, “More wireless devices than people,” http://bits.blogs.nytimes. com/2011/10/12/the-u-s-has-more-wireless-devices-than-people/?scp=16&sq=wir eless+networks&st=nyt, October 12, 2011.

The evolution of w ir eless data serv ices 211

Unlike Ness Technologies, the company did not address its domes-

tic market first. Aicent was founded to provide a mission-critical

service to the global wireless telecommunications industry. This

placed it squarely in the largest and fastest-growing segment of the

world economy: in 2010 service businesses accounted for 63.2 per-

cent of global GDP.2

Aicent’s business depends on the wide global implementation

of new wireless technologies, and the rapid growth of mobile com-

puting and messaging. But its success was based on the vision of its

founder and the company’s execution of its business plan. Having

entered the market early, Aicent was in a good position to ride the

rising tide of international data traffic. To fully appreciate its story,

we need to understand how wireless networks have evolved as plat-

forms for data services.

The evolution of wireless data services

Consumer wireless (cellular) service is so ubiquitous today that one

easily forgets how young it is and how quickly it has grown. It only

emerged as a major industry in the 1990s, but by 2004 its global sub-

scriber base had reached 1.7 billion. In 2011 that number was over 5

billion. Practically every inhabited part of the planet has wireless

consumer service.

Cellular mobile service started with first-generation (1G) ana-

log wireless systems, in use in the 1980s and 1990s. These were

designed to provide mobile voice-only telephony, and the handsets

were simply portable telephone receivers. There was practically no

standardization of technology in those early years. Had the industry

stayed analog and voice-only, there would have been no market for

an Aicent.

Everything changed with the introduction of 2G systems in

1991. This second-generation technology switched transmission and

2 Statistic from The World Fact Book, published by the US Central Intelligence Agency, available at www.cia.gov/library/publications/the-world-factbook/ fields/2012.html.

Connecting the w ir eless networ ks of the wor ld212

reception from analog to digital, opening the door to data services as

well as voice calls. In 1993 text messaging was the first data service

to be introduced.

Digital takes over

Three new generations (2.5G, 3G, and 4G or LTE) of digital wireless

networks have appeared since then, each representing a significant

advance over its predecessor. As carriers deployed these improved

networks, handset makers sought to exploit their capabilities, and

tempted consumers with ever newer, more sophisticated handsets.

Changes came incredibly fast. While analog landline telephones had

stayed virtually the same for decades, mobile phones had a model

lifespan measured in months.

Early digital handsets provided only telephony and short

message service (SMS, the foundation of today’s Twitter network).

They soon added more data services, such as full Internet access,

first announced by NTT DoCoMo in Japan in 1998. Eventually they

evolved into today’s smartphones. Smartphones have become plat-

forms for entertainment, personalization, and rich media commu-

nications. Voice communication is just one of their many functions.

Subscribers can use their smartphones to listen to music, connect to

the Internet, get GPS-based travel directions, access email, exchange

short messages, and send and receive pictures and short videos

recorded with cameras incorporated into their handsets.

These devices also serve as gateways to an ever-growing number

of personalized applications offered by the networks, such as online

payments and social network interaction. Data and video applications

dominate the list of features on handsets from companies such as

Apple and Research in Motion (RIM), maker of the BlackBerry phone,

and those equipped with Google’s Android operating system.

Building out the network

Digital wireless networks grew rapidly, thanks in large part to the

orderly development of standards by international industry organi-

zations. Carriers seeking to upgrade their networks selected their

The evolution of w ir eless data serv ices 213

digital technology from a limited menu of accepted standards. Most

carriers, including those in developing countries in Asia and else-

where, adopted GSM (Global System for Mobile Communications)

technology, which had originated in Europe. A smaller group, includ-

ing a few Asian carriers and Verizon and Sprint in the US, adopted

CDMA (Code Division Multiple Access) technology, developed by

another California startup, Qualcomm.

Regardless of which system a carrier chose, it was built on

digitally “packetized” data technology (discussed in Chapter 5). For

GSM operators, the need to offer data services meant adopting the

GPRS (General Packet Radio Service) standard. CDMA operators

had their own standards, which were not compatible with GPRS. In

either case, subscribers could access the Internet from handsets at

data rates higher than 100 kbps (kilobits per second).

Carriers deployed data-service-enabling networks in most of

the world between 1999 and 2009. As these networks proliferated,

smartphone sales grew rapidly, particularly after 2004 when many

networks were already in place. Sales increased from 35 million

handsets in 2004 to over 500 million units in 2011. Recently they