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1 Executive Summary INTRODUCTION This report examines the role of small high-tech companies, inclucting high-tech start-ups, in the development of six different industries. That examination is used: to draw some conclusions about the role of small companies in the development of industries and the economy; to characterize the inclustry-specific conditions that deter- mine the opportunities for small high-tech companies; and to examine how government policy either limits or increases the ability of small high-tech companies to contribute to industries and the economy. The findings and conclusions of the study are based on com- mittee members' experiences and on insights cleveloped by com- paring and contrasting the role of small technologically innovative companies in the six industries studied: advanced displays and visual systems; implantable and surgical medical devices; software; environmental testing services; network services ant! access de- vices; and outdoor sporting goods. Current government policies and programs are not evaluated. The committee's approach to the policy issues was to ask, How do 1

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2 RISK AND INNOVATION government policies affect the formation and survival of small high-tech companies? The committee elected to focus on general policy practices and effects rather than specific programs, recog- nizing that government programs affecting small high-tech busi- nesses are varied and constantly evolving. For the purposes of this investigation, a high-tech company is one in which technical innovation or specialized technical compe- tence is regarded as one of a limited number of key elements of competitive success. A small company is defined relative to inclus- try norms-small companies in an industry have many established, or plausible potential, competitors that are the same size or larger in terms of employees or revenues. THE ROLES OF TECHNOLOGICAL START-UPS AND SMALL INNOVATIVE COMPANIES IN THE U.S. ECONOMY The industries studied for this project illustrate the technologi- cal, market, and policy risks often borne by small companies. They also illustrate how a varied set of small companies pioneer and develop new markets and provide product diversity and innova- tion in small markets. Small companies in the software and the network devices and services industries are prototypically entrepreneurial and high- tech. New company formation is supported by: relative ease of entry because of relatively low initial capital requirements; a sig- nificant number of successes, which serve to encourage entrepre- neurs to enter the industry; companies that appear to have sub- stantial value if sold, even though they are not necessarily long-term survivors; availability of venture capital financing; and a public market for the shares of companies at relatively high valua- tions, compared with other industries, on the basis of revenues or profitability. In both of these industries, there are large, dominant companies, but the technological dynamism and fragmentation of the market create opportunities for small companies. In both soft- ware and network industries, the development and commercial proof of a wide range of emerging technologies, as well as the clevelopment and growth of the industry, depend on the invest- ments and actions of small companies willing to take linked tech- nological and business risks. Small companies play an unusual role in the advanced display

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EXECUTIVE SUMMARY 3 industry. In the early 1990s, technological uncertainty, wiclely ex- pected but unrealized large markets, and government (Department of Defense) funding created a cadre of small, relatively research- intensive companies in search of a valuable proprietary technologi- cal position. In the advanced display industry, small companies have been the repository of technical capability during the devel- opment of both core and complementary technologies and prod- ucts. In both the outdoor sporting goods and implantable and surgi- cal medical device industries, user-inventors play an important role in bringing new products to market. Also, in both industries, small companies and user-inventors have provided innovation and product diversity in small markets (i.e., markets that are too small to attract and hold the attention of larger innovative companies). Differences are also evident. In medical device innovation, most user-inventors are highly technically trained, the "field testing" of products is often a formal clinical trial in a university hospital, and, historically, venture capi- tal was widely available for mectical device start-ups. Further- more, medical devices are sold to physicians (and increasingly to health care organizations) rather than to consumers directly, and they are increasingly regulated by the FDA, a change that industry observers believe may alter forever the way medical device inno- vation is done and, perhaps, eliminate small-company participa- tion. The outdoor sporting goods industry and the implantable and surgical medical device industry illustrate the range of small markets that are served by small innovation-oriented companies. They also illustrate how small companies often pull fundamental technical advances from outside the industry into new applica- tions. The environmental testing service industry is dominated by small companies, but it has a unique characteristic: Demand for services is created by regulation and driven by enforcement. Barri- ers to entry into the industry are low, but so are the opportunities for growth; economies of scale, if they exist at all, are small, and the opportunities for innovation are slight. However, environmental testing laboratories serve an important public function. Without good testing services, environmental regulation and some aspects of environmental protection would not be possible. In this sense, environmental testing laboratories serve the economy by provid

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4 RISK AND INNOVATION ing an important technical service in small, often geographically differentiated markets. In many industries, small high-tech companies play a critical and diverse role in creating new products and services, in develop- ing industries, and in driving technological change anc! growth in the U.S. economy. In consumer markets, substantial benefits of linked commercial and technological risk taking accrue directly and immediately to inctividual consumers and to the national econ- omy. These benefits include the rapid exploration of market po- tentials, the development and refinement of new products and ser- vices, certain types of technical innovation, and product diversity. In intermediate or industrial markets, the willingness of small com- panies to shoulder technological and related market risks may en- able other companies (both large and small) to pursue otherwise unavailable technological approaches to improving productivity or introducing new products. In small consumer and intermediate markets slowly growing markets with total annual demand in the tens of millions rather than hundreds of millions of dollars- small companies are often the only source of products or services and are, therefore, responsible for all product diversity and for bringing innovations to the market. These market functions are an important part of economic de- velopment and, as such, are key in the economy's learning process about which technologies, at what price, will or will not satisfy demand. The principal economic function of small, entrepreneur- ial, high-tech companies is to probe, explore, and sometimes de- velop the frontiers of the U.S. economy-in products, services, tech- nologies, and markets in search of unrecognized or otherwise ignored opportunities for economic growth and development. OPPORTUNITIES FOR SMALL TECHNOLOGY-ORIENTED COMPANIES Small technology-oriented companies exist in most industries, but they exist in abundance in industries that share the following characteristics: Markets that are fragmented, technically dynamic, and rap- iclly growing; Low barriers to entry;

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EXECUTIVE SUMMARY 5 An adequate regional and national technical and business infrastructure; Good access to potential customers; Availability of financing; and A culture (recent history) of entrepreneurship in the indus try. Where these conditions exist, they are often accompanied by a predictable set of business and technological risks. The character- istics of a product or service market are key determinants of small- business technological opportunity. The demands of successful commercial innovation in different markets differ, leading to var- ied levels of expenditures on research, development, demonstra- tion, and to variation in the organization of company technical effort. Small companies can have inherent advantages in fragmented, technically dynamic, and rapidly growing markets in which there are low barriers to entry. The rapid pace of change in such busi- ness environments often creates nascent or rapidly growing mar- kets where a small company may establish an early position by luck or skill. The interactions between new technology-intensive companies and larger companies are myriad, diverse, and critical to the growth of many industries. Small companies can exploit certain opportu- nities, but that set of opportunities is often at least partially deter- mined by the actions of larger companies. Most small companies do little research. The importance of spin-outs of technology, per- sonnel, and business opportunities from large-company expendi- tures and efforts in research and development should not be un- derestimated as a source of opportunity for small companies. Much high-tech activity by small companies is regionally rein- forcing. The ability of some regional economies to spawn new businesses is well recognized. There are important regional sources of entrepreneurs and ideas, certain regional conditions that have an important impact on the ability of a region to foster start-ups, and a related but separate set of conditions that affect the ability of a company to grow in a region. Furthermore, there is increasing awareness of both the predictable and unpredictable dynamic char- acteristics of regional, high-tech economic growth. in sum, the regional vigor of entrepreneurial activity is determined in large measure by local and regional characteristics, including:

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6 RISK AND INNOVATION sources of people and ideas, such as research universities and large corporate labs; supportive infrastructure, such as business incubators, seed capital, entrepreneurial networks, and advisory services; and resources for company formation and growth, such as a strong technical and managerial workforce. HOW GOVERNMENTS CAN NURTURE SMALL COMPANIES AND TECHNOLOGICAL INNOVATORS This study did not specifically evaluate the numerous govern- ment programs that support small high-tech businesses, but it did review programs aimed at helping small business, fostering tech- nology development, and assisting companies that are both small and technology intensive. A number of national policy matters affect directly the prosperity and performance of small high-tech businesses. it is the committee's judgment that the federal govern- ment can help maintain the vigor and contribution of small high- tech businesses in the following ways: Working to ensure that financial market regulation, banking laws, and securities regulatory agencies are sensitive to the par- ticular demands of small high-tech companies; Monitoring and when possible reducing federal, state, and local regulatory burdens on small high-tech companies; and Maintaining, especially in light of prospective cutbacks in research and development spending, a rich portfolio of university research as a source of potential new commercial opportunities for start-up companies. A wide variety of government actions aimed at and justified by other missions public safety, environmental quality, and national defense, for example also have an enormous impact on small tech- nology-intensive companies by affecting the cost of innovation or the risk of failure. The relevant question for policymakers is, What types of policies substantially encourage (reduce the risk of, or increase the likely return on) commercial technical experimenta- tion by small companies and start-ups? With regard to the inadvertent impact of government actions, it is clear that government itself is a substantial source of risk for

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EXECUTIVE SUMMARY some small companies; part of the risk that small high-tech busi- nesses often bear is that created by the unintended consequences of government actions. in the committee's judgment, the conse- quences of government actions for technically oriented start-ups and small companies-and by implication for their ability to as- sume technological risk and drive innovation are often poorly understood both by the public and by policymakers. The committee suggests that federal activism on behalf of small business and technology initiatives focus first on establishing mech- anisms within government many of them off-budget that can improve the general environment for innovative enterprises. Be- cause the structure and implementation of regulations affect the character and speed of innovation (through the risks they can cre- ate or remove for companies), regulatory approaches across a wide variety of government functions need to be carefully considered with regard to their impact on small high-tech companies. With regard to programs for active support of small technically oriented businesses, the committee suggests that the central issue is whether federal support will make a difference in the economy's technological development. Private investment is likely to be much greater than any reasonable level of public investment in frag- mented, technically dynamic industries with low barriers to entry and a history of (or widely perceived prospect of) successful entre- preneurship. in such industries, the important question is, How can government research, development, and demonstration com- plement the much larger private investment (risk taking) to the benefit of the national economy? The challenge in program design and implementation is to articulate and adhere to an industry- specific rationale for government support in light of substantial private-sector activity. Finally, in the committee's judgment, many government policy mechanisms to promote economic growth- some types of federal R&D funding, technical assistance programs, local business incu- bators, university-industry collaborative ventures need to be de- signed and managed regionally or locally. Local and regional pro- grams may have an advantage in that they are closer to the resources that small companies need and are potentially more able to adapt to the needs of small high-tech companies.