Silicon Valley, Born Again

Venture capitalist Ann Winblad's office sits on the edge of South Park, a leafy urban oasis in an industrial area of San Francisco and the frequent site of exuberant launch parties in the dot-com boom years.

"It's an exciting time to be auditioning innovation," says Winblad of Hummer Winblad Venture Partners. Photo by Jeffery Newbury

The mood back then sometimes went beyond exuberance and into manic territory. Such as the time a stranger, claiming an emergency, talked his way past a security guard at Hummer Winblad Venture Partners. His business plan was later found taped to the men's room wall. "I don't want those days of the plan on the restroom wall to come back," Winblad says with a laugh. The giddy days in the greater San Francisco Bay Area are gone. But Silicon Valley is back, and it just might be more relevant to business-technology managers than ever, as it hosts a new crop of startup vendors that are more focused, more globally connected, and more disciplined than their predecessors. Their work is centered on creating better, faster, and cheaper IT infrastructures. Among the highlights are startups developing software as a service, data security technologies, and virtualization software. "Higher-quality companies are getting to the starting line," Winblad says of the new startups. "We're in a very vibrant cycle right now. It's an exciting time to be auditioning innovation." This part of Northern California is historically the country's most important region for technology development. Ten to 15 years ago, San Jose and its neighboring cities were the headquarters for computer and chip manufacturers--hence the name Silicon Valley. Today that designation extends to any tech development on the 60-mile strip of land that starts in San Jose and travels north, ending near the Golden Gate Bridge. Winblad's firm helped launch 11 Valley startups in the past 14 months, including ActiveGrid Inc., which introduced an application server for grid computing in April, and Five9 Inc., whose virtual-call-center software automatically routes calls to centers with available capacity. And earlier investments seem to be paying off. Voltage Security Inc., funded three years ago by Hummer Winblad and Morgenthaler Ventures, is seeing its encryption software being bought by major companies such as Fujitsu and Siemens, says Rishi Kacker, one of Voltage's co-founders. The recovery is visible in the South Park neighborhood next to Winblad's office, where the groups of software-startup employees congregating at lunchtime have grown in recent months, and the din at Caffe Centro has risen, with a line of software developers, VCs, and young business executives once again snaking out the door. It can be seen in the cities just south of San Francisco, such as Burlingame, Palo Alto, and Menlo Park, where venture-capital firms are investing more in new companies than they did last year. Menlo Park also is the site of IBM's venture-capital unit, which encourages selected startups to explore technology areas that complement its product lines. (For more details about IBM's VC unit, see story, "Big Names Keep An Eye On Small Startups.)

	Hangouts like Buck's are again filled with the sound of venture capitalists talking about deals. Photo by Jeffery Newbury

At Buck's--a restaurant in Woodside, a hamlet close to Menlo Park--the VCs again "are talking about the new half-billion-dollar fund they just created," says owner Jamis MacNiven. Nationwide, venture-capital investments increased $1.5 billion last year to $20.4 billion--the first annual uptick since the peak year of 2000, when investments hit $94.6 billion before plummeting over the next several years, according to VentureOne, Ernst & Young's venture-capital advisory group. Last year, Silicon Valley got nearly 30% of VC money, compared with 14% in 1995 and 35% in the aberrant year of 2000. Silicon Valley is holding its lead as the most popular place to launch technology ideas. Vehicle-choked roads, a skyrocketing cost of living, and one of the lowest-ranked state public-school systems in the nation haven't discouraged the Valley's bright-eyed entrepreneurs: In 2004, Silicon Valley established 157 new venture-backed companies, compared with 54 in New England, 39 in the New York metropolitan area, 30 in Washington state, and 28 in Texas, VentureOne says. These startups are grounded in fields ranging from IT to medical devices, but of these, Silicon Valley has the highest percentage of technology startups.

Businesses that expect to use technology as a differentiating factor had better keep an eye on where the innovation is coming from. "IT managers who forget about the Silicon Valley do so at their own peril," says Paul Holland, a partner at venture-capital firm Foundation Capital in Menlo Park. "Every year, something new comes out of it." One of the key trends coming out of the area's tech industry is the software-as-a-service model, where vendors sell online access to applications through subscriptions. Indeed, some of Silicon Valley's most successful companies, such as eBay, Google, Salesforce.com, and Yahoo, aren't traditional hardware or software providers but have built technology platforms to launch services over the network.

Voltage Security co-founder Kacker "did the march" along Sand Hill Road in search of funding. Photo by Jeffery Newbury

Salesforce's $110 million initial public offering and steady growth in revenue show how quickly the age of software- as-a-service is dawning. Salesforce was built without venture funding, but Emergence Capital Partners, a Burlingame VC, secured a 1% stake in Salesforce from an internal owner before the company, which now has a market capitalization of $1.5 billion, went public. Emergence now has a $125 million fund to start software-as-a-service companies. Since beginning in 2003, Emergence has invested in Bay Area firms such as SuccessFactors Inc., a supplier of online employee performance-management services, and MegaPath Networks Inc., a supplier of broadband access and management services. SuccessFactors had 150 customers in 2004, its third consecutive year of 100% revenue growth. MegaPath was profitable in 2004, with revenue of $87 million, up 28% from the year before. Gordon Ritter, a partner with Emergence, is eager for his company to get four to five software-as-a-service startups under way this year, and don't be surprised if a number of them hail from Silicon Valley. "We're getting in with the sharp point of the arrow," he says. Storm Ventures in Menlo Park also wants to fund four new startups this year, possibly in the networking hardware and wireless markets. If necessary, the firm will come up with its own ideas and recruit people to staff ventures, says Ryan Floyd, one of the partners. Those startups most likely will be based in Silicon Valley so Storm can keep in close contact with them. That unorthodox approach of generating and staffing its own startup ideas has worked for Storm in the past. In 2002, it launched one of its own concepts--distributed Ethernet switches--with a Valley company named Airespace Inc. The word on the street was that there was no demand for the prospective product, earning the venture firm the sobriquet "Black Storm." Yet Storm and four other firms--Alcatel, Battery Ventures, Nortel Networks, and Norwest Venture Partners--sold Airspace to Cisco Systems for $450 million, after investing a total of $60 million in the company. The need for data-security and government compliance also will keep the next round of startups busy, and odds are that the tech-centric Valley will play host to most of these ideas. Companies' IT infrastructures continue to mesh more closely with the Internet, and security problems will likely increase. "There's a lot of holes in the cheese," Winblad says, and opportunities "to build the things that never got built." Voltage's founders thought so. In 2002, 20-year-old Kacker and fellow Stanford University students Matt Pauker and Guido Appenzeller wanted funding for their approach to data encryption. "We went up and down Sand Hill Road. We did the march," says Kacker, referring to the street between Interstate 280 and downtown Menlo Park studded with venture capitalists' offices. Once the three co-founders secured Winblad and Morgenthaler funding, they wanted more seasoned leadership. "We said, 'We want an external CEO. We don't mind adult supervision,'" Appenzeller recalls. They hired Sathvik Krishnamurthy, 36, a former VP of marketing at Valicert, a supplier of secure file-transfer software, and general manager of the security division of Worldtalk Corp., which was acquired for its secure messaging system by Tumbleweed Communications. Terence Spies, a 36-year-old who did startup time at Asta Networks, came onboard as VP of engineering. Spies promptly advised them to do what may become standard operating procedure for startups in the next few years: Use offshore talent. They've hired half their engineers to work in the company's Palo Alto headquarters and the other half under long-term contract in India. That's a cost-savings advantage from the get-go, Appenzeller and Kacker explain over breakfast at Cafe Borrone, a popular spot among the Menlo Park tech set. VCs demand that kind of operations savvy in addition to sound ideas before parting with cash. "VCs are a lot more careful about what they fund," says Robert Fanini, CEO of GroundWork Open Source Solutions Inc., which offers open-source software to monitor IT infrastructures and is backed with $11.5 million from Mayfield Fund and Canaan Partners. "I know a lot of people who are still struggling" to get funding. Before funding for Groundwork came through, Fanini had to face tough questions about how many customers the firm had, its market potential, and what sort of talent he'd assembled for a management team.

Businesses need the innovation engineered by startups such as Voltage, GroundWork, and Force10 Networks, which is backed by Morgenthaler Ventures and others, and produces gigabit and 10-Gbit routers. Phil Gaskell, global manager of network technologies at Veritas DGC Inc., which analyzes geophysical data for energy companies, bought 90-port routers from Force10 to connect data centers in the United States, Canada, Singapore, and the United Kingdom. "When we go to Cisco and ask them for [oversized, high-speed routers], we don't fit into their business model. Small startups tend to be a lot more flexible," Gaskell says. And Silicon Valley startups have the advantage of drawing from some of the best brains from around the world to help drive their innovations. The Stanford University Graduate School of Business says that from its graduating classes of 2003 and 2004, 38% stayed in the San Francisco Bay Area; the engineering school reports that 53% of its graduates stayed. The University of California at Berkeley's alumni office says 50% of engineering grads stayed in the Bay Area between 1999 and 2004, as did 57% of business grads. Eight percent of Harvard Business School's MBA graduates and 9% of MIT's School of Engineering grads head west each year to Silicon Valley, too.

South Park, a frequent site of launch parties during the dot-com era, is again a thriving spot for VCs. Photo by Jeffery Newbury

The same goes for some businesses that want to be in the mix. MySQL AB used to have its headquarters in Stockholm, Sweden. But in 2003, it moved its headquarters to Cupertino, Calif. "It's an enormous boost for us to be here," because of the mix of talent, networking opportunities, and potential partnerships, says Marten Mickos, CEO of the maker of the popular open-source database. MySQL has partnerships with Embarcadero Technologies, Hewlett-Packard, Silicon Graphics, SugarCRM, Veritas, and Zend--all in the greater Bay Area. "We know the Silicon Valley is the premier trading place for software, the premium place for software talent," he says. A good percentage of Silicon Valley talent in recent years has come from foreign nationals. According to AnnaLee Saxenian, dean of the Berkeley School of Information Management and Systems, Chinese and Indian professional organizations such as the Indus Group and the Chinese Software Professionals Association have functioned as social networks, cutting across companies and keeping talent moving around. But more than 200,000 jobs disappeared in Santa Clara County between 2000 and 2004, and many Indian and Chinese engineers and business execs affected by these cuts took their skills and went home to booming economies, says Junfu Zhang, a researcher at the Public Policy Institute of California, a private San Francisco think tank. Yet even with that brain drain, the concentration of talent in Silicon Valley is hard to duplicate. In Austin, Texas, a technology startup "might have a choice among 12 candidates for CEO," says Foundation Capital's Holland. "Here, there's a hundred choices." Meanwhile, the highest concentration of jobs in Silicon Valley is in technology design and software development, says Doug Henton, president of Collaborative Economics, a Palo Alto economics research and consulting firm. About 27% of venture capital in Silicon Valley went into software in 2004, up from 23% the previous year, Henton says. "We think it's a positive sign," he says, because those jobs are usually involved with developing software for new products. Software is now a strength of U.S. companies in worldwide markets, says David Yoffie, a Harvard Business School professor. Not only are U.S. software developers maintaining a competitive edge in the IT infrastructure, they're pushing back Japanese dominance in consumer goods, he says. China and India aren't a threat on this front, yet. "They work the lower end of the software stack, not the innovative, creative end," says Yoffie, though he adds that this will change over time. There's no shortage of brainpower or entrepreneurial spirit in either country, making them potential innovation powerhouses, but it takes time to build up the fluid capital mechanisms that characterize the movement of money stateside, and practice to develop a risk-embracing culture that tolerates frequent failures in hopes of hitting the big one. For now, Silicon Valley is the place business-technology managers are watching. That includes Jeffrey O'Halloran, manager of Internet services at Millipore Corp., a maker of fine filters and membranes for pharmaceutical and food-processing companies. O'Halloran found he could speed up delivery of application results from his Billerica, Mass., data center to any spot in the world through TCP/IP-acceleration technology that's the brainchild of startup Netli Inc. of Palo Alto. That saved the $820 million-a-year company the cost of building duplicate data centers near customers. "You never know where the next big thing is going to come from," O'Halloran says. But by all accounts, it's a good bet that in the foreseeable future it will come from Silicon Valley. Continue to the sidebars: Success Story: Voltage Emerges From Class Research, and Big Names Keep An Eye On Small Startups