The Tech Bubble, Four Months In

Earlier this year, we looked at the boom in the US tech sector and what it means for people running tech businesses and captive IT. Four months later, the tech sector has gained momentum. Buyers and sellers of tech services must deal with rising costs and tighter margins, respectively. This is a function of tech wage inflation (Google's 10% across the board pay increase is indicative of this) and increased recruiting and retention pressures (tech employees offered career advancement with other firms).

This is a far cry from where the tech sector in the US was just 3 years ago, so it's worth looking at the near-term durability of the tech sector bull market.

US corporate spending on tech is at its highest since 2001. This is being driven by extraordinarily high corporate profitability and a surge in US manufacturing. This, in turn, is being fueled by a cheap US currency. Meanwhile, the tech investment frenzy continues, with Silicon Valley venture capital fundraising up 76% in Q1 2011 from a year earlier. The demand for tech is very robust.

There are a number of things on the horizon that might affect this. But are any of them serious threats to tech?

• QE2 ends in June, but even without a QE3, there is no shortage of liquidity.
  Sufficient liquidity means there's ample high risk and low risk capital, a lot of which will find its way into tech.
  
• Interest rates can only go up, but they don't look to be going up soon. For one thing, US inflation is being sanitized by high US unemployment. For another, US house prices remain moribund. An increase in interest rates will chase buyers and create more downward pressure on housing.
• The US fiscal future is being debated. S&P rattled sabers by issuing a negative outlook for US Treasurys, but the bond market largely ignored it.

What this means is that in the absence of a seismic event, the tech sector bull market does not have to cool off any time soon.

Now, like anything else, tech is a fickle business. Even if all these things turn out to be true, US tech faces its share of risks.

• A US currency rebound. This could be caused by any number of factors. For example, Greek sovereign default would weigh on the Euro, which could have the effect of driving money into traditional safe haven of US Treasurys, stimulating dollar purchases. The stronger dollar cuts US exports, which cools the US economy.
• Signs of US inflation or bond market vigilantes cause Fed to increase interest rates. An increase in rates will likely cool business investment, which will slow tech spending.
• Failure from within the tech sector itself. Those cartoonishly high valuations don't pan out for one reason or another (e.g., eyeballs don't convert to revenue) and we get another round of dot-bombs.
• Tablet/smartphone revolution fails to live up to it's hype. One critical difference between today's mobile revolution with that of personal computers and the mainframes/minis they displaced was that you can code solutions for a PC on a PC. You can't code solutions for a smartphone on a smartphone. Subserviating the mobile device to the PC could unintentionally impair solution design: by being preventing smartphones from being truly independent devices, their evolution could be stunted. (Which raises the point that perhaps Motorola is onto something with their ATRIX product, but that's another blog post for another day.) Also, tablets are fantastic output devices but they're still not brilliant at input. The point is, if tech underwhelms in the short term - much as home computers failed to live up to their hype in the early 1980s - the tech sector will cool until the capabilities emerge.

Of course, there are many more risks, most of which may not be obvious now but any of which will seem clear as day after the fact.

In the meantime, tech's bull market credentials don't look to be at risk for now. For the tech exec, that means expecting supply constraints and inflation in labor and services to last for some time.

Corporates and Start-Ups: Casual Friends, not Soul Mates

An executive of a corporate behemoth wants to shake up a troubled division. Being both impatient and aggressive, the executive hires somebody with a few start-ups under their belt - or acquires that person's current business - with the intent of having them take over the troubled unit to deliver start-up-like results.

While it looks like a way to inject new strands into the corporate DNA, it may do little more than play kick the can the can on the problem. It might also inflict further damage on their troubled business.

Start-up entrepreneurs do well in the early stages of a corporate turnaround situation: it's not difficult to get some sparks of life from a situation left for dead. A remit to "fix the department" gives license to change relatively obvious things that had left previous leaders immobilized.

Unfortunately, the rate of miracles declines after the first few months and with it the lustre of the miracle worker. The easy changes are made all too quickly. It isn't long before all remaining options require heavy lifting. And heavy they are: untangling a large, messy business requires broad, systemic, fundamental change.

This brings the parachuted entrepreneur face-to-face with their commitment to their adopted team: they didn't hire the people, they had no say in the technology, they're unable to innovate (drowning in problems as they are), they're immersed in corporate overhead they consider a nuisance, and they get nothing but resistance and obstinance from their peers. The mission turns out to be different than it first appeared to be: success requires them to be change leaders, not just execution leaders. This is not what they signed up for: they were told to infect the corporate DNA, yet now they face infection themselves.

This is a big commitment wall to climb.

Some choose to climb it, trading small start-up for large firm. It has been my privilege to know and work with several people who have successfully made this change - with some later reverting to their start-up roots. But for many start-up entrepreneurs the thought of settling in for a long-haul turnaround in a large corporate is not terribly appealing. The most self-aware redefine their mission to make the situation less bad, which is not the same as making it brilliant. They'll steer it through rehab, bringing it to the threshold of the long path of becoming a better corporate citizen, bowing out to let other, more corporate types, take it from there. In effect, an uncommitted person will make the business less unattractive, and flip it to somebody else.

The worst case scenario is when an uncommitted entrepreneur doubles down on trying to make the corporate into a start-up, focusing on immediate outcomes at the exclusion of everything else. This leads to long-term damage because systemic problems are starved for investment, displaced by tactical spend in the mad pursuit of getting something - anything - done. After a few months, people lose the appetite to fix the root problems, having gorged at the feast of the proximate problems and finding themselves out of money, out of energy, out of faith, or out of time. They finish a few sprints, but get nowhere near the finish line of the marathon.

This happens because the things that work in a small start-up tend not to have profound success - and in fact, can backfire badly - in large corporates. Start-ups are guided by a few principles, corporates by voluminous rules. Start-ups are able to rapidly evolve; large corporates move more slowly and deliberately. Start-ups have the luxury of being able to focus on how they start: because of their dynamic nature they may re-start a dozen different things a dozen times each before they finish one thing. A large corporate does not have this luxury: it has too many people, too much specialization, too many geographies, too much low-bandwidth communication. To succeed at anything, the large corporate must concentrate fully on how they finish.

Small start-ups are great at creating things with only intellectual brilliance, time, and a few packages of crisps. But accustomed as they are to shoestring budgets, they rarely manage excessive investment wisely because few can conceive the strategic. Modifying a line from The Simpsons: "the start-up with money is a bit like the mule with the spinning wheel: nobody knows how he got it and dang if he knows how to use it." Survivor bias (firms such as Facebook) leads us to erroneously believe in outsized probability of start-up success. Flashes of tactical brilliance can produce some one-hit wonders (remember when flying toaster screen savers for Windows 3.1 were all the rage?) But the fact is that the start-up that matures into an independent, sustainable success is the exception, not the rule. As a friend of mine who has been CFO for several tech start-ups once pointed out, his prior companies went from being voluminous independent websites to a few bullet points on the website of their acquirer. Start-ups can generate enormous potential, but generally that potential is realized by others.

Pharmaceuticals are a case-in-point. Big pharma firms have large scale manufacturing, distribution, marketing and sales. As the pipeline of blockbuster drugs have dried up, they've dismantled their captive R&D while simultaneously entering high-volume generics. They haven't given up on R&D, they've outsourced it to small start-ups: when a start-up pharma produces a promising drug, big pharma firms enter a bidding war to buy it. Although the winner might over-pay for a specific firm, they'll spend less on R&D as they don't subsidize the failures. Big provides the scale, little provides the creativity, each in their respective corners.

This is not to suggest that corporate bloat is acceptable, that small start-ups are poor businesses, or that start-up entrepreneurs never succeed in corporate environments. It is to say that corporates and start-ups make good casual friends who can share the odd sweaty evening together, but should suppress any thoughts of marriage. The honeymoon ends quickly, the arguments are legion, divorce comes all too soon and the rate is all too high, and their offspring are more likely to have the corporate's obesity twined with the start-up's ADHD.

But what if you're an executive in a large corporate with an under-performing division that begs for an entrepreneurial spark? Recruit a courageous leader with an entrepreneurial streak, someone with the temperament to orchestrate comprehensive restructure while fostering innovation and inspiring people to act, with the self-awareness to realize that the mission is one of change leadership, not simply execution brilliance. Lou Gerstner did it at IBM 20 years ago. Perhaps Stephen Elop will do it at Nokia.

You may very well find that person in a start-up. Just remember that you're hiring the person, not the environment from whence they come.