City Journal

Guy Sorman
The Silicon Lining
California’s innovative high-tech firms keep creating wealth, but will bad state policies drive them out?
Spring 2010

Eric Demers can’t remember how many pseudo–Silicon Valleys he has seen around the world while traveling for Advanced Micro Devices. The globe’s second-largest microchip designer and producer (after Intel), AMD was created 40 years ago in the authentic Silicon Valley in California. Demers, the firm’s chief technology officer, has no intention of moving. Across the world, he points out, private and public attempts to create new Silicon Valleys have achieved only “pale copies” of the original.

Silicon Valley.

That original has remained the undisputed cradle of high-tech and communications innovation. Historic leaders like Hewlett-Packard and Intel have stayed here; more recent giants Google, Facebook, and Twitter cluster around the pioneers. The Valley’s economy, concentrated in a 60-mile corridor running from San Francisco to San Jose, attracts one-third of all venture capital invested in new businesses in the United States—39 percent in 2009, though the $7 billion made it a slow year. A new start-up launches every working day. From among these high-tech ventures will emerge the next Google or Intel.

Silicon Valley faces a serious threat, however: the fiscal and regulatory earthquakes rocking California, which verges on becoming a failed state. Measured by per-household state and local government spending, California ranks third-highest in the nation, behind Alaska and New York. The state government is trying desperately to squeeze money out of any profitable activity to meet the crippling costs. Further, California continues to impose onerous regulations on the private sector. High taxes and stifling regulations give companies a strong incentive to move elsewhere. In this increasingly business-hostile environment, will Silicon Valley’s unique entrepreneurial spirit survive?

Forty years ago, when Silicon Valley began to expand and soon came to dominate the high-tech universe, most of its companies were manufacturing enterprises, producing microchips and computers right on the spot. No longer. Starting in the 1980s, Valley firms began moving away from production to concentrate on inventing new products and services. AMD, for example, outsourced most of its manufacturing years ago to factories in countries like China, India, and Taiwan—places with lower wages and high production quality. The approximately 3,000 employees at the company’s Sunnyvale offices are designers, marketers, accountants, and mechanical engineers; what tiny production lines remain are for building prototypes.

Was so much outsourcing necessary? Jason Clemens, research director for the Pacific Research Institute in San Francisco, one of California’s few free-market think tanks, acknowledges that countries like Taiwan offer a powerful “pull” factor for shifting manufacturing to East Asia. But there has been a major “push” factor, too, Clemens argues: the Golden State’s excessive income and property taxes and its web of regulations, which, he believes, have driven up outsourcing. As Berkeley-based journalist Francis Pisani puts it: “Outsourcing is the only answer to taxes and regulations.”

California has piled every imaginable burden on businesses. Minimum-wage laws are among the highest in the country, and health and safety regulations are among the strictest; cities like San Francisco and San Jose require businesses to offer employees health insurance; labor laws are extremely union-friendly; environmental policies drive up energy costs—and on and on. Small firms have the toughest time in this business-toxic climate. A recent study by Sanjay Varshney, dean of the College of Business Administration at California State University in Sacramento, estimates that the cost of state regulations in 2007 reached an average of $134,122 per small business—the equivalent of one job lost per company. And it’s not just the small guys: Google, which uses colossal amounts of electricity, is building its data centers in other states or abroad, where energy is much cheaper.

Hank Nothhaft is the CEO of Tessera, a firm in the field of semiconductor miniaturization. He shows me the vacant office parks and empty lots around his company’s San Jose factory. Silicon Valley, he observes, lost more than a quarter of its computer, microchip, and communications-equipment manufacturing jobs from 2001 to 2008, and Tessera proved no exception. The company has kept some of its assembly lines and industrial operations going here, but it now produces two-thirds of its nanotechnology chips in less expensive North Carolina and in various countries overseas, with China becoming the latest contender for a production facility. Just back from a trip there, Nothhaft says that he has been offered terms he “cannot decently refuse.” Using the Internet and videoconferencing, he can manage Tessera factories around the globe without leaving his San Jose office. “The business environment is becoming awful in California,” Nothhaft complains—just by moving his headquarters to Nevada, he’d save $5 million a year in taxes.

Why doesn’t he, then? “Inertia,” he answers. “We have a very good team here, which I wouldn’t want to disband.” He also holds out hope for change: “Things would turn around if the government became pro-growth.”

Outsourcing has allowed local entrepreneurs and would-be entrepreneurs to remain as creative as ever—for now. The Valley continues to attract innovators who share a “built-in start-up mentality,” Pisani says, risk-takers who believe that “they can change the world through technical innovation and become billionaires while doing it.” They’ve brought “permanent revolution” to the Valley, he adds. After the microchip, the PC, and the Internet, Silicon Valley entrepreneurs might have rested on their laurels. But the innovation hasn’t stopped. Smartphones inaugurated a new era of personal nomadic devices. Now comes Apple’s iPad.

These dazzling products have opened a new frontier for the software industry: the seemingly infinite world of digital applications, or “apps,” for mobile gadgets. Relatively cheap to launch and not requiring heavy investment or sophisticated equipment to create, apps could be invented anywhere, Pisani says. But it so happens that most of them are still created in Silicon Valley—or in other parts of the Bay Area that can offer cheaper rents. It is invaluable, Pisani explains, to be “not farther than one hour’s drive from Palo Alto and Sand Hill Road,” where all the venture capitalists work.

The Valley is a “vast, informal club,” observes Jean-Louis Gassée, formerly with Apple and now a venture capitalist. Socializing and networking become vectors of creativity. Palo Alto’s University Avenue cafés, school PTA meetings, and gyms become places where one can meet customers, vendors, collaborators, and investors. Skilled engineers and smart high-tech entrepreneurs also cluster in the imitation Silicon Valleys of Bangalore, Saclay (near Paris), and Shanghai, Gassée acknowledges. But no hub can match the Valley’s innovative start-up mentality.

Outsourcing has encouraged that creative spirit not just by keeping costs down but by bringing Silicon Valley firms into daily contact with other cultures. As a result, Valley entrepreneurs recruit engineers in Africa, Asia, Europe, and South America; a permanent two-way flow of people, products, and services unites the Valley with hundreds of regions across the planet. Silicon Valley, observes Alan Eustace, a Google vice president at its Mountain View campus, has become a “high-tech melting pot within the U.S. melting pot.” He adds that the array of ethnicities and backgrounds of Google employees is a tremendous benefit for the company. Google’s search engine, based on what Eustace calls “the wisdom of the crowd,” is a good example: it works well in any civilization, he maintains, because technicians from all civilizations have helped conceive it. Today, foreign-born entrepreneurs found half of the Valley’s start-ups.

Silicon Valley entrepreneurs, recognizing the benefits of this cross-fertilization, express frustration with current immigration law. The federal government’s annual cap on H-1B visas—issued to professionals working in certain fields, many of them high-tech—is absurd, says Nothhaft. “Asian students are not allowed to stay in the U.S.; after they get a degree, they have to return to India or South Korea, where they become our competitors.”

Where did Silicon Valley’s entrepreneurial, creative spirit come from? There are as many answers to that question as there are political ideologies, says Kevin Kelly, the founder of Wired, a magazine that in the nineties was the paper expression of Valley mystique. Kelly eventually sold Wired to Condé Nast (though he retains the title “Senior Maverick”). One could argue, he begins, that the government helped create Silicon Valley during World War II by installing military facilities there, which bought goods and services from surrounding private businesses and helped them flourish. Or maybe it was luck: working from his garage, David Packard initiated a technical revolution in radio transmission—and he just happened to live in Palo Alto.

Stanford University, Kelly continues, may be another explanation. Stanford not only trains some of America’s best engineers; it also has a tradition of cooperating with the private sector. The university encourages students to start their own companies as soon as they’ve completed their studies, a practice that began with a professor of engineering in the 1930s, Frederick Terman, who would give his students small pots of money to help them test their ideas in the marketplace. Among his students were Packard and William Hewlett, who couldn’t have started their firm without Terman’s cash. When Terman returned to Stanford after the war to become dean of the School of Engineering, he expanded on this policy by leasing Stanford land to high-tech firms. Silicon Valley’s venture capitalists consider Terman their “godfather,” says Randy Komisar, a partner at one of the leading VC firms, Kleiner Perkins Caufield & Byers. Today, Silicon Valley is a “plug-and-play” environment where innovators can readily seek out funding—and also tap into the best accountants, engineers, public-relations professionals, and bankers, all available on the spot.

But it’s the cultural explanation that Kelly likes best. He sees Silicon Valley as the ultimate Wild West: a geographic frontier and—at least in the beginning—an unregulated one. This helps explain how the Valley won out over the Boston area as a high-tech center in the seventies, Kelly believes. Home to MIT and leading high-speed computer manufacturers like Cray (which has since disappeared), Boston was the leader then. But Massachusetts was heavily taxed and regulated; at the time, California wasn’t. The Silicon Valley pioneers thus had greater leeway than their Boston competitors to experiment, even to fail. They could explore fields like software, which wasn’t considered valuable intellectual property yet but which would pay off hugely over time. The freewheeling Wild West triumphed over the more controlled New England. As Michael Bernstam, a scholar at Stanford’s Hoover Institution, says: “Capitalism is most creative at the frontiers.”

We keep an edge over the rest of the world,” says Komisar. “We know where the future is.” Forty years ago, Silicon Valley capitalists knew that computers were the future; later, they knew that the Internet was the Next Big Thing, and later still, social networking. Knowing exactly which companies would flourish in these fields was, of course, more difficult. Only 10 percent of start-ups survive their first year, and half of those are still alive after two years, with just a few rising to the level of an Intel, a Google, or a Facebook.

“Alternative energy is the next big adventure,” Komisar tells me. It’s a plausible argument. True, alternative energy and energy-saving technologies won’t replace the existing energy industry—they simply don’t generate enough power. But Komisar contends that, in the long run, the cost of oil will only increase, while the cost of alternative energies, through innovation, can only drop. Even if cap-and-trade legislation goes nowhere and no global-warming treaty ever wins ratification, he says, companies will want to become more energy-efficient to improve their balance sheets. Amit Chatterjee, founder and CEO of Redwood-based Hara, a start-up financed by Komisar’s fund, sells software that helps manage natural resources. “We do not sell green tech, ” he insists. “We sell cost reductions.” Among Hara’s first customers: Rupert Murdoch’s News Corporation. “They count on us to become carbon-neutral in 2010,” Chatterjee says.

Not all of the Valley’s venture capitalists share Komisar’s and Chatterjee’s enthusiasm for green energy, it’s important to add. Some competitors believe that the Obama administration’s support is artificially boosting the momentum for alternative energy. The future may not be as green as some expect. Komisar admits that public subsidies have played a major role in this latest Valley mania, but he notes that the Internet enjoyed initial support from the government, too. “We think long-term,” he says. “We are not playing with derivatives. We associate with entrepreneurial teams for many years and create real value.”

Time will tell. Kleiner Perkins Caufield & Byers typically sells its participation in a project a full ten years after beginning to fund it. The pension funds, endowments, and wealthy individuals who trust their money with the roughly 20 elite venture-capital firms on Sand Hill Road aren’t short-term speculators, either. Surrounding these top-tier firms are approximately 500 smaller, more adventurous, venture-capital companies that are willing to fund smaller, shorter-term investments, like social networks today. There aren’t enough Facebooks and Twitters in Silicon Valley to make all the firms wealthy. Some will strike gold, however, and perhaps join the elite.

Given California’s harsh business climate, it’s remarkable that entrepreneurs still flock to Silicon Valley, Sonia Arrison wryly observes. She’s a Pacific Research Institute scholar with a reputation for being a high-tech prophetess. “It’s a trade-off,” she says. “If you leave the Valley, you lose a lot.” The cost of doing business in the state is rising, but outside the Valley, it remains more difficult to find venture capital and recruit brilliant students.

Will competitors displace Silicon Valley? “There is pervasive fear of Chinese competition,” Arrison notes, but China lacks the Valley’s global appeal and “will not become a melting pot—at least not in the near future.” Where does she see the next revolution taking place? “Smartphones are hot,” she says, “and tablets are as hot as microprocessors were a generation ago. The next big thing could be cloud computing, and farther out, three-dimensional printers ” (which would be able to create objects in three dimensions, starting with basic plastic devices). Whatever the next innovation is, though, Arrison thinks that it will happen in the Valley.

Carl Guardino concurs, up to a point: he calls the Valley “the innovation leader of the world,” but he won’t rule out high-tech breakthroughs elsewhere. As president of the Silicon Valley Leadership Group, which represents the interests of the region’s 300 most significant firms, Guardino looks closely at the competition. So far, he’s less impressed by China and India than by Ireland and Singapore. “The error of many of our competitors is to copy Silicon Valley,” he tells me. “They try to reproduce who we are and what we do: the Indian and Chinese governments built somewhat artificial high-tech parks without any real entrepreneurs working there.” A more productive strategy, he thinks, is what Ireland and Singapore are doing: encouraging research and development by lowering taxes, loosening regulations, and improving education.

On January 27, 2010, two major events took place in the United States. In Washington, D.C., President Obama, in his first State of the Union address, announced steps to help small businesses create jobs. In San Francisco, Steve Jobs, Apple’s visionary CEO, presented his latest invention, the iPad. Which event will prove more significant to America’s future and the world’s?

Tessera’s Hank Nothhaft suggests the answer when he tells me that his elder son has just created a start-up in the Valley. “We can’t help it,” he says. “We’re just a family of serial entrepreneurs.” Innovation still tends to happen first in Silicon Valley. Even the sclerotic, near-failed state of California hasn’t yet stifled the extraordinary energy of this unique place. A good thing, because California’s economic recovery—and America’s—will depend heavily on its continued vibrancy.

Guy Sorman, a City Journal contributing editor, is the author of Economics Does Not Lie and other books.

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