What Does the Financial Crisis Mean for Innovation? Xconomists Weigh In

9/30/08Follow @bbuderi

Yesterday was a dark day on Wall Street, and, according to many observers, a dark day for our political system. But what does the financial crisis mean for innovation, and what are the key things that investors, entrepreneurs, and big companies should do or not do during such an upheaval? Xconomy asked this question of a panel of our Xconomists, and also asked what the crisis likely means for each of their specific fields.

The responses have been pouring in. You can click a name below to jump to that person’s response, or simply page through the whole post. And we’ll be updating this post frequently as more Xconomists are heard from, so check back from time to time.

Michael Greeley (9/29/08)

Staggering. There is no other way to characterize what we just witnessed. Our elected officials in Congress just put themselves in front of the collective national good. I am sure that their philosophical differences are real but today was a day for compromise. Many millions of investors around the world just spoke—and they did so very loudly. While flawed, the bail-out was a critical first step in what will be a long difficult recovery and it should have passed. There will be significant job losses; many companies will go bankrupt as they struggle to access credit to fund basic operations, much less expansion.

So where does that leave the “innovation economy?” Arguably battered and bruised, but like Rocky, it will answer the bell. Venture capitalists are obviously concerned—less about the losses today in the public markets than what that implies for how long they will need to support a portfolio of private companies that require on-going funding as these companies build their products, develop new markets. Any plans we had for liquidity were suspended months ago. VCs have been focused on building valuable private companies for generations—so now we just need to hold on to them a few years longer. Over many investment cycles it has been proven time and again that investments in innovation outstrip returns investors can get elsewhere.

The bar has been set even higher for the funding of new investments—but expect that there will continue to be investment activity, especially in the early stage marketplace. Entrepreneurs will most likely be asked to take less capital and focus on near-term milestones. Venture-backed companies will be asked to look at aggressive cost-cutting scenarios to understand worst-case scenarios. And VCs will re-evaluate their reserve policies across their portfolios to ensure that existing investments will be adequately supported. Unfortunately for those under-performing companies, expect to see less investor patience and a higher mortality rate than we might see in less volatile times.

Clay Siegall (9/30)

I have experienced a few financial downturns, most recently post-9/11 which lasted into 2003. At times like these, it is important to focus on what you do best, while being careful to utilize the resources that you need, not those that you want. I have observed that most truly innovative ideas come from individuals or small teams that can ask and answer questions rapidly.

For entrepreneurs, financial uncertainty forces efforts to be streamlined. This is often when the best concepts arise as great innovators are excited by and step up to challenges much as great athletes reach deep within themselves to achieve peak performance. Above all, don’t follow others during a downturn as that is a sure way to halt innovation and progress.

Investors should take positions with companies that have a diversified product portfolio and strong balance sheet. It is times like now in which investors can generate large returns if they take advantage of the discounted stock prices of companies that are making great progress. Investors should consider reducing their exposure to companies that have a poor track record of hitting corporate goals.

For big companies, now is an incredible time to utilize their enviable cash position to acquire innovative companies. While big and small companies have both seen their share values erode, large companies often have substantial cash positions that obviate the need to utilize equity in a transaction. Big companies normally focus on acquiring approved products (low risk) or novel technology (distant risk). They should use this time to acquire near term products, which are normally shunned by internal big company champions. With depressed stock prices, such deals are more appealing even to the most risk averse.

For biotechnology, it sometimes feels as if we are always in a financial crisis. The timelines of drug development are long, the costs are high, and the investors are impatient to say the least. Due to being in a relatively constant state of financial crisis, biotechnology may be more equipped to ride out a downturn than other industries. It is likely that there will be less expansion and hiring as companies will focus on the top products in their pipeline. We may also see more company to company deals that can provide the smaller of the two companies with necessary capital at a time like now when it is difficult to raise dollars with VCs or on Wall Street.

Michael Schrage (9/29/08)

There are several thoughts that come to mind as I read the extensive—and not very good—coverage of the ongoing financial crisis. (I make an exception for the Financial Times, whose journalists and columnists do not seem to have slept with every hen in Chicken Little’s coop.)

The first is that I am both fascinated and flabbergasted not by the “failures” of regulators or the bizarre willingness of banks to lend to lend large sums of money to people who should only have access to smaller sums or the even crazier behavior of trusting unproven and untested financial instruments as a dominant source of growth…but by the complete, utter and total inability of the boards and directors to have (apparently) any clue as to how exposed and leveraged their institutions were. These boards—which have very highly regarded and exceptionally well-paid establishment types as directors—have failed in their fiduciary duties. They were supposed to represent the interests of shareholders (investors) and they did a miserable, miserable job.

How does this relate to the future innovation economy? Barring a complete economic collapse—that is to say, rioting in the streets, the disappearance of savings and retirements accounts, triple-digit inflation and unemployment skyrocketing to 20 percent—I think this is fantastic news for innovators.

Here’s why. The financial sector was—in the words of Harvard’s excellent Ken Rogoff—clearly “overbanked.” The financial services sector will now be as tightly regulated as the pharmaceutical industry. The bankers (commercial and “investment”—ha ha ha) will be forced to practice conservative and fundamental finance for the foreseeable future.

This begs a simple and obvious question: where will better-than-average growth investments come from in this environment?

Well, I don’t think it will come from a new restaurant concept or “better” candy bars or “cheaper” automobiles or Project Runway fashion breakthroughs. I think it will come from genuine innovations that offer genuine value in, say, consumer electronics, office productivity, energy efficiency, new materials, and medical devices.

In other words, when you blow away the foam and froth and flush away the poor quality crap, the reality is a bright, clear, crisp and refreshing well of innovation still flows. Your readers should draw no small sense of satisfaction from the fact—not the perception—the fact that in the wake of the popping of the Internet bubble and the even-bigger telecom bubble that the level of growth and innovation in both those sectors has assumed remarkable proportions.

Yes, I am an optimist. I believe that human ingenuity mixed with free markets is a powerful recipe for economic growth, improved quality of life and improved standards of living. When credit tightens—as it undeniably will—there will be an understandable skepticism about an innovation’s promise…and then the sullen, gradual, hopeful recognition that—jeez!—this could be a big business opportunity. It’s certainly likely to grow faster than traditional X, stodgy Y, or credit-limited Z.

Will there be a slowing of growth? Of course—just as there was after our millennial bubbles popped. Is that slowdown a sign of “end of days” or the sky falling or the end of market capitalism as we know it? Of course not! We have seen not just the popping of a credit bubble but the popping of the financial services bubble.

It’s time for the “real” economy to assume primacy over the financial economy. It’s time for digital, material, environmental, medical and operational innovators to assume primacy over financial innovators.

Do I think that’s a good thing? No—I think that’s a great thing.

Chris Gabrieli (9/29/08)

Right now, the upheavals in the financial system have very little effect on the venture business or the entrepreneurial innovation domain. Venture funds have multi-year vintages and plenty of dry powder capital, and innovators are driven by their passion and creativity in a specific area. In the past, this insulation, combined with the fact that successful ventures depend on general capital markets’ health three to five to seven years from when they get going, not the current conditions, has allowed VCs and entrepreneurs to quietly go about their business during crises such as October 1987, the real estate crash of the early 1990s, the Long Term Capital collapse, and even, to a surprising degree, our own crisis of the Internet bubble at the turn of the century. But that’s because these crises resolved within months or a couple of years. It is too early to tell what will happen now. The worst-case scenarios would surely hurt all of our fields.

In the short term, I would counsel all involved to stick with the knitting and be glad we are fundamentalists, not market sharpies. If we are working on important potential solutions to important market needs, we will surely find a path to success eventually. However, wise players would trim back expenses, revise plans to assume slower growth and longer ramps, and eschew any strategy that absolutely requires huge amounts of OPM. If nothing else, it is always good to have these plans in the drawer, ready to go.

Finally, I would add that the impact will vary greatly according to market segment. Those of us in life sciences are likely to be very little affected as health care needs and spending have historically been quite recession-resistant. On the other hand, the venture business is more direct-to-consumer oriented than ever in my career, and surely consumers will cut back on spending, especially on newer, less proven and perhaps less critical items. The wild card will be the new class of green tech investments—will they boom even in a bust because of the fundamental shift in the cost of oil and the deep attitude changes around energy and the environment, or will they face troubles as budgets are pared back and oil prices ease a bit?

Ken Morse (9/29/08)

Our top notch entrepreneurs are not oblivious to the sea changes going on around us, but they usually have a much longer-term perspective about the opportunities they are pursuing. Market cycles come and go, but the long-term trends remain, and with them opportunities for innovative applications of game changing technologies.

Over the last two weeks, in Europe, I met many ambitious entrepreneurs who realize that the high Euro will make many European companies uncompetitive outside the Euro zone. There will be layoffs, and it will be easier to recruit experienced talent. It is a great time to be starting a company:

“How did you become an entrepreneur?”
“Simple—I got fired”

(This is reminiscent of Jack Kennedy’s comment…
“How did you become a war hero?”
“They sank my boat.”)

Meanwhile, back in the labs here at MIT, our geniuses are creating many of the next new things which will eventually pull us out of this mess and lead to new levels of prosperity. There is a feeling in the air here (which is NOT schadenfreude) that real technology—which you can touch—is perhaps more real, and sustainable, than financial wizardry with unsustainable fees. This is one guy’s opinion, not an official view.

James Geshwiler (9/30/09)

1. Don’t panic. The tech sector, by and large, has been isolated from the liquidity crisis. Unless you’re selling to Wall Street firms, some of your customers might be nervous, but sell them hard value and ROI.

2. Begin to worry about inflation and other side effects. The cure may cause other problems, chief among them, large infusions of liquidity usually has the equivalent effect of printing more money. It won’t happen overnight; there isn’t enough liquidity now to fuel inflation, but it could pick up in a year or two. That seems like tomorrow’s problem, but you can anticipate it in pricing agreements and contracts.

3. Worry more about the lingering problems of Sarbanes Oxley and pending regulatory changes. Is the backlash to try to prevent the last set of problems going to stifle the ability of small companies to grow and generate value?

Bill Aulet (9/29/08)

Times of upheaval are generally very good times for innovation. If people are safe and sound, they are unlikely to try new things or make significant changes. If they have a “burning platform” on which they are standing, then they are much more likely to embrace new ideas and give them a fair shot. A lack of urgency is one of the top reasons people do not change, so in a very real sense, times of turmoil can be good for innovation.

For the reasons above, I think [entrepreneurs] should be even more aggressive and be very clear about their value proposition—and that a crisis is an opportunity to make changes that the “thought leader executive” who is their advocate needs.

The demand for energy does not go away. These companies are not counter cyclic, but in some sense immune to shifts in demands like other industries. That being said, in times like this, the policy dimension of energy gets more complicated, as governments are more apt to pull back strategic investments (e.g., startup subsidies for renewables) and ironically keep energy prices artificially low (e.g., see Pakistan today, where energy prices are highly subsidized).

So while it is good for entrepreneurs in general, I think it is less good for energy entrepreneurs because of the political dimension.

Martin Simonetti (10/2/08)

We are all well aware of the turmoil on Wall Street and in Washington.

As the capital markets close their window, the opportunities to raise capital become less obvious. We are all going to be faced with difficult decisions about which programs do we focus our efforts towards, how many people we need to move our programs forward, and how are we going to create value from these programs with less resources. While this is always the case, the inability to raise capital will force these decisions sooner. What does that mean? It means we will all be making decisions with less information and/or data.

From there, one can argue both ways as to whether or not this will hurt or help innovation. I do believe that that the smarter companies will emerge stronger and in a better position to take advantage of the capital markets when the window opens. They will have made good decisions with limited information. This argues in favor of innovation. One can also argue that less capital is available to fund new ideas. An argument against innovation. Both of these facts are true and the real answer as to whether or not innovation will slow down as a result of this downturn is that innovation will always win out.

Another aspect of the current capital market situation that will hit home with all companies over the next few months relates to the 2009 budgets. As the cost of capital increases, it will force biotech companies to decide between funding their lead development programs and funding research. One can never cut enough discovery research to pay for clinical development. However, I believe more companies will be forced to do this over the next year. As we all know, development programs provide more to the overall valuation than do research programs but the cost of maintaining a development program relative to a discovery program is an order of magnitude. Companies will focus on value creation in the short term, giving up the long term value creation of discovery research. It is a difficult capital market and the stronger companies will figure out ways to balance these activities so as not to give up innovation to fund development.

So in the end, valuations will drop and companies that are cash rich will find the lower valuations of innovative companies to be an acquisition opportunity. They will be buying companies that can’t find capital from other sources. Don’t get me wrong, this is good for the industry and will lead to further innovation. Time and again, this has proven to be the case. When value creating acquisitions occur, those same entrepreneurs start anew. And the cycle continues.

Bob is Xconomy's founder and editor in chief. You can e-mail him at bbuderi@xconomy.com, call him at 617.500.5926. Follow @bbuderi

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