Vision on Innovation: 3. Why is the US outperforming Europe
?
The virtuous circle of leading-edge
giants and new challengers
Let us recap, what we have learned so-far. Based
on our analysis of the STOXX 1800 index, we concluded
that the US has been outperforming Europe significantly since
WWII on the creation of extremely successful fast growing
companies. The US based companies created after 1945 now make-up
over 33% of the total market capitalization of all US based
on companies in the STOXX 1800 together. The corresponding
score for the Dutch companies in the STOXX 1800 index created
after 1945 is 5%, which is a representative figure for Europe
as a whole.
We believe that it is pivotal to the European innovation
policy to gain a better understanding why European has been
underperforming so significantly along this dimension and
what needs to be done to reverse the trend. Fast growing companies
not only take a lion share in the creation of jobs and GDP
growth, but also improve the competitive position of a nation
in global competition. New companies in specific industries
can flourish, because local, leading-edge giants assure the
presence of skilled labor, a network of relevant supplier
and supporting companies and a benchmark for competitive performance.
New companies are often best capable of exploiting the market
opportunities that so-called disruptive technologies bring,
is the key observation made by Clayton
Christensen in his book "The Innovators Dilemma".
By synthesizing the ideas of Christensen with those of Michael
Porter, we conclude that both large and new companies
are essential for regions to remain competitive and exploit
the opportunities that new ideas and technologies bring. Large
companies, according to Christensen, will improve product
and service performance by leveraging so-called sustaining
technologies, thereby supporting both their own competitive
advantage and that of the national economy they operate in.
According to Porter, new companies can flourish due to favorable
factor conditions, such as skilled labor and local infrastructure,
and the availability of supplier industries and related industries
created by the regional presence of industry leaders. Those
new companies can bring disruptive new technologies successfully
to market, thereby creating economic growth and new jobs,
as well as the large companies of the future. We refer to
this positive feedback loop of large and new companies as
the virtuous circle of leading-edge giants and new challengers
leveraging disruptive technologies.
How are innovative, fast growing companies created ?
Economic
indicator systems like the European Innovation Scoreboard
(EIS) equate public and private R&D spending, patents filed,
and the share of the populating graduating and working in
science & engineering with the key drivers of innovation.
It can indeed be shown that the score on these indicators
has a positive correlation with economic performance measures
as GDP growth and jobs creation, e.g. see the analysis of
TrendChart. However, a positive correlation does
not prove a causal relation. It might as well be the other
way around: If there are more successful high tech companies,
there will be more private R&D and more people employed in
science and engineering, creating a higher demand for S&E
graduates, leading to a higher inflow of students in these
faculties, causing a higher spend in public R&D because most
universities receive more funding when they have more students
in their faculties.
Along the same lines, the success of large technology oriented
firms is often attributed to their superior technical and
scientific knowledge and excellent intellectual property rights
(IPRs) position, but this claim is not generally supported
by the historic facts: Philips did not invent the electric
light bulb; Unilever did not invent the margarine production
process; Microsoft did not develop the DOS operating system,
nor invent the graphical user interface, nor the Internet
browser; Oracle did not invent the relational database; The
Apple IPod was far from the first MP3 player on the market,
nor was iTunes the first online audio distribution system;
TomTom did not invent car navigation systems and is not the
owner of the geographical data; etc. So what did these companies
do right at the time to become a fast growing company, if
it was not for their strong R&D and patent position ?
Scholars who have studied the market dynamics of innovations
indicate that the successful market introduction of products
and services is generally not a unidirectional pipeline process
progressing from fundamental to applied science, to product
development, to market launch (technology push model), nor
the other way around from market opportunity assessment, to
product development, involving applied and fundamental science
(market pull model). It is rather a process of trial and error
on a world scale with many cyclic interactions between different
actors from various disciplines, as expressed by the Cyclic
Innovation Model, among others. This tells us that
new technology should be matched to market needs - which will
be an interactive process - and that the strategic marketing
functions within companies therefore have a job to do. However,
this provides merely a high-level description of the process
and does not really explain what some companies did so exceptionally
well to become fast growers.
In order to answer that question,
we did take a look at the big hitters in the telecom, IT and
media industry (since that is the industry we know best),
and came to the following hypothesis: The success of innovative,
fast growing companies is related to their ability to change
the name of the game by leveraging often generally available
leading edge technologies to create change along one or both
of the following two dimensions:
- Customer behavior: New product or service propositions
may offer new benefits to the customer, alter the attributes
of existing services or changes the weight that customers
assign to different attributes. When new propositions are
compelling, they will ultimately change the way that customers
behave, although this may take a long time and may initially
be limited to certain market segments. When mobile networks
were introduced in the nineties, for example, the new benefit
offered was a personal phone that works anywhere (provided
that there is network coverage). Mobility became such an
important attribute of voice services that users where willing
to pay a higher price, while accepting a lower voice quality.
Over the past decade mobile phones have changed the behavior
patterns of people in terms of where and when they communicate
and, for instance, how they separate work and private life.
- Market structure: Some innovations can unleash
forces that fundamentally alter the competitive landscape
of an industry. Michael
Porter's Five Forces model provides an excellent
framework to assess the impact of innovations on market
structure. Innovations affect the market structure when
they radically change one or more of the five forces: The
threat of new entrants, the threat of substitutes, the bargaining
power of suppliers, the bargaining power of buyers or the
rivalry among competitors. The introduction of the PC in
the early eighties represents a dramatic example of a technology
induced change in market structure. Prior to 1980, vertically
integrated players dominated the computer market, designing
and producing the chips, computers, operating systems and
applications internally and using their own direct sales
and distribution networks. IBM was the clear market leader
with a dominating position in mainframes and companies as
DEC and WANG lead the niche market of mini computers. By
the mid-nineties the picture had changed dramatically, as
shown in the figure below. New players like Intel, Microsoft
and Compaq successfully created a market space for themselves
by focusing on one layer of the value chain within the horizontalized
market structure.

The introduction of the PC in the early eightes strongly affected both customer behaviour and market structure
and compannies like Intel and Microsoft were able to profit from that on an unprecendented scale. In the figure below we have mapped our judgments for
a number of innovations in the ICT and media industry in terms
of their impact on "customer behavior" and "market structure".

Our method of classifying the different innovations
into the four quadrants has no scientific pretensions, but
merely represents our ballpark judgment to convey the idea.
We believe that the innovations in the upper half of the two
by two matrix have truly changed the behavioral patterns of
people and organizations that have "consumed" the products
or services resulting from the innovation - e.g. the mobile
phone, the graphical user interface and productivity applications
(for word processing, spreadsheet calculations or the production
of presentations) - and that the innovations in the right
half have fundamentally changed the market structure.
The developments in the lower left "business as usual" may
be involving very advanced technology, but they are not changing
customer behavior, nor market structure. In the terminology
of Christensen,
this is the area of sustained innovations, done best by existing
industry leaders. The new fast growing companies will be those
that brought a truly new proposition early to market ("customer
focused innovation") or radically changed the market structure
("business model innovation"). The biggest hitters did create
change along both dimensions and reside in the upper right
corner, thereby "changing the game" altogether.
Many of life's most useful insights are often quite simple,
and this idea might be one of them: The pace of technological
progress outstrips the ability of industries and markets to
consume it. Fast growing companies are those that were capable
to fill this space. These companies are familiar with leading
edge technology - not necessarily the inventor of such technologies
- and have leveraged the potential of those technologies to
change customer behavior, market structure or both.
Not all companies with good ideas become successful. Strategic
positioning is one thing, good execution is another. Creating
a successful new venture is never a routine job, nor an easy
ride. It requires vision, focus, hard work, a passion to deliver
best-in-class results and a bit of luck. Many companies that
passed that first bridge and successfully launched their initial
products or services, subsequently fail to make the transition
from the early adopters market - dominated by a few visionary
customers - to the mainstream market - dominated by a large
block of customers who are predominantly pragmatists in orientation.
As Geoffrey
Moore explains, crossing this "chasm" must be the
primary focus of any long-term high-tech marketing plan. A
successful ride through the different stages of the "Technology
Adoption Life Cycle" requires a company to adapt to each phase.
The real big hitters not only focus on the right strategic
position - one that can ultimately change customer behavior
and market structure - but also manage their companies exceptionally
well through the different stages of market adoption.
What stops European entrepreneurs from just doing that ?
If this is the way how many start-ups in the US became highly
successful, fast growing companies, what stops us in Europe
from doing the same ? We believe that this is an important
topic that deserves further research, but these are our initial
thoughts:
Lack of early stage venture capital. Many
of the fast growing companies require significant up front
investment in technology and infrastructure, as well as capital
to finance the operations up to the break even point, i.e.
to the point in time that a positive cash flow is generated.
Depending on the development phase, the financing is referred
to as "seed capital" (for the feasibility study, business
case development and product development), "start-up financing"
(for the roll-out of the organization, infrastructure and
the acquisition of launching customers) or "expansion / bridge
financing" (for the funding of the growth until a positive
cash flow is generated). These categories together are denoted
as "early stage venture capital".
Europe scores badly compared to the US on the availability
of early stage venture capital. The figure below on the left
hand side shows the development of risk capital investments
of Dutch VCs by financing form. It excludes buy-out investments
by foreign VCs (which amounted to another €1,500 million in
2004). The figure on the right hand side compares the sum
of seed and start-up financing per capita in The Netherlands
with that in the US. The figures for The Netherlands shown
in these graphs are representative for Europe, as can be inferred
from that the data provided by the
European Innovation Scoreboard (EIS). The EIS shows
that the Dutch score on early stage venture capital is in
fact slightly above the European average.

The European VCs have continued to invest significant
amounts of money after the burst of the bubble, but primarily
in buy-outs and turn-arounds. Seed and start-up financing
has practically vanished and amounted to 1.5 €/capita in 2005
in The Netherlands, which is about 10 times less than in the
US.
In our opinion, VCs around the world have been (and still
are) too strongly lead by sentiments rather than fundamentals.
They have over responded to - and perhaps created - the big
swings in the hype
cycle, as described by Gartner. The over-investments
in the late nineties has been followed by a period of significant
under investments. Whereas European early stage financing
has been considerably lower than that in the US for as long
as this form of financing exists, the ratio between early
stage financing in the Europe and the US per capita has never
been worse than at this moment.
Similar findings are reported by the
Global Entrepreneurship Monitor (GEM) 2005. According
to the GEM, the classic venture capital in the US rose to
US$ 21 billion in 2005 (up from US$ 18.9 billion in 2003)
against US$ 13.5 billion in Europe en Japan combined. Sweden
and Norway are two European exceptions and are closing the
VC gap with the USA. Sweden raised 480% more than in 2003
and Norway 170% more. The USA invests 16 times as much into
high-technology companies and 4.6 times as much in biotech
companies as Europe. American venture capitalists invest more
funds in fewer companies than their counterparts in Europe
and Japan. The average investment per company was US$ 8.8
million in the US versus US$ 2.8 million in Europe. US venture
capitalists are highly selective, providing more in emerging
high-technologies. The GEM 2005 report states: "The venture
capital differential per company explains in no small measure
why American companies dominate most sectors of emerging high
technology. Just look at the Internet. In 2000 the Internet
bubble burst. Many companies failed. Others were forced into
fire-sale mergers. Investors were hammered, many jobs were
lost and doom and gloom about the Internet was pervasive.
There was much hand-wringing about the incredible wastefulness
of the US method of financing new industries. However, by
August 9 2005, the tenth anniversary of Netscape's Initial
Public Offering, some Internet companies founded during the
Internet gold rush were thriving. The market capitalization
of just four of them - Google, eBay, Yahoo! and Amazon.com
- was about US$ 200 billion, which handily exceeded all the
venture capital invested in all the US Internet-related companies
through 2000. What's more, it even topped the amount raised
from venture capital and IPOs combined. True, there were many
more losers than winners, but five years after the burst,
it is clear that the US as a whole has already benefited mightily
and the best is yet to come."
Risk attitude: No guts, no glory. Adverse
attitudes to risk and adaptability, as well as fear of failure,
are anchored in the perceptions Europeans in general and perhaps
the Dutch in particular. The risk adverse attitude has far
ranging implications in many areas: On the number of entrepreneurs
(According to the Global European Monitor Entrepreneurship
2003 for The Netherlands, over 2/3 of the Dutch population
prefers to be employed and 50% is of the opinion that one
should not start a business when there is a chance of failure),
the availability of early stage venture capital (as outlined
above), the willingness of government and businesses alike
to act as launching customer for new ventures ("nobody got
ever fired for hiring IBM") and the fragmentation of budgets.
The Dutch process of allocating budgets, as a senior governmental
official once commented, resembles the Japanese art of cultivating
Bonsai trees, where every tree gets just as much to prevent
it from starvation, but not so much to let it really grow.
Fragmented European market: Difficult to reach scale
before being swallowed. Despite the introduction
of the Euro, the European market is still highly fragmented
compared to the US. Europe, famously seen from the outside
as a unified economy, is, as the inhabitants know too well
still a radically diversified continent. It may be economically
"unified," but language and cultural differences still mean
that what on paper is a trading bloc of some 25 countries
and 456 million people (versus 292 million in the U.S.) is
in reality a highly fragmented market. It is therefore far
more difficult for new companies to reach a scale that justifies
to remain independent. As a result, successful new companies
are swallowed by large firms from Europe or the US and do
not become giants by themselves.
Absence of the virtuous circle of leading-edge giants
and new challengers: A self-fulfilling prophecy.
As asserted above, new companies can flourish due to favorable
factor conditions and the availability of supplier industries
and related industries created by the regional presence of
industry leaders and new companies in turn can bring disruptive
new technologies successfully to market, thereby creating
economic growth and new jobs, as well as the large companies
of the future. The virtuous circle of leading-edge giants
and new challengers leveraging disruptive technologies has
not fully emerged in the high tech sector in Europe, which
to some extend, creates a self-fulfilling prophecy. For the
computer, software and Internet services industries in particular,
the US offers an enormous advantage to new companies due to
the presence of leading giants as Microsoft, IBM, Oracle,
Dell, Cisco, Yahoo!, eBay, Google and the like, as probably
anybody who visited areas as Silicon Valey, Seattle, Boston
and the research triangle in North Carolina can subscribe
to.
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