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.