Creative Thinking:Entrepreneurship in the Digital AgeJ. Peterman Rides Again! Bold Corporate Venturers CreativeDestruction’s Creator The Internet as Creative Destroyer CommonS e n s e f o r S e c u r i t i e s M a r k e t s H o w t o T h i n k A b o u t t h e S p e c t r u m

STERNbusiness

J. Peterman Rides Again! Bold Corporate Venturers CreativeDestruction’s Creator The Internet as Creative Destroyer CommonS e n s e f o r S e c u r i t i e s M a r k e t s H o w t o T h i n k A b o u t t h e S p e c t r u m

Creative Thinking:Entrepreneurship in the Digital Age

F A L L / W I N T E R 2 0 0 1

destruction” to the entrepreneurialinitiatives that established compa-nies undertake to help create newbusinesses.

In keeping with its spirit, theBerkley Center has acted like,well, like an entrepreneur: build-ing relationships with Stern com-munity members active in thefield, and forging alliances withother institutions. In February, itco-hosted a venture capital eventwith the Massachusetts Instituteof Technology EntrepreneurshipCenter. In April, the Centersponsored the Second AnnualMaximum Exposure Business PlanCompetition which provides Stern

students who aspire to be entre-preneurs with exposure to newventure investors and the venturecapital community, as well as aca-demic and business leaders in thefield of entrepreneurship. There’smore – far more – to come. Lastspring, Stern received state-wideapproval to offer Entrepreneurshipand Innovation as a co-major, andin the fall, we will introduce fournew courses, including Negotiationfor Entrepreneurs and GlobalEconomic Integration andEntrepreneurship. And high-pro-file entrepreneurs, CEOs, and ven-ture capitalists will regularly visitStern to exchange ideas with ourfaculty and students.

Entrepreneurship is “hot” nowin academic circles. Here at Stern,we’ve been studying and talkingabout the subject too long toregard it as a fad. Many investingand business models have comeand gone in recent years. But thevalues, principals, and techniquesof entrepreneurship endure.

I commend this issue ofSternBusiness to you heartily, andinvite all members of the Sterncommunity to sample our offerings– on entrepreneurship and othervital subjects.

George DalyDean

STERNbusinessA publication of the Stern School of Business, New York University

President, New York University ■ L. Jay OlivaDean, Stern School of Business ■ George DalyChairman, Board of Overseers ■ William R. BerkleyChairman Emeritus, Board of Overseers ■ Henry KaufmanAssociate Dean, Marketing

and External Relations ■ Joanne HvalaEditor, STERNbusiness ■ Daniel GrossProject Manager ■ Caren L. PielaDesign ■ Esposite Graphics, New Orleans

Letters to the Editor may be sent to:NYU Stern School of BusinessOffice of Public Affairs44 West Fourth Street, Suite 10-83New York, NY 10012

http://www.stern.nyu.edu

dean

With technology radicallychanging the way enterprises ofall sizes operate and link up withone another, and the relentlessforce of globalization creating newopportunities and challenges,institutions of all types are nowexpected to act as entrepreneurs.Fortune 500 corporations createventure capital funds, universitiesincubate biotechnology compa-nies, governments continuallyseek processes of reinvention, andindividuals regard themselves asfree agents.

In fact, the entrepreneurialmindset is crucial for anyonehoping to survive and thrive in

this new era. And, for many,embracing the mind-set hasproved difficult. That hasn’t beenthe case here at Stern, whereentrepreneurship is both a pri-mary academic core competencyand a guiding animating spirit.

We offered our first course inentrepreneurship in 1982, longbefore the Internet entered the lin-gua franca. And in the years since,we have inculcated the conceptsand practices of entrepreneurshipinto our faculty and students – asa strategic way of thinking.

Since 1983, the Berkley Centerfor Entrepreneurial Studies,endowed in 1996 by WilliamBerkley, chairman of Stern’sBoard of Overseers, has provedboth an anchor and a motor. Ledby Professor Ari Ginsberg, it haspioneered new curriculum andbrought highly regarded scholarsand practitioners into the Sterncommunity. Last year, theBerkley Center launched anEntrepreneurship Scholar-in-Residence Program with theappointment of Thomas McCraw,the renowned Harvard BusinessSchool historian. We are proud tofeature his article on JosephSchumpeter, the great theorist ofentrepreneurship, in this issue.We are also pleased to feature AriGinsberg’s article on corporateventuring, which linksSchumpeter’s notion of “creative

a l e t t e r f r o m t h e

SternChiefExecutiveSeries

Interviews withKenneth Cron, page 2J. Peterman, page 4Andrew Stenzler, page 6

10Innovative Thinkingby Daniel Gross

contents F A L L / W I N T E R 2 0 0 1

C r e a t i v e T h i n k i n g : E n t re p re n e u r s h i p i n t h e D i g i t a l A g e

Illustrations by © artist(s)SIS: Theo Rudnak, Bruno Budrovic,and Januscz Kapusta

Robert O’Hair and Michael Caswell

12Blue ChipEntrepreneursby Ari Ginsberg

18Thinking Aheadby Thomas G. McCraw

24Creative Destroyerby Allan Afuah

and Christopher Tucci48 Endpaperby Daniel Gross

30Speculative Schemersby William Greene

36Common Senseby Larry Alan Bear

and Rita Maldonado-Bear

42 Keeping it Realby Lawrence J. White

ML: Tell us about your interac-tive entertainment and gamescompany, Uproar. KC: I got involved in Uproarafter we sold CMP Media in1999. CMP published maga-zines, newspapers, producedtrade shows, conferences, allabout information technology.We built CMP into about a halfa billion-dollar company. Wesold it to United News andMedia for about $920 million.Then I retired. After a couple ofmonths of taking my family toEurope, I realized that sittingon boards and investing incompanies wasn't going to be

a full-time job. Operating com-panies is what I know how todo. So, I decided to jump backinto something.

One of the investments Ihad made was in a companythat was sold to Uproar whichwas a Hungarian bingo site. Iflew over to Hungary to look atthe company. At that point, inmid-1999, everyone thoughtthat entertainment on theInternet was a great opportuni-ty. The thinking was that whenAmerica and the world startedgetting online, the Internet,which was then an informationmedium, would give way to

entertainment. So, we decidedto do something with the com-pany. We redomiciled it inDelaware and took it public.We took the company public inMarch of 2000, and basicallyacquired and kept building anentertainment venue. Bingo,trivia, “Family Feud,” “To Tellthe Truth,” and a number ofvery easy, mass-market,leisure-type games that peoplecould play for 10 minutes or fortwo hours, and be bombardedby pop-ups and interstitialsand advertising.

ML: It was advertiser sup-ported?KC: Yes. When the marketstarted to crash in the Internetarea, we were unique in thesense that our genre of contentis very horizontal. We actuallyhave about 15 million uniqueusers and 23 million registeredusers. We're somewherebetween the 15th and the 20thlargest site in the world. Andwe're very sticky. Our usersaverage about 30 to 35 min-utes per month on the site. So,our advertising base did noterode at the same level asmany of the other dot-coms.

sternChiefExecutiveseries

Kenneth Cronchairman and ceo Uproar

Kenneth Cron is a CEO with a vast range ofexperience in both new and traditional media.He was the president of Publishing at CMPMedia. In September 1999, he joined Uproar, aleading interactive entertainment company, as CEOand was appointed Chairman of its Board ofDirectors in December of that year. In March 2001,Flipside, the publishing arm of the global mediaand communication company Vivendi Universal,acquired Uproar, and Mr. Cron joined Vivendi asChief Executive of the combined company, knownas Flipside. The combined company operates a

family of advertising supported, interactive entertainment web sites. With nearly13 million unique users per month, Flipside ranks among the top 20 web proper-ties and reaches 14.5 percent of the online audience in the U.S.

2 Sternbusiness

Our revenues actuallyincreased during the year.Unlike many dot-coms, oursales kept going up and ourlosses kept declining.

What we did see was ourmarket cap drop from a high of$1.4 billion to a market cap ofsomewhere around $60 million.At that point, we knew that ful-filling the entertainment visionof the company would be verydifficult on our own. Our abilityto acquire was severely ham-pered. We felt that the rightway to go was to find a veryimportant strategic partner thatcould allow us to leverage theassets, leverage the contentand the distribution to allow usto fulfill the entertainment visionfor the company. So we foundVivendi Universal. We closedthe transaction last week forthree dollars a share, a signifi-cant premium over the tradingrange.

Now we're in the process ofintegrating the companies.They had a site called Flipside.The entire combined companyis now called the FlipsideNetwork. We anticipate that wewill be profitable in Q3 thisyear.

ML: Tell us something aboutVivendi Universal.KC: Vivendi Universal is a $70to $80 billion market cap com-pany. It's the second largestmedia company in the world,behind AOL Time Warner. Itowns a huge cable televisionbusiness called Canal+ inEurope, telecommunicationsservices, publishing, UniversalFilms, Universal Music, andtheme parks. It's a huge, hugecompany in the entertainmentfield. Now our employees lookat the company and see agreat opportunity.

ML: What do you think this willenable Uproar to do that it oth-erwise could not do?KC: Ultimately, what we wantto do is have access to uniquecontent and have access to

unique distribution. VivendiUniversal has 900 million cus-tomer contacts every year. It'sa great opportunity for us if wecan get at that customer base,and now we are their largestInternet activity.

ML: You've announced sub-stantial layoffs at both Uproarand Flipside. Why do you thinkthey're necessary? KC: It's really tough. But, thereality is that downsizing is animportant component to mak-ing companies profitable.

ML: You are one-third of thesize in terms of employees ofwhat you were at your peak?KC: Yes. We're literally half adozen companies now, puttogether to create a profitabledynamic entity. With thatcomes duplication in alldepartments. You inevitablyend up with a situation whereyou have to make those con-siderations and make thosechanges. And it's hard.

ML: What are some of yourother challenges and how doyou plan to manage them?KC: For me, a challenge iscreating a dynamic businessthat grows. It doesn't matterwhat business you’re in.Managing costs in a companyis certainly a very valuable taskand one that needs to bedone. But the deciding factorin a business, the excitementthat employees get, is not fromcutting costs. What creates theexcitement is when sales aregrowing significantly, whenyou're in areas and businessmodels that are really hot. As aCEO, my job is to create thatenvironment. If I don't createthat environment, I've let every-body down.

ML: You mentioned thatUproar has experienced hugefluctuations in market capital-ization. How have you man-aged to keep the company ona reasonably even keel

throughout all those wild fluctu-ations?KC: It's been very challengingand very difficult. When thestock starts at 35 dollars andends up at three, you feel terri-ble because you know peopledidn't do well. On the otherhand, given where the marketwent subsequent to our deci-sion to merge into anothercompany, we certainly madethe right decision. We gotabout a 200 percent premiumover trading range. From thatstandpoint, it was a great deci-sion. Yahoo! saw its price gofrom 240 dollars to 15 dollars.The same thing withPriceline.com and all thoseother companies. So when Ilook at the relative value ofwhere this stock has gone, Ifeel pretty proud of the job thatwe did.

That being said, it was verydifficult. I think there's a ten-dency for management to dothe wrong things when thestock price fluctuates wildly.The idea is to keep it going inthe right direction. Don't over-manage it. Keep a steadyhand. Stay the course. Alwayskeep in mind that the compa-ny's survival is number one,because if it survives, it canthrive. And don't do anythingever to put the company inperil.

I think one of the things wedid right at Uproar was wenever lost our focus. We neverlost our direction. And weworked through the problems.And we managed to getresults. So, sales went up.Losses went down. We weredisciplined about it.

I think a lot of the free flowof capital that came into themarket was so irrational andthere weren’t enough seasoned

managers to handle it. Therewasn't enough discipline inplace. There was too muchspeed and it just cycled out ofcontrol. When things reallystarted getting out of control,people didn't know what to do.They hadn't done it before.And I'll be frank, had I notdone it before myself, I would-n't have known what to doeither.

ML: Let's take you back toyour days before Uproar. Tellus about your experience withCMP Media. KC: I went to the University ofColorado. While I was inBoulder, I worked at IBM. IBMhad a large computer plant outthere and they were doingsome programming forGrumman and some of theaerospace defense compa-nies. That's how I got into thebusiness. I worked there forthree years and during the timethat I worked there, they weretalking about the coming PCrevolution. I got enough of ataste for that industry that Iconvinced myself that it wasgoing to be the wave of thefuture.

I had always liked themedia business so, when Imoved back to New York, I gotinvolved with a small start-up,which was CMP. They pub-lished some capacitor andresistor newspapers in the tech-nology field. I came to the com-pany and started some PC-based publications. I beganpublishing in the computer areafor the company and took thecompany in that direction,which turned out to be wherethe company needed to go.

I founded a publication

Marshall Loeb, the former managing editor of Moneyand Fortune, conducts a regular series of conversationswith today’s leading chief executives on the Stern campus.

continued, page 8

Sternbusiness 3

"I think there's a tendency formanagement to do the wrongthings when the stock pricefluctuates wildly."

ML: You have created a com-pany that achieved cult status.J. Peterman was absorbed intothe culture. You were evenplayed as a character on"Seinfeld." Tell us how you hap-pened to create the J.Peterman Company, what itdid, and how it achieved someof the status that it had.JP: First of all, we had noplan. I found this coat thatbecame our first product juston the spur of the moment. I'mbasically a romantic and thecoat – a duster – had romanceattached to it. Romance isn'tjust hugs and kisses. Romance

is hardship. It's adventure. It'sall the things that you haveread about in your life but thatyou never do. So I bought thecoat. A duster is a long, can-vas coat that cowboys used towear in the 1800s to keep thedust off when they were ridinghorses. They were long so thatthey would cover your legs.Cowboys were romantic fig-ures in my mind. They don'tsay a lot. They spend a lot oftime by themselves. Theyalways have an opinion onthings. That's a romantic figureto me.

To me, the duster was a

way to escape from the hum-drum everyday world of infor-mation overload, of all of thethings that go on in our livesthat contain us. I could escapeby just putting on this duster. Iwore it around wherever I went.People everywhere would giveme looks of approval. That wasmy market research. So I said,"Let's see if we can sell a few."

This copywriter friend ofmine and I, we wrote an ad.We placed it in the newspaperin Lexington, Kentucky. And wedidn't sell any coats. We rananother ad and we sold onecoat. Finally, we ran an ad in

The New Yorker and we sold70 coats.

ML: How did you build fromthere? JP: It wasn't until the fall of1987 that we got a secondproduct, which was the J.P.shirt. It's a colonial-period shirt.Again, it defined who we were.So, we had two products fromthe little space ad. Then wehad the heirloom bag. Then amail bag. We had a real fire-man's coat. These were theproducts that we started outwith, all in space ads. Then westarted testing other maga-

sternChiefExecutiveseries

J. Petermanco-founder and former ceo

J. Peterman Co.J. Peterman is the co-founder and former CEO ofJ. Peterman Company, a classic American start-upsuccess story. After receiving 100 rejections fromventure capitalists, Peterman finally lined up finan-cial backing after running advertisements for his off-beat apparel products in the New Yorker. Startingwith $500, a $20,000 unsecured loan, and oneunique product, Mr. Peterman built his start-up intoa $75 million catalog company. A cash flow crisis in1999 forced the company into bankruptcy. J.Peterman recently wrote and published the bookPeterman Rides Again (Prentice Hall Press, 2000), andoffered a professional and personal examination of

his business in a Harvard Business Review case study. Peterman is an expert speaker onentrepreneurship, brand building, corporate culture and the painful but essential art oflearning from mistakes. He is currently in the process of developing a second Petermanbusiness, J.Peterman.com.

4 Sternbusiness

zines like GQ, Esquire, andHarpers.

Next, I borrowed $20,000from the bank, unsecured. Andthen I got a $200,000 SmallBusiness Administration loan. Iwent to my banker, and hesaid, "You need capital. Youaren't going to get any moreloans unless you get somecapital." I knew nothing of whatventure capital was or evenwhat capital was. I was verynaive. So, I educated myselfquickly and developed a busi-ness plan.

If I were to show you thebusiness plan that got me $1.2million in backing, you wouldall die laughing. It was so rudi-mentary, and so weak in somany areas that it proved tome in retrospect one thing:venture capitalists want toinvest in a good idea.Ultimately that business planbrought in about $20 million inventure capital.

ML: Do you need some recordof success to get venturecapital? JP: I can only speak from myown experience. The fact that Ifailed was not a detriment. Ifyou haven't failed, you probablyhaven't tried to do anything.And failing is just part of theprocess of learning. Venturecapitalists look at that. Theyactually look or some blemisheson the record of entrepreneursthey invest in.

ML: What was the next step?JP: I could see space ads tap-ping out. We had 23,000 cus-tomers from the space ads sowe created a small catalog –seven items, black-and-whitesketches – and we mailedthem to the 23,000, and thenwe mailed to the same 23,000again at Christmas time, andwe were off and running.

ML: Can you base a mail-order business virtually any-where, particularly now with theInternet and the kind of com-

munications we've got?JP: Absolutely. It has alwaysbeen my contention that itdoesn't matter where you startthe mail-order business. Youdon't need a storefront. Today,I can have real-time input intothe development of the pagesitting in my office while theartists and the art director areworking in New York and themerchants are sitting some-place else. We can all partici-pate at one time.

ML: How did you determinewhat kinds of products to get? JP: There are six things thatconceptually identify a J.Peterman product. Romantic.Authentic. Unique. Wondrous.Journey. Excellence. Those sixthings define the product. Weweren't selling products. Wewere selling romance. We wereselling individualism. We wereselling "Be Your Own Person." Iwant the customer to feel spe-cial, to feel smart, to be able toshow people that they havegood taste. Individualism.Romance. That's the definitionof the concept.

The opportunities for prod-ucts are fantastic. There's noshortage of new ideas. Now,there may be a shortage ofpeople who can recognizethem. But I'll guarantee you,there's no shortage of newideas and of wonderfulproducts.

ML: Take me to J. Peterman atits peak. JP: At our peak, we mailed 18million catalogs. That was sixmillion catalogs too many.Anything done too much getsboring. If I mail you a catalogtoday, you think it's great, dif-ferent, wonderful. I mail youanother catalog next week."Hey! that's good." I mail anoth-er one next week. "Oh!" Andthe week after that, you know,you get tired of it. There is anunsaid number of times thatyou can go to somebody.

We also at our peak were

developing over 2,000 newitems a year. That was about1,000 too many. Any time youincrease the quantity of some-thing, you affect the quality.Those were some of the can-cers that were creeping in atthe peak.

ML: When did you fall off thecliff? JP: In retrospect, the cliffappeared in 1995 with thisadditional proliferation of items.That was the cancer. We tookin another round of financing.The company was at a plateauso we decided to expand intoretail and we hired all thesehigh-level people, got another$7 million, and we opened up10 new stores in 1997. Weincreased the catalog circula-tion from 14 million to 18 mil-lion. We added several newcatalog efforts. Peterman'sNotebook was a brand-neweffort. We had a holiday cata-log. We were just doing toomuch too quickly. We ran intosome bumps with the bank inthe summer and completedanother financing in the begin-ning of September 1998 of $10million and got into a cash cri-sis. We were vitally aware of acash crisis in October 1998and identified it as a disasterin November.

ML: Right before Christmas?JP: Right before Christmas. Inmy book I call it my voyage onthe Titanic. It's a perfect analo-gy. The Titanic is going along.The band is playing. Everythingis wonderful. Oops! What wasthat? The bump? But it is anunsinkable ship. We're goingforward. Full speed ahead.

Band is still playing. Oops!We're starting to list a littlehere. What's going on? Well,we have a problem, and it's apretty serious problem. But thisis an unsinkable ship. So, wego on, and we go on, and thenthe thing begins to really list.And then there's a great flurryof activity. And all of a suddenwe have bankruptcy experts inthere to keep us out of bank-ruptcy.

So, by mid-October, we’veidentified that we're going tohave a $6 million hole. Thebank was squeezing us. Thenthe ship started going down.And all the people who couldjumped off. Some of us wentdown with the ship.

The inventory was alreadyin. We had already paid for it,so it was just sitting there,using cash. The printer wentdown in a disaster in the print-ing factory in September so thesecond draft of our Fall catalogwas three weeks late goingout. Our Peterman's Notebookwas an economic disaster.Nobody bought anything out ofit. You put all of those thingstogether and you get a cash-flow crisis. You know, notenough money.

We declared bankruptcy onJanuary 25th,1999. It was soldat bankruptcy auction onMarch 7th.

ML: How much did the credi-tors collect on the dollar?JP: Nothing yet. The bankrupt-cy is still going on.

ML: It's not easy to get upafter that kind of failure. Youhad 40 million people out therecontinued, page 8

Sternbusiness 5

"I found this coat that became ourfirst product just on the spur ofthe moment. I'm basically aromantic and the coat hadromance attached to it."

ML: Did you work on the ideafor Xando while you were atStern?AS: I got the idea for Xando inmy second to last semester atStern. The day after I graduat-ed, I headed up to Hartford,which was where the first loca-tion was. I was on the cell phone in the middle ofgraduation, closing the realestate deal for that location.

ML: What was the ideabehind Xando? AS: Xando was the first con-cept to combine coffee by daywith drinks at night. We were aquick service, over -the-count-er coffee bar by day, much likeStarbucks. The unique thingthat we do is table service inthe evening. We are the neigh-borhood gathering place thatStarbucks tried to be.

Most restaurants get threeusages out of their real estate,i.e. breakfast, lunch, and din-ner. We get five full day parts:breakfast, lunch, afternoon,evening, and late night. Whenwe acquired Cosí, we took theCosí product and we put itinside the Xando format. Nowlunch and dinner are our twobest parts of the day, becausewe have Cosí sandwiches.

We had two great brandnames, Xando, which camefrom "X" and "O", hugs andkisses. And we had Cosí. Cosíwas a better name for us. Itwas well known here in NewYork. And so, slowly but surely,the Xando name is going away.

ML: Tell me about these fiveaspects of the day. AS: We change our productline throughout the day. We

change our atmospherethroughout the day. It might beclassical music in the morning,and more upbeat music atnight. We might serveSquagels, square bagels madefrom Cosí bread, in the morn-ing, but pizza at night. It's amore complicated idea, harderto operate. But as hard as it isto operate, it has made us spe-cial, and it has also been agood barrier to entry for com-petitors.

ML: How can you cook a fullmeal in this environment?AS: Another secret to the Cosíconcept is we don't do a lot ofcooking. We do one thinggreat. And that's make bread.We make the best damn breadin New York City. And we usethat bread in many differentways throughout the day. So

there's no kitchen at Cosí – it isall right in front of you.

ML: Tell us how you got theidea for the very first café thatopened in 1994.AS: The first idea for Xandocame from going around tovarious coffee bars to discusswhat business we wanted togo into. It was under my nose.I thought there should besomeplace better for us tomeet. We came up with thecoffee and bar idea, wrote thebusiness plan in two weeks,and raised $400,000. I found-ed the company with my bestfriend from childhood. We'vebeen lucky enough that ourmatch worked.

ML: How many units do youhave today?AS: There are 55 stores today.

sternChiefExecutiveseries

AndrewStenzlerchairman and ceo

Xando Cosí, Inc.After receiving his MBA from Stern in 1994, AndrewStenzler founded Xando, Inc., a leading chain ofcafés, which combine the traditional coffee housewith a full liquor bar. In October 1999, Xandoacquired Cosí Sandwich Bar, creating Xando CosíIncorporated, which had 55 outlets as of April 2001.Mr. Stenzler is currently the Chairman and CEO ofthis successful chain of cafés.

6 Sternbusiness

There are another 20 going upthis year. We own them all, andlease the real estate for them.We're in seven states, fromMassachusetts to Virginia. Werecently entered Illinois, andwe'll be opening near my otheralma mater, in Ann Arbor,Michigan, in May.

ML: What are your revenues?AS: Well, it's a private compa-ny, but we'll do north of $100million in revenues this year.

ML: Isn't coffee a low-profitbusiness? How can you makemoney in your enterprise?AS: God bless Starbucks.They set the prices for coffeeand we followed them. They'rethe price leader. We set thesandwich price, because wethink we're the sandwichleader. Our average ticket iseight dollars. With the combi-nation of products that weserve, everything is high-mar-gin. Liquor is high-margin. Webake, and make ourselves thehigh-margin piece of the sand-wich and our pizza and coffee.So you really have three veryhigh-margin products. Ourcafés typically do three timeswhat a coffee café would do.

ML: How do you maintainquality control?AS: Very carefully. We startedstandardizing everything wedid with store one. We thoughtthis was going to be a bigbusiness the day we started it.We created training manuals.We had to make it so that it feltlike the owner was at everystore. We've been lucky thatwe've had the capital to investin the training programs neces-sary to create consistency forboth the product and the serv-ice. It took a lot of time. Wegive everybody stock options.We want our employees to talklike owners and act like own-ers. A typical manager at ourrestaurant might go through aneight-to-10-week training pro-gram. And an hourly partner

might go through seven to 10days before he ever hits thefloor of the restaurant.

One of the goals in theretail business is to becomethe employer of choice. We'relucky, because we've got agreat concept, and peoplewant to work for us. So asmuch time as we spend tryingto make Cosí a better concept,we spend more time trying tomake our people better.

ML: Yours is a private compa-ny. How do you have a market-place for the stock for peoplewho want to cash in theiroptions? AS: People know we are goingto be a public entity soon.When we go public, that willcreate the liquidity that willenable us to continue to incen-tivize employees through stockoptions. You want to be a man-ager at Starbucks? You canhave freely tradable stockoptions. You want to be a man-ager for us, you can makemany more stock options, but itmight be longer before youcan liquefy them.

ML: How do you create thebest, for example the Cosíbread, and how do you main-tain it over time and from loca-tion to location?AS: Reinventing the businessevery year is something we do.If you rest on your laurels, youjust can't compete. So wespend as much time thinkingabout what's the next phase, orwhat are the next products, orwhat's the next thing that hasto change. What we did whenwe first started was coffee andliquor together. We got lucky,nobody was doing it. Sixmonths later there were knock-offs. We realized if you're goingto be good, you have to contin-ually reinvent the business. Astastes change and societychanges, you have to change.

ML: Let's talk a bit about howyou differ from Starbucks.

AS: How do we differ? We're abread place and a food place.Starbucks doesn't cook any-thing on site. And they neverwill. We like to go to areaswhere they are, becausethey've gotten people to pay$3.50 for a latté already. That’svery good for us. They'vetrained the consumer. Theyhave a company-owned storemodel. We like company-owned, as opposed to franchis-ing, because we can control it.

ML: What other lessons arethere to be learned from yourexperience that would apply tovirtually any other enterprise?AS: There are two things. Oneis, you never have enoughmoney. Whatever you startedwith is the wrong budget. Theother one is, it’s not true thatyou should never sign person-ally for anything. If you don’t,you never start. You need totake risk.

I also think we set a goodexample with the merger.Communication was the key.People fear for their jobs. Youcan’t give guarantees, but youcan let people know what youare going to need in eachdepartment and let peopleknow what they need to do ifthey want to stay in the organi-zation. We also did a lot ofresearch on the company webought so that we wouldn'thave a clash of cultures. I thinkthe digging and the due dili-gence that we did was one ofthe reasons that we were suc-cessful. And the two conceptsworked well together.

ML: What are some of thesecrets of finding just the rightlocation for a Cosí outlet?

AS: The secret is information.The concept was working wellat our first location up inHartford. When we went to oursecond location in New Haven,it was kind of a dud. What ittaught us is you can't be onthe wrong side of the street.And you can't be the 11th cof-fee bar in the neighborhood.Now, when we go to a newmarket, we've already mappedout every single trade area. Wematch them up to how ourexisting stores are doing. And,based on that, we makeassumptions about how we'regoing to do in the new market.You have to have patience andwait for the locations thatyou've already pre-selected.With each new store you'reable to put into your modelhow you did. So it becomesless and less theory and moreand more actual statistics onhow well you're going to do.

ML: What are some of theother ingredients in creatingcustomer satisfaction?AS: It starts with the sourcingand selection of the peoplethat work at the company. Youhave to orient them. Then youhave to train them. Then you'vegot to give them more educa-tion. You've got to promotethem. It's the people each stepof the way.

ML: How do you create newproducts?AS: When we first started itwas in the living room sittingaround going, "What do youthink will work?" These daysyou've got to be on trend andon consumer taste. We have to

continued, page 9

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"Most restaurants get threeusages out of their real estate,i.e. breakfast, lunch, and dinner.We get five full day parts."

Kenneth Cron interview cont’d.

called Computer Retail News,which became Computer ResellerNews, which turned out to be a$100 million publication. Wewent on to publish, NetworkComputing, Information Week,Communications Week, InternetWeek, Windows Magazine, HomePC, and it just went on and on.We started developing tradeshows, conferences, and lo andbehold, we built the companyinto a worldwide, very, veryprofitable media company.

In 1997, we took that com-pany public. We raised $100million and about 18 monthslater, we decided to sell thecompany to United News andMedia for $920 million.

When we sold the company,my background in technologyand media was the perfect setup to get involved in theInternet. And publishing wasvery much a business I under-stood. And what was theInternet but just publishing onthe screen. So for me it was notas foreign as it might havebeen for someone else. I under-stood advertising, organizingaudiences, selling access toaudiences, and organizing anddelivering those advertisingmessages.

Q & A with students:

Q: How did you manage tomaintain one integrated compa-ny in the face of so much M&Aactivity?KC: I look at M&A activity as anevent that is purposeful for adesired outcome. I can use it toexpand my audience, toexpand my content, to changethe geographical distribution ofmy business, to get talent inthat I don't have, or a combina-tion of all those things. I look atit from the standpoint of a kindof holistic picture of what thecompany needs. And you kindof look at that picture and get asense of what the value of a

company is to you. A companydoesn't have an intrinsic value.A company has an intrinsicvalue to a buyer.

The people who work for mein the product and technologyarea, their job is to actually takethe game content and integrateit with the existing game con-tent. We integrate our gameswith the user in mind. What theuser wants is global registra-tion, a common database. Sowhen you are acquiring differ-ent companies it becomes ahuge database issue.

Q: How are you going to beable to integrate yourselves intoa company as large as VivendiUniversal?KC: I would say over the nexttwo to three months, my job isgoing to focus on getting ourorganizational structure rightand moving us to profitability.Large companies tend to focuson two basic areas when theyacquire: financial and humanresources. If they control themoney and they control the peo-ple, they control the company.

In other words, when weorganize ourselves into VivendiUniversal, what they will takecontrol over is human resourcesand the financial structures. Iam the CEO of the combinedcompany and, for the most part,we're an autonomous organiza-tion within Vivendi. They run itthat way because what theybought was literally the man-agement team, because theassets, especially in the mediabusiness, are the people. It'snot as though you own a rail-road or you own an office build-ing. With the media business it'sthe management team you real-ly want to keep in place.

Q: How can you manage toattract talent for a company thatis so volatile in terms of itsstock price?KC: The assignment of thecompany is really to fulfill itsmission. If you just keep moving

ahead with that mission, therewill be people that stay with itand people that don't. I don'tthink ultimately people come forthe stock options. I actuallydon't even think, in the end,people come for the compensa-tion. Ultimately, if the compen-sation isn't right, you're going toleave. And ultimately, if thestock options aren't right, you'regoing to leave. But it's not thedeciding factor. The decidingfactor is, do you like the busi-ness you're in? Is it exciting? Isit interesting? Is it where youwant to be? Does it providegrowth for you as an individual?If all those things are in place,you'll probably stay with thecompany for a good long time.

We have had very little trou-ble retaining our very best peo-ple. We did have trouble findingthe new talent we neededbecause the market was sooverheated at that time.

Q: Where do you see most ofthe growth from Flipside comingfrom? KC: I would say advertising willalways be a part of our busi-ness model, the vast majority ofour revenue stream. I thinkthere will probably be a bunchof different models in the future.There will be pay for play mod-els. There will be subscription-based models. And I think therewill be hybrid models and Idon't think we know what all ofthose will look like yet. I thinkwe have a unique situation atFlipside in that we have a largeenough revenue base to beprofitable. And that's unusual,because most companies havenot been able to do that. Iwould say that right now we arein the midst of looking for newrevenue streams. Because weare on our way to becoming aprofitable company, we havethe time to look around and fig-ure it out. I do think that enter-tainment on the net is poised togrow significantly. ■

J. Peterman intervieww cont’d.

watching you. Tell us how youworked through what must havebeen one of the most difficultperiods in your life.JP: Well, I got depressed. Ihad a home office and I had mycomputer. I sat there during thenight and I walked around withnothing to do. So I said, okay,I'll start writing a book. I startedwriting a book, six, seven hoursa day, for three months. At theend of June, 2000 I took a lookat it. It was the worst piece oftrash that had ever been writ-ten. I threw it away.

But it was a cathartic expe-rience. It was the beginning. Itwas a step. And then I did theHarvard Business Review article.When I re-read that, I noticedthere was still a little tint of bit-terness in it, so I knew that Iwasn't better yet.

Then I started in on thebusiness plan. I thought I hadthe most wonderful dot-comscheme in the world and I hadsome venture guys interested init. Then I stood back and Ilooked at that, and I said, "Whatare you, stupid?" It was thesame thing on a bigger scale. Ithad no soul. So, I threw thataway.

Then, when the HarvardBusiness Review article cameout, some financial guys startedtalking and some things startedhappening. All of a sudden,things began to come intofocus. Now I own my J.Peterman name again. So we'reoff and running.

It just takes time. It's likedeath or divorce. It just took acertain period of time before Ibegan to get a passion for liv-ing, a passion for life.

ML: Tell us about the new busi-ness. JP: It's the same kind of mer-chandise. Romance. Unique.Authentic. I don't want another500-person company. I don'twant millions of dollars of inven-

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tory. I do want a focused,strong, exciting brand. So, I'vecreated a licensing company.And I'm going to control themerchandising, and I'm goingto control the creative. Andthen, I will license the catalog. Iwill license the website. I'm pre-sented with another opportunityin life. I have a new opportunityto develop the brand further,the way it originally was con-ceived. I don't have venturecapital in this time, I have pri-vate capital. One of theinvestors happens to be JohnO'Hurley, the guy who playedme on "Seinfeld!"

ML: Do you think that yourname and your reputationhelped you to raise capital forthis new venture?JP: Yes. I think because of theJ. Peterman brand name,because of my personal reputa-tion, because I have a millioncustomers, and because I havename recognition with over 40million people in the US, Ihaven’t had any trouble raisingmoney. In fact, I’m oversub-scribed. There is a waiting list!

Also, the business model isgood for this venture. Thelicensing company generatescash. In the old business, if youmade $5 million, you probablydidn't have any money. Just golook in your warehouse andthere's your $5 million. In thisbusiness, if you make $5 mil-lion, there's $5 million in cash.The company's set up as a lim-ited liability corporation, so theprofits will pull through. Will itwork? Yes, I think it can work. Ithink we have a great leg up. Ithink that we've retained avery good licensing agency.It's still shepherding the brand,but now I don’t have to focuson a lot of the mechanics ofthe business.

Q & A with students:

Q: How do you know, whenchoosing merchandise, what isgood for your eye versus what's

going to sell to the public? JP: It is tough. And that's thetrick. What I look for is, what isromantic about that? What isunique about that? What isauthentic about that? It takesthe process to another level. Itstill comes down to your eye. Itcomes down to whether or notyou can pick the good stuff.

Q: Would you say that one ofthe problems was that you lostthe mission of your company,and you actually became a bitunromantic, focused perhapson the profits more?JP: You’ve got the right idea.Because there were so manyproducts, they weren't veryromantic.

Q: When you were starting thebusiness, how did you knowhow much of your own moneyto put into it? How much didyou risk? JP: All the way. I mortgagedmy house up to the hilt. I wasmarried with four kids, three incollege. But you know what? Imade it. Either you believe inwhat you're doing, or you don't.You've got to commit. ■

Andrew Stenzler interview cont’d.

start with the consumer, under-stand what market trends are,and then create products thatwe can be best at. Then we testthem. We get feedback fromour focus groups. And we rollout the products. One of ournew products, the Squagel,was an idea just five monthsago. And it's already in twostores and about to go nation-wide because we can movereally fast. If you're at Starbucksthese days, it's three yearsfrom the time the product isconceived to the day it hitsthe stores.

Q & A with students:

Q: How did the CEOs of othercompanies become yourmentors?

AS: Fred DeLuca of Subwayone day went to the New Havenlocation. Even though weweren't making any moneythere, it was always crowded.So Fred came into that storeand he wanted to meet theowner. I happened to havebeen there that day. So that'swhere I met Fred DeLuca, whenI had two stores. Then Subwaytried to buy us. They thoughtthey could franchise the hell outof us. Fred invited me toSubway. He started on one sideof a blackboard and he outlinedSubway's way of doing busi-ness to me so that a third grad-er could understand it. I walkedout of there and I was flooredbecause I had learned somuch. So I just became friendswith Fred and bounced ideasoff of him. Starbucks tried tobuy Xando in 1998. That's how Imet Howard Schultz. Howardwas my idol. Now he too is afriend. It was very tough whenwe decided not to sell toStarbucks, because here I waswith my idol and we didn't dothe deal. It strained our relation-ship during that period of time.But today, he's a person that Istill emulate and certainlyaspire to be like.

Q: Why did you decide not tosell, to go it alone? AS: The reason we didn't sell iswe really felt that we could cre-ate a greater return for investorsthan they were going to getinside Subway, or insideStarbucks. And we had thesupport of investors. We arebacked by Henry Kravis andInvesco, among others. We hadinvestors who allowed us totake the high road. We wereable to always do what wethought was best for the long-term life of the company. Andthat is a big luxury. When wedidn't sell to Starbucks, theyknocked it off with two con-cepts, both of which really don'texist today. We feel pretty goodthat our concept might not bearound today if we had sold it

to someone who wasn't 100percent focused on it.

Will this be part of anothercompany one day? It may be, ifwe had the right strategic part-nership with someone whocould create more value. It'scertainly not an ego thing or mewanting to be in charge. I wantto do what's best for theinvestors.

Q: At what stage of your busi-ness were you able to gainaccess to investors such asHenry Kravis and Invesco?AS: Our original investors werejust anybody, family, anybodylike that, 10 grand a pop. Wehad to bootstrap capital togeth-er for the first three or fouryears. We started to meet somehigh net worth individuals or"angel investors." In our third orfourth year, we ran our first realprivate placement memoran-dum. You've got to go meetevery venture capitalistbecause 99 percent turn youdown. We had to find theinvestors who understood retail,who thought maybe we werebuilding a big brand. We ranthat first round and raised $5million. And then we ran a $14million round that was headedby Invesco, the large mutualfund company.

Q: Is there a limit to the expan-sion of Cosí stores?AS: What we've already startedto do is plot all of the UnitedStates for those stores that canhit our economic models. We'vealready plotted out 1,500 storesthat we think we can do here inthe United States. As you learnmore, you can continue to upthe amount. We serve a needthat's unfulfilled in Americatoday, which is the all-day café,a place to congregate withgreat products. We truly believethat every neighborhood canhandle a Cosí. And if that's thecase, hopefully there will bemany thousands. ■

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U.U.S. SupremeCourt Justice PotterStewart famouslysaid of pornographythat he couldn’tdefine it, “but I knowit when I see it.”

One might verywell say the samething about entrepre-neurship. We allencounter entrepre-neurs in our work.We recognize themwhen we see them.But when pressed fora definition, wemight find it difficultto come up with aconcise answer. Whatmakes an organiza-tion entrepreneurial?What are the distin-guishing characteris-tics of an entrepre-neur? Is entrepre-neurship a trait peo-ple are born with, orcan it be taught andlearned? A survey ofSTERNbusiness’diverse readershipwould undoubtedlyyield dozens ofanswers.

Of course, intoday’s economy,when no marketleader’s status issecure and competi-tion can rise from myriad sources,the ability to act like an entrepre-neur is crucial to survival – whetheryou’re a car manufacturer or a uni-versity. Indeed, in the lead article of

this issue, Professor Ari Ginsberg,director of NYU Stern’s BerkleyCenter for Entrepreneurial Studies,examines how managers in larger,mature corporations have focused

on the important roleof entrepreneurship increating opportunitiesfor corporate growthand renewal (p. 12). Infact, Ginsberg notes, allsorts of firms are using“corporate venturing”to leverage their assetsand capabilities andcreate new businesses.

Of course, classicentrepreneurs are indi-viduals who start busi-nesses from scratch, ortake tiny enterprisesand grow them intosomething much, muchlarger. That’s why thetrio of successful entre-preneurs whoseappearances at Sternare chronicled in thisissue are particularlyappropriate. Takentogether, the words ofthese three CEOs con-stitute a sort of first-person manual on howto start, grow, andre-start businesses.And there are somevaluable lessons to belearned from theirexperience.

An often overlookedcomponent of entrepre-neurship is knowingwhen to sell. That fre-quently excruciating

decision, after all, can often meanthe difference between survival andextinction. Kenneth Cron (p. 2),who led the Uproar Network, anInternet-entertainment start-up,

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through the dot-com shakeout, rec-ognized the necessity of joining upwith a larger outfit and engineeredthe sale of his company to Vivendi.While many of its independentrivals have been relegated to thedot-com dustbin, Uproar is stillalive and well.

The essence of entrepreneurshipis seeing an opportunity where oth-ers do not and making the most ofyour resources. In 1994, upscaleurban coffee shops were popping uplike wildflowers after a spring rain.But Andrew Stenzler (p. 6), whoreceived his Stern MBA that year,saw a niche. He founded Xando,Inc., which combined the coffeehouse concept with a neighborhoodbar. “Most restaurants get threeusages out of their real estate, i.e.breakfast, lunch and dinner,” hesaid. “We get five full day parts.”The company, since renamedXando Cosí, now has an impressive55 outlets.

What else defines an entrepre-neur? How about resilience? J.Peterman, co-founder and formerCEO of J. Peterman Company, wasrejected by 100 venture capitalistsbefore an advertisement in The NewYorker helped coax an investor tofund his catalog of off-beat prod-ucts. The rest is history: the compa-ny grew rapidly, Peterman evolvedinto a cult hero, and the firm raninto troubles and went bankrupt.But Peterman himself was unde-terred by the failure. “I’m presentedwith another opportunity in life,”he says. Peterman took some timeoff, worked on a book – PetermanRides Again – and, naturally, hasstarted a new company.

There’s also much to be learnedby studying those who wrote andthought about entrepreneurship.Take Pulitzer-prize-winning histori-an Thomas McCraw’s profile of theleading theorist of entrepreneurship– Joseph Schumpeter (p. 18).Although he died a half-centuryago, Schumpeter is enjoying some-thing of a present-day vogue. Afterall, he coined the term “CreativeDestruction,” a buzzword of theNew Economy. But the economist’slegacy was far greater than a fewcatchy terms, McCraw argues.Schumpeter delved into history,sociology, and psychology to makepenetrating observations on theworkings, motivations, and effectsof entrepreneurs.

In their article, Anthony Afuahand Christopher Tucci put some ofSchumpeter’s theory into practice(p. 24). The authors wonderedexactly how one of the great vehi-cles for entrepreneurship – theInternet – acts as a force of creativedestruction. They constructed a the-oretical model, which they thenapplied to three broad industrygroups, defined by the ways inwhich they use technology. Theirconclusions may prove valuable tomanagers and executives.

The relationship between patentsand entrepreneurs has always beencomplicated. Patents, after all, havelong provided inventors and inno-vators a way to protect their newproducts from imitation. On theother hand, patents have also beenwielded by their holders as a bluntinstrument in warding off potentialcompetition. In the Internet econo-my, patents covering business mod-

els have emerged as a topic of greatcontroversy and litigation: thinkPriceline.com’s shopping system orAmazon.com’s one-click orderingmethod. William Greene providessome valuable perspective on thehistory of business-method patents(p. 30).

Aside from the United StatesPatent and Trademark Office,there’s another government agencythat has occasionally proved some-thing of a challenge to entrepre-neurs: the Federal CommunicationsCommission. Among other responsi-bilities, the FCC manages the air-waves, which have been a platformfor entrepreneurship dating back tothe first radio stations in the 1920s.And analysts are placing great storein the publicly-managed spectrumas the host to wireless and othernext-generation Internet applica-tions. But Lawrence White (p. 42)argues that the FCC’s spectrummanagement philosophy, rooted inthinking that may have made sensein the 1920s, is outdated andserves to stifle entrepreneurship andinnovation. White proposes a radi-cal, but logical alternative: regula-tors should think of the airwaves asanother form of real estate, andenact a regulatory regime similarto that which governs the use ofproperty in this country.

It’s precisely this sort of entre-preneurial thinking that makes thisissue of STERNbusiness an enjoy-able, interesting, and useful read.

DANIEL GROSS is editor ofSTERNbusiness.

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chumpeter portended thenew economy in his seminalbook Capitalism, Socialismand Democracy (1942). He

believed new technologies and “com-binations” that disrupt the prevailingequilibrium were the key to long-term growth and the development ofcapitalist economies – not the steadyaccumulation of capital stock, aseconomic orthodoxy held. “Theprocess of industrial mutation,” hewrote, “incessantly revolutionizes theeconomic structure from within,incessantly destroying the old one,incessantly creating a new one.”Schumpeter dubbed this process“creative destruction,” and arguedthat it was “the essential fact aboutcapitalism.” This idea is so powerful

that even people who have neverheard of the long-deceased economistare familiar with the phrase hecoined.

Schumpeter was referring to theprocesses that influence the outcomeof a collection of companies ratherthan the processes that occur within asingle company. But creative destruc-tion can take place in both a macroand a micro setting. In a corporatesetting the most dramatic acts of“destruction” are the decisions to sellor shut down a division. A milderform might be to spin off a businessunit. The point of destruction in thesecases is, as Schumpeter implied, tomake way for creation, to refresh orrenew the corporation.

But individual companies do not

do nearly as good a job of creativedestruction as capital markets.Richard Foster and Sarah Kaplan,co-authors of the recent bookCreative Destruction, argue that mar-kets – not corporations – allow newcompanies to enter more freely, andruthlessly force the elimination ofthose companies without competitiveprospects. Moreover, markets changemuch faster and on a larger scalethan do corporations. Whereasmarkets operate on the assumptionof discontinuity and accommodatecontinuity, corporations assumecontinuity and attempt to accommo-date discontinuity.

These major differences pose aserious threat to managers of even themost successful and well-established

By Ari Ginsberg

The escalating pace of change over the last few years has introduced new termssuch as hypercompetition, disruptive technology, and new economy into the businessvernacular. This high-growth, high-risk world of continuous discontinuity reflects thetransformational power of entrepreneurship and technological innovation – a dynamicanticipated over half a century ago by Joseph Schumpeter, the famed Austrian-borneconomist whose ideas about capitalism have made him a 21st century superstar.

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corporations. Based on the results ofa McKinsey & Co.-sponsored study ofmore than 1000 companies in 15industries over almost four decades,Foster and Kaplan predict that by2020 more than three quarters of theS&P 500 will consist of new compa-nies that will be drawn into the mael-

strom of economic activity from theperiphery.

So, how can corporations makethemselves more like the market?The answer, according to Foster andKaplan, is to establish a moredynamic view that mandates manag-ing creative destruction first andoperations second. But the corpora-tion must do so in a highly decentral-ized way, without sacrificing control.

This is easier said than done. Fewcorporate leaders have the energy ortime to manage the processes of cre-ative destruction, especially at thepace and scale necessary to competewith the market.

Corporate VenturingOne answer that many have

turned to is corporate venturing.Corporate venturing is a practice thataims to enable companies to success-fully surf the waves of creativedestruction. It involves the develop-ment of an organized effort to

leverage existing assetsand capabilities to helpcreate new businesses.It differs from othertraditional businesspractices that facilitategrowth through accessto new technology, suchas acquisitions andcorporate research anddevelopment (R&D).New businesses devel-oped through corporateventuring are typicallydeveloped through anincubation processrather than throughacquisition and integra-tion into the company.Corporate venturinginvestments are usuallyriskier and less subjectto rigid managementof internal costs thanconventional R&D. Infact, protecting venture

investments from such controls is akey reason why start-ups are organ-ized separately from the ongoingcorporate business.

The history of corporate venturingreflects an enduring corporate fasci-nation with the success of venturecapital (VC) firms over the last fortyyears. Venture capitalists are certain-ly not infallible; they are eminentlycapable of entering markets too earlyor too late, picking the wrong start-up teams, and riding some invest-ments longer than they should. Butover the past twenty years, VC firmshave done a far better job of embrac-ing the spirit of creative destruction

than traditional operating compa-nies. In replacing the traditionalassumption of continuity with theassumption of discontinuity, theyhave become important drivers ofchange in the world’s largest econo-my, created enormous wealth fortheir investors, and shown how indi-vidual companies can create value atthe pace and scale of the market.

he first corporate ventureprograms were inspired bythe successes of the VCfirms that backed such

start-ups as Digital Equipment andRaychem. During the late 1960s andearly 1970s, more than 25% ofFortune 500 firms had corporateventuring programs. Many were dis-banded in the second half of the1970s following a severe decline inpublic market and VC activity.Following dramatic growth in the VCmarket in the early 1980s and thesuccesses of firms that backed suchsmash hits as Apple and Genentech,corporations again set up venturingprograms. By 1986, corporate ven-ture capital represented 12% of totalVC investing. Many of these pro-grams were again discontinued afterthe 1987 market downturn and theensuing dramatic drop in VCfundraising. Almost 40% of corpo-rate venturing programs wereabandoned within four years oftheir initiation. By 1992, corpo-rate venture capital had fallen to5% of total venture capital investing.

The second half of the 1990sbrought a third wave of venture cap-ital success and inspiration. Fueledby emerging technologies, opportuni-ties posed by the Internet and arobust economy, independent venturefunds began to notch annual returnsof more than 50% after 1995. VCinvestment rebounded from an annu-al average of $6 billion in the mid-1980s to over $17 billion in 1998,and to over $100 billion in 2000.

TThe first corporate ventureprograms were inspired bythe successes of the venturecapital firms that backedsuch start-ups as DigitalEquipment and Raychem.

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And once again, corporate venturingprograms followed. Between 1995and 1999, the number of U.S. com-panies that made corporate ventureinvestments increased from 62 to415. According to the research firmVenture Economics, corporate ven-ture capital activity soared from$542 million in 1996 to $1.1 billionin 1997, $1.6 billion in 1998, $8.6billion in 1999, and $16.5 billion in2000.

The Track RecordEarly studies of corporate ventur-

ing programs, which took place in the1980s and early 1990s, led many toconclude that they were inherentlyunstable and unlikely to succeed.Researchers observe such difficultiesas building and sustaining internalsupport for new ventures fromtop management, poten-tial inherent conflicts ofinterest arising between thesponsoring firm and the newventure, and the inability ofthe corporation to providean appropriate risk/rewardcompensation to new venturemanagers.

But more recent empiricalresearch paints a much morepositive picture of the valueof corporate venturing pro-grams. In a study comparingover thirty thousand invest-ments in start-ups over a 15-year period, Professors PaulGompers and Josh Lernerfound that corporate ventureinvestments appear to be atleast as successful (usingsuch measures as the proba-bility of a portfolio firmgoing public) as traditionalventure capital firms. Inanother study analyzing over300 venture capital-backed,information technology IPOsin 1998-1999, researchers

Marku Maula and Gordon Murraydemonstrated that emerging technol-ogy companies performed better withcorporate equity investments thanwith traditional VC investors. Thefinancial involvement of GlobalFortune 500 ‘Infocom’ companieswas directly associated with higherfirst-day valuations. In both thesestudies, success is correlated with thestrategic fit between the corporateparent or corporate investor and theventure.

Both the problems and successesin corporate venturing can be tracedto the fundamental differencebetween such programs and inde-pendent venture capital. In contrastto VC firms, which have financialreturns as their fundamental goal,most companies pursuing corporateventuring programs cite strategic

returns as their fundamental aim.Strategic returns include exposure toradically new and disruptive tech-nologies, access to new products andmarkets, and identification of acqui-sition targets.

major cause of corporateventuring failure is thedesire to accomplish a widearray of objectives that are

not necessarily compatible. To maxi-mize financial returns, firms are bestadvised to emulate independent VCfirms. They need to provide completeautonomy to the new ventures’ man-agers and to compensate risk-takingbehavior with equity stakes. Theyalso need to exercise strict disciplineby staging the financial supportpending the achievement of certainmilestone events and by providingintensive guidance and oversightwithout interfering with the basicdecision-making responsibilities ofthe entrepreneurs who run the busi-ness. This includes a practicedindifference to potential synergiesor complementarities with otherbusinesses in the corporate portfolio.

Resolving ConflictsBut this posture can create con-

flicts. By emulating such venture cap-ital practices, firms negate the impor-tant strategic mandate of corporateventuring programs. If the primemotivation for the new venture isstrategic, then providing greaterautonomy, a disproportionately high-er compensation level, strict financialdiscipline on the downside, andignoring strategic complementaritieswill increase the likelihood of poten-tial conflict between the new ventureand the established business.

Given such conflicts, it is notenough for corporate venturing pro-grams to be managed more like pri-vate venture capital. Instead, theymust be hybrids. Corporate venturingprograms must be designed to benefit

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from certain practices employed byventure capitalists, while at the sametime leveraging structural advantagesto manage the development and com-mercialization of new technologiesthat are not available to independentventure capital firms.

Let’s take a few examples of howthis works. All investments made byprivate venture capital firms areassumed to have a limited life – typi-cally seven to 10 years or less. At theend of that time VCs are required tosell their investments and return thecapital to their limited partners. Thislimited horizon creates an incentivealignment between limited partnersand the venture capital partners thatencourages venture capitalists toinvest only when they have a clearidea about the pace and scale ofthe gains that can be achieved.Corporations, on the other hand, donot face the same pressure to produceliquidity events for new businesses.As a result, they can fund and sustainlonger-term projects, which ofteninvolve the development of radicalinnovations and technological break-throughs.

A second important structuraladvantage comes from the corpora-tion’s ownership of important physi-cal, knowledge-based and intangiblecomplementary assets that cannot befreely traded in the external markets,like a company’s brand name or itsreputation. In addition, certain tech-nologies require the coordination ofcomplementary technologies in orderto deliver value. For example, lastyear Qualcomm, the wireless tele-phone company, created a $500 mil-lion corporate venture fund to investin start-ups that develop wirelessInternet applications – particularlythose that will lead to the adoption ofa technology for transmissions thatcomplements the standards employedby Qualcomm.

Finally, there is the potential learn-

ing advantage companies gain frominvesting in new ventures even whenthey fail. For example, 3M has devel-oped a culture that not only toleratesfailure but has also institutionalizedpractices that facilitate learning andknowledge transfer among employeesinvolved in technological innovation.Each of the investments made byEastman Chemical Company this pastyear led to the development of astrategic relationship that has giventhe company access to early develop-ment of important technology.

Elements of CorporateVenturing Strategy

So what can a corporation do toincrease its odds of succeeding at cor-porate venturing? First, it must becommitted to the mantra of creativedestruction. Does senior managementregularly think about the companiesthat define the periphery of theindustry? Do they have the courageto shut down ventures that are notworking out? Is the company willingto let customer demand control how

its corporate venturing investmentsare allocated even if this means lesscontrol over the direction the newventure will take?

Second, senior management mustdecide on the principal goals of thecorporate venturing initiative. Thismeans more than declaring that thegoals are primarily strategic. It meansidentifying the specific type of goaland ensuring that multiple goals arecompatible. Does the corporationwant to have access to new technolo-gy that will lead to capitalizing on the

next “new, new thing?”Does it wish to invest incompeting technologies inwhich a dominant newstandard is likely toemerge, but in which theoutcome is unclear? Doesthe company want to investin start-ups that will serveto promote demand for itscore products? Or does thecompany just want toexpand its current R&Defforts by complementingthem with external invest-ments?

Third, senior manage-ment must determinewhether it has theresources and talent neces-sary to carry out thesegoals. Does it have employ-ees with the requisiteexperience to lead the

initiative? Can it easily hire them?Does it have the capital to finance thelarge investments that are required?Does it have a culture that encour-ages the sharing of informationacross units?

Fourth, senior management mustdecide on the appropriate design forthe corporate venturing unit and itsgovernance. Corporations use a vari-ety of structural forms to engage inventuring. These forms reflectincreasing corporate internalization

The most recent wave ofcorporate venturing activityreflects a much greaterfocus on strategic benefitsand much stronger long-term commitment by parentcompanies.

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or involvement, and range from act-ing as a limited partner in venturefunds established by independentventure capitalists to creating a cor-porate unit that makes direct invest-ments in start-ups, some of which aresubsequently “spun out” as inde-pendent companies while others are“spun in” as acquisitions. For exam-ple, when Procter & Gamble’s newventure, Reflect.com, confronted thecorporation’s inability to provide itwith necessary know-how regardingthe Internet and e-commerce, P&Gopted to use an “outsourced model,”in which the company worked inpartnership with an independentventure capital firm. P&G agreed toinvest $35 million in the Web busi-ness and keep a 65% equity stake,licensing its patented manufacturingtechnology to Reflect.com. The inde-pendent venture capital firm agreedto invest $15 million and take a 15%equity stake. Each party received twoseats on the board. Xerox, in con-trast, has opted for a “businessincubation” model, forming a newentity – Xerox New Enterprises – in1996 to capture the value ofXerox technologies in a portfolioof entrepreneurial companieswith important document pro-cessing hardware and softwaretechnologies in various stages ofdevelopment.

wo other important aspectsof design involve thereporting structure and theincentive system. Research

suggests that to be successful, a cor-porate venturing unit must have ahigh-level champion within thecorporation. To increase company-wide support, corporate venturingunits should have their managersreport directly to the CEO or to a keybusiness-unit head. Designing incen-tive packages to be in line with themarket for venture capitalists as wellas with the compensation received byemployee peers within the corpora-

tion poses an inherent conflict. Aneffort should nevertheless be made todesign an incentive system that fitsthe goals of the corporate venturinginitiative, the risk/reward levelsinvolved, and the length of the per-formance horizon.

A New WaveGiven the “boom and bust” histo-

ry of corporate venturing that tookplace over the last forty years, onecannot but wonder whether therecent economic downturn and theensuing meltdown among VC firmswill lead once again to a reduction incorporate venturing activity. Thereare certainly some signs of retrench-ment. During the first six months of2001, a number of major corpora-tions disclosed that their venture cap-ital portfolios incurred significantlosses. These include banking andinvestment giants J.P. Morgan Chase& Co. and Wells Fargo, and leadingcomputer companies Compaq andDell. Lucent Venture Partners, theventure capital unit of LucentTechnologies, is now investing at aslower pace than in years past becauseof the pull-back among the tradition-al VCs with which Lucent co-invests.And Motorola Ventures, the venturecapital unit of Motorola, will beinvesting in fewer deals this year dueto a shift in investment strategy.

In general however, this go-around appears to be differentthan past cycles. Companies suchas Qualcomm, Nokia, EastmanChemical Corporation, UPS, GeneralMills, and even Coca-Cola continuedto invest aggressively, even in the dis-mal fourth quarter of 2000 and thegloomy first quarter of 2001. Despitethe serious problems plaguing bothMotorola and Lucent, neither com-pany has slated its corporate ventur-ing programs for elimination. Andwhile Compaq recently shut down itscorporate development office in thewake of a company-wide restructur-ing, it still expects to make the same

number of venture deals through itsexisting business units.

he most recent wave of cor-porate venturing activityreflects a much greater focuson strategic benefits and

much stronger long-term commit-ment by parent companies. Thedramatic reduction in funding byindependent venture capitalistsduring this time has created moreopportunities for corporations toinvest. And the impressive trackrecord of many corporate venturingprograms in helping early stage com-panies develop has given them morecredibility with entrepreneurs as wellas conventional VCs, who are nowmuch less prone to viewing corporateventure capital as “dumb money.”

Increasingly mindful of the dis-ruptive capabilities of new businessentrants, managers of large corpora-tions are more aggressive than everabout winning the creative destruc-tion game. And they appear to havea much better grasp of the importantrole of corporate venturing in creat-ing opportunities for corporategrowth and renewal. Strong finan-cial pressures will certainly forcesome corporations to reorganize ordownsize their corporate venturingefforts. But savvy executives havecome to understand that theircompanies cannot afford to stopinvesting in innovation during aneconomic slowdown. So while manyVC firms continue to lick theirwounds from the “destructivecreation” they helped generateamong Internet start-ups, corpo-rate venturing has an unprecedent-ed opportunity to drive the nextwave of technological change andeconomic growth.

ARI GINSBERG is Harold Price professorof entrepreneurship and director of theBerkley Center for EntrepreneurialStudies at NYU Stern.

T

T

Sternbusiness 17

TH

INK

ING

AH

EA

D T h e 2 0 t h c e n t u r y ’s t h e o r i s t

o f 2 1 s t - c e n t u r y e n t r e p r e n e u r s h i p

18 Sternbusiness

By Thomas G. McCraw

a n a g e m e n tjournals andNew Economymagazines are

filled with an unendingstream of thinking andwriting about entrepre-neurship. But amid theproliferation of manage-ment gurus, there’s onetheorist whose voicepierces through the clut-ter: Joseph Schumpeter.More than a half-centuryago, the Moravia-borneconomist coined theenduring term “creativedestruction” as a greatmetaphor for capitalism.But his understandingof the dynamics ofcapitalism and the roleof entrepreneurs arejust as salient andincisive today as theywere when he firstmade them.

M

Sternbusiness 19

© a

rtis

t(s)S

IS

orn in 1883, Schumpeterwas educated at the Univer-sity of Vienna, where he

received degrees in law and politicaleconomy. From 1909 until 1911, hetaught at the University ofCzernowitz, where he wrote TheTheory of Economic Development,the 657-page foundation stone of histheory of entrepreneurship. Hetaught at universities in Austria,Germany, and Japan, worked as alawyer in Egypt, briefly ranAustria’s finance ministry in 1919,and served – unsuccessfully – aspresident of Vienna’s privateBiederman Bank from 1921 until1924. Meanwhile, he found timeto indulge in a plethora ofromantic liaisons, of whichhe liked to boast. (Hewould marry three times.)Schumpeter came to Harvardpermanently in 1932, andbecame an American citizen.He died in 1950.

A serious scholar – he hadalmost no recreation otherthan the occasional game oftennis – Schumpeter was oneof the great polymaths of thetwentieth century. Between1905 and 1950, he produced15 books, six pamphlets, about 100book reviews, and at least 148 arti-cles, and comments. But it isn’t justthe quantity that impresses, it isthe quality. The intellectual histori-an Martin Kessler argues thatSchumpeter was, apart from JohnMaynard Keynes, “the only trulygreat economist the 20th century hasproduced.” And business historianslike Alfred D. Chandler, Jr., regardSchumpeter as the economist whobest understood the rise of bigbusiness and the central roles ofinnovation and entrepreneurship.

Unlike many famous scholars,Schumpeter exhibited a lively inter-

est in and respect for well-done workregardless of the disciplinary bannerunder which it appeared. As hisHarvard colleague Seymour Harrisonce put it, Schumpeter was prima-rily an economist, but “historiansand sociologists can include him asone of their stars” too. He held as anarticle of faith that all good econom-ics must include theory, history, andstatistics. And he relentlessly evan-gelized in favor of econometrics.Schumpeter helped organize theEconometric Society and served asits president from 1937 to 1941.

Although his work encompasseda wide range of subjects, it ishis theory of entrepreneurship –

a word and phenomenon withwhich his name will likely forever belinked – that is most relevant to con-temporary business practitioners.Schumpeter developed his innova-tive theories in three main books:The Theory of Economic Development(1911), Business Cycles (1939),and Capitalism, Socialism, andDemocracy (1942).

The Theory of EconomicDevelopment

In the early 20th century, eco-nomic thought was dominated bytheorists who posited that economicsystems were fueled by a “circular

flow” of inputs and outputs, andwere generally at a state of equilibri-um. But Schumpeter found that thistraditional economic analysis lackeda workable theory of innovation orfinance – i.e. a realistic model of theway saving and investment actuallyoperate in a dynamic economic sys-tem.

In his 1911 book Die Theorie derWirstshaftlichen Entwicklung (theEnglish version, The Theory ofEconomic Development, did notappear until 1934), Schumpeter setforth the first thoroughgoing exposi-tion of a more complex system. Inhis new model, economic routine isperiodically interrupted by entrepre-

neurial behavior that comesin clusters and disruptsequilibrium. Entrepreneurs,who could effectively functionas free agents, unconnected toa single firm, disrupt thecircular flow by “carryingout new combinations.” This,he asserts, is the basis ofeconomic development, andembodies the essence ofcapitalism.

In an effort to divine themotivations of entrepreneurs,Schumpeter departed from

economics and dipped into the realmof psychology. “The typical entre-preneur is more self-centered thanother types, because he relies lessthan they do on tradition and con-nection and because his characteris-tic task consists precisely in breakingup old, and creating new, tradition,”he wrote. An entrepreneur is moti-vated by “the dream and the will tofound a private kingdom.” Othermotivations, he wrote, include “thewill to conquer,” “the impulse tofight,” and “the joy of creating.”

Schumpeter also saw profoundsociological implications in the riseof some entrepreneurs and the obso-

B

Between 1905 and 1950,

he produced 15 books, six

pamphlets, about 100 book

reviews, and at least 148 arti-

cles and comments. But it isn’t

just the quantity that impress-

es, i t is the qual i ty.

“

”

THINKING AHEAD

20 Sternbusiness

lescence of others. Just asbusinesses rise and fall,so too do entrepreneursand their families. Or ashe put it in one of hismany great metaphors,“the upper strata of [acapitalist] society arelike hotels which areindeed always full ofpeople, but people whoare forever changing.”Schumpeter also notedthat just as intellectualentrepreneurs proposingnew theories face oppo-sition, business entre-preneurs seeking tooverthrow conventionalwisdom encounter resist-ance from entrenchedinterests. Those whosepositions are threatenedby innovation, he wrote,may be expected to fightinnovation, even toorganize against it bythrowing up legal andpolitical impediments.

The last vital elementin the system Schumpeterdelineates in The Theoryof Economic Developmentin what he calls “theswarm-like appearance of entrepre-neurs,” which represents the kickoffof a new business cycle under capi-talism. He relates his theory of entre-preneurial activity directly to whatwas for his generation the most diffi-cult analytical problem posed bycapitalist economies: the “jerky dis-turbance” of “the equilibrium posi-tion,” as Schumpeter himself calls it– not any gentle ebb and flow, butrather “a disturbance of a differentorder of magnitude.” It was to themysteries of such disturbances thatSchumpeter would devote his nextbig book, Business Cycles (1939).

Business CyclesSome 27 years elapsed between

the publication of The Theory ofEconomic Development and the1939 appearance of BusinessCycles: A Theoretical, Historical,and Statistical Analysis of theCapitalist Process. During thoseyears Schumpeter experienced mul-tiple personal traumas: livingthrough World War I and its after-math in Austria, fleeing Germany,and losing his family. By 1939, hehad become deeply pessimisticabout the state of the world.

A book with grand ambitions,

the 1,100-page, two-volume work nonethe-less proved a monu-mental disappointmentto Schumpeter’s manyadmirers and to theauthor himself. It wasthoroughly upstagedby Keynes’s GeneralTheory of Employment,Interest, and Money,which appeared in1936. Schumpeter didnot work well with edi-tors, and was loath toshow work-in-progresseven to his professionalcolleagues, let alone toseek editorial advice. Asa result, his work wasrepetitive and undisci-plined; his aversion tothe editorial may havelimited his influenceamong the larger public.

In Business Cycles,Schumpeter again setabout to marry multipledisciplines. He tried toturn cyclical economicpatterns into predictivescientific wave theoriesborrowed from physics.The book is also imbued

with a remarkable richness of histor-ical detail and understanding.Although the technical explanationof cycles remained problematical,the historical vision that underlaySchumpeter's effort at synthesis wassquarely on point: that capitalism –not all economic activity, just capi-talism – is fundamentally an unsta-ble, disequilibrating process. Despiteits sophistication, Business Cyclessold only about 1,500 copies.

Capitalism, Socialism, andDemocracy

The failure of Business Cycles

He came to believe that capi-

talism contains the seeds of its own

destruction – not for economic reasons

but for sociological ones.

“”

Sternbusiness 21

may have informed Schumpeter’snext book, Capitalism, Socialism,and Democracy, which was pub-lished in 1942. It is as though theauthor, now deeply pessimistic notonly about the indifferent receptionof Business Cycles but also about thestate of the world, decided tounburden himself on an array ofother subjects in addition to eco-nomics narrowly construed.

Despite the book’s title, it con-tains little of lasting interest abouteither socialism or democracy. But itbursts with ideas about capitalism,and as a “performance” – a termSchumpeter liked to apply to oth-ers’ works – it may be the bestanalysis of capitalism ever writ-ten. It was here thatSchumpeter first coinedthe oxymoronic phrase“creative destruction,”which quickly took secondplace only to AdamSmith’s “invisible hand”in the history of a disci-pline already rich in mem-orable metaphors.

Schumpeter’s core argu-ment in Capital ism,Socialism, and Democracyis reducible to three majortenets:

1. The essence of capitalism isinnovation (“creative destruction”)in particular sectors. Certain stan-dard tools of economics, such asstatic equilibrium and macroeco-nomic analysis, are useful; but car-ried too far they can disguise realityand mislead scholars and students.

2. The virtues of capitalism – inparticular its steady but gradualpattern of growth – are long-runand hard to see; its defects, such asinequality, apparent monopoly, andwild gyrations in the business cycle,are short-run, conspicuous, and

directly hurtful to important inter-est groups.

3. It is dangerous for economiststo prescribe “general” recipes andnostrums for reform, because politi-cal and social circumstances arealways changing.

In many ways, Business Cycleswas a synthesis. Some of the majorthemes of Capitalism, Socialism,and Democracy represent rework-ings of ideas Schumpeter had firstpresented in articles published longbefore, while in his twenties (he was59 in 1942, when the bookappeared). Others came directly outof Business Cycles. A capitalist econ-omy, he now wrote, “is not and can-not be stationary. Nor is it merely

expanding in a steady manner.Every situation is being upset beforeit has had time to work itself out.Economic progress, in capitalistsociety, means turmoil.”

The contemporary structure ofbusiness, Schumpeter argues, is bestunderstood as having evolved from along “organizational development.”It reflects a “process of industrialmutation – if I may use that biologi-cal term – that incessantly revolu-tionizes the economic structure fromwithin, incessantly destroying theold one, incessantly creating a newone.” In sum, the process is one of

“creative destruction” – the sweep-ing out of old products, old enter-prises, and old organizational formsby new ones. “It is what capitalismconsists in and what every capitalistconcern has got to live in.”

It may sound relatively mild tothe contemporary ear. But with theseradical declarations, Schumpeterwas, in effect, indicting the entireprofession of mainstream economicsfor failing to acknowledge that con-tinuous innovation is endogenous tocapitalism. Pushing his analysis toits limits, Schumpeter further identi-fies capitalist entrepreneurship withtechnological progress itself. As amatter of historical record, theywere “essentially one and the same

thing,” the first being“the propellingforce” of the second.

These vital state-ments led Schumpeterto a somewhat morepessimistic conclu-sion. For he came tobelieve that capital-ism contains the seedsof its own destruction– not for economicreasons but forsociological ones.

Capitalism, Socialism, and Democracydelves deeply into sociology todescribe the ways in which capital-ism undermined the traditionalunderpinnings of civilized societyand created new economic orders,which in turn sets off recurringcycles of creative destruction.Capitalism is so successful economi-cally, he wrote, that it “creates, edu-cates and subsidizes a vested interestin social unrest.” He concludes, inthe end, by professing to see not onlythe decline of capitalism but also theultimate triumph of socialism. “Cancapitalism survive?” he asked. “No.

Pushing his analysis to its

l imi ts , Schumpeter fur ther

ident i f ies capital ist entrepre-

neursh ip wi th technolog ica l

progress itself .

“”

THINKING AHEAD

22 Sternbusiness

I do not think it can.”When Cap i ta l i sm ,

Socialism, and Democracywas first published in1942, it received a mod-icum of attention, proba-bly because World War IIwas dominating not onlythe news but intellectualand economic life as well.A second edition, whichappeared in 1946, attract-ed wider notice. But thethird edition, published in1950 at a high point in theCold War, when capitalism andsocialism were, in fact, competingfuriously for the world’s allegiance,became an international best-seller.It produced thousands of future cita-tions by scholars in sociology, history,economics, and other disciplines.Translated into at least 16 lan-guages, Business Cycles still sellswidely in paperback editions.

Creative Destruction andEntrepreneurship

Of course, Schumpeter turned outto be incorrect. Several decades afterhis death, it was capitalism that ulti-mately triumphed over socialism –not the other way around. But thelasting value of Schumpeter’s worklies not in his accuracy as a prognos-ticator, but in his brilliant analysis ofhow entrepreneurs work, and in hisability to change the way econo-mists, students, and practitionerswrite and think about entrepreneur-ship and technological change.

Schumpeter’s work began to finda wider audience during the 1960sand 1970s, and a still broader one inthe last two decades of the 20th cen-tury. In the years after his death,scholars began to analyze not onlythe process of creation, but also thedestruction that was its inevitable

concomitant. They wondered aboutthe human costs of economic“progress,” and started to rethinkthe nature of human existence undercapitalism. They turned theirthoughts to the inescapable tradeoffsbetween economic values on the onehand and social ones on the other.

In the 1980s and 1990s, thedemise of command economies ineastern and central Europe and theremarkable economic performanceof China and other Asian countriesraised perplexing questions aboutthe relationship between capitalismon the one hand and democracy onthe other.

At the same time, in many busi-ness schools, perhaps most notablyHarvard and Babson, entrepreneur-ial studies took off. Masses of stu-dents began to express interest in thesubject and to demand curricula.The total number of business schoolswith offerings in entrepreneurially-oriented courses soared from six in1967 to 370 by 1993.

At the Harvard Business School,where in the late 1940s Schumpeterhad helped to set up the ResearchCenter in Entrepreneurial History,enrollment in elective coursesoffered by the newly organizedEntrepreneurial Management Unit

reached more than 1,100 in1996. In 1999, the School'sadministration introduced anew course entitled “TheEntrepreneurial Manager”into the required curriculum.

Meanwhile, in the UnitedStates, and to a lesser extent inWestern Europe, the phenome-nal run-up of securities mar-kets throughout the 1990spiqued sharp new interest inthe entrepreneurs who becamedot-com millionaires and bil-lionaires. In this new setting,

Schumpeter’s work on entrepreneur-ship acquired a compelling newinterest. Scholars from many disci-plines began to find in his writingseither answers to their own questionsor valuable maps and guidebooks fornew avenues of research. During the1990s, the number of academic cita-tions to Schumpeter’s works actuallyovertook those to Keynes’s, a phe-nomenon that would have seemedinconceivable a generation earlier.

In the end, the fundamental rea-son for the ongoing relevance ofSchumpeter to the study of businessand social science comes down tohis passionate insistence on the indi-visibility of intellectual inquiry,together with the sheer fertility andpower of his mind.

Has there ever been a more pen-etrating analyst of capitalism inall its dimensions than JosephSchumpeter? No, I do not thinkthere has.

THOMAS MCCRAW, the Isidor Strausprofessor of business history atHarvard Business School, is editor ofthe Business History Review. Lastspring, the Pulitzer Prize winner wasthe entrepreneurship scholar-in-resi-dence at NYU Stern’s Berkley Centerfor Entrepreneurial Studies.

Has there ever been a

m o re p e n e t r a t i n g a n a l y s t

o f c a p i t a l i s m i n a l l i t s

d i m e n s i o n s t h a n J o s e p h

Schumpeter? No, I do not

think there has.

“

”

Sternbusiness 23

By Allan Afuahand Christopher Tucci

reative destruc-tion” is the terme c o n o m i s tJ o s e p hS c h u m p e t e rcoined to de-

scribe the way entrepre-neurs create new wealththrough innovation thatdestroys existing mar-ket structures used byincumbents to derivecompetitive advantage.Of course, technologicalchange — like the adventof the Internet — can bethe basis for creativedestruction. And the termhas been much in voguein recent years as theNew Economy picked upsteam. But how wide-spread and deep is thecreative destruction froma technological changesuch as the Internet?What types of industriesare likely to be affectedand how deep is theimpact likely to be ineach? Where shouldentrepreneurs seek oppor-tunities? And how canincumbents exploit theirexisting positions?

C

24 Sternbusiness

“

A m o d e l f o r

u n d e r s t a n d i n g

t h e I n t e r n e t ’s

a b i l i t y t o

w r e a k h a v o c

o n y o u r

i n d u s t r y

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Sternbusiness 25

© artist(s)SIS

o get at these largequestions, we con-structed a modelof the Internet ascreative destroyer.Then we applied

the model to three broad industrygroups, defined by the ways inwhich they use technology. Theresults provide some interestingconclusions and guides for furtherresearch.

The ModelOur model, shown in Figure 1,

posits that a new technology such asthe Internet can lead to creativedestruction through four means: cre-ating new value, rendering function-

al capabilities obsolete, renderingarchitectural capabilities obsolete,and reducing product costs.

Creating new value. Customervalue comes in different forms:product features, timing, andproduct mix. The Internetimproves all these forms of value.Better coordination between andwithin a firm, via intranets andexchanges, means firms can inventproducts or services with betterfeatures for customers, e.g., make-to-order customized cars. TheInternet can also increase customervalue by increasing the mix ofproducts a firm offers. As of May1999, for example, Amazon.comoffered 16 million items for sale on

its store front.Rendering functional capabili-

ties obsolete. In performing theiractivities, the functions that com-prise a company’s system must inter-act with each other. Building a carrequires not only knowledge ofdesign, manufacturing, and market-ing, but also knowledge of the link-ages between these functions. Theimpact of the Internet in this areavaries by industry: it depends on theextent to which the Internet offersnew and better ways of performingeach function. The Internet may notfundamentally change the way carsare manufactured, for example, butit does radically change the wayclients invest in stocks.

TCREATIVE DESTROYER

26 Sternbusiness

Rendering architectural capa-bilities obsolete. Architecturalcapabilities refers to knowledge ofhow the functions interact with eachother. The more different functionscan coordinate their activities, themore effective they can be.With the Internet, functionsthat were physically separatedin a bricks-and-mortar worldcan now communicate andexchange information thatthey could not before.Companies can make infor-mation available to far-flungemployees by using a corpo-rate Intranet, for example.

Reducing Costs. Formany industries, the Internetcan lower transaction costs,e.g., the costs of searching forsellers and buyers; collectinginformation on products; andnegotiating, writing, monitoring andenforcing contracts. For productssuch as software, music, and videothat are in digital form, the Internetcan also sharply reduce transporta-tion costs. Since production usuallyinvolves an exchange of information,the Internet can also reduce produc-tion costs.

These then, are the four ways thatthe Internet can effect creativedestruction. The depth and impactof each of the four determinants,however, depends on another vari-able: the extent to which the valueadded is information.

Applying the ModelFor the purposes of our study, it

made sense to apply the model todifferent industries, according to theway in which they use technology.

Several years ago, J.D. Thompsonproposed that the technologies onwhich firm activities in differentindustries rest can be divided intothree groups: long-linked, mediat-ing, and intensive. We found this a

useful means of categorization.Long-linked industries are ones in

which inputs are transformed intooutputs by a set of sequentiallyinterdependent activities, say X, Y,& Z, in which activity Y can be per-formed only after successful comple-tion of activity X, and Z performedonly after successful completion of Y.A chip maker will start fabricatingthe chips only after they have beendesigned, and assemble and testthem only after they have been fab-ricated. Manufacturing firms arepredominantly long-linked.

ediating industriesare ones that usetechnolog ies tolink clients or cus-tomers who areinterdependent or

would like to be. Mediating tech-

nologies can potentially exploit thenetwork externalities (the valuethat clients derive from a networkbased on the size of the networkitself.) Commercial banks, whichlink borrowers and depositors;

investment banks, which linkissuers of equity to investors;and the telephone system,which links people who wantto communicate are all goodexamples of this category.

ntensive industriesutilize intensive tech-nology to effect achange of some object.And the mix ofresources they use to

do so is a function of the feed-back that they get from theobject. Consider a hospital inwhich the object is a patientwho gets admitted and may

require some combination of dietary,x-ray, laboratory, and housekeepingservices as well as such specialties aspharmaceutical services, occupa-tional therapies, social work, andspiritual or religious services. Theresources used and the order inwhich they are used are a functionof the state of the patient and theresults of the patient using theother resources. Universities, hos-pitals, research laboratories, andmanagement consulting firms areprimarily based on intensivetechnologies.

The Impact of the Interneton Different Industries

Table 1 (page 28) summarizesthe results of the impact of theInternet on industries grouped bythe three technologies.

MSternbusiness 27

The impact of the Internet

depends on the extent to which

the Internet offers new and better

ways of performing each function.

The Internet may not fundamen-

tally change the way cars are

manufactured, for example, but it

does radically change the way

clients invest in stocks.

“

”I

For long-linked industries, theInternet drastically improvescommunication and coordinationbetween and within stages, X, Y,and Z. Such an improvement canresult in, for example, improved carquality and lead times. It also poten-tially has a huge impact on the link-ages between stages. However, manyof the core concepts that underpineach functional area remain thesame. The Internet may allow autodesign and development groups toobtain information directly fromcustomers, or allow manufacturingto follow the design and develop-ment of a car as it progresses. It mayeven let customers check the statusof their cars as they go through theassembly line. But it does not affectas deeply a firm’s knowledge of thefundamentals of thermodynamics,combustion engineering, and metal-

lurgy on which internal combustionengineering rests.

The Internet is therefore anarchitectural innovation to firmswhose products/services rest onlong-linked technologies. Now,changes in linkages can triggerenough changes in components toresult in improved cost or value tocustomers. A build-to-order systemthat relies on the Internet can drasti-cally reduce shipping costs, forexample. But such a system wouldrequire shorter lead times from theexisting 30-60 days that it now takesfrom metal forming to complete car.

For mediating technology indus-tries, the impact of the Internet isdeeper. Mediating technology firmscan use the Internet to reach greaternumbers of customers, and to offercustomers larger networks andgreater convenience. A banking

client using the Internet can not onlyperform banking transactions 24hours a day, she can also examineher account transactions and thestatus of a loan application. TheInternet also creates entirely newvalue networks for mediating tech-nologies – e.g., business-to-businessexchanges, which act as intermedi-aries between buyers and sellerswhere parties can go to find infor-mation about potential partners.

Since the Internet is a superiorlinking technology compared tomany bricks-and-mortar mediatingtechnologies, it renders obsoletemany bricks-and-mortar functionsand underlying capabilities. Pre-Internet, stock brokers were a keyresource for most brokerage clients.With the Internet, they are notimportant for many clients, whohave access to much investment

CREATIVE DESTROYER

28 Sternbusiness

information and can make theirown choices.

Unlike long-linked technologies,where the value added and deliveredis both information and physicalcomponents, the value added anddelivered in mediating technologiesis all information. Offline, brokeragecustomers would talk to bro-kers on the phone, and bro-kers would send investmentand research reports by mail.In an Internet world, theclient has direct and instantaccess to numerous invest-ment reports on the Web, andto his or her account. Thus,any capabilities that a brokerdeveloped in a bricks-and-mortar world to interact withhis or her research depart-ment to more efficiently get researchreports to customers or to morequickly enter orders for a client arenow obsolete. The Internet has alsoallowed companies using mediatingtechnologies to reduce costs: the per-trade cost for brokerage firms hasdropped from $180 to about $8.

or intensive tech-nology industries,the Internet canalso have a signifi-cant impact. Mostof the value thatintensive technolo-

gy firms offer customers comes fromthe information asymmetry thatexists between firms and theirclients. A mathematics professoradds value by imparting some of theknowledge he has that students inhis classroom do not. With the helpof the Internet, the same professorpotentially can teach millions of stu-

dents at their workplaces or homes.Frequently asked health or consult-ing questions can also be madeavailable to clients via a Web site, 24hours a day.

The core concepts that underpineach of the functions that are drawnon to effect change in the object in

an intensive technology are notchanged by the Internet. But thelinkages among them do. In a hospi-tal, for example, the core conceptson which x-ray, laboratory work,surgery, and occupational therapyrest are not changed radically by theInternet. But in an online world, x-rays do not have to be physicallydelivered in person. Moreover, physi-cians and specialists from anywherein the world can collaborate inexamining the x-rays in real time.Thus, architectural capabilities thatserved firms well in a bricks-and-mortar world may be rendered obso-lete by the Internet.

ConclusionsThe impact of the Internet on the

four determinants of creativedestruction suggests that mediatingtechnologies should have the highestlevel of creative destruction. For

long-linked and intensive technolo-gies, the Internet has the sameimpact on the four determinants ofcreative destruction. However, thevalue added by or delivered to eachfunction for intensive technologies islargely information, while that forlong-linked technologies is largely in

physical components ormaterials. Therefore wepropose that the Internetcauses more creativedestruction in intensivetechnologies than in long-linked technologies.

Of course, creativedestruction can be opera-tionalized by severalmeasures. This includesthe market value of start-ups, number of new

entrants, number of incumbents thatfail, number of incumbents that exitbusinesses, rate of drop in incum-bent profits, increase in the ratio ofnew entrant profits relative toincumbent profits, number of entriesby new firms, number of newentrants relative to number ofincumbents, and reduction inincumbent sales and profitabilityare all possibilities. Given the highlevel of activities that the Internet isgenerating in business and thepotential for research on its impacton competitive advantage, ourpropositions are only the start ofwhat can be fertile ground fortheory development.

A L LAN AFUAH is professor of corporatestrategy and Hallman fellow of electron-ic business at the University ofMichigan, and CHRISTOPHER TUCCI isprofessor of entrepreneurship and inno-vation at NYU Stern.

F

The impact of the Internet

on the four determinants of

creative destruction suggests

that mediating technologies

should have the highest level

of creative destruction.

“

”

Sternbusiness 29

SPECULATIVE SCHEMERSBy William Greene

30 Sternbusiness

Phot

oDis

c/M

icha

el C

asw

ell

Most contemporary th inkers don’t regard Ralph

Waldo Emerson as much o f a management

th inker. The New England t ranscendenta l is t was

more concerned wi th mat ters o f the mind and

spi r i t than cash- f low f igures and mot ivat ion. But

Emerson did grasp one of the fundamental drivers

of American-sty le entrepreneur ia l capi ta l ism. " I f

a man can wr i te a bet ter book, preach a bet ter

sermon, or create a bet ter mousetrap than

his ne ighbor, " he wrote, " though he bui lds

h is house in the woods the wor ld wi l l

make a beaten path to h is door. "

B o l d

e n t r e p r e n e u r s

a r e t r y i n g t o

p a t e n t b u s i n e s s

m o d e l s

i n t h e d i g i t a l

e c o n o m y

Sternbusiness 31

nventors, tinkerers, andentrepreneurs have long beenlaboring in their houses in thewoods (and in their garages inthe suburbs) to create the

proverbial better mousetrap. Formore than two centuries, the desksof clerks at the U.S. Patent andTrademark Office (USPTO) havebeen cluttered with patent applica-tions for wondrous new devices: alight bulb (Thomas Edison, 1880),a flotation device (AbrahamLincoln, 1849), a new self-guidancesystem for torpedoes (actress HedyLamarr, 1942), and a compound tohelp sufferers of depression (EliLilly, Inc. The drug Prozac is cov-ered by six chemical patents grantedbetween 1974 and 1986). In recentyears, patents have assumed animportant role in the burgeoningfield of e-commerce. But not allpatents are created equal: considerU.S. Patent No. 5,443,036, grantedin 1995, which is shown below.

This is not a joke. The patent isheld by Messrs. Kevin Amiss and

Martin Abbott, who managed todemonstrate both the utility andnovelty of using a laser pointer toplay with a cat. Now, it is possible theapplicants and the USPTO were justhaving fun. But the patent nonethe-less illustrates an important trend. Itwas not granted for a device, or athing. Instead, it is a patent for howto do something. Other intrepidinventors have been awarded patentsfor methods of completing quotidianactivities, like finding the right brasize (No. 5,965,809) and hitting atennis stroke while wearing a kneepad (No. 5,993,366). While thesepatents may seem like novelties, thistrend is not entirely new. TheUSPTO has been awarding so-called“methods” patents for decades. Butin recent years, the numbers haverisen dramatically. And patenting“business methods,” some of themstunningly obvious – such as using asingle mouse click to complete anonline book order – has become ahallmark of entrepreneurship in thedigital economy.

The Background of PatentsThe patent law of 1790 created

an office that was empowered bythe Constitution to “Promote theProgress of Science and useful Arts,by securing for limited Times toAuthors and Inventors the exclusiveRight to their respective Writingsand Discoveries” (Article One,Section 8). In 211 years, the USPTOhas established a proud tradition ofrewarding the development of tech-nologies of all sorts (though often forthings that might seem at a distanceto be trivial, or obvious, or both).The objective has always been todraw out of the collective geniusinventions that would promote thegood of the nation. But grantingpatents can be a Faustian bargain.On the one hand, by commerciallyrewarding the efforts of inventors,we call forth their creative efforts.On the other hand, we createmonopolies and all the evils thatattend them.

The patent laws grant inventors a20-year window during which they –and only they – may exploit thecommercial potential of their workas they see fit. The philosophy of theUSPTO seems to embrace the ‘soli-tary genius’ model of innovation,wherein the lone innovator receivesprotection from competition while heor she perfects the reaper, or the cot-ton gin, or the cellular phone. Butother elements of our governmenthave expressed ambivalence aboutthe granting of exclusive monopo-lies. “It was never the object ofpatent laws to grant a monopoly forevery trifling device, every shadowof a shade of an idea, which wouldnaturally and spontaneously occurto any skilled mechanic or operatorin the ordinary progress of manufac-tures,” the Supreme Court ruled inan 1882 case (Atlantic Works vs.Brady). “Such an indiscriminate cre-ation of exclusive privileges tends

I

SPECULATIVE SCHEMERS

32 Sternbusiness

United States PatentAmiss et al.

METHOD OF EXERCISING A CAT 5,194,007 3/1993 Marshall et al.

Primary Examiner– Todd E Manahan

[57] ABSTRACT

4 Claims, 1 Drawing Sheet

Amethod for inducing cats to exercise consists of di-recting a beam of invisible light produced by a hand-held laser apparatus onto the floor or wall or otheropaque surface in the vicinity of the cat, then movingthe laser so as to cause the bright pattern of light tomove in an irregular way fascinating to cats, and to anyother animal with a chase instinct.

US005443036A[11] Patent Number: 5,443,036[45] Date of Patent: Aug., 22, 1995

Inventors: Kevin T. Amiss, 255 S. Pickett St.,#301, Alexandria, Va. MartinH Amiss, 10549 Assembly Dr.,Fairfax, Va. 22030

OTHER PUBLICATIONSCarayan et al., "Effects of tianeptine on the Perform-ance of a reaching movement in a cat",Psychopharma-cology, vol. 104, Issue 3, Berlin, 1991, pp. 328-336.Levesque et al., "Visual 'cortical-recipient' and tectalrecipient pontine zones play distinct roles in cat visuo-motor performance", Behavioral Brain Research,vol. 39,Netherlands, 1990, pp. 157-166.

Appl. No.: 144,473

Filed: Nov. 2, 1993

Int. Cl.6 .................................................A01K 29/00U.S, Cl. ........................................................ 119/707Field of Search ................ 119/702, 707, 174, 905;

466/485References Cited

U. S. PATENT DOCUMENTS

3,877,171 4/1975 Sloop et al. ..................... 466/4854,208,701 6/1980 Schock4,231,077 10/1980 Joyce et al.4,757,515 7/1988 Hughes4,761,715 8/1988 Brooks4,926,438 5/1990 Macs et al.4,985,029 1/1991 Hoshino5,056,097 10/1991 Meyers

[54]

[76]

[21]

[22]

[51][52][58]

[56]

[19]

Rob

ert O

’Hai

r

rather to obstruct than to stimulateinvention. It creates a class of specu-lative schemers who make it theirbusiness to watch the advancingwave of improvements, and gatherits foam in the form of patentedmonopolies, which enable them tolay a heavy tax on the industry of thecountry, without contributing any-thing to the real advancement of thearts.” Six-score years later, thesewords resonate with those who viewsome contemporary business modelpatents as little more than sandthrown into the gears of the digitaleconomy by “speculative schemers.”

Patenting Business MethodsThe idea of patenting a method of

doing business is as old as theInternet is brand new. ToddDickinson, director of the USPTO,offers as evidence a patent awardedin 1867 for a method of registeringhotel guests in a book with adver-tisements in the margins that “lookssuspiciously like a commercial(web)site.” But even those complete-ly comfortable with the idea ofpatenting a “how to” might still bepuzzled by Patent No. 4,744,028,awarded in 1988 to NarendraKarmakar, then at Bell Laboratories,for the solution to a mathematicalproblem – the linear programmingproblem with large numbers ofactivities. After all, haven’t we beentaught that equations are laws ofnature? Apparently not all are, sincedozens of patents have beenawarded for equations, includ-ing, Pierre Duhamel’s Patent No.4,797,847 for the Discrete CosineTransform, a mathematical resultthat is used in designing compactstorage for video data. (For readerswho may suddenly feel inspired topatent Einstein’s E=mc , save yourenergy. This one is viewed as a law ofnature, and is regrettably notpatentable.)

In order to bepatented, an equationmust be new, and musthave some commercialpotential. Karmakar’ssolution was new, andit has proved very use-ful to the airlines inassigning planes toroutes and flights. Buthere, again, the gov-ernment has createdsomething of a muddle. TheSupreme Court has singled outmathematical algorithms for exclu-sion from patentability. They areunpatentable if they merely representan abstract idea – abstract ideascan’t be patented. But, in a 1981case, Diamond v. Diehr, the court leftthe door ajar; noting that “certaintypes of mathematical subject matterstanding alone, represent nothingmore than abstract ideas untilreduced to some type of practicalapplication.” Of course, any businessmodel is an idea, an abstract expres-sion. But, one can certainly arguethat a business model has a practicalapplication, especially when it is putinto use.

When an Internet entrepreneurtries to gain a patent on a businessmethod, she is not just patenting theidea – she is patenting the softwarethat runs the transaction. And inorder to obtain a patent on software,one has to be able to patent analgorithm, which is essentially anequation. In the mid-1990s, whendealing with such a question, theUSPTO seemed to turn a corner thatled to the current flood of businessmethod patents.

The ‘Hub and Spoke’In 1993, designer/inventor Todd

Boes created a “Hub and Spoke”data-processing system for SignatureFinancial Services Corp. The systemwas designed to keep track of indi-

vidual mutual fund investments thathad been pooled into a single portfo-lio. Boes created a computer algo-rithm for doing the computations.At the time, computer programscould be copyrighted but notpatented. (The distinction between acopyright and a patent is subtle.Superficially, a copyright gives theholder protection only against phys-ical reproduction for commercialgain of their idea or creation whereasthe patent literally protects the useof the idea. Thus, for example, twopeople could both copyright the samedramatic photograph or painting –assuming they had created themindependently.) The patent holder,say to an equation, can prevent allothers from using their idea forcommercial gain without theirpermission. Boes, however, didobtain a patent for the underlyingidea, which was assigned toSignature Financial Services in 1993.

State Street Bank and Trustattempted to negotiate a license touse Signature’s technology. Whenthe negotiations broke down, StateStreet sued, arguing that the patentwas invalid since it covered a math-ematical algorithm. The districtcourt agreed, and granted a summa-ry judgment in State Street’s favor,with the judge noting that “as estab-lished by a series of older cases,business methods are unpatentableabstract ideas.” However, theFederal Circuit Court disagreed and

"Patenting 'business methods',some of them stunningly obvious – such as using a single mouse click to complete an online book order– has become a hallmark ofentrepreneurship in the digital economy."

Sternbusiness 33

2

overturned, and the patent held. This case, which forms the foun-

dation of the current environment ofbusiness model patenting, openedthe floodgates. Individuals andgroups such as Walker Digital, theStamford, Ct.-based idea factory runby Priceline.com founder JayWalker, have been emboldened tocomb the intellectual landscape forpatentable ideas great and small.The number of applications forbusiness model patents jumped fromroughly 700 to 2,600 from 1996 to1999. The number of patents grant-ed for business methods jumpedfrom less than 100 to over 500 in thesame period. In general, applicationsfor Internet-related business-methodpatents seem to have been warmlyreceived at USPTO, though some-times the agency makes obviousmistakes. In 1993, it awarded apatent to Compton’s New Media(Compton’s Encyclopedia) whichapparently laid a basis for the com-pany’s claim to multimedia itself.The patent was as ridiculous as itseems, and at the instruction of

USPTO Director Dickinson, Compton’sclaims were ultimately overturned.

Walker Digital has applied forhundreds of business model patents.One of them which was granted isfor “shopping up,” a system inwhich a customer at a store, such asa Kentucky Fried Chicken outlet,takes their change “in kind,” in theform of an additional food product.Even more striking, and perhapsbetter known, is Walker’s patent onthe pricing method used byPriceline.com, which looks like apatent on the English Auction, adevice which has been in the publicstock of knowledge for decades. Theposter child for this entire debate isAmazon.com’s famous “1 click”method and system for placing apurchase order via a communica-tions network (U.S. Patent No.5,960,411, granted in September,1999).

The Rationale for DigitalCommerce Patents

Why should we have businessmodel patents such as these? By his

own account, Jeff Bezos ofAmazon.com has been besieged withcorrespondence about Patent No.5,960,411. In an open letter on thissubject he argues that businessmodel patents should be treated dif-ferently by the USPTO. And whilehe suggests a shorter track fromapplication to award and a shorterlifespan for the patent (five yearsinstead of 20), he nonetheless enthu-siastically endorses them as good forboth his shareholders and his cus-tomers. After all, he writes, “online,the balance of power shifts awayfrom the merchant and toward theconsumer.” What one takes awayfrom Bezos’ missive is the sense thatonline entrepreneurs need patentsfor business methods because theheat of competition on the web isgreater than in the “old economy.”Entry is easy, and customers arefickle – branding is difficult and cus-tomer loyalty is hard to come by.Amazon.com’s mantra, “Get BigFast,” should more appropriatelyread “get it as fast as you can, whileyou can.” First-movers like Bezos

SPECULATIVE SCHEMERS

"The idea of patent ing a method of doing business is asold as the Internet is brand new."

34 Sternbusiness

obviously believe a little sand in thegears to slow down the competitioncan't hurt. But I’m not sure this jus-tifies a fast track to quick monopolyprofits before they evaporate.

One could argue that patent pro-tection provides a crucial role inallowing developers of “things” suchas pharmaceuticals to recoup thehuge, sunk research and develop-ment costs. Obviously, it costs a sub-stantial sum of money to design andbuild a truly effective website. But,as a general proposition, this hardlyseems a compelling case for patent-ing methods of conducting businesssuch as shopping up, or a system forproviding expertise online – asAskJeeves.com, another WalkerDigital creation, did in Patent No.5,862,223.

One of the challenges facingpatent-granting bureaucrats is thatthe amount of prior art (existingknowledge) which must be verifiedfor business model applications isvast and the art, itself, is oftenambiguous and diffuse. And thelingo and newness of the Internetsometimes aggravates the situation.American University law professorJames Boyle believes, “the PatentOffice is issuing patents for blinding-ly obvious things just because theyare being done with software or onthe Internet,” and that such patentsare causing a “chilling effect on elec-tronic commerce.” New YorkUniversity Law School’s RochelleDreyfuss argues forcefully that busi-ness model patents “undermine thevery basis on which the anti-monop-oly argument depends.”

There has been very little proofoffered in the literature to supportthe notion that monopolies on busi-ness methods are a good thing. Andthe prodigious volume of entry (and,of late, exit) of new businesses on theInternet makes it hard to accept theargument that these temporary

monopolies are reallynecessary to give entre-preneurs incentive to trytheir newly inventedhand at business on theWeb.

Even so, some patentprofessionals embracethe notion of grantingb u s i n e s s - m e t h o dpatents. USPTO DirectorDavid Dickinson states that businessmodel patents represent “a very log-ical extension of the patent system”that has served America so well.Dean Alderucci, head legal counselfor Walker Digital, suggests, “If youhave a new and useful businessmethod, a patent can force themoney out of it and benefit thepublic.”

The challenge for the USPTO –and for those who would apply forsuch patents – is that the criterion ofnew and useful are subjective. Andthe conundrum for those who wouldchallenge such patents is that thedefinitions of ridiculous and obviousare equally in the eye of the beholder.

Courting ControversyIn the end, many of these ques-

tions may be settled in the courts.Amazon.com’s “1 click” featurewas made available to its customersin September, 1997, and the com-pany received a patent for iton September 28, 1999. Threeweeks later, on October 20, Amazonsued rival bookseller Barnes &Noble – and its online subsidiary,barnesandnoble.com – for infringe-ment. U.S. District Court JudgeMarcha Pechman granted aninjunction on December 14, 2000.But, on February 14, 2001, afederal appeals court overturnedthe injunction.

For the time being at least, “1click” is public domain. The trial atwhich the issue is supposed to be

resolved will convene in Seattle onSeptember 10, 2001. Until then, thiscase suggests that at least some arereconsidering the wisdom of a trendtoward ubiquitous patenting ofevery mechanical aspect of Internetcommerce. But even as it preparesfor trial, Amazon.com has alsoserved notice that it will defend itsrecently obtained patent on “affiliateprograms,” which are widely usedon the Web. These programs areused by many Internet retailers tolink their sites to other retailers’ cat-alogues. This is a far-reaching andpotentially very disruptive patentthat is certain to evoke a cornucopiaof lawsuits and countersuits.

But perhaps there is justice (and atouch of irony) in cyberspace. Aspart of its expansion efforts,Amazon.com in the late 1990s beganoffering CDs for sale, and it usednew technology to let potential cus-tomers listen to a snippet of a FrankSinatra song before buying thewhole disc. It turns out another com-pany already had that idea. OnApril 12, 2000, San Francisco-based Intouch Group Inc. suedAmazon.com for infringing patentedmethods for consumers to previewmusic samples over the Internet.

It may not be entirely original,but what goes around, comesaround.

W I L L I A M G R E E N E is professor ofeconomics at NYU Stern.

"The poster child for thisentire debate is Amazon.com’s famous ‘1 click’‘Method and system forplacing a purchase ordervia a communicationsnetwork’"

Sternbusiness 35

he securities marketshave been at the epi-center of the ongoingrevolution in technolo-gy, finance and global-

ization. And in this hypercompeti-tive environment – in which everytrade is viewed as a zero-sum game –the ground has been about as solidas quicksand. Traders are seen asmodern-day gunslingers, usingsharp elbows to gain whateveradvantage they can while adheringto the established rules. But as stock-trading moves online, and as newplayers and structures continue totransform the market, the rules seemto be shifting. What was acceptablein 1996 may not be acceptabletoday. And common practices todaymay be outmoded and deemedunfair in 2003. Despite several scan-dals and setbacks, the U.S. markets

have weathered the changes ratherwell. And for that, we can thank ourunique age-old legal tradition – theCommon Law – which should con-tinue to guide market participantsand regulators as we enter the 21stcentury.

The U.S. Constitution lays downseveral bedrock principals, amongthem the separation of church andstate and the right to free speech.But it is the common law that deter-mines the practical shape these val-ues assume, and how they are pro-tected and enforced. The CommonLaw system, which derives frombroad principles based on notions ofjustice, reason and common senserather than the strict adherence tocodes, originated in England andwas adopted in the United States.Importantly, these principles, how-ever, can change to respond to

changing social, economic and polit-ical conditions. Judges, who makethe Common Law, must honor rul-ings in similar cases. When judgeswish to depart from this doctrine ofstare decisis, they must elucidate, inwriting, a good cause for doing so.And they are subject to reversal by ahigher court.

In the U.S., Congress and statelegislatures are charged with enact-ing laws. But since no legislativebody could possibly maintainoversight over all industries, leg-islative bodies enable administra-tive and regulatory agencies likethe Securities and ExchangeCommission (SEC) to flesh out thebasic laws with due concern to thesocial affects as dictated by ourCommon Law philosophy. Thus, anagency like the SEC deals not onlywith what brokerage houses and

Common Sense.H o w a n a n c i e n t l e g a l t r a d i t i o n c a n g u i d e r e g u l a t i o no f t h e b r a v e n e w w o r l d o f s e c u r i t i e s t r a d i n g

By Larry Alan Bear and Rita Maldonado-Bear

T

36 Sternbusiness

© a

rtis

t(s)S

IS

investment banks do, in fact – i.e.their actual conduct – but with whatthey ought to do.

his presents something of aconflict. For many marketparticipants believe thatsimply playing strictly by

the rules as they are currently writ-ten is all that is required. “As ananonymous participant in financialmarkets, I never had to weigh thesocial consequences of my actions,”hedge fund trader George Soroswrote. “I felt justified in ignoringthem on the grounds that I wasplaying by the rules.” “This,” hecontinued, “makes it all the moreimportant that the rules that gov-ern markets should be properlyformulated.”

Soros has actually shown hisconcern for social consequences andconditions by actively engaging in a

range of socio-political endeavors,ranging from promoting democracyin Eastern Europe to supportingschools in New York City. But wedon’t buy the notion that in thefiercely competitive struggle forprofits “playing by the rules” is allthat can be asked – or expected – ofany participant. For given thenature of our Common Law, anysecurities market manager whoengages in unethical action may notonly find himself in serious person-al trouble, he may well harm hisfirm and the reputation of hisindustry. In fact, we are convincedthat, given recent developments inregulation, legislation, and technol-ogy, ethical and socio-politicalinsights and skills should berequired of every manager withauthority to act for his firm in secu-rities markets operations.

Crime and PunishmentUntil very recently, corporations

were generally not held criminallyliable for illegal actions taken bytheir employees. But in 1984,Congress passed the SentencingReform Act, which set up a FederalSentencing Commission. As an out-growth of the Commission’s work,Congress in 1991 enacted Chapter8 of the Federal SentencingGuidelines, which dealt with white-collar crime and organizations. As aresult, organizations themselves cannow be held responsible for viola-tions of any of 3,000-odd federallaws dealing with securities, com-mercial banking, anti-trust, andgovernmental fraud, listed in 46separate categories.

Chapter 8 is evidence of officialgovernment recognition of an impor-tant ethical reality: that much of the

T

Sternbusiness 37

illegal action of an organization’semployees arises out of the corporateculture within which they function.For under the guidelines, the way acompany and its executives behaveand conduct themselves bears adirect relationship to the severity ofthe penalty.

The Federal SentencingGuidelines specifies penalties forspecified violations, which judgesmust faithfully apply – unless theirreasons for deviation are fullyexplained and justified, in writing.Offenses are ranked on a scale.Minor offenses are ranked at six orless, and can carry fines of $5,000,while more serious ones, such ascertain anti-trust offenses, can beranked as high as 38 and carry finesof up to $72.5 million.

enalties may be adjustedupward or downward with-in the mandated categoriesdepending upon the steps

the organization has previouslytaken to avoid criminal conduct,upon cooperation with the govern-ment, and upon the involvement ofhigh-level personnel in the infrac-tion. These elements become thebasis for what is referred to as theorganizational “culpability score,”ranging from a low fraction up tofour. If a particular corporate crimeis at level 38 or above, and the cul-pability score is at four, the total finefor that one infraction would be asobering $290 million. Conversely,corporations may have taken actions

that would mitigate theoffense level, say downto 28. Given aninsignificant “culpabili-ty score,” the totalpenalty could be $10million rather than$290 million.

One major before-the-fact mitigating fac-

tor is the existence within the organ-ization of “an effective program toprevent and detect violations of thelaw.” There are 10 elements thatmake up such a program, includingcompliance standards and proce-dure, oversight by high-level person-nel, and a “reporting system”employees might use without fear ofretaliation. As part of the punish-ment, the government can place acompany on probation and force itto install “an effective program.”The government could also assignan overseer to watch over the newprogram, on site.

The Guidelines are, to our knowl-edge, the only such body of law inthe world focused on corporatebehavior and calculated to motivatethe maintenance of a corporate cul-ture that actively promotes lawfuland ethical behavior. To be sure, theword “ethics” does not appearspecifically in Chapter 8. But inpractice, government regulators arevery much affected by the presence,or the absence, of a corporate code ofethics that supports a corporatecompliance program.

The Organizational SentencingGuidelines, however, do not substi-tute the corporate offender for theindividual offender. In fact, corpo-rate punishments can be mitigated ifthe corporation proactively self-reports its offenses and helps identifyindividuals responsible for the crim-inal conduct. Employees whocontinue to believe that they are

acting properly as long as what theydo satisfies the prevailing corporatebehavior are in for a rude awakeningwhen that same corporation suddenlyhangs them out to dry.

The numbers are beginning toadd up. In 1999, in addition to bar-gained and settled organizationalcases under the Guidelines, 255organizations were sentenced underChapter 8, a 15.9% increase from1998. Fines were imposed on 200organizations. The sentenced organi-zations pled guilty in 91.4% of thecases; 8.2% were convicted aftertrial. As in 1998, fraud was the mostfrequent offense committed by anorganization. The highest fine in1999 was $500 million. Some56,000 individual defendants werereported to the Commission underthe Guidelines in 1999, up from some51,000 in 1998. Behind drug traf-ficking, fraud was the section of theGuidelines most frequently applied.

The Federal Sentencing Guidelinesare the legal result of a CommonLaw process whose basic purpose isto eschew the civil law function ofreducing all behavior to inviolaterules. And while many securitiesfirms have run afoul of theSentencing Guidelines in such areasas insider trading and other forms offraud, some securities firms have runinto trouble with behavior that wasseemingly within commonly accept-ed Wall Street rules but wasnonetheless ethically and legallyquestionable – as the followingexamples show.

Spinning IPOsIn the 1990s, a practice on Wall

Street known as spinning initialpublic offerings was relatively com-mon. As a way of building up good-will and attracting future business,investment banks would allocateshares of IPOs to the accounts they

P

"We don’t buy the notion thatin the fiercely competitivestruggle for profits ‘playingby the rules’ is all that canbe asked – or expected – ofany participant.”

COMMON SENSE

38 Sternbusiness

held for individual corporate exec-utives and venture capitalists.Brokers at the investment bankswould quickly sell – or spin – thestock if the IPO took off.

According to the rules of WallStreet, there was nothing wrong withthis practice. But fiduciaries like cor-porate officers and brokers have anaffirmative duty not to profit byvirtue of their position as a fiduciary;and an affirmative duty to discloseto principals – i.e. other brokeragecustomers – any and all informationin their possession that bears uponany decision the principals mightmake. And in spinning stocks for topclients, brokers seemed to violatethis duty. Many firms who spun IPOstock for major firms’ officers hadbeen effectively preventing lessercustomers of the firm, who manageto get a small piece of an IPO, from“flipping” the very same stock.

hen the process wasexposed in the press,the “justice, reason andcommon sense” of the

Common Law process was set inmotion. The SEC is investigatingspinning. State securities regulatorslike those in Massachusetts chargedbrokerage firms with wrongdoingand stated that “requiring firms toabandon (these) policies is one of themore severe sanctions we willimpose.” If it hasn’t been abandonedentirely, spinning has been signifi-cantly reduced. And those who insiston playing that game are nowopened up to lawsuits, in which the“rules” will be no defense.

Is Bear Baron’s Keeper?Or consider the case of Bear

Stearns and A. R. Baron & Co. BearStearns is one of the leading clearingfirms on Wall Street. Clearing firmsare large brokerage houses that arehired by smaller firms, called intro-

ducing brokers, to execute and settletrades for them, and to maintain andprocess client records. The clearingfirm requires introducing firms toput up a deposit, usually about$250,000, levies a “ticket charge”of $10 to $25 on each trade it con-ducts, and charges interest, usually1% per month, on margin loans itmakes to these customers.

Since 1982, when commissionswere deregulated, clearing firms havenot had legally determined oversight

responsibilities for their introducingbrokers. No rule specifically statedthat the clearing firm had to be con-cerned with the ethical character ofthe introducing firm. One of theclearing clients of Bear Stearns,whose clearing operations represent-ed more than 25% of its multi-billiondollar business in recent years, wasA.R. Baron & Co., a highly dysfunc-tional firm. In 1995, Baron’s creditwas so bad it was unable to qualifyfor a corporate gasoline credit card

W"Under the Sentencing Guidelines, the waya company and its executives behave andconduct themselves bears a direct relation-ship to the severity of the penalty."

Sternbusiness 39

and it paid a $1.5 million fine tosettle NASD charges that it bilkedcustomers. But when Baron’s capitalfell below the regulatory minimumand a Baron customer notified BearStearns of unauthorized trading in itsaccounts, Bear Stearns simplyreferred the matter back to Baronand injected $1.1 million into thecompany to keep it afloat. After arange of investigations, the SECordered Baron to halt all operationsin May, 1996. Baron was alsocharged by the Manhattan DistrictAttorney with being a criminal enter-prise that defrauded investors out of$75 million. The firm ultimatelywent bankrupt.

y early June 1997, NYSEand NASD officials metwith several clearingfirm officials. One firm,

Oppenheimer & Co., announcedplans to stop processing trades forany introducing broker clientaccused by regulators of chargingexcess commissions. But BearStearns took the position that aclearing broker had neither accessto, nor control over, any introducingbroker, and that if it were subjectedto customer claims, the firm mightwell get out of the business altogeth-er. The SEC then let Bear Stearnsknow it was preparing to considermaking civil securities fraud chargesagainst it, with attendant SentencingGuidelines penalties if the U.S.Attorney went further with criminalcharges. Bear Stearns settled, agree-ing to pay a fine and $25 million inrestitution to A.R. Baron customers.The Bear Stearns senior executive incharge of the clearing business laterresigned.

How could a major investmentbank fail to see changes blowing in thewind? It could be that Bear Stearns’admittedly strong compliance culture(nobody there is allowed to actually

break the law) did not focus on ethicalsensitivity at all. More likely is that itoverlooked the Common Law notionthat the system assigns basic duties ofcare to those who are paid to provideskilled services to others for a fee –and the definition and application ofthese duties are susceptible to changeand evolution.

Common Law for a CyberWorld?

The growth of technology has

further complicated some of theseissues, as the advent of online trad-ing has already changed the struc-ture of the securities industry. Onlinetransactions in 1998 rose from lessthan 11% of total stock trades in thefirst quarter to 13% in the fourthquarter. Today, many customerstrade on the Internet much as theywould on the ground, while othersday trade, darting in and out ofstocks rapidly.

It might be argued that we are in

B"Bear Stearns likely overlooked theCommon Law notion that the systemassigns basic duties of care to those whoare paid to provide skilled services toothers for a fee – and the definition andapplication of these duties are susceptibleto change and evolution."

COMMON SENSE

40 Sternbusiness

a brave new world in securities trad-ing, where the true ethic is “assump-tion of the risk.” As customers placeand execute orders by themselvesonline, they may be fully responsiblefor their choices, win or lose. But anethic calling for the consumer’s fulland complete assumption of the riskis no ethic at all. To negate meaning-ful duty to investors in the presenceof technological leaps would be toargue that constitutional values arenow outmoded. The Rule of Lawwill, and must, prevail, even on theInternet. But in keeping with ourCommon Law tradition, new work-able, practical legal and regulatoryshapes that cannot now be foreseenwill have to emerge, just as theyalways have.

ffline, all stockbro-kers have some formof legal duty to everysingle client. A brokerreceiving a simple buyorder from a sophisti-

cated client must properly executethe trade. A broker advising an eld-erly widow has a far higher duty ofcare. And if the broker is handling a“discretionary” account in which shehas full authority to buy and sell forthe client’s portfolio, then the bro-ker’s duty is fiduciary.

An investor choosing to investonline with the advice and assistanceof a broker is entitled to brokerduties of care equal to any on-the-ground transaction. The New YorkStock Exchange requires that bro-kers in all instances know theirclients’ overall goals, risk prefer-ences and time horizon before theyexecute an order. This is referred toas the “suitability” rule. The NASDholds brokers firmly to a suitabilityrule when the seller has recommend-ed the transaction, and is consider-ing enlarging the duty to all transac-tions in cyberspace.

Certainly, what isreasonable in cyber-space may require dif-ferent suitability rulesdepending upon thenature of the relation-ship; however, someduty of suitabilitymust be implied, evenin cyberspace –whether it involvesmandatory pre-trading customerinformation filing or trade blockingfor particular customers of specifiedrisky investments. The form thistakes must be dictated by the pres-ence of transparency, honesty, andnon-misleading behavior and byreasonable accommodation to thenew structure and function of exist-ing technology.

Much of the burden in forgingthis brave new world will fall, at ithas in the past, on the regulators.This is a challenge. Technology-driv-en market change has outrun ourcapacity to comprehend fully themeaning of what has already hap-pened in our securities markets,much less what ought to be happen-ing in the future. Nonetheless, regu-lators ought first to examine wherecurrent securities markets changesappear to be taking us – in the direc-tion of rapid institutional and prod-uct development and diffused deliv-ery systems. And they must be sensi-tive to the potential conflicts ofinterest posed by the new develop-ments. Newly formed computerizedstock trading services known as elec-tronic communications networks, orECNs, are applying to the SEC tobecome new stock exchanges. Butcustomers may find that best execu-tion and best price may not alwaysbe forthcoming from an ECN ownedby a brokerage firm. Meanwhile, inresponse to such upstarts, estab-lished exchanges like the NASDAQ

and NYSE are contemplating sellingshares to the public and becomingpublicly-held for-profit companies.One might also legitimately askwhether a publicly owned NYSE,with self-regulating powers, could betruly dependable and fair to all cus-tomers in the face of the Wall Streetimperative to make as much moneyas possible for its owners.

Dealing with these issues, even inthe absence of cyberspace technolo-gy has not been – and still is not –easy. But our trump card has alwaysbeen an established culture of publicinterest protection. For more thantwo centuries, our Common Law-based system has allowed for effec-tive legal and regulatory responses tosocial demand. In essence, it haspromoted adherence to the spirit, aswell as to the letter, of the law.Maintaining this law and regulatorysystem in the face of rapid techno-logical development will be evermore difficult, but ever more essen-tial, if we are to protect and preservethe Constitutional value systemupon which we – as investors andcitizens – all depend for safety,growth and fulfillment.

LARRY ALAN BEAR is visiting profes-sor of business ethics and RITAMALDONADO-BEAR is professor offinance, are professors at NYU Stern.

An expanded version of this article is toappear in a special issue of The Journalof Banking and Finance, June 2002

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"The Guidelines are, to ourknowledge, the only such bodyof law in the world focused oncorporate behavior and calcu-lated to motivate the mainte-nance of a corporate culturethat actively promotes lawfuland ethical behavior."

Sternbusiness 41

42 Sternbusiness

nfortunately, the spec-trum is mired in a sys-tem of all-encompass-ing federal regulationthat sometimes makes

the former Soviet Union look like aparagon of efficiency. The time islong overdue for fundamentalreform. The answer lies not in rein-venting government jargon, but inthe simple language of one ofAmerica’s oldest and most entrepre-neurial sectors: real estate. Only by“propertyzing” the spectrum – i.e.,applying real-estate-like propertyrights to the spectrum – will weunleash the full potential of this

immensely valuable but invisiblenational resource.

The SpectrumThe spectrum encompasses all

possible frequencies of electromag-netic waves. The radio spectrum,which is what needs reform, coversthe range from 30 Hz (cycles persecond) to 300 GHz (billion cyclesper second). These “airwaves” areused for an ever expanding array ofover-the-air electronic transmissionsand wireless devices – radio andtelevision broadcasting, cellularphones, mobile radio, satellite com-munications, microwave cooking,

garage door openers. A large part ofthe “broadband revolution” will occurthrough spectrum-based devices.

Different bands of the spectrumhave different characteristics thatmake them better or worse for varioususes. Some frequencies are better atlong-distance transmission; othersare better at penetrating solidobjects. And one person’s use of aportion of the spectrum can be easilyinterfered with by another person’stransmission use of the same wave-length, in the same place, at thesame time. Interference also occursfrom incidental transmissions origi-nating in neighboring geographical

KEEPINGIT REALWA N T T O F R E E U P T H E A I RWAV E S F O R I N N O VAT I O N ?T H I N K O F T H E S P E C T R U M A S R E A L E S T A T E .

By Lawrence J. White

The electromagnetic spectrum can't be seen, tasted, smelled, ortouched. It isn't high on most people's lists of daily concerns. But it isintegral to the development of modern telecommunications, includingthe broadband revolution of information dissemination and retrieval.

U

Sternbusiness 43

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locations or spectrum bands andfrom extraneous sources such assunspots, lightning, electrical motorsor generators, and transmissionlines.

Spectrum Management andMismanagement

In 1927, when interference“chaos” threatened the nascentbroadcasting industry, Congress andPresident Calvin Coolidge whofamously said “the chief business ofthe American people is business” –enacted a Soviet-style central plan-ning solution: The federal govern-ment would prevent interference bymaking all spectrum allocation deci-sions. As a result, for the past 74years the spectrum has effectivelybeen the property of the Americanpublic, and the FederalCommunications Commission

(FCC) has been charged with man-aging the spectrum “in the publicinterest.” To this day, the FCCdecides the use – say, broadcasting,or cellular phones, or garage door

openers – to which a specif-ic block of spectrum will beput. Then it defines theparameters of service, suchas transmitter power andlocation. The FCC grants alicense to a specific party tooperate a transmitter over aspecific frequency ban, andthen enforces its alloca-tions, service rules, andassignments to ensure thatinterference does not arise.

In the 1920s, when thetechnology was rudimenta-ry and the possibilities werelimited, this managementprocess was arguably toler-able: The early users ofspectrum – radio broadcast-ers – were like homestead-ers: First-come, first-servedfor a free renewable FCCspectrum license was anacceptable method ofassignment.

But since the 1920s, thetechnologies of spectrumuse have exploded. And as

the rising value of the multipleuses of the spectrum has becomeincreasingly apparent, competi-tors, in ever-larger numbers, havecontended for the use of variousspectrum parcels.

The FCC has tried to adapt to thechanging climate. From the late1920s until the late 1970s, if theFCC concluded that, say, an addi-tional AM radio station should bebroadcasting in Dubuque, theagency held comparative hearings(“beauty contests”) to decide whichparty would best serve “the publicinterest” and thereby receive theFCC’s free renewable license.

This process collapsed of its ownweight in the early 1980s as the FCCprepared to assign the first set oflicenses for cellular telephone serv-ice. The agency was swamped withapplicants and appealed to Congressto allow other allocation methods.Congress responded by authorizinglotteries for the free licenses.

The lotteries were duly conduct-ed. But the FCC and Congress soonrealized that the process was arbi-trary and that many lottery winnerssimply “flipped” their licenses andearned large windfall profits.Accordingly, the FCC and Congressconsidered other alternatives.Auctions seemed a natural choice.But incumbent license holders –especially broadcasters – fearedthat auctions for new spectrumallocations might someday be theprecedent for auctioning their(currently free) spectrum parcelsand fiercely opposed them.

evertheless, Congress,desperate to raise budg-etary revenue, author-ized auctions in 1993.As of June 2001, 34

auctions, many of them for cellphone spectrum usage, had raisedabout $42 billion. Despite someglitches, the auctions have been asubstantial success. Cell phone usagehas exploded; over a third of totalU.S. telephone “lines” today are cellphones. But while they were a wel-come improvement, the auctionshave affected only a small fraction ofthe usable spectrum. Use and servicerestrictions still apply even for theslivers of spectrum that have beenauctioned. In the end, auctions havebeen simply another assignmentmethod occurring within the largerFCC allocation process.

An Unworkable SystemThis allocation system simply

can’t be efficient, or even equitable.

N"The spectrum is mired in asystem of all-encompassingfederal regulation thatsometimes makes the for-mer Soviet Union look likea paragon of efficiency."

KEEPING IT REAL

44 Sternbusiness

At its foundation, the FCC’s spec-trum management process restsupon a fallacy: that the agencyknows exactly the right uses of theright bands of spectrum in the rightplaces using the right technologiesand by the right parties – in everyinstance. As new technologies arise,Congress expects the FCC will recog-nize them and unerringly accommo-date them.

quick comparison easi-ly shows the absurdityof these expectations.Imagine, for a moment,that private ownership

of real estate was not permitted inthe United States and that a singlefederal agency made all decisions asto the specific uses to which specificland parcels could be put, the tech-nologies that could be used on them,and who would be allowed to use theland rent-free, with indefinitelyrenewable leases.

If the FCC were perfect andomniscient, and if incumbents didn'tlobby fiercely to retain their spec-trum parcels once granted, the sys-tem might work as designed. But alltoo often the FCC has discouragedcompetition, and favored incum-bents over entrants and innovators –all the while claiming its decisionsand actions were “in the publicinterest.” In the early 1950s, in thename of encouraging a local orienta-tion for television channels, the FCCassigned channels in a way thatmade nearly impossible the forma-tion of more national networksbeyond the three incumbents. In the1960s and 1970s, the FCC impededthe expansion of cable television. Inthe 1980s and 1990s the FCC andthe Congress stymied the expansionof locally based (“wireless cable”)and satellite-based (“direct broad-cast satellite”) alternatives to incum-bent local cable companies. TheFCC delayed the initial rollout of

cellular telephone service by 10-15years, and then initially licensedonly two carriers per region in such away as to reduce the competitivepressures that cellular telephonewould bring. And theFCC's national allocationpatterns of spectrum formobile radio uses havemeant, for example, thatforestry communicationsallocations have lain idle inNew York City, while itsallocations of spectrum fortaxicab communicationshave been idle in Idaho.

There are other draw-backs. The FCC’s manage-ment process, combinedwith the free licenses, hasyielded “shortages” ofspectrum for current uses.And the spectrum “short-age” has provided a justi-fication (unfortunately,upheld by the SupremeCourt) for the FCC and theCongress to impose contentobligations on radio andtelevision broadcastersthat would be outrageousConstitutional violations ifapplied to the print media.

The problem is not clumsiness orincompetence by FCC personnel.The FCC has been, is, and will con-tinue to be staffed by knowledge-able, able, hard-working individu-als, with capable leadership. But itstask is impossible. No organizationcould gather all the necessary infor-mation, process it, and make theright decisions – and then do soagain and again, as technologyand/or economic conditions change.And a cautious, bureaucraticenvironment with constant, fre-quently excruciating pressuresfrom Congress and lobbyists is notone that encourages innovation andentrepreneurship.

A Better WayThere is a better way and U.S.

real estate provides a good model.At first blush, the two spheres

don’t seem to have much in common.

But upon examination, real estate andspectrum share a great deal of simi-larities, and their management anduse present some of the same chal-lenges. Both are finite. Productiveland is “scarce;” the same is true ofspectrum. As with land, differenttypes of spectrum are often inherent-ly better suited for different uses.Technological change can improve theefficiency of the use of both land andspectrum. Technological change canexpand the amount of land that isconsidered usable and productive;ditto for spectrum. And some uses ofboth land and spectrum may interferewith neighboring uses of the sameresource.

A"Only by ‘propertyzing’ thespectrum – i.e. applying real-estate-like property rights tothe spectrum – will weunleash the full potential ofthis immensely valuable butinvisible national resource."

Sternbusiness 45

The solution is thus to construct alegal and regulatory regime thatwould treat spectrum much the wayour legal system currently treats realestate. Here’s how, in principle, itwould work:

The government would recognizea property right (in perpetuity) foran owner to transmit over a specified

spectrum band, so long as the signalsdo not exceed a specified strengthbeyond specified geographic bound-aries during a specified time period.The owners of such parcels wouldhave the right to be free from others'transmissions that interfered withthe reception of their own spectrumtransmission. Owners, includinggovernment agencies, would be freeto sub-divide and to buy and sellparcels. Owners would also have theright not to use their parcels, just asreal estate owners do. Non-use wouldmake sense if, for example, spectrumuse requires investment in comple-mentary facilities and the ownerexpects that technological change oruncertainty could render currentinvestments obsolete. The antitrust

laws would, of course, apply. Andinterference claims would initially beaddressed through negotiations, withultimate recourse to the courts.

An interim “expert” agencywould initially configure the entireset of spectrum “parcels,” whichwould then be auctioned. Winningbidders could subsequently buy and

sell so as to reconfig-ure their parcels andrenegotiate beyond-boundary signal-strength limits amongthemselves. As newtechnologies open newpossibilities and aseconomic demands forspectrum-use change,the owners of parcelswould be free contin-ually to reconfigurethe parameters of theirparcels. Formal orinformal spectrummarkets, with brokersand other intermedi-aries, would surelydevelop rapidly tohelp owners buy, sell,

lease, or rent parcels.This would not be “privatiza-

tion;” it would be “propertyzing.”Under the new regime, governmentagencies could bid for and becomeowners of spectrum, just as they cur-rently hold and own real estate andother forms of property. Currentgovernment/public uses of spectrum– public radio and TV broadcasting,defense and public safety communi-cations, emergency communicationschannels, radio astronomy, etc. –could continue, so long as taxpayersare willing to fund the purchase andmaintenance of the spectrum facili-ties. To facilitate transactions andassist in the enforcement of proper-ty rights, a national registry ofspectrum ownership would be

maintained, comparable to localland registries.

How to Get There from HereImposing this ideal structure on

the current spectrum system wouldbe politically impossible. There aretens of thousands of incumbentholders of FCC-issued licenses, andvirtually all of them treat theirlicenses as de facto property. Manybought their licenses indirectly bypurchasing companies that alreadyowned licenses. Tens of billions ofdollars of investments in facilities,equipment, personnel, and brand-name reputation surround thoselicenses.

ut we can start from wherewe are today. The FCC’slicenses constitute a set ofde facto properties, withprotections against inter-

ference. Unfortunately, the licensesare often defined in terms of inputs(the power of a transmitter, theheight of the transmitting tower)rather than in the output terms of asignal’s strength beyond a territoryperimeter. Nevertheless, these licens-es should simply be assigned, as is,to their incumbent holders in perpe-tuity, with the existing protectionsagainst interference. This wouldappear to be a giveaway of valuablepublic properties. But the FCC hasalready given away most of theusable spectrum through its licenses,with their near-automatic renewals.And it is unrealistic to believe thatincumbent holders of these licenseswould readily yield them back to theFederal Government at zero cost.(Because the new flexibility in usecould be a “windfall” for incum-bents, the possibility of taxing someof the windfall gains ought to beconsidered.)

The owners of these licensescould then sub-divide, buy, sell,

B"The solution is thus to construct a legal and regulatoryregime that would treatspectrum much the way ourlegal system currently treatsreal estate."

KEEPING IT REAL

46 Sternbusiness

lease, or rent their parcels. Further,they could begin to adjust their inputcombinations, so long as they didnot violate the interference restric-tions that are implicit in thelicense, or they could negotiatemutually advantageous arrange-ments with transmission “neigh-bors.” Interference disputes thatcould not be settled by negotiationwould, during an initial transitionperiod, be referred to the FCC forarbitration. The FCC should hastenthis process by offering (quickly) toredefine the input-oriented licensesinto roughly equivalent output-ori-ented licenses. After the transitionperiod, disputes would be referred tothe courts rather than to the FCC,and the FCC would transform itselfinto a restricted-scope “pollution(interference) control” agency, witheconomic efficiency as its goal.

Bands of spectrum that are cur-rently under-utilized should beauctioned.

Government agencies wouldreceive the same property rights totheir currently held spectrum licens-es as would other holders; butCongress should require governmentagencies to make a special evalua-tion of their spectrum inventoriesand to auction the surplus. The gov-ernment currently holds a claim onabout a third of the usable spectrum,which is substantially in excess ofwhat it needs. In the late 20th centu-ry, Congress successfully legislateddisposals of surplus military realestate (military bases); it could dothe same with surplus spectrum. Themarket prices for spectrum that willquickly emerge will provide a valu-able benchmark for the Congressand spur disposal decisions.

Benefits of PropertyzingThere are many benefits to this

approach. In a property rights

regime, the owners of spectrumcould flexibly adapt their uses – forbroadcasting, telephone, data trans-mission, Internet, mobile radio, andany new uses that might arise – tonew technologies and new economicdemands. A spectrum “drought”would be impossible; artificialscarcities could not exist. Thescarcity justification for the FirstAmendment restrictions on broad-casting would vanish.

f course, a systemof property rightsand markets forspectrum use wouldsometimes reachoutcomes that, with

the benefit of 20/20 hindsight, aren’tthe most efficient. Entrepreneursmake mistakes; markets are not per-fect. But a system of property rightsand markets for spectrum would befar less likely to be biased towardincumbency and discouraginginnovation, as the FCC has been. Inthe fast-changing world of the 21stcentury, a “propertyzed” spectrum’sflexibility and responsiveness wouldsurely bring high returns to the U.S.economy.

With the FCC (and Congress)removed from the processes of spec-trum allocation and assignment,radio and television over-the-airbroadcasting, cable transmission,local microwave (wireless cable)transmission, and satellite-basedtransmission would be unleashed tocompete. Similarly, cellular tele-phone and other mobile communi-cation services would be freed fromregulatory shackles; an evengreater cornucopia of competitiveinnovations would surely follow.

A Brave New WorldSome might object that this

scheme would lead the FCC to aban-don its charge to maintain the “pub-

lic interest.” But the “public inter-est” is a vague, ill-defined concept,which has led the government toestablish far too many anti-competi-tive, anti-innovative, inflexible, out-put-limiting, anti-First Amendmentregulatory regimes.

Others might argue that the prop-erty rights regime might favor largeand powerful corporations overindividual entrepreneurs. But mostholders of current FCC licenses –including large corporations such asGeneral Electric (NBC), Viacom(CBS), Disney (ABC), Verizon, andAT&T – are not exactly the meekand the poor. The FCC stewardshipand licensing system has in factimposed severe limitations on gener-al access to spectrum use, and thelimitations have favored rich indi-viduals and sizable companies.Though spectrum ownership wouldsurely mimic the distribution foundfor other kinds of property – richerindividuals would own more – aproperty rights system woulddemocratize this valuable resource.Antitrust laws would apply to spec-trum markets, just as they apply tomost other markets in the U.S.

The transformation is not likelyto be friction-free or uncontroversial.Though aggressive actions by a“propertyzing” minded FCC couldsurely move spectrum policy strong-ly in the right directions, ultimatelythe Congress would have to pass newlaws.

But under a property rights sys-tem the spectrum truly wouldapproach real estate in its rights anduses. And the U.S. economy wouldbe all the better for it.

LAWRENCE J . WHITE is the Arthur E.Imperatore professor of economics atNYU Stern.

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In recent months,there has been agreat deal ofhandwringingabout the demiseof Internet-related

companies that raisedhundreds of millions, and,in some instances, billionsof dollars. E-Toys, whichcame out of nowhere tocompletely alter the dead-ly serious business of sell-ing toys, filed for bank-ruptcy. Now, aggressivelyentrepreneurial Internetinfrastructure firms likeExodus Communications,Level 3 Communications,and Global Crossing, arestruggling for survival.

Of course, we’ve seenthis all before. Technologybooms have alwaysunleashed entrepreneurialenthusiasm and prodi-gious fundraising – and ultimately,bankruptcy and consolidation.

A century and a half ago, soonafter Samuel F.B. Morse inventedthe telegraph, hundreds of upstarttelecom moguls began erectingpoles and stringing wire. Their net-work-building efforts were fundedby the antebellum version of ven-ture capital: subscriptions by localinvestors and government subsidies.By 1866, with strikes, competition,and the Civil War disrupting busi-ness, Western Union emerged as apowerful consolidator. With its solidbalance sheet, control of patents,and 44,000 miles of telegraph wire,

Western Union was in a position toabsorb its two remaining seriousrivals. It went on to control 90% ofthe telegraph business.

etween 1860 and 1890,investors poured nearly $9billion into the next newthing: railroads. The

hyper-construction led to competi-tion and excess capacity, which wasgood for freight shippers and pas-sengers. But when an economic cri-sis hit in 1893, it spelled disaster. In1895, about 20% of the nation’srail capacity was in bankruptcy. J.P.Morgan cleaned up the mess, andcleaned up in the process.

By 1908, the yearHenry Ford started hiscompany, some 515 carmanufacturers had enteredthe decade-old industry –and half of them hadalready failed. Twentyyears later, GeneralMotors, Chrysler, andFord controlled 80% ofthe market.

Similar processesoccurred with revolution-ary technologies such astelephony, radio, and thepersonal computer:remember the Commodore,the TRS-80, and Packard-Bell?

But just as the failureof most of the local tele-graph companies in the1850s and 1860s didn’tsignal an end to the tele-graph’s influence on socie-ty, the present-day trevailsof dot-coms and Internetinfrastructure firmsdoesn’t mean the Internetis done transforming theway we live.

Internet usage is stillgrowing, albeit at a slower pacethan originally predicted. Newproducts and services that utilizethis immensely powerful platformare introduced each month.

Unfortunately, the aggressivefirst movers may not be around toreap the ultimate profits. Creativedestruction, it turns out, is the motjuste to characterize our entrepre-neurial economy – and especiallythe Internet economy. Many newcompanies have been created;almost as many will be destroyed.

DANIEL GROSS is editor of STERNbusiness.

Built to Last?By Daniel Gross

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