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The next big thing Featured

9:06am EDT July 5, 2005

David Morgenthaler looks at innovation on a grand scale. The founding partner of Morgenthaler Ventures isn't interested in mundane improvements; he's looking for life-changing innovations.

Many executives would consider a new, efficient inventory management process innovation. Others would restructure their distribution system and call that innovation.

Morgenthaler looks far beyond that. To him, the combustion engine is innovation. The Internet is innovation. Innovations change the way we live. Those other things are just slight gains in efficiency, not innovation in its truest sense.

When someone invents a true innovation, it can change a region almost overnight, serve as a driver of economic development and spin off other related innovations for decades. Look at what the automobile industry did for Detroit or what the computer chip did for Silicon Valley.

Morgenthaler spends his days trying to predict what the next great life-changing innovation will be and which entrepreneur or company holds its secrets. He heads Morgenthaler Ventures, and with an $800 million venture fund and $2 billion total under management, a lot of investors think he might find it.

Do you think you have it? If you are based in Northeast Ohio, the odds are against you. And that's part of the challenge the region faces now and in the future, and why Morgenthaler spends a lot of time looking for the next big thing elsewhere.

"Each new innovation that comes along is like a big fruit tree," says Morgenthaler. "When the tree gets mature, the low fruit has been picked. The automobile was the innovation that created the low-hanging fruit in the first half of the 20th century."

Northeast Ohio benefited from the auto industry and the spin-offs it created, but the semi-conductor eventually supplanted the automobile as the driver of innovations, and the region missed out on new opportunities as a result.

"Fundamentally, this region has picked all the low-hanging fruit," says Morgenthaler. "This region basically missed the semi-conductor, which was the economic driver of the second half of the 20th century. If you missed the semi-conductor, you missed out on one of the most important parts of innovation.

"When a technology matures, your low-hanging fruit has been picked. What remains is high up the tree, which means it is hard to do, hard to get to and very expensive in capital investment."

In Northeast Ohio, as the automotive industry matured, there were fewer and fewer innovations. The same thing has happened with semi-conductors.

"If you wanted to go into making semi-conductors in the 1950s, you could do it for a few thousand or a few hundred thousand," says Morgenthaler. "If you wanted to do it today, it would cost somewhere between $3 billion and $4 billion. If you want to get into semi-conductors, that fruit is way up the tree. It's still an innovation that's going on, but the low-hanging fruit has been picked."

Cleveland was happy with the prosperity the auto industry brought. The area had developed world-class expertise in all kinds of metal fabrication and other auto-related skills but missed out on new opportunities.

"We missed it because we were happy and prosperous with essentially what the auto had done for us," says Morgenthaler. "Today, our competitive advantages in the region are principally in health care services. You get a certain amount of spinout from those kinds of places, a certain amount of medical devices and medical discoveries, but the big medical discoveries are mostly therapeutic and coming out of the small biotech companies. That's where there is still some low-hanging fruit."

He says that innovations are spun out of needs, and increasingly, technology is the driver behind those innovations. With most of the technology centers located elsewhere in the country, it becomes harder for a local company to find the next big thing.

"That is the underlying problem in the area," he says. "We were so prosperous in the '60s, the leadership in the region was not very concerned about the next wave of technology because they were happy with the one they had.

"The mature regions with the mature technologies have the problem that many of the innovations have been picked. You don't get new innovations as often. There are again corollaries to that in the sense that if you don't have a lot of innovation coming along, then there are not a lot of opportunities for entrepreneurs, so they'll go where the innovations are coming, which is why Silicon Valley is loaded with entrepreneurs and serial entrepreneurial managers."

This is part of the brain-drain you hear so much about. You need the top managers who know how to apply new inventions or ideas in a way that can make them marketable.

"There are not enough innovation opportunities," says Morgenthaler. "Consequently, we don't have enough people here trying to pull out and commercialize innovations. It becomes a critical mass problem, the result of which is this region lags behind, as do other regions."

The horse race

Morgenthaler uses a horse race analogy to describe what it takes to have a successful innovation. There's a horse, a rider and the race. The innovation is the horse, the entrepreneur is the rider and the market is the race.

"Look at the innovation and the entrepreneur that drives it: the horse goes nowhere without the rider," he says. "A great horse with a lousy rider means the rider falls off the horse, and that's 60 percent of your failures. A great rider with a slow horse is not good enough to succeed. A great horse with a great rider but with a small market is like running at the county fair with a prize of $50. You win the race, but what do you get paid?

"In this region, we haven't been generating enough of the horses because we are in the old technologies and missed the new ones. Because we are not turning up enough horses, the riders are not hanging around. Very often, when you want an appropriate rider, like a serial entrepreneur, they are not here. If you try to talk them into coming from Boston or Silicon Valley, it's hard to do."

The lack of critical mass in new companies means it's a high-risk proposition for the entrepreneur. Because the failure rate of young companies is high, there's a good chance the entrepreneur will have to find another job, and that's much easier to do where there are a large number of start-ups. If one venture fails, he or she can find a new opportunity without having to relocate.

So what is it going to take to increase the region's chances of being part of the next great innovation? A combination of good science, good government and good luck.

Morgenthaler is seeing some positive developments starting to take shape.

"I think things are beginning to happen now," he says. "Universities have to understand our needs today. They need to understand the technology transfer functions which, in the last few years, they have finally done.

"Government is funding fundamental research where you advance science and knowledge. Most industries can't fund that, it's too far upstream. Science helps us understand what goes on. Science tells us why the sky is blue, but how do we make any money off the fact that the sky is blue? What you do in a beaker in a lab can show effect, but that's not commercial. You have to develop the technology. Technology enables innovation."

Discoveries are often made by accident, and where they are commercialized is often a matter of where the entrepreneur lives or went to school. Making the area attractive to start-up companies will help keep the critical mass the region needs to attract the serial entrepreneurs needed to run them. Morgenthaler says venture capital is available if the three keys -- the horse, the rider and the race -- are all in place. The critical mass will attract more venture capital money to the region.

"We're not the key, innovators are the key," he says. "If we don't have innovations, we don't have anything to finance. Entrepreneurs walk around looking for horses. He sees a market and a way to fill it -- he sees a race and a horse."

But right now, there just aren't enough winning entrepreneurs in this area.

"We venture capitalists look at the business model," says Morgenthaler. "We say, 'OK, sub in Chinese labor costs and show how you can compete and win. You have to have a business plan that will work and not just a hope. Nothing is more worthless than someone who comes in and says, 'I'm just a good clean American boy and I want to work hard. Give me a fair chance, and I'll win.' The Chinese don't spend any time worrying about whether you have a fair chance or not. You better have some sort of comparative or entrenched advantage. I like to call it an unfair advantage. They have an unfair advantage as far as labor costs and a huge market. We stay up nights worrying about that.

"You have to put an integrated plan together and that market is what it is. Markets are unforgiving. They don't care. We are all consumers. We all walk into a store with money in our pocket. It's a very democratic process. We look at the goods, look at the price and the money in our wallet. We decide yeah, we want it, or no, it's too damn much. That's what a market does."

How to reach: Morgenthaler Ventures, www.morgenthaler.com


Local contender

While David Morgenthaler usually finds companies that interest him in other states and regions, he has found one locally that he deems worthy of risk.

Five Star Technologies, a small nanotech firm located near Cleveland Hopkins Airport, has attracted a package of $4.5 million in investment by a group led by Morgenthaler Ventures.

The company has a process involving hydrodynamic cavitation that can be used to improve existing materials or create new ones at the nanoscale. It can be used to improve anything from drug delivery to making better metals.

Whether the firm has the key to the next big thing or is a multimillion dollar science fair project for Morgenthaler remains to be seen. With venture capital, you never really know which way it will end up.

Morgenthaler once invested 10 years and $250 million in a Nobel Prize-winning process by another company that made human RNA act catalytically. Eventually, they were able to get it to do good things.

"But not good enough," says Morgenthaler. "So that money was all wasted. Technology may or may not be able to produce an innovation that people want.

"Five Star has a great way of making nanodimensional particles. Now we are working to find uses for the product. I can make a hell of a lot more nanoparticles than I can sell at the moment."

Jim Mazzella, president and CEO of Five Star Technologies, is confident that he has the right team in place to find the success Morgenthaler, his company and the region all want.

He says that attracting experts in the life science areas will be a challenge as the company continues to grow, but that he is seeing government support for young technology companies to help them along the way.

"I feel like it's going in the right direction," says Mazzella. "I see support from Gov. Taft and the Third Frontier Program for technology like this. Community investment is critical for the state to acquire the next generation of technologies. It's something other states are doing, and we've got to at least stay on par and be very effective and efficient with the money that goes into development in the early stages."

Mazzella says one or two success stories can lead to other spin-offs, which, in turn, can attract more venture capital. As the reputation of the region grows, venture firms start looking at Northeast Ohio as a viable place to invest. Successful companies also create the pool of talent needed for new start-ups.

"One example, and I wish there were a lot more, is Steris," says Mazzella. "We now have a pool of former Steris people who are involved in other start-ups. It's one example of what we need dozens of, but it won't happen overnight. You have to build one successful example at a time."

How to reach: Morgenthaler Ventures, www.morgenthaler.com; Five Star Technologies, www.fivestartech.com