Tracking economic disruption in the digital age

Artificial intelligence (AI), big data analytics and the internet of things (IoT) are just a handful of technological innovations upending established market sectors. How these trends will reorder industry sectors remains to be seen, but if the past is a prelude, one factor will remain constant: new economic innovations will emerge alongside the technological shifts.

[ Related: IoT Sector Report: How to prepare for tech’s Wild West ]

Not that long ago, during the early years of the space race, venture-funded startups emerged as one of those economic innovations. To be more specific: In 1958, President Eisenhower signed the Small Business Investment Act into law. The Act provided tax breaks and other incentives that sparked the rise of “Small Business Investment Companies” (SBICs), which in turn triggered a new means of financing risky ventures: ownership-based private equity.

Before the rise of SBICs, entrepreneurs either took out loans or relied on wealthy benefactors to finance their endeavors. Now, private equity was at least somewhat democratized, a trend that is still marching forward today, giving rise to innovations like crowdfunding.

Fairchild Semiconductor is typically considered the first successful startup based on the new venture capital (VC)-equity-stake model, but what would soon become obvious was that it wasn’t just the money that was important. Due to the complexities of forming VC-backed companies in the Eisenhower and Kennedy eras, the ecosystems that VCs build around them (financiers, lawyers, business experts, operational experts, executives) became every bit as important as the cash infusion.

In other words, as creative destruction became operationalized during the early rise of Silicon Valley, VCs directed not just where the money would flow, but where the most talented people would go as well.

Creative destruction isn’t as destructive as you think

When German sociologists Werner Sombart first coined the term “creative destruction” to describe the natural economic churn in capitalist systems, he most certainly wasn’t thinking about startups.

In his 1913 book War and Capitalism, Sombart looked at deforestation in Europe as an act of creative destruction:

“Again, however, from destruction a new spirit of creation arises; the scarcity of wood and the needs of everyday life . . . forced the discovery or invention of substitutes for wood, forced the use of coal for heating, forced the invention of coke for the production of iron. That these events, however, made possible the enormous development of capitalism in the 19th Century, is beyond doubt for any well-informed person.”

In other words, necessity is the mother of invention. But Sombart did not have the last word on “creative destruction.” In fact, Sombart is usually relegated to the footnotes, eclipsed by Austrian economist Joseph Schumpeter, who popularized the term. Building on the work of Sombart, Marx, and even the philosopher Friedrich Nietzsche, Schumpeter took the concept further, arguing that “gales of creative destruction” are the engine of the capitalist economy.[1]

Schumpeter came to believe that creative-destructive cycles would eventually overwhelm capitalism as a system. This isn’t exactly how things have worked out, and startups – the agents of creative destruction in many markets – are a big reason why.

One of the classic examples of creative destruction is in transportation. The automobile industry displaced the horse-drawn carriage industry … but not completely.

Artificial intelligence (AI), big data analytics and the internet of things (IoT) are just a handful of technological innovations upending established market sectors. How these trends will reorder industry sectors remains to be seen, but if the past is a prelude, one factor will remain constant: new economic innovations will emerge alongside the technological shifts.

[ Related: IoT Sector Report: How to prepare for tech’s Wild West ]

Not that long ago, during the early years of the space race, venture-funded startups emerged as one of those economic innovations. To be more specific: In 1958, President Eisenhower signed the Small Business Investment Act into law. The Act provided tax breaks and other incentives that sparked the rise of “Small Business Investment Companies” (SBICs), which in turn triggered a new means of financing risky ventures: ownership-based private equity.

Before the rise of SBICs, entrepreneurs either took out loans or relied on wealthy benefactors to finance their endeavors. Now, private equity was at least somewhat democratized, a trend that is still marching forward today, giving rise to innovations like crowdfunding.

Fairchild Semiconductor is typically considered the first successful startup based on the new venture capital (VC)-equity-stake model, but what would soon become obvious was that it wasn’t just the money that was important. Due to the complexities of forming VC-backed companies in the Eisenhower and Kennedy eras, the ecosystems that VCs build around them (financiers, lawyers, business experts, operational experts, executives) became every bit as important as the cash infusion.

In other words, as creative destruction became operationalized during the early rise of Silicon Valley, VCs directed not just where the money would flow, but where the most talented people would go as well.

Creative destruction isn’t as destructive as you think

When German sociologists Werner Sombart first coined the term “creative destruction” to describe the natural economic churn in capitalist systems, he most certainly wasn’t thinking about startups.

In his 1913 book War and Capitalism, Sombart looked at deforestation in Europe as an act of creative destruction:

“Again, however, from destruction a new spirit of creation arises; the scarcity of wood and the needs of everyday life . . . forced the discovery or invention of substitutes for wood, forced the use of coal for heating, forced the invention of coke for the production of iron. That these events, however, made possible the enormous development of capitalism in the 19th Century, is beyond doubt for any well-informed person.”

In other words, necessity is the mother of invention. But Sombart did not have the last word on “creative destruction.” In fact, Sombart is usually relegated to the footnotes, eclipsed by Austrian economist Joseph Schumpeter, who popularized the term. Building on the work of Sombart, Marx, and even the philosopher Friedrich Nietzsche, Schumpeter took the concept further, arguing that “gales of creative destruction” are the engine of the capitalist economy.[1]

Schumpeter came to believe that creative-destructive cycles would eventually overwhelm capitalism as a system. This isn’t exactly how things have worked out, and startups – the agents of creative destruction in many markets – are a big reason why.

One of the classic examples of creative destruction is in transportation. The automobile industry displaced the horse-drawn carriage industry … but not completely.

Yes, new companies such as Ford and GM emerged to displace such now-obsolete organizations as the Columbus Buggy Company, which went broke in 1913, but other companies managed the transition from buggy to automobile, and a handful of them are still around today.

According to Thomas A. Kinney, author of The Carriage Trade: Making Horse-Drawn Vehicles in America, while many of the 13,000 businesses that existed in the wagon and carriage industry in 1890 failed, others survived by tweaking their technological expertise so it was relevant to the auto industry.

For example, the Timken Company, which created wheel bearings for wagons effortlessly adapted their products to automobiles. Even a buggy whip company – the very avatar of being relegated to the dustbin of history – survived. Westfield Whip Manufacturing a leader in the horse-drawn-carriage era still exists today, creating products for the equestrian market.

westfield ship Westfield Whip Company

Since 1884, the Westfield, Massachusetts-based Westfield Whip Manufacturing Company has remained in continuous operation. 

[ Related: How the earliest of tech startups are surviving]

Quantum, blockchain and the status quo

A similarly messy, but manageable dynamic played out when cloud computing knocked the on-premises computing industry on its head. Creative destruction elevated several startups, such as VMware, Google, Rackspace and Salesforce.com, to industry leaders. But creative destruction in the cloud market also opened the way for existing giants to expand into new markets (Microsoft, IBM, Oracle).

[ Related: 10 hot quantum-computing startups to watch ]

Cloud-era creative destruction also gave a company that was notorious for having never turned a profit (Amazon) a cash-cow division with AWS. In fact, when Amazon first revealed AWS revenues in 2015, it shocked industry experts by just how profitable it was.

On an April 2015 earnings call, Amazon announced that AWS had generated $5.16 billion in revenue over the previous 12 months, a number that represented a 49 percent year-over-year growth rate. Even though many skeptics predicted going into the call that AWS would be a drag on Amazon, the division’s revenues translated into a $680 million profit.

Amazon share prices jumped 14 percent overnight.

Cloud-era creative destruction, which hasn’t yet fully played out, has already remade the computing market, but not in a way that necessarily doomed older companies to obscurity. The cloud offered something for everyone, and you could argue that the major change the cloud brought with it was one that could not be patented, copyrighted, or otherwise monopolized.

The biggest change that the cloud ushered in wouldn’t be about the tech, but about the business model: the shift from products to services.

This new business model (and the recurring revenues that came along with the shift) was so central to the value proposition of cloud computing that early pioneers named their spaces software-as-a-service, infrastructure-as-a-service, and platform-as-a-service. Fast forward to today we even have such oddities as blockchain-as-a-Service (BaaS), IoT-as-a-service, and quantum-computing-as-a-service.

By now, perhaps you won’t be surprised to learn that the first company to give quantum services a big push was not a startup. . . but an incumbent, IBM. Coincidentally, IBM is also toying around with BaaS too. Another behemoth, Microsoft, has projects in all three of these novel as-a-service markets. Other major vendors pursuing BaaS include HP, Oracle and SAP.

In other words, while creative destruction does indeed disrupt markets, experienced incumbents with deep-pockets are often in the best positions to take advantage of those disruptions.

How to hedge against creative destruction

Back when Silicon Valley was an economic backwater just finding its feet, the early semiconductor and electronics startups didn’t ramp up on VC money, since there was none in Silicon Valley. Rather, they were backstopped by government contracts as the space race and Cold War heated up.

In fact, government funding was just as, if not more, important to the innovation of VC-backed startups as the Small Business Act.

The successful launch of the Soviet satellite Sputnik shocked the world, the U.S., and the entrepreneurs who had earlier fled the buttoned-up, gray east coast for a sunny, free-wheeling culture, into action. The threat from Sputnik was an obvious one: now that the Soviet Union had the ability to launch satellites into space, they also had the ability to target U.S. cities with nuclear weapons from afar.  

The U.S. responded to the threat with a resource it had in much greater abundance than the Soviets: money.

“The defense contracting spigot opened into a firehose,” according to Margaret O’Mara in her book The Code: Silicon Valley and the Remaking of America. “Dollars flowed out of D.C. to propel ever-more powerful missiles up into the heights of the atmosphere and down into the depths of the ocean. Further billions poured into the Strategic Air Command, the radar- and transistor-driven communications network on which American military survival now depended.”

Even more important was the money that flowed into research-heavy initiatives like ARPA and NASA. “Propelled by missiles and the Moon shot, R&D made up more than 10% of the entire U.S. federal budget for the first half of the 1960s,” O’Mara notes.

The loose defense purse strings boosted a number of regions, but Silicon Valley used the influx of dollars like rocket fuel.

“NASA transformed all the places it landed. The Santa Clara Valley was no exception,” O’Mara writes. “Eisenhower’s missile program and Kennedy’s Moon shot boosted demand for precisely the kinds of things the region’s electronics labs already developed and sold: microwaves and radar to track satellite trajectories, oscillators and transistors to provide lightweight and potent energy sources, and networks to communicate with spacecraft hurdling beyond the outer atmosphere.”

It would take another 30 years before Silicon Valley became the engine of the world economy that it is today, but that early combination of fear (of Soviet attack), optimism (to the Moon!), and money (the new VCs) would lay the groundwork for an emergent type of self-sustaining creative destruction that had the power to reshape empires.

Related: 10 success techniques of high-growth startups

Cold War creative destruction redux?

Today, defense spending still adds fuel to Silicon Valley’s creative-destruction engine, but the region has moved beyond transistors and missile components to focus on everything from social media to virtual reality to self-driving vehicles.

But with Russian attacks on our elections in 2016, ongoing instability in the Middle East, and the security threats posed by espionage-driven companies like Huawei, Kaspersky and ZTE, we may see defense dollars once again poured into R&D and startups.

After all, those new Silicon Valley trends I listed above (social media, VR and autonomous vehicles) all have military applications, as does quantum computing, which threatens pretty much all modern-day encryption schemes. In fact, quantum computing, if it delivers on its promises, could well spark the twenty-first-century version of Kennedy’s Moon shot. But today, with many corporations having budgets larger than most countries, the nature of R&D has changed, and the push may need to come from outside of the government.

If we are indeed in the early stages of a new Cold War, U.S.-based tech businesses are a sleeping giant that could play a deciding role in the conflict.

Not content to play defense as startups disrupted their business models over and over again, incumbents have invested in their own Venture Capital funds, formed their own incubators, and launched flashy competitions to spark innovation and lure in startups – just the sorts of R&D efforts that the government used to spearhead.

Incumbents have also created any number of collaborative R&D projects, such as IBM’s Q Network. In a flashback to time-share mainframe computing, IBM is granting partners access to chunks of time with IBM’s quantum computers, with a special emphasis on startups developing complementary technologies.

Startups in the Q network are working on everything from quantum-augmented cybersecurity (Cambridge Quantum Computing) to quantum cloud services (QC Ware) to tools that help eliminate quantum decoherence (Q-Ctrl).

Corporate venture capital, corporate-backed incubators, and quantum computing ecosystems are just a few reasons why Schumpeter’s prediction – that creative destruction would destroy capitalism – was wrong. In fact, creative destruction could well be the force that keeps not just capitalism, but also democracy, alive and well.

[1] Historically, the concept of creative destruction is a universal one that can be traced back to a variety of myths, including the Phoenix rising from the ashes, Shiva the Destroyer, and the Mayan Great Cycle.

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