Industrial and Corporate Change, Volume 12, Number 5, pp. 963–1034 The stock market and innovative capability in the New Economy: the optical networking industry Marie Carpenter, William Lazonick and Mary O’Sullivan The purpose of this paper is to analyze the impact of the stock market on the innovative capabilities of high-technology companies that have been central to what in the last half of the 1990s came to be called the ‘New Economy’. The empirical focus is on equipment suppliers in optical networking—an industry that integrates the bandwidth potential of fiber optics with the data communications potential of the internet. The study covers the period from 1996 to 2003, during which the optical networking industry was, first, central to the New Economy boom, and, then from 2001, ensnared by the bursting of the New Economy bubble. This paper shows how, responding to the New Economy business model brought into the industry by Cisco Systems, three Old Economy companies—Nortel Networks, Lucent Technologies, and Alcatel—sought to use their corporate stock as a currency to acquire technology companies and compensate talented people, and thus accumulate innovative capability. To understand the relation between the stock market and innovative capability in the Cisco ‘growth-through-acquisition- and-integration’ model and in the ‘creative responses’ of the Old Economy companies to the Cisco challenge, we apply an analytical framework that links four functions of the stock market—control, combination, compensation and cash— with three social conditions of innovative enterprise: strategic control—the abilities and incentives of strategic decision makers to allocate resources to uncertain investments in innovative capabilities; organizational integration—the structure of incentives that motivates employees to apply their skills and efforts to collective learning processes; and financial commitment—the availability to the enterprise of resources to sustain cumulative learning processes until, by accessing markets, they can generate financial returns. Using this framework, we show that the ways in which the Old Economy companies used their stock to accumulate innovative capability in the New Economy boom of 1998–2000 made them more vulnerable to the stock market collapse and the slowdown in the optical networking industry in 2001–2003. 1. The Promise of the New Economy The New Economy of the late 1990s promised sustained growth through the Industrial and Corporate Change 12/5 © ICC Association 2003; all rights reserved. 964 M. Carpenter, W. Lazonick and M. O’Sullivan commercialization of information and communications technology (ICT). In the USA—the home of the New Economy—the previous half-century had seen a massive accumulation of ICT capabilities. The development of computer chips from the late 1950s had provided the technological foundation for the microcomputer revolution from the late 1970s, which in turn had provided the technological infrastructure for the internet boom of the last half of the 1990s. The research funding for this accumulation of ICT capabilities had come mainly from the US government and the research laboratories of established Old Economy high-technology corporations. Each wave of technological innovation, however, generated opportunities for the emergence of start-up companies that were to become central to the commercialization of the new technologies. The importance of start-ups in the accumulation of ICT capabilities created a much more prominent and, in some ways, different role for the stock market in the US corporate economy than had previously been the case. The Silicon Valley venture capital firms that, by funding semiconductor start-ups from the 1960s helped give the region its name, saw an initial public offering (IPO) as the main way of transforming their ownership positions into returns on their investments. It is no accident that the National Association of Securities Dealers Automated Quotation System (NASDAQ), launched in 1971 and with listing requirements that were (and remain) much less stringent than the New York Stock Exchange (NYSE), became the stock market of choice for venture-backed New Economy firms, including, among the most successful, Intel (founded 1968, IPO 1971), Microsoft (1975, 1986), Apple (1976, 1984), Compaq (1982, 1983), Sun Microsystems (1982, 1986), Dell (1984, 1988) and Cisco Systems (1984, 1990). To recruit and retain highly mobile technical and managerial employees, young ICT firms offered stock options as partial compensation, with these ‘deferred wages’ also helping the fledgling companies to conserve cash by paying salaries somewhat below the market rate. In 1982, for example, Microsoft launched a stock option program that applied to all its personnel. When the company went public on NASDAQ four years later, it was primarily to give liquidity to the Microsoft shares that its 1000 or so employees obtained in exercising their options. As companies such as Intel, Microsoft, and Cisco Systems grew large, employees numbering in the tens of thousands were included in their broad-based stock option programs. At the same time, these companies grew not only through internal expansion but also through acquisitions of smaller companies that had developed new technologies and/or had access to new product markets. Especially in a booming stock market, companies preferred to use their highly valued stock rather than cash as the currency to acquire other highly valued technology companies with highly uncertain revenue prospects. In March 1998, for example, Steve Ballmer, president of Microsoft, articulated the rationale for stock-based acquisitions in recounting how his company responded to Netscape’s competitive challenge: We’ve had to step up and either make or not make big investments on The stock market and innovative capability 965 internettime.LikeWebTV.LikeHotMail.Someofthem,Ithink,will prove smart. Maybe some of them won’t prove smart. But they’re not huge decisions. We have a currency [with our stock price] that makes them relatively small decisions. These deals [WebTV and HotMail] were both done for stock. I still think it’s real money, whatever it is—$400 million or so per acquisition. But I can stop and say, ‘OK, that’s half of one percent of Microsoft.’ That’s probably a reasonable insurance policy to pay. (Quoted in Cusumano and Yoffie, 1998, 302, with parentheses in original). A company’s stock came to be an important ‘currency’ for accumulating innovative capability—both for compensating innovative employees and combining innovative companies. During the New Economy boom, the ability of a high-tech company to use its highly-valued and appreciating stock as a compensation and combination currency appeared to be a potent source of competitive advantage in the accumulation of innovative capabilities. Rapidly rising stock prices became a competitive weapon for innovative companies in their attempts to attract and retain ‘talent’ and, through acquiring young innovative firms, to gain quick access to new technologies and markets. During the boom, the ebullient stock market seemed to be driving the innovation process. In a society that had by the 1990s come to accept that ‘maximizing shareholder value’ was the key to economic prosperity, the stock market appeared to be a central institution in delivering the promise of the New Economy. With the bursting of the NewEconomybubblein2001,however,itbecameapparentthattheboomhadbeen,in large part, a speculative frenzy in which corporate managers faced strong incentives to take actions—in most cases within the letter of the law—to convince public investors of the growth prospects of the stock valuations of the particular companies to which they had inside connections. What, then, was the relation between the stock market and the accumulation of innovative capability in the New Economy boom? Did the stock market drive innovation, or did innovation drive the stock market? Was the speculative frenzy of the New Economy boom and the consequent disappearance of paper values with the stock market’s collapse simply the price that an innovative economy has to pay to mobilize resources to take advantage of fast-breaking technological and market opportunities? Or would the accumulation of innovative capabilities have been better and cheaper, although perhaps slower, had the stock market played a less prominent role in influencing the innovation process? Notwithstanding the collapse in the values of technology stocks as well as the depressed conditions in many sectors of ICT in 2001 and 2002, the stock market remains a prominent economic institution. An analysis of the relation between the stock market and innovative enterprise is important for understanding how advanced economies allocate resources and generate economic growth and the implications for employment stability and income distribution. Section 2 of this paper provides an overview of the technological, market and competitive conditions that characterize the optical networking industry. Section 3 966 M. Carpenter, W. Lazonick and M. O’Sullivan presents a conceptual framework for analyzing the relation between the stock market and innovative capability. This framework relates what we call the ‘social conditions of innovative enterprise’ (Lazonick and O’Sullivan, 2000b; O’Sullivan, 2000b; Lazonick, 2002)—encapsulated in the terms strategic control, organizational integration and financial commitment—to the different functions of the stock market—summarized as control, combination,