A new dawn breaks over the sunken valley of the dot coms

A report from San Francisco on survival after the hi-tech fall-out

When Greg Williams negotiated an options package with his new employer at the height of the internet boom, he joined the growing ranks of middle-income Americans who saw the dot-com revolution as a route to sudden riches. He had a decent salary, a high-flying job and the knowledge that if anything went wrong there were numerous other opportunities across Silicon Valley. What he didn't predict was that one year after the crash, he'd be left with a $70,000 tax bill for shares that are now close to worthless.

Mr Williams' plight represents just one of numerous "riches to rags" tales in Silicon Valley. California's energy crisis may have led to rolling blackouts, but the lights have gone out permanently across large parts of the hi-tech industry, and the social and business impact has been astonishing.

Next week Sun Microsystems, the hardware company which helped to drive many new-economy businesses, will close down to coincide with the 4 July holiday. Employees have been ordered to take a vacation or unpaid leave.

As many victims of the downturn pack their bags and head out of town, the industry is looking to pick up the pieces. It isn't easy. Demand in many parts of the sector has sunk through the floor. Venture capitalists who got their fingers burnt in the crash have either closed the door on further investment or are imposing ruthless terms for later-round funding. From an employment perspective, meanwhile, companies are juggling with two contradictory problems – the need to reduce head count, and the need to keep their remaining employees motivated at a time when nerves are jangling and share options are under water.

Partly because of the speed of the market collapse, life in San Francisco and down the hi-tech dominated peninsula now verges on the surreal. The cash-strapped unemployed organise their social calendars around their local bar's happy hour, swapping stories ranging from the bizarre to the outrageous. One account manager of a large software company recalls having been fired at three o'clock in the afternoon, only to be told an hour later that she was too valuable to lose.

Another management consultant tells how he was laid off on a Monday by his firm's East Coast headquarters, and re-employed on Tuesday by his local West Coast office as a contractor, with higher pay and, ironically, better redundancy protection.

A marketer at Intel, which plans to shed 5,000 jobs by the end of the year, points out that the chip giant is in effect laying off people who haven't even joined the company, offering those who have accepted new positions two months' salary and their hiring bonus if they agree to walk away.

Meanwhile, a programmer at Sun Microsystems, which has so far avoided compulsory lay-offs, laments the demise of the company's free doughnut programme. It's all about perspective.

To outsiders, it's hard to feel sympathy for people embroiled in the Valley's problems. This, after all, was a boom that turned 20-somethings into overnight millionaires on the back of start-up schemes that broke all the rules of business. The wild parties and other excesses gave the impression of an economy fuelled by greed, and those who lost out are seen to be victims of their own avarice.

In reality, the picture is far more complicated. Many of the people who have joined the ranks of the unemployed took gambles, sharing the risks of start-up operations in the hope that they would also share the rewards. Several leading dot coms used option schemes as a reason for keeping salaries relatively low – relative at least for the Valley – arguing that the long-term payback was worth a short-term sacrifice. But as the bottom started falling out of the market last March and share values collapsed, the strike prices made the options meaningless. Looking back, those who failed to cash in during the boom years realise they lost not just the promise of wealth, but also hard cash in their monthly pay cheques.

Worse, tax incentives have backfired on many option holders. Because capital gains tax drops sharply on shares held for more than one year, many employees exercised their incentive options early. If these remained unsold at the end of the tax year, they became subject to Alternative Minimum Tax, payable on the difference between the exercise price – perhaps $1 – and the deemed value at the time – say $10. That was no problem in a booming stock market but it hit hard when the market crashed. Middle-income employees, like Greg Williams, who failed to sell before their shares plummeted now face huge tax bills with no collateral to offset against them.

Although they can do little to address these problems, many companies are taking steps to minimise the impact of the slowed economy on their remaining employees. For example, Agilent Technologies, a spin-off from Hewlett-Packard, has cut all salaries by 10 per cent rather than axe jobs. This is not the first downturn Silicon Valley has experienced and, inevitably, the longer-established organisations often fare better at the task than their newer rivals. Inexperienced managers at many internet companies have responded to the collapse with near panic, laying off staff in dribs and drabs and repeatedly changing strategy as they grapple for a way forward.

For many new-economy companies, however, the critical issue right now is not staff retention but cash burn. According to a PricewaterhouseCoopers survey, investment by venture capital firms plummeted 40 per cent in the first quarter of 2001. Moreover, it's clear that funds being invested in later-round financing come at a heavy price. Investors are increasingly imposing draconian terms that give them priority profits on exit and ruthlessly water down existing shareholders. For venture capitalists specialising in start-up funding, the process can be painful. Silicon Valley specialist Angel Investors tells how it was washed out of one investment when the new-round funder imposed a massive 50:1 preference.

Angel Investors general partner Bob Bozeman says the outlook is starting to improve, though more stability will be required in the markets before the venture capital funds start flowing again. Even if the short-term outlook remains tight, however, others agree that there's cause for medium-term optimism. Martin Gagen, who set up 3i's US operation in autumn 1999, predicts 2001 will be a "vintage year for investment" largely because most companies able to attract investment are quality operations with high-calibre, experienced managements.

Taking stock of the events of the last year, Mr Gagen believes that the venture capital industry is now going back to basics when it comes to making investment decisions, asking itself where – or even whether – revenue streams will kick in along the value chain.

Over the last five years, he argues, many venture capitalists "outniched themselves", focusing on specialist areas and local geographies. In the future, he believes there will be greater collaboration between firms as the specialists seek broader, global expertise.

He adds: "Today is a brilliant time to be cash-rich and willing to invest." But he points out: "Everyone will need to keep their nerve for the next couple of years." As Greg Williams – who faces a tax bill for thousands of dollars – will testify, this is easier said than done.