FORTUNE -- Talking toys are a dime a dozen. But intelligent talking toys? Not so much. The amount of computer code and processing power needed to pick up on the nuance of human conversation -- even one with a child -- is vast. More importantly, being entertaining requires different skill sets than, say, Apple's Siri which, besides the occasional barb, is essentially a voice-recognizing search engine.
ToyTalk, an 18-person startup nestled in San Francisco's SOMA neighborhood, hopes to be the first to market a kid-friendly iPad app that does just that. The young company has assembled an impressive group: If you've watched any of the computer-animated Toy Story films, you've seen their work. Founder and CEO Oren Jacob worked at Pixar (DIS) for 20 years and served as the studio's chief technology officer; Bobby Podesta, ToyTalk's chief creative officer, was the supervising animator on Toy Story 3; and, Martin Reddy, the venture's CTO, spent five years at SRI International's Artificial Intelligence Center, the organization responsible for Siri.
Their backgrounds and vision for an app that neither touts itself as a social network nor a commerce engine have generated wide interest in Silicon Valley. ToyTalk has raised nearly $16 million in funding so far from backers like Greylock Partners, Charles River Ventures, Path CEO Dave Morin, and entrepreneur Scott Bannister. "As an entrepreneur, Oren has that very rare combination of technology skills and storytelling chops from being CTO of Pixar," explains David Sze, senior managing partner at Greylock. "There are very few people I've met who have that."
Rapidly changing technology -- ranging from tablet and smartphone apps to increased processing power -- is busily reshaping the $100 billion U.S. toy market. New models for success appear to be emerging every few months. Outfit7, a Cyprus-based startup, created the hugely popular Talking Friends, some 19 apps in which cartoon animals mimic users in funny voices. The company has generated 500 million global downloads and has more than 120 million active monthly users in a short time. Traditional game maker Activision's (ATVI) Skylanders series -- toys that can interact with PCs, consoles, and tablets -- surpassed $1 billion in worldwide sales in just 15 months.
How will ToyTalk work exactly? The app will be available for download for free. Kids will sit within a few feet of their iPads. The tablet's camera works to display a real-world image of the child and his or her favorite toy onscreen. Users casually talk to their toy and vice versa, with the toy's side of the conversation expressed by voice and onscreen by speech bubble. At first, toys will take on one available "personality," a wry British male named Winston and voiced by Bay Area-based actor Dan Clegg. Clegg was recently hired on to lend Winston some trademark wit. He spends three hours a day, three days a week in a small soundproof recording studio in ToyTalk's offices taping thousands of lines of dialogue penned by young adult novelist Kathleen Hale.
A typical conversation might go something like this:
User: Hello, how are you today?
Winston: All right. A dog picked me up by the head today, and his mouth was goopy. I didn't like it.
User: What else did you do today?
Winston: Today? Slow day, really. Tried to achieve my dreams. I took a red sock and dueled the cat like I was a matador. What did you do?
User: I tried to get to my meetings on time.
Winston: You look fit. Have I ever shared with you my exercise routine?
User: No. Are you working out now?
Winston: Stair repeats. Last time, I did five times. Up and down. Beat that, soccer mom!
User: My mom works out. I don't think I'd say that to her.
Winston: I thought you were a giant, but that lady's huge!
Eat your heart out Teddy Ruxpin. To accomplish this kind of conversation, ToyTalk employs a complex set of speech and visual recognition software it developed internally. Jacob argues their work is far more challenging than Apple's (AAPL) Siri. The voice assistant must simply retrieving information users are looking for. ToyTalk's app must start and sustain a natural-sounding, engaging conversation. Jacob and his team are tackling issues like context, steering the conversation back to a particular topic, even pacing. "Ask any comedian what's important, and they'll say timing," Jacob says, pointing to the classic "Knock knock" joke as an example. "Achieving that in this space is extraordinarily difficult to do," he adds.
When Fortune met with ToyTalk last August, Jacob demonstrated an early build of the app. It was capable of holding short, lively conversations not unlike the smart dialogue featured in, no surprise, a Pixar film. But there remained a noticeable lag between responses. A company spokesperson attributed it to in-house WiFi issues; Jacob says that won't be the case in the final product. Still, ToyTalk's ideas are ambitious, not to mention tried before with mixed results.
The app is due later this year. The company is exploring the idea of a subscription model to generate revenue. Users might pay to access hundreds of new lines of dialogue each month, for example. "I am confident this will never work in a preschool with 30 kids in it," admits Jacob. "But if you're with a child and having a tea party with three dolls and tea, tossing some legos and trucks around, well, I think we have a shot at that." Indeed, no one can say Jacob and company aren't aiming high.
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