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managing for shareholder value in the  age of the internet
living on the fault line

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start me up, i’ll never stop

          And as I mentioned, half of my time is spent with Mohr Davidow Ventures, a classic early-stage venture company. What I'm going to describe to you now is how a venture capitalist looks at a new deal in light of these models.

          Here is the promise we are looking for. There is an existing industry that is making money.  

The Promise

Copyright 2000, Chasm Group LLC

Life is good, but now a disruptive technology has entered the marketplace.  You show up and say, “If you will fund me through the early stages of getting this market category started, I will perform a miracle.  If I succeed in that miracle, we'll actually take valuation away from the old guys and we'll park it in my company.  There will be some new stuff that was never on the planet, but I'll also steal a bunch from the old guys.”

          That's the promise.  When you make it, by the way, you make it with a totally straight face.  You show up with your entire team¾three of you, a spectacular set of PowerPoint slides and that's about it.

          The fact is, we might invest.  How is that possible?  I mean, how could you possibly stay in business with this idea?

          This is where the technology adoption life cycle comes into play.  The whole basis of venture investing is based on a model that's about 50 years old.  I have been milking it pretty hard for the last 10.  This model says that when new, disruptive technologies are introduced into marketplaces, people self-segregate according to different ways of adopting the new technology. 

Technology Adoption Life Cycle

Copyright 2000, Chasm Group LLC

          At the front end are innovators, technology enthusiasts who just love to get their hands on it.  Then we see early adopters, the visionaries who say, “I don't want to use it personally, but I want to use it in my company to create a disruption in my market category so that we can catapult ahead of all my competitors.”  The Sabre system for American Airlines or Amazon.com using the Internet in the retail industry are both visionary business adoptions of technology.  The next group are the early majority, the pragmatists who say, “I will adopt this technology as soon as I see other people like me adopting it because I think it's probably pretty good, but, if it doesn't succeed I don't want to get stuck.”  Some of these things fail, so they’re going to wait and see.  It's a “go with the herd” mentality.  It works for zebras; it's going to work for them.  And it does, by the way.  The probability of this strategy working is something roughly reflected in the size of the area in the curve.

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          The fourth strategy is the late majority, the conservatives who say, “I have a system that works, and that’s not a common event in life.  I'm going to hold on to it.  I understand there is a disruption, and I hope it never reaches me.  If it insists on reaching me, I'll probably do it whatever the pragmatist does.  I just want to be last, okay?  I don't want to be first.”  Finally, there are the laggards, this group at the end that says, “Au contraire, this is a bad idea.  You don't want to go anywhere near this thing.  Shoot it, just get it off the table.  This is a terrible idea and it's never going to work.”

          All five strategies have a certain amount of success.  Every one of us could make any one of those responses depending on the offer made.  Having said that, from an investor’s point of view and a market development point of view, there is only one strategy that matters, the strategy of the pragmatist herd because they move as a herd.  That means, if they come into the market, they are going to come in all as a group and they are going to make the market category happen.  If they come in, it's going to take off; if they hang back, the category will never take off.  Think of the pragmatists like a junior high dance with boys on one side of the gym and girls on other.  Will we ever get to dance?

          “I'm not going first.”

          “Are you going first?”

          “Uh-uh!”

          Then everybody runs out to the floor.

          It creates this pattern in market adoption that we have seen over and over and over again, with the early adopters sponsoring a new technology way ahead of the herd; taking huge personal, professional and company risks to perhaps re-engineer an entire industry.  After those folks have been at it for a couple of years, the market asks, “Well, what are the rest of you folks doing?”  We hit this period called the chasm.  The chasm is simply that moment when people are asking, “Are you doing this yet?”  “Yes?”  “No?”  “Me neither.”  “Okay, good.”  The pragmatist herd pulls back.  They go to a lot of seminars, but they don't actually buy very much.

The Different Market Phases

Copyright 2000, Chasm Group LLC

          My book Crossing the Chasm was all about how to get the second wave started, what we call the bowling alley.  It's based on going after niche markets of pragmatists in pain who feel compelled to fix something that they can't fix with the existing technology.  They are in charge of some business process that's totally hosed.  They can't fix it, so they look to technology to help them out.  If you can provide the pragmatist with the complete solution to that problem, not only will he or she buy it, she will recommend it to everybody else in her segment that has that problem.  That's how the herd moves.  You get a little herd to move and that stimulates a second herd or an adjacent herd to move, then another.  If you get this thing going right, you get a tornado.

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          A tornado is just the opposite of the chasm. If the chasm is pragmatists saying "Hmm, you're not doing it?  Okay, me neither," the tornado is saying, "You are? You are?  Oh, crap.  Me, too!"  All of a sudden, markets become flooded with customers.  In 1995, nobody had a Web site; in the year 2000 my limo driver has a Web site.  So does my dog, thanks to my youngest daughter.  Everybody got a Web site in five years.  That's a pretty amazing diffusion record.  It's what the tornado is all about.  It creates massive appreciation in shareholder value.  This is where that green curve you promised the venture investor came from.  Next, markets go to Main Street where they start to settle down.  Going forward from there, they look a lot like markets in non-technology sectors.

          If you look at this diffusion model and ask, “What is the wealth creation life cycle that goes on top of that?” 

The Wealth Creation Life Cycle

Copyright 2000, Chasm Group LLC

The way it works is that you start with a technology adoption life cycle, and, during the first three icons¾the early market, the bowling alley and the tornado¾you are either creating a market category or you are doing a land grab for market share within a highly- or hyper-expanding category.  At no time are you trying to maximize earnings during any of those three phases.  You are teeing up a vision of a market category that is going to extend long after the technology adoption life cycle is done.  We probably absorbed cars in, oh, I don't know, the late '30s and '40s?  We have been buying cars for 60 years ever since.  The key is that the market share you gain during the tornado is the market share you have to work with for the life of the category.  General Motors became the market share leader in the automobile industry about 1931.  In 1998, it was passed.  That was 67 years of uninterrupted market share¾some would argue uninterrupted mismanagement.  I mean, this is not an industry that has actually shined in that category.  The fact of the matter is that we are very conservative with market share; they last and last and last and last.  This is the basis for appreciation.  The future unrealized potential of your company is based on getting a market share win during the tornado which this model can extrapolate to the end of the green curve, calculating the net present value of that share in the present.  That's the promise you are making to a venture investor.

          If you get there, as you mature, the investor would like you now to reinvent yourself; maybe sell off some of the old businesses and reinvent yourself.  Corning got out of pots and pans and got out of health care testing and went into fiber optics.  It cut its revenues in half, and its stock went up 20 times, although it may have crept down a little bit in the last month.  Xerox, by its CEO's own declaration, did not do this.  Two weeks ago, the CEO of Xerox declared in the Wall Street Journal that the Xerox Corporation has an unsustainable business model.  That's a little bit of a shock.  Xerox is a household name, but he was right.  They had gotten to a point where they had not reinvented themselves, despite having possibly the greatest invention laboratory on the planet in Palo Alto.

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          That is what the investor wants you to do.  The first part is the venture process, and the first thing a venture investor does when trying to value your business is to look not at you, but at the category you are talking about, because categories have competitive advantage.  The wireless category has very interesting advantages over fixed wire; digital photography has very interesting advantages over film, regardless of whether you are Kodak, Nikon or a startup.  They look at a category's advantages, and so the valuation begins with the category.  Forget about how many companies are going to be in it, the question is how much wealth this new category can create.  That sets the maximum amount of future unrealized potential.

          By the way, it's a totally made-up number.  It's not really a number; it's just a word.  It's either, “this sounds big,” or “this sounds really big,” as if you are William Shatner or Guy Normous.  Err on the Guy Normous side when you are coming to a venture investor, because that tends to be the adjective of choice, okay?

          So, what category are you in?  Then your company gets valued within that.  This is how it happens in the public startup market as well as with venture investors.  How much is optical worth?  Then how much within that is Nortel worth?  Or Lucent, or Ciena or whatever?  The comparables, the values of the other companies that make it a category, are what fleshes out your value.  If there is nobody else in the category but you, it is not a category; it is an idea, okay?  Part of creating a category is that you have to have competitors.  It's a rule.  What the investors are going to do is say that the sum of the value of all the companies equals the value of the category.  Then they ask, “How much of that should you get?”  That's kind of how public investors sort through it, and that's what the book The Gorilla Game was all about.  

The Start-up's Dream Vision

Copyright 2000, Chasm Group LLC

The Gorilla gets 50% of the value of the category, the first chimp gets 30% and the other seven monkeys have to fight it out for the last 20%, something along those lines.

          Positioning means getting your company put in the right category and making sure it's a category that you win.  But it's also got to be a category that's valuable, and this is a huge challenge for startups.  Positioning is the key marketing challenge for the startup.  The promise you make to a venture investor is that you have found a category that's entering the tornado and it's going to get bigger and bigger and bigger.  Of course, it's going to divide up into a gorilla and a bunch of chimps and you are going to be the gorilla, right?  That is the investment thesis of venture capital¾we buy lottery tickets to a gorilla game.  In the venture world, if 20 companies are in your portfolio and two deliver on that promise, you have more than rewarded your investors.  Remember, venture people have their investors, too.

          That's how the model works, and there is a lot of room for failure in that model.  One of the things I notice when I go around the world is that in this society¾and in the sub-societies represented here in Greater Washington, in Silicon Valley, along Route 128, in Seattle and other key technology cities around the country¾failure is considered a necessary and, in some cases, a desirable attribute of your resume.  If you haven't failed, you probably haven't tried hard enough.  Elsewhere around the world, that's not the case, so American culture gives us, I think, a huge running start on venture propositions.

          That's the view of startups.  The first part was shareholder value; the second part was startups.  In the last three years, a new category of startups came into being that we started calling the dot.coms.

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up and dot.com-ing

          The dot.coms were initially the recipients of unbelievably optimistic treatment.  Everybody who wasn't at a dot.com looked at anybody who was with envy and despair and a whole series of emotions that they put in the seven levels of Hell.  They were all down there¾pride, envy, hatred, whatever¾but everyone said, "I'm so  very happy for you."  Then came the reversal, "Oh, it's just too bad!"

          The problem in having gone through this incredible whiplash—and when I say “gone through,” there is still plenty of whip left in the lash—is that it completely disoriented us to the stock market.  Management teams didn’t have the covenants with the stock markets that they thought they did, both in the dot.coms and in the non-dot.coms.  It really confused the heck out of everybody.  I think that we have to take a minute to take stock.  Let's look back over those last 12 months for a second and ask: What were we thinking?  What happened there?

          First, the Internet was the most investable category any of us had ever seen.  We said that if the average discontinuous innovation is a 10X change, this is a 100X change.  This is a lifetime event.  We gotta put money into this thing.  There was a very limited supply of Internet stocks, particularly in 1997 and 1998, even in 1999, although it began to correct in 1999.  By the way, the stocks that were out there had very limited floats.  There weren't a lot of shares you could get, and this limited supply drove up valuations.  People wanted to put their money in the Internet and this was all they could put it in, so they just kept bidding it up and up and up.

          Then the comparables methodology of valuing companies that we just talked about began to institutionalize inflated valuations.  “If Yahoo! is worth this, I gotta be worth at least that, right?”  If that argument sticks, hooray!  “If Geoff's worth that, I gotta be worth at least this!”  Pretty soon we had this phenomenally institutionalized inflated valuation.  That’s because the theory of comparables never looks at absolute value, it only looks at relative value.  It’s always saying, “If X is worth that, then Y is worth so much of X.”

          Needless to say, in the middle of this, speculation started to increase the froth.  Not all investors are value investors.  A lot of investors are speculative, and the market absorbed an enormous amount of abuse.  We took dot.com after dot.com after dot.com after dot.com until, apparently, if you put “.com” at the end of your company's name, you could go public and become a paper millionaire, billionaire, gazillionaire.

          Needless to say, when you put up a sign that says “free money,” people come.

          That's what we did, and that's how the system got out of control.  By the way, the comparable system was a very good system, except in this situation.

          Then we went through a correction.  You knew it was going to happen sometime, but why March?

          Well, what happened was that the Fortune 500 had, by and large, stayed out of the game in 1999, at least to the investor community's visibility.  Part of the reason why stocks got so high in 1999 is that people thought that those folks in the Fortune 500 were brain-dead, right?  “They don't get it!”  Remember?  There was a whole year of "Do you get it?" Get it?  "They don't get it, you know?"  Maybe we just take the Dow and move it over to the Nasdaq.  Boom.  Just do it once.  Get it done with, okay?

          The Fortune 500 had been on hold for 1999 because of Y2K, and when they got released from that leg iron, they started to enter the fray.  Remember that first quarter?  The automobile exchange was announced, the aerospace exchange was announced, pharmaceuticals, a couple of computer exchanges were announced.  Now the investors said, “Hang on.  I thought that was supposed to be the dot.coms’ business?  You mean these guys can compete for it?”  They started to correct for that and they asked, “Who is actually getting transactions?”  They went to the independent exchanges, and the independent exchanges said, “Well, we have some ‘prototype’ transactions, you know?”  They were trying to find some word they could use.  Meanwhile, the Fortune 500 was saying, “Hey, it's our money, right?  We are the transactions and we are bringing it with us, okay?”

          Particularly on the buy side exchanges, the investors said, "Oh, my goodness. Hmmm . . . ."  The industry part of the marketplace had the upper hand, and the dot.com marketplaces, particularly in B2B dot.coms, just got hammered.  Bam!  We used to have the B2B.com marketplaces in the earlier market, but now the lifecycle moved to the industry-sponsored ones to steal that position.  It sort of shoved the independents into the chasm. 

Investor's View of dot.coms

Copyright 2000, Chasm Group LLC

          By the way, on the other side, B2C is actually in the tornado.  The problem is, it's not clear that you can make money at it.  B2C does not have an adoption problem, it has a margins problem.  Discount B2C and people said, “No, B2B is what it's all about.”

          Never before had the public markets been asked to hold stocks during a chasm phase.  Prior to the last three years, when stocks went public they had already crossed the chasm¾they had earnings, they were viable, they were moving forward. Whether or not they were going to get into the tornado, at least they weren't burning money.  We changed that rule in order to expand the amount of capital that could be thrown against the Internet because it was a once in a life of the planet type of opportunity. Arguably, this might have been good for the planet, but it's not going to be good for the folks left holding pieces of the bag.  Much of that bag was actually illusion.  There were paper stocks buying other paper companies with more paper stocks, so I don't think it's quite as draconian as it might seem, but it's serious.

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          The question we have to ask is: what would it take to get B2B dot.coms out of the chasm?  We know a lot about crossing the chasm now; it's a 10-year-old idea.  Here is the drill.

Crisitcal Sucess Factors: A Progression

Copyright 2000, Chasm Group LLC

There are four stages in the development of a tech market, and you have a different business goal for each stage.  The first one is, get visible.  I think we have to give the dot.coms an A+ on getting visible.  Who would have thought that Ron Insana would be a rock star on CNBC?  Who would have thought that USA Today would have Nortel as the big headline on the front page?  We got visible.

          Crossing the chasm means getting viable, and that means having positive cash flow.  It means making money so you don't have to raise money anymore.

          Getting into the tornado is about getting scale; and getting on Main Street means getting profitable.  You actually suspend profitability until Main Street, but you are going to work that for the life of that green area we talked about earlier.

          The issue that the industry is now focused on is viability, and they have interpreted it as liquidity.  Which exchanges are going to get which transactions?  How many transactions?  Service transactions or product transactions?  Fee or commission?  Nobody really cares too much about the model; they just want to know when you will get the level up to where income exceeds outflow.  That's what they want to know.  P2P¾path to profitability¾is a function of creating liquidity.

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          We have learned that this is where you must get the pragmatists to come over to the new technology.  Remember, pragmatists don't want to move.  We know that you have to focus on satisfying a problem for them, specifically.  We call it transaction satisfaction on an exchange.  What's the probability that if I come to your exchange with the motive you say I'm going to fulfill, that I actually will fulfill it?  You want to get the probability that both the buyer and the seller are fulfilled to a very, very high percentage.  It's achieved via focus.

          If your exchange carries cars and Barbie dolls and insurance, the chances of getting somebody coming to it and hitting the selection they want is very low.  On the other hand if you say, “Hey, we only do insurance.  In fact, we only do re-insurance.  In fact, we only do maritime reinsurance and we have the email addresses or snail mail addresses of every maritime-shipper that needs this,” now you're increasing the probability that, if you get some of these people to the site, they will find a transaction they want to do.  You focus down very, very narrowly to get across the chasm.  You want to start this network effect, this increasing returns effect, much as Netpreneur.org has started in this room.  You want to start one of these in your market, where there is viral marketing and people starting to say, “This is a very cool place to solve a very tough problem that we have always complained about.  Now you don't have to complain about it; go to this site.”

          That's the drill.  It's a liquidity versus scale problem.  The issue is that you went into the earlier market and bragged about the scale you were going to achieve.  That's why the venture person got in, because it’s guy-normous.  But to cross the chasm, you actually have to let go of that promise and go for focus in order to get it started.  Once you start the fire, fan the flames.  Now you can go back to scale.

          The strategy for scale is very different from the strategy for liquidity, but what we did was to make early market promises focused on scale, and now, in the short- to medium-term,  we have to make a course correction.  We have to redirect to the race for liquidity, and we have got to get there in time for investors because the additional money that will be put into the system now is very limited.  We have to figure out a way to get there now, with the resources that we have.  It's not a scale problem; it's a liquidity problem.

          Thank you for staying with me this far. That was three out of four.  If you have been with me this far, you get to nod off.  It's okay.

  [continued]

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Statements made at Netpreneur events and recorded here reflect solely the views of the speakers and have not been reviewed or researched for accuracy or truthfulness. These statements in no way reflect the opinions or beliefs of the Morino Institute, Netpreneur.org or any of their affiliates, agents, officers or directors. The transcript is provided "as is" and your use is at your own risk.  

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