Beyond 2001: Investing in Internet and Early Stage Technology Companies

Chris Rollyson

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The volatility in the 1996-2001 investment climate for Internet and early stage technology companies was nothing short of remarkable. Although it would be easy for any economist to write off the period as another example of the classic boom/bust pattern, in reality the volatility reflects the interaction of several trends that are much more interesting: the revolution in business and society driven by electronic communications, a broadening of investor participation in Internet and early stage technology companies¹, and the complexity of the value propositions represented by these companies. The trends and level of complexity have created confusion in the investment climate as of Fall 2001: the volatility ratchets the level of opportunities and threats upward, and the market demands more sophistication of investors when the average level of investor knowledge is lower due to the increased number of individual investors. However, by understanding the trends and how they interact, it is possible to mitigate investment risk and to enjoy solid returns.

The stock market of 1996-2000 reflected in large part investors’ discovery of some elementary aspects of the electronic communications revolution, and their excitement about the potential economic value the investments promised. The correction in the financial markets during 2000-2001 was not a simple matter of "greed getting its just desserts" or a "boom/bust pattern." It reflected an extremely useful realization: there are many unknowns about the revolution, as well as the technology and business models that underlie it, and investors have not yet understood it well enough to maintain investments under intense scrutiny and adversity. Investors, when faced with pressure, must be confident of their investments to be able to hold them when the environment becomes difficult; if they are not, they desert their investments.

The "investors" in early stage technology companies (hereafter ESTC) are a diverse group, but they have in common that they will benefit from understanding how ESTCs create and maintain value. Stockholders, employees, customers, alliances, suppliers and government all have finite resources to allocate among "investments," and they often forgo some percentage of immediate reward for future "upside." Making informed investment decisions requires a sound understanding of the electronic communications revolution and transformation as well as insight into the "customer context." Only then can one formulate intelligent strategies to approach investments in early stage technology companies going forward.

The Impact of the Electronic Communications Revolution²

The electronic communications revolution is drastically changing the investment climate and introducing unknowns into virtually all equations because it changes the economics of communication.³ These changes are so fundamental—to individuals, businesses and societies—that they are difficult to appreciate fully. Yet the sweeping nature of such a change means that virtually everything is affected, directly or indirectly.

Electronic communications is the widespread digitization of previously analog communications, largely through the use of computers and transmitted or delivered through wireline or wireless networks. Such digitization changes the economics of communication so that it transforms the nature of relationships and organizations, begetting the "transformation" moniker. Its value proposition is legendary for information-based communications between people: the average customer service phone call costs the servicing company $10 U.S., while corresponding service via a website is typically $1 U.S. or less. Other often named advantages are an automatic digital record and very low variable costs that enable expanded service (365x24x7). In sum, it reduces transaction costs while enhancing service.⁴

The Significance and Challenges of E-Business

E-Business describes the strategic, process and technology activities that "bricks and mortar" (BAM) organizations undertake to digitize communications. Considering that analysts are in widespread agreement that business to business (hereafter B2B) transaction value and e-business investment will dominate business to consumer for the foreseeable future⁵, BAM companies represent the "customer context," or buying environment, for ESTCs’ products and services; therefore, insight into issues relevant to BAM e-business initiatives will be critical to early stage technology entrepreneurs. Likewise, BAM executives recognize that the trend of using technology to create and drive their companies’ competitive advantage is a growing one. Therefore, these executives will benefit enormously by knowing how to understand ESTCs’ potential value in the context of their companies so that they can be "smart buyers" of technology.

There are many customer context elements that have nothing to do intrinsically with e-business but that dramatically affect the value it can create. The BAM’s strategic goals and attitude around the initiative are often defined by its existing market position relative to peers and neighbors in its value chain. If the company is disadvantaged, it may attach a high strategic importance to the project with the intent to grow its market position aggressively by using quick adoption as a competitive weapon. Likewise the company’s culture has a major impact on its attitude toward the investment: does the company see itself as an innovator, is it confident of its ability to derive value from innovations, and what is its track record of late?

Realizing verifiable economic value from BAM e-business investments can be a challenge, although the value proposition is simple to understand. Significant expenditure is required to create the strategy that stipulates what processes should be targeted first; often significant retraining and redeployment of human resources is involved; if advanced technologies are used, unknown complications can arise. Even more fundamental: it isn’t terribly easy to measure transaction costs with unassailable certainty. Lastly, transforming processes within BAM organizations requires time, during which the organizations’ processes change for other reasons than the e-business effort.

Technology is a major driver of the potential of e-business, and it is comprised of hardware, software and network engineering at the most simplistic level. The ESTC is likely only one of hundreds of technology vendors with whom the BAM works. Vendors are all changing very rapidly, driven by high competition. Therefore, applying myriad components of technology solutions to achieve a measurable economic result is a very complex proposition.⁶ It is well known that more than three-fourths of technology projects fail to deliver promised expectations due to the complexity of the technology and the degree of change at the client where it is being developed or installed.

Evaluating the economic benefit realization proffered by e-business is a challenging proposition. On one hand, the value is extremely compelling, intuitive and certain (lower transaction costs, better service). On the other, technology is very complex and difficult to measure. And if that part of the proposition were not daunting enough, it is only part of the answer because it is the business use of technology that generates economic value, not the technology itself. The technology solution must be used by the company long enough to measure the value of the transactions processes, which must often be compared to the transactions prior to the e-business solution, which were often not measured with certainty.

The coup de grâce in e-business economic benefit realization arises due to the digitization of communications itself. Digitization explicitly and visibly connects people where they were not connected before. For example, a BAM’s corporate office had 500 staff, each making an average of 30 analog phone calls per day. The explicitness and awareness of the phone calls was minimal prior to e-business, so measuring their economic benefit was not an issue or possibility. If 35% of these communications can take place through e-business transactions, an investment will be required, which will drive a desire to measure an economic benefit. Theoretically, it can be done, but this will be new territory because measuring the value of the calls is inherently difficult, not only because e-business is suspect.⁷

Moreover, the digitization of communications, because it decreases transaction costs in most cases, often increases the number of transactions, which "diminishes" the cost savings and increases the organization’s ability to change (in fact, a desired result). The degree of change makes it more difficult to isolate economic benefit because there are fewer constants. Furthermore, the point at which value is generated can and does move. Practically speaking, knowing where to define value is an art as well as a science, and it will be imbued with uncertainty for the foreseeable future.

Therefore, electronic communications represents at once a very compelling value proposition coupled with complex technology choices, increasing change within organizations and inherent challenges in measuring economic benefit delivered beyond a reasonable doubt. This state of affairs requires BAMs to make investments carefully, and it creates a complex selling environment for ESTCs.

Analytical Framework for Early Stage Technology and Internet Investments

When investments are made in the context of a major transformation such as the electronic communications revolution, a strategic outlook is best because it will seek to identify risks and unknowns, and it will specify the intentions to act to minimize the impact of the risks. This contrasts with the "rush to market" mentality during 1996-2000 in which most investors dealt with the complexity of value propositions by focusing on the simple, intuitive truths that they could experience first-hand, such as electronic banking, self-service, configuring made-to-order products and massive product selection. As 2001 draws to a close, investors are confronted with deserting the market or making a concerted effort to master the complexity represented by these investments.

A more robust analytical discipline that draws on a strategic perspective will enable investors to grow beyond the stereotypical "short-term return mentality." Increased strategic understanding will also bring investors closer to ESTC and Internet company executives with whom they will be able to have a more insightful dialog, which will dramatically increase their ability to capitalize on the high degree of risk and reward.

The framework presented here is comprised of several "lenses" through which potential investments can be viewed. Professional investors routinely use these lenses during their due diligence process as well as to review the progress of the companies in which they invest. Of course, not all lenses are required to evaluate each investment, but experimenting with them will be useful in itself because learning how they work and interact will increase proficiency over time.