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

Geoffrey Moore is perhaps the best known and most respected thought-leader on the subject of the New Economy. At this Morino Institute Netpreneur.org event held October 26, 2000, he explained how managing for shareholder value is all about increasing your company’s future unrealized potential and how startups, dot.coms and going concerns can do that more effectively. If you understand the technology adoption lifecycle and focus on those things which enhance competitive advantage, Moore says we can maximize the Internet, this “most investable opportunity we’ve ever seen,” and create a New Economy where a network of interlocking companies all focus on the core functions they do best.

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.  

Copyright 2000 Morino Institute. All rights reserved. Edited for length and clarity.  

 one: mary macpherson: welcome

Good evening and welcome to Living on the Fault Line.  It's great to see you.  I'm Mary MacPherson, Executive Director of the Morino Institute's Netpreneur.org.  On behalf of the Institute, the Netpreneur.org team and this evening's sponsors, I'd like to thank you for coming.  We invite you to sit back and enjoy what's going to be a terrific program.

          Joining us live via the Internet are folks from all over the planet.  Here in Washington are over 1,200 of our closest friends.   This definitely qualifies as the biggest party we've hosted since starting our learning community for Internet startups in 1997.  The fault line isn't just in California; it's everywhere.  It's the Internet.  And speaking of parties and the Internet, this morning The Washington Post reported on a UCLA study that concluded that the Internet has become a new source of social contact.  Duh!

          We can safely say that the Internet has been bringing us together here in Greater Washington for some time, both online and off line.  How we all came to be here tonight is a story in itself.  In the best tradition of viral networking, you helped us get the word out.  How many people in the audience got more than one email about this event?  How many got more than three?  We heard again and again that people were getting multiple emails about it, but they were interested in seeing the thread and seeing who they were coming from.  We truly have an organic network of hundreds of groups and thousands of individuals involved in Greater Washington's entrepreneurial community, so thanks to all of you who helped get the word out--corporations, associations, user groups, schools, individuals and organizations.  Please give yourself a hand, and I'd like to give a special recognition to Mitch Arnowitz, the Netpreneur team's viral marketing maestro, who orchestrated our connecting effort tonight.

          Let me tell you about tonight's program. Geoffrey Moore will lead off.  He will then be joined by two entrepreneurs to expand the conversation, followed by open microphone Q&A.  Those of you watching via Webcast can email your questions.  Finally, Mario Morino will bring it together as he does so well to wrap up the evening.  The conversations can continue afterward, over coffee and dessert served in the foyer outside.

          That dessert and this entire evening are made possible by our sponsors.  They have stepped up in a major way to support you, and we encourage you to learn more about their services and how partnering with them can benefit your businesses.  Thanks to our community partners, Imperial Bank, Heidrick & Struggles, Deutsche Banc Alex. Brown, The Staubach Company and The ProMarc Agency; and to our premier partners, Brobeck and Washtech.com.  We hope that you have noticed the big changes in the print edition of The Washington Post and in the new Washtech.com site.  Business and technology coverage has come a long way since the days of being in the back of the Post’s sports section.  Finally, a special thanks to our marquee event partners, UUNET's Head Start program and NaviSite.

          NaviSite, as part of the CMGI family, has grown guided by the vision of David Wetherell.  Like many of you, he is a true entrepreneur who started a small company called College Marketing Group (CMGI).  With his vision, CMGI went from selling direct marketing services 30 years ago to a Nasdaq 100 company, now, managing, developing and investing in the most diverse network of Internet companies in the world.  NaviSite is the leading provider of managed application hosting services, and they provide what companies need to launch and sustain their Web businesses.  A little later in the program, Andy Sherman, NaviSite's Vice President of Sales, will lead our audience Q&A session.  Andy is building a national sales team focused on responsiveness, a solutions orientation, flexibility and professionalism.

          It is now my pleasure to introduce Brad Wise, Vice President of Channel Sales & Development for UUNET.  Having quickly grown to be the largest ISP, UUNET has not forgotten about its entrepreneurial roots.  Through its Head Start program, the company now offers full-service support and access to startups while they are still young and have the potential to become the next generation of large UUNET customers. Brad Wise has been there since the beginning and is one of the people at UUNET who has kept the entrepreneurial fires burning with the Head Start program and other initiatives.  Please help me welcome Brad Wise, who will introduce tonight's speaker.

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two: brad wise: introduction

Good evening, ladies and gentlemen.  It is my pleasure to be here.  I'm Brad Wise, Vice President of Channel Sales & Development at UUNET, and I'm excited to be a part of Living On The Fault Line tonight.  Our Head Start program was also a sponsor of the Cluetrain event back in March.  At the time, I did not think the excitement and enthusiasm could be exceeded, but I believe tonight we're going to prove that wrong.

          It is my pleasure to introduce our featured speaker this evening.  He is a guy with many dimensions--venture capitalist, author, business and market strategist and tech visionary--and none of this happened until he was 32 when he wrapped up his career as an English professor and took the plunge into business.  Since then, he has written books about a chasm, a tornado, and, now, a fault line.  And let us not forget Geoffrey's gorillas, which were the inspiration for Netpreneur.org's Garage2Gorilla event last year.  Amid these geologic and anthropologic things, there is some extraordinary wisdom for people in the audience tonight, whether it’s two of you in a garage, a startup that recently received a first round of funding or a brick-and-mortar company looking at what you need to do with your business model.

          Geoffrey Moore's latest book is Living on the Fault Line, subtitled Managing for Shareholder Value in the Age of the Internet.  In his remarks tonight, Geoff will talk about new metrics, navigational tools and new strategies for achieving and sustaining the competitive advantage.  Please help me welcome Mr. Geoffrey Moore.

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three: geoffrey moore: gaps, caps, & pragmatists in pain

Thanks, Brad.  Thank you all.  This is amazing.  It’s exciting from the point of view that when networks start to come together, there is something called increasing returns--you folks are right in the middle of increasing returns.  It's a huge tribute to yourselves, to Mario and Netprenur.org, and I'm just delighted to be a circumstance in this process.

          Building a network is crucial to economic development, particularly around disruptive technologies, so, to kick this off, I’d like to add two nodes to your network by introducing two individuals.  I’m affiliated with both the Chasm Group and Mohr Davidow Ventures, both of which now have offices in this area.  Brian Nejmeh of InStep is providing Chasm Group consulting services for the DC area as an affiliate of the Chasm Group, and we are absolutely delighted.  Michael Sheridan is our newest General Partner in Mohr Davidow Ventures, and he is opening up the office for the Greater Washington corridor.  I hope you get a chance to introduce yourselves to both of them sometime tonight.  Thanks, guys.

          For this first part of the evening, I want to put four ideas in front of you, then engage with the panel and Q&A around how applicable they might be to your current economic challenges.  It's pretty well known, however, that can you only retain three ideas in any one speech, so I'd like you to look carefully at this list, and pick the one you are going to zone out on:

1.         Managing for shareholder value . . .

2.   . . . in a startup.

3.   . . . in a dot.com.

4.   . . . in a going concern.

Just pick the three you want and we'll make it go. It's a little bit of a long run, but I really want to share all four ideas with you.  The first one, Managing for shareholder value is a framework for understanding stock price and shareholder value.  The others are applications of that framework to startups, to dot.coms and to existing, going concerns.  In each context the framework changes in interesting ways, so let me start with stock price.

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what is managing for shareholder value?

          If you spend some time with a Wall Street analyst, as I did when I was writing The Gorilla Game, you learn that the actual price of a stock is set by whatever people will pay for it.  The theoretical value of a company, however, is the present value of all your future returns forever, discounted for risk.  Those three ideas--present value, all future returns and discount for risk--are all wrapped up in how people are trying to calibrate whether valuations are too high or too low.

          One argument you could make is that we were insensitive to risk in 1999, and that today we are hypersensitive to risk.  We experienced both in the press, right?  In 1999, no matter what happened, somebody found a good news story out of it and we went up.  Now, no matter what happens, somebody finds a bad news story in it and we go down, so the discount for risk has got to recalibrate around technology.

          Let me show you a picture of that same idea, then tie it back to the thing that you can control as a manager in your own company.  If you think about this issue of future returns discounted for risk, the first thing we can talk about is that your company has some current returns. 

Forecasting Future Returns

Copyright 2000, Chasm Group LLC

They are a benchmark.  The investor uses it as a frame of reference for understanding your future.  When I buy a share of your stock, I'm only buying a part of your future.  I'm not entitled to the current returns, so, fairly quickly, I will ask, “How are you going to do in the future?”  Now, you entrepreneurs are remarkably consistent in how you answer that question, so investors have to say, “Okay.  Looks good.  Yep.”

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          Then the investor asks, “How am I going to respond to your promise in terms of valuing it in the present?”  They apply the notion of discounting for risk.  They break it up into two chunks.  One has to do with the present value of money.  Basically, that it's a function of interest rates--how could that money be put to work today in a bond, which is essentially a risk-free investment.  The haircut I just got, that's the money that I could have earned from a bond’s compound interest going forward in time.  I'm not going to give you any credit for that because I can get that "risk free."  The second and more powerful discounting phenomenon is discounting for risk, based on looking at your future going forward.

Discounting for Risk

Copyright 2000, Chasm Group LLC

The further out in the future you promise returns, the greater the discount for risk I apply to them.  It's just an issue of future uncertainty--competitors could enter the market, conditions could change, oil prices could go up, we could go back to an inflationary economy, on and on and on.  The further out in time we go, the higher the risk discount until eventually it becomes 100%.  That simply means, once you get to the end of that green curve, I will assign no additional value to any promise you make outside that point in time.

          Now, the area under the green curve is a visualization of your market capitalization, whether you are a public company or a private company. 

Visualizing Shareholder Value

 Copyright 2000, Chasm Group LLC

It is the value of your company from a fundamentalist investor's point of view.  This isn't a speculator's idea; this is a person who says, “I really do want to value you on the present value of your future returns, discounted for risk.”  From this investor's point of view, you have one job--make the green area bigger.  This is actually pretty easy to do in PowerPoint, but harder in the real world.

          When you deconstruct the challenge, the key thing is that you want to start with the notion of making the green area bigger.  You either have to make it taller or wider.  It turns out that the actionable equivalent of taller is to take management actions which will increase the gap between your company's offers and those of your closest competitors.  The greater the Competitive Advantage Gap (GAP), the greater the differentiation in terms of a vector that the customer values in making buying decisions.  If you can create greater differentiation, there’s a higher probability that you will win the sale and a higher probability that you will be able to win it at a premium price.  The higher your GAP, the greater the suggestion that you will have very privileged earnings going forward.

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          Most management teams understand this in spades.  In fact, this is what most managers spend most of their days talking about, starting with their sales force explaining why the GAP is too small, engineering explaining why the GAP can't shift for three months and marketing explaining how you never did the GAP that they asked for.  We are always talking GAP, GAP, GAP all the time, so I don't think there is a lot you need in terms of getting educated on that vector. It's the other vector that gets lost in the shuffle.

          The other vector the investor is interested in is how long you can keep your GAP.  We call it the Competitive Advantage Period, or CAP.  The more sustainable that competitive advantage, the more I can give credence to your future projected earnings statements.  Conversely, if I think you have a GAP right now but your competitor is going to ship the same product in three months, then I have to assign a much lower valuation to that advantage because it's not going to last very long.  Okay?

          That issue of sustainability of competitive advantage is what gets lost in the shuffle of day-to-day management.  When we look at the two ideas, we put a lot of attention on GAP, such as new product introductions which get the entire company mobilized.  Lower priced offerings, a sales force that's up for it, superior customer service--those things are all a little bit CAP-ish, but you can still get GAP stuff going around that.  CAP things like patent positions, market share leadership or brand loyalty--investments that take time to put in place--they tend to get the short shrift in highly competitive situations.  This is where managing for shareholder value is the thing that rescues you because, in the short term on this quarter's P&L, investing in CAP is a losing proposition.  It won't pay off in the quarter that you expense it.  Shareholders, however, are able to look past that to your competitive advantage position as a whole and value it.  If you use your stock price instead of your P&L as a guiding point, you get that input back into the corporation.  If you compensate the corporation with stock options, you have the opportunity to get that same thinking as part of the motivation of the company going forward.

          Managing for shareholder value has the opportunity to keep management accountable to its best self going forward. There is a dark side to this, as well, and we'll get there, but it has the opportunity not only to build advantage in the present, but to make the investments necessary for sustainability going forward.  The key is that investors value power.  They do not value P&L statements in and of themselves.  Yes, investors like to see revenue growth, but it turns out that they really want to see good revenue growth.

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          The notion that there could be such a thing as good, neutral and bad revenue will not go over well with your sales force, okay?  That's not an idea they want to entertain, but, from an investor's point of view, it's absolutely true.  Good revenue is any revenue you get from a customer where the business you do today actually tees you up to do more and better business in the future.  It means a good customer in your target market making an investment today that implies future investment with you later.  Neutral revenue is opportunistic revenue that you take from a customer that you will probably never see again.  God bless them, though, it's a purchase order and the check cashes, so it’s a good thing.

          The danger zone is bad revenue.  Bad revenue comes from agreements you make with customers who are not appropriate for your company.  They require you to make ongoing investments in ways that divert scarce resources from where you should be investing.  Over time, actually, it will be harder for you to make your numbers in future quarters when you make this quarter's numbers by taking bad revenue.  You will have fewer resources to deploy next quarter and you will have a harder nut to crack.  Managers have asked, “But Geoff, if I'm going to miss the quarter shouldn't I take bad revenue?”

          The correct answer to that question is: You have already missed the quarter.  The only question is, which quarter do you want to miss?  It turns out that if you are going to miss a quarter, you want to miss the current quarter.  Every time you defer that reckoning, it gets worse.  There was a spectacular example of that in the Bay Area about five years ago with a company called Informix.  They had an incredible management team; the CEO was a very charismatic salesman who made what I would call diving catches in the end zone at the end of quarter after quarter after quarter to keep up with or exceed Oracle’s growth.  On the sixth quarter, he missed his numbers.  He only missed it by one digit, but it was the first digit, so it was a serious miss.  Bad revenue is serious, and you must have this discussion with your management team about what’s good, bad or indifferent revenue.

          This isn't to say that you can blow off the P&L when you are talking to investors, but understand that your P&L is always a trailing indicator.  It actually establishes your credibility about past promises you made and whether or not they came true. The investor is always investing in your future, not your past, and that's the first lesson of this section.  This is the thing that you don't want to lose sight of: managing for shareholder value equals managing for competitive advantage.  If you are serious about stock price, if you are serious about managing for shareholder value, then understand that you are managing for competitive advantage.  Understand that market capitalization¾whether in good markets, bad markets, mature markets or disruptive markets--is always a representation of the future unrealized potential of your company.

          When shareholders buy your stock, they need you to increase the future unrealized potential of your company in order for them to sell at a price higher than they bought.  Instead, if you milk that potential to make numbers and end up with a company that has less future unrealized potential, then, when they sell, they lose money.  That's what we are managing for when we are managing for shareholder value--future unrealized potential.  It is inherently future-oriented, and it is inherently a build-and-hold kind of idea.

          That's fundamentalist investing, by the way.  There are other forms of investing, such as momentum investing and speculation, but this is a Warren Buffet-type of fundamentalist investing.  I think it's the one you should teach your employees, customers and partners.  You should recruit investors who believe in those ideas.

          Now I want to apply these ideas to three zones, and the first zone is the domain of the startup.

[continued]

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