for shareholder value in the age of the internet
on the fault line
page two of
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.
2000, Chasm Group
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.
2000, Chasm Group
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.
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?”
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?”
“Me neither.” “Okay,
good.” The pragmatist herd pulls back.
They go to a lot of seminars, but they don't actually buy very
2000, Chasm Group
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.
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
If you look at this diffusion model and ask, “What is the
wealth creation life cycle that goes on top of that?”
2000, Chasm Group
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.
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.
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.
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.
2000, Chasm Group
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
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
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
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.
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
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
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.
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
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,
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,
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
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.
2000, Chasm Group
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.
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
2000, Chasm Group
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
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.
a function of creating liquidity.
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.
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