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traditional companies versus .com startups:
the battle for internet consumers

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strategy one: transformation

Let's have a look at what the traditional companies are doing. What are some of the successful models that traditional companies have pursued to get into this space and compete against .coms?

The first one is a model that we call wholesale transformation. This is when the traditional company says "Aha! I have to turn into an Internet company because all or most of my business is going to be done on the Internet in the future." They go through a transformative process and emerge as an Internet company at the end of the day. [slide 18]

I'm going to argue that this is the process that Charles Schwab has gone through to transform itself from a traditional discount broker into an Internet company. If you look at the market, E*Trade, particularly, was early, but Schwab is the biggest now. The reason is that when a traditional company is able to anticipate the market in that way and pull off a wholesale transformation, they often are able to eclipse new startup competitors in their sector. It's a very radical move for a traditional company to make, and it requires enormous courage and leadership on the part of the management, but it's a very successful strategy overall, one which really needs to be done from strength.

The company I want to look at is Intuit and its TurboTax tax preparation product. Many of you probably use TurboTax to create your tax return. Intuit had a tremendous market share, over 75% in the tax preparation market. They aren't required to be on the Internet since nobody was competing with them, but they see two things. First, it's expensive to stamp out disks, print manuals and shrink wrap boxes. They can slash costs out of their production if they can get people to do their work on the Internet instead. Second, they see that the Internal Revenue Service would like to have a huge portion of individual income tax returns filed electronically. I think they have a stated long-term goal of 70% in 2007. If Intuit can put themselves as the central processor and batch deliverer of individual income tax returns, making the IRS dependent on that, how fantastic a business is that? So, they see these two things going on and realize that they have to take a transformative approach to TurboTax.

When they began, the first thing that happened was that they had to change technology. This happens to all traditional companies that go through a transformation. In the case of Intuit, they had to move from a Windows platform to a UNIX platform in order to handle millions of concurrent tax filers. They also had to develop a new business model. TurboTax at retail sells for $35. On the Web it sells for $19.98. They have done a big song and dance that each one of those shrink-wrapped TurboTaxes is used to do two tax returns in order show their retailers that it isn't really a 50% price cut, but this has been a fairly difficult thing for them to manage and people have been none too happy, especially since those retailers often use TurboTax to draw people into the store and sell other stuff. It drives foot traffic.

They also had to become a service provider. Let's open a window into Intuit creating TurboTax in the past. They would have all these changes to the tax code happening across the nation in all 50 states plus the federal tax codes. They would run like mad to try to get all these changes into the TurboTax application and get the thing stamped out on to the gold master disk by the end of December. They would run like crazy, stamp that thing out and then the whole company would go collectively on vacation. They would just relax because now the product is in the channel and it's not their problem until next year. Intuit was incredibly good at it. They always hit their deadline within five days which, if any of you have been in the software industry, you know that's an incredible efficiency accomplishment. All of a sudden, however, Intuit faces a situation where the work doesn't end in December, it begins. People file their taxes all the way up through April, so they had to have a huge cultural change within the company to adapt.

Finally, they have had to partner with other companies. When it was a stand-alone application, TurboTax didn't connect to anything. As soon as it was a network application, consumers naturally expected it to show bank information, mutual fund information and so forth. They've had to commit to other things. It's a brave move on their part in a market where they didn't strictly have to do it.

Here are some of their results. [slide 20] In the tax preparation market, you can see they have 7 million returns filed. The 1999 date is actually their expectation for what they are going to do for this tax year, so those numbers won't be final until the end of April, but you see the kind of growth they are expecting. They already did very well in their first year, 1998. In electronic filing, they are expecting an even more dramatic shift, and part of that is due to the fact they are going to do a free 1040 EZ form. They decided instead of trying to capture that as a revenue market, they would create the volume that makes the IRS dependent upon them.

That's a successful strategy for traditional companies, wholesale transformation. I think you see it at Schwab, and you see it going on right now at Intuit.

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strategy two: risk balancing

Another strategy is one that we call risk balancing. This is saying, "Okay, we're a big complex organization and we can't possibly transform our whole company into an Internet business. What we are going to do is take a unit and combine it with venture capital, and maybe an Internet startup, and make a new business." Possibly some of you in this room are in risk balancing ventures of traditional companies. It is becoming increasingly popular. If you look at the venture capital market right now, this is the number one kind of deal they are looking for, the spin-off from a traditional company.

These companies go through a similar kind of process to become an Internet company, [slide 22] but rather than anticipating changing the market they are looking simply to participate in it. It is a fundamentally conservative strategy because it preserves the strength in their traditional business and it's done from strength. It's not something they are doing because they are forced to.

Again I want to take a look at a traditional company that's done something like this—Disney and its path to the Go Network. Go Network is one of the top five media properties on the Internet. It's the only top five media property that's owned by a traditional company, so let's have a look at how it got there.

All the way back in 1996, Disney bought ABC [slide 23] and with it acquired the ESPN brand which had this funky little licensing relationship with Starwave up in Seattle for ESPN Sports Zone. Before Disney bought it, ESPN had thought so little about the Internet that they just made this little licensing deal and said, "Sure, you use ESPN for the Internet. That will be no problem." It was a great deal for Starwave, but then Disney came in and realized that this is no joke. Disney is a company that really controls its brands. They went in and strong-armed Starwave. They said, "Here are your choices, boys. You are going to sell us half of this company with the right to take over the rest of it, or we're going to pull the ESPN brand from Starwave." Starwave kind of wiggled around. I know they went out and tried to get brands like Sports Illustrated and others, but they ended up selling just under half the company to Disney with the right for Disney to take over Starwave if it ever deemed that the ESPN brand was being badly used.

Now Disney looks around and says, "Okay,, that's a pretty good family property. We've got ESPN with sports, and that's a fairly good property. We've got; that's an okay property. But we don't have a Yahoo! here. We're not playing in the big leagues." If you're Disney, you want to play in the big leagues; that's just how it is.

So, now they realize that they need a search engine. They combined Infoseek with Starwave, and here's how they did it. They bought all of Starwave and gave it to Infoseek. Then they took a little under half ownership position in Infoseek, again with the right to buy control. They created the Go Network and began to market it through Disney properties. You see it marketed on television and in the theme parks. Disney is just now in the process of taking control of Go. By the end of this year it is going to be the only major media company to own a top five Internet property.

This strategy is interesting when you look at it from Disney's point of view as a traditional company. What does it mean for them? The first thing is that they avoided the startup costs—tens of millions of dollars in losses in Starwave and again in Infoseek. They get to bring the company into the fold after it's no longer generating those crippling losses. That is the source of the funding advantage .coms have over traditional companies. The traditional companies can't incur those kinds of losses. Disney has avoided that here, and they control the brands at every point. That's been a very important part of their strategy as a traditional company. They also have been able to support the Internet businesses fully. If you look at Disney television, you see Go Network promoted on a regular basis. You can't buy that from Disney. If you are not part of the Disney empire, you can't buy that kind of marketing. You can't get marketing in the theme parks unless you are owned by Disney, so they have been able to support their businesses without recognizing the losses in the near term.

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the implications for netpreneurs

We have looked at the consumers, the battle and how traditional companies are responding. Now, I'd like to look at some of the implications for startup companies or .coms. What does this mean as you begin to build a business and try to compete against these increasingly aware, increasingly aggressive traditional companies?

The first challenge is offsetting IPO-mania. On the one hand, it's a tremendous advantage to have the possibility of saying to people, "Look, we are a startup company. We are looking to go public two years from now. You can join us, and this is going to be great." You have to realize, however, that this IPO-mania has created a kind of cancer and it mostly affects .coms. In the long run, it is a bad thing for the startup company. It is very difficult, after you have gone public, to find that your employee base has split between people who have won and made a lot of money, at least on paper—oh, by the way, they are still investing and it's tough to do all that work, but they think they are rich—and the people who haven't. That's a very difficult management divide for most startup companies.

There is also a tremendously difficult management challenge when employees who have options see the company go public, particularly when the stock runs up. Let's face it, it's really unsupportable. It's impossible to make an argument for some of these Internet valuations, yet your employees watch that stock run up and they calculate it. You can go out at $16, run up to $60, then fall back to $31. That's a pretty darn good job at $31, but the employee feels like they are off from the $60. That stays with people throughout the first two or three years after going public. It's an extremely difficult period for the .coms. I actually know a guy who is president at a .com, and he ended up leaving after going public because his investment bankers wouldn't allow him to trade. He decided it was better to resign, and said to me, "I did the math. I figure I have to be here six years to make this company worth what it's worth today. It's better for me to just cash out and do something else with it." It's a very difficult challenge.

Creating multi-channel brands is an important thing for .coms. You have seen this with some companies creating magazines. There needs to be a physical presence for the .com on the newsstand, in the physical world and also on television or radio. There needs to be a multi-channel sense of .com brands, particularly in order to appeal to mainstream consumers.

Developing a physical presence is one of the big questions that this world needs to be asking itself. It's extremely expensive to develop a physical presence, but I don't think that we are going to be able to depend forever that traditional companies won't figure out how to build Web sites. It's easier to build a Web site than it is to build a chain of retail stores. Developing physical distribution ability and also physical presence in the business is going to become one of the most burning questions for .coms.

Finally, there is an enormous pressure to scale up fast. I want to have a quick look at some of these economics. If you look at the startup company getting going, what happens? You have this upward spiral and a lot of you are probably in the spiral right now. [slide 27] The first thing you do is go out and market. You try to get a world brand. You spend a lot of money on that, so you have to upgrade your technology and infrastructure because now you have created some traffic. You always upgrade your technology and infrastructure beyond what you need for today's purposes, so now you are in a situation where you need to re-leverage that technology infrastructure. You spend some more on marketing and therefore you have to upgrade your technology again, and so it goes. There is a tremendous upward cost spiral that exists, and you find that these marketing and technology costs exist almost as fixed costs for startups. In a traditional company, you might see less than 5% spent on technology. In a startup company, it's not at all uncommon to see 15%-20% of revenues spent on technology; in many cases even more than that. In a traditional company, even the biggest ones, Coca Cola is spending 20%-23% on marketing. In a startup company, it's not at all uncommon to see 35%, 40%, 50% of revenues spent on marketing.

What does that mean? Startup companies that end up forward-loading their costs, spending a lot up front in marketing and technology, end up being able to build revenue momentum. You can see that in this model. [slide 28] There are two places to be profitable, one is at sub-scale, and the other is at super-scale. The thing that nobody knows the answer to is, how big is this scale?

America Online (AOL) followed this model, and so did Yahoo!. Amazon, right now, is providing us all an industry-wide test case on how far out the curve is. I don't think any of us really knows the answer. I'm sure that Amazon doesn't, and I think they are taking a big bet. I really do. They are taking a bet about whether they are going to win big or they're going to lose big. They are basically betting that this curve is way further out, that they can have way bigger losses and way more up front expenditures than anybody realizes. Certainly that was AOL's market back in the time when they were checking out a lot of losses. It came out for AOL, but it's not clear, yet, how big the scale really is.

What happens a lot in more cautious companies, and I think this is the fault of traditional companies more than startups, is an insufficient early investment in technology and marketing. That fails to create the kind of growth that's required to ever get above the cost curve. That's one of the chief challenges for the startup company, being able to get enough momentum going by spending enough in the early time.

What does this mean for industry structure? I would suggest that in most Internet sectors you are going to see an industry structure that looks like this. [slide 29] There are going to be a few very dominant big players and they are going to be a whole lot of entrants. The price of entering into Internet businesses is very low, and probably will continue to be fairly low. I think of this as being a little bit like the software business. If you look at the software industry, there are a few huge, super-dominant, powerful players, but there is also an enormously busy, churning entrepreneurial group below them. The critical element here is the transition point. Every couple of years, a big, dominant player loses control of the brand and the technology because these are not fixed assets like railroad tracks or telecommunications infrastructure. It's all intangible, so in these kind of industries the major players fail on a fairly regular basis. Inside of two or three years you can see somebody zoom from the entrance space up into the successful space, and you can see somebody fall away as well. It's important for a startup company to get through that transition point, and that's what leads to scale.

Startup .coms have taken the early lead on the Internet, but traditional companies can still win. You definitely see this in the financial services market, and certainly in the travel space. I would say that the airlines have been the absolute biggest winners in the travel space. You definitely have to take into account that the traditional companies will be among the top two or three players. In almost every category, you will see at least one traditional company. Startups need to build management, brand and presence to win, particularly with the consumer.

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what do analysts want?

Before I wrap up, Mary asked me to speak briefly about how to approach industry analysts.

There are a lot of startup groups being formed every day, and the job of the analyst is to sort out which of them have a unique offering in the marketplace and which of them are just me-too companies. Literally, as an industry analyst right now, it's not at all uncommon to get invitations on the order of 10-12 a day from companies that want to tell you about what they are doing. Since it's not humanly possible to meet with every one of them personally, there has been a real push to understand, up-front and fairly quickly, what they do that's different. What makes them not just another kind of me-too company? That's particularly true in the E-commerce space, and that's challenging because there are many ways in which to do it.

One of the things that analysts are definitely looking for is a new kind of sales model. They are very much responding to a new idea in terms of how the sales process is done. Something which gives insight into how consumers behave is usually a very compelling and an interesting hook.

What's not so interesting is, "Oh, we are a .com selling bags, clothing, whatever it is that ends up being sold." At this point, it's a mistake to think that being a .com makes you inherently interesting. Now the onus is being able to establish something unique beyond that.


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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, 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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