|Issue No 105||03 August 2001|
2.1 - The Changing Corporate Landscape
In the second part of their series on the impact of new technology, Peter Lewis and Michael Gadiel try to understand the new corporate playing field.
The transformation towards a networked society is being driven by business. But it's not the old model of companies rising to power with a new product. Instead there is a mad rush to occupy the territory. The new economy revolves around the information, how it is packaged, transmitted and received. Those with money link up with those with the ideas, fast-track development, then win or lose( in recent times more likely the latter). The new dynamics have transformed the business world, with a new high-risk, high-return sector overlaying the traditional blue-chip culture. Understanding this new world is a first challenge for policy-makers
The New Economy consists primarily of people who use and understand the network and have been quicker to embrace the cultural changes that the technology engenders.
But a qualification before we get started: not all that is wired can be characterised as 'new economy'; there are new products and new aspects of business that are being delivered through information technology, but it doesn't distinguish them in any way from old bricks and mortar businesses. There's nothing about the technology itself that makes the business either 'new' or successful.
The new and old economies can also be distinguished through how businesses are built. The old way of building a business is by working really hard for five years, doing lots of research and development - growing the company, and. maybe - five years later, you'd have a viable company. On the other side you have the new economy cowboys who's growth strategy is hype and acquisitions For instance, take Sausage Software or Solutions 6, who, just put whole lot of cash on the table and buy out other companys, rather than doing things the conventional way, spending a whole lot of years slogging it out. It has largely been hype that has driven the extraordinarily high share value associated with these types of organisations.
The Big Boys and Defensive Speculation
While there has been a lot of new activity amongst start-ups, you wouldn't write the old mega-corporations out of the picture just yet. There's probably a change in orientation towards big player, historically, that have an information background, like a News ,Sony , IBM or Microsoft.
We've seen some very big names emerge in a very small period of time, for instance, Yahoo, AOL, Netscape, Amazon. Their value has been on the back of big investment by the markets, investors wanting a slice of the new economy, even though they are not sure quite where the value will lie. So we've seen this rush of money into the information sector, from the old economy that is not entirely rational. In recent times this has finally come home to roost.
But as we trawl over the entrails of the dot-Bomb, recognised the failures for what they were: defensive investment. It was rational from the point of view that established players could not afford to risk not taking to risk. Everybody was talking about their business-to- business position, or their eCommerce position, because the market said they had to. The actual validity of the strategy wasn't being looked at. When they were, a lot of the strategies began to unravel at an amazing speed.
But if you consider the underlying dynamics driving this New Economy, the defensiveness was - and remains - entirely justified. If you accept our underlying thesis that network technologies flatten hierarchies into matrixes, big corporate edifices have a lot to fear. Look at the media sector - how can organizations that have traded in scarce information, position themselves in a world where technology makes information easily accessible? For a while, they can attempt buy up each new technology, but this may only allow them to defy gravity for a while. Although the IT crash has slowed down this process, it has only delayed this effect, not stopped it.
The Start-Up and the Golden Handcuffs
The vehicle for a lot of this defensive speculation is the start-up. A start-up is a fast company. It's formed quickly, and has a very short time to market. Within that window of opportunity it is attempting to do things much more quickly than a traditional company. That includes recruiting people, and in the technology sector, that has been a difficult ask. It's attempting to leverage some capital investment, in various ways, either from Angel, and/or from venture capital, some sort of very rapid investment of capital so it can grow.
It's typified by the "burn rate" - the rate at which it's spending that money. They've not got any significant revenue, they're not making a profit. They've not got any profit in sight in any of their business or financial plans...the best is maybe we'll make a profit in four years time...who knows.
The rationale behind them is to get acquired, make a profit and get out, selling to one of the larger companies seeking a new economy asset. So the defining characteristic of a start-up is that there is an exit strategy.
This requires a shift in mindset from the industrial model of innovation. The classic Australian problem has been, that if I'm an inventor, I hate giving up any percentage of my idea in exchange for money. This new generation of start-ups understand that at the end of the day if I get "x" million dollars for my idea, and I'm no longer in the company then that's been a worthwhile exorcise.
Because the prizes are so high, people are prepared to work ridiculous hours for the sake of a start-up. Call it geeksploitation - young workers giving blood in the hope of rewards down the line. You'll find these companies have options plans for staff that become a set of golden handcuffs. You have to make them part of the vision, part of the company, give them a percentage stake. The deal is: stick around, work hard, it's a different less formal atmosphere, you'll be exposed to ranges of skills and responsibilities you'd never be exposed to normally and in a year to eighteen months time when you shares vest, they'll be worth hundreds of thousands of dollars. Those handcuffs get stronger as you move up the hierarchy of staff.
In the industrial age the value of a business entity was tied up with the value of it's capital. Except at the very top, the employees were expendable and interchangeable. Each person had a defined role and any person could be easily replaced. In the New Economy, a lot more of the value of the firm is linked to the skills of the individual people who make up the organisation. It is now more important, from the viewpoint of the owner or investor, that the employee has an incentive to remain.
Valuing the Asset
The new generation of businesses are very much people driven. It's not so much the technology as what you do with it and who does it. The venture capital community will tell you that the idea doesn't have to be the gleaming idea extends the knowledge envelope, it just has to be sound. They invest in the people and their capacity to deliver that idea, or indeed hand it on to another organisation to commercialise it to the next stage. It is a different model: the people are the key - which may force us to re-evaluate our concept of capital.
An example is Solution 6 which is currently valued on the share market at around $4.9 billion. Solution 6 are an old style IT company, trying to look like a new style IT company, making software for accountants. Last year they made a $66 million loss, but they're talking like a start-up and talking themselves up as application service providers. Currently they're in a merger with Sausage. And what does Sausage do?. Five years age they used to make a dinky little visual basic HTML editor and then the founder of that company tried to do things called snaglets, then he had e-vand and then they did something else. So Sausage Software does something different every six months. Nobody could really say what they do except they seem to be doing except they're making a $1.6 million dollar profit.
So what do either of the companies do? Well at the moment they don't do very much. But they've got a management team there that probably regularly plans to take over the world and you can see their aggressive acquisitions that go towards hyping them up. They talk themselves up and with everybody else talking them up as well they build this phenomenal valuation. If they become big enough, they may be able to have an entrance onto a global stage.
But where does the value in those companies lie? It's largely in relation to whether they are the first to market. So the valuation is potential market share. In the new information economy the expression of these business ideas probably doesn't have precedent.
Whenever a new idea is first to market its valuation will be high. The big question will then be whether they have the personnel to pull the idea off - which is why technology valuations are so fraught with difficulties. It's different from starting a car manufacturing plant and forecasting to produce cars five percent cheaper. In this case the market will come up with a valuation of this technology based on a track record of manufacturing automobiles. In contrast, a lot of the business ideas being invested in here represent a trip into the unknown. For example everyone says Amazon hasn't made money yet, but people still support it because, the idea, if it's able to be delivered, and they get the logistics right...sounds fantastic. So it's the potential that characterises these valuations. That why they're so high - they haven't got a track record to assess potential against...whereas in traditional industries, you do.
The other thing about the new economy is that the markets for these potential product ideas are always expanding. If I'm putting together a proposal for a new type of lathe, the market returns that I can responsibly project over five years might amount to tens of millions, at best. A similar amount of grant money to invest in something associated with the internet, I can project hundreds of millions of dollars of revenue based on the assumptions of the Internet, because the potential applications of any idea are limited only by the take-up of the technology. That's because every market is new, and theoretically global. A new application can be that lucrative - it's just a case of choosing which ones will fly.
Venture Capitalists and Angel Inverstors
Venture capital is a financing mechanism for corporations. The key characteristic is that the investor has an exit strategy. The idea is to come in at a particular stage and provide money combined with some business skill to convert that business to something of greater value, which is then passed on, through an Initial Public Offer (IPO). The game for VCs is simply to cash in their chips and get a return much greater than their initial contribution.
It's more than a loan because the venture capitalist maintains some level of involvement with the running of the business. You get a percentage of equity in the business for your investment as a venture capitalist. Generally most people invest with the initial entrepreneur but over time the entrepreneur's role changes. The entrepreneur, at start-up phase has to accept that at some point in time they might exit the company themselves. They are unlikely to be the CEO of the established company. And that makes sense. Because the one with the good idea, or the one who started up, put all the hours in, isn't going to be the one who can manage a 100 million dollar company.
The biggest myth about venture capital is that it's actually not for new ventures. The venture capital market in Australia is extremely conservative; the way in which it pitches to it's potential candidates is: "You have to jump through an enormous number of hurdles in order for us to be interested in you", so they're not actually promotional, they're very defensive and they don't actually provide money for true start-ups. They generally want to see some sort of track record in a business before they invest.
But there is an earlier phase where a good idea may be seeded by an 'Angel' investor. Angel investment is generally for people with a track record and for getting businesses into shape earlier, because it's really difficult at the start. Once upon a time Angels may have been slightly philanthropic, self interested, small business people with a couple of hundred thousand or a million to invest in a company. Now they're getting together in groups and so you'll see the emergence of groups like the Tin Sheds, East Coast Angels to really give that initial seed investment. You're then looking at further rounds of more full-on venture capital or perhaps institutional investment. That what's typically called first and second round.
The other thing to realise in this is the venture capitalist is not actually not looking at taking a controlling share of the company. If they come to you and say, "we'll give you a million dollars for eighty percent of the company" - then you don't have a company any more. That's the first thing to realise, it's not actually selling the company. Eventually, as you go through successive rounds, everybody is effectively reducing their shareholding. So it may be that the original people in the start-up end up with 10-20% of the company. Even the first round venture capital investors will reduce their shareholding in order to obtain a second round. All the time, when you're doing that, you are in turn, further valuing the company.
So you're getting layers upon layer of venture capital going into a company at various stages. And what makes it an attractive investment is that it is actually a very clean vehicle. Sure you'll have the initial shareholders, some staff, the Angel etc. The second round VC may be the same as the first round VC - if they're happy with the way it's going they may put in some more. Every time they put in more, you're pushing up the stakes. They're always pushing....they're pushing it fast...they're really riding you, because they don't want their money in five years time, they want out in eighteen months time.
The New Corporate Landscape
So if we've got all these start-ups emerging, you've got venture capital funding many of those projects. What does this all mean in terms of the big picture? In the 19th or 20th century corporate landscape, it was virtually impossible to set up a new business because there were enormous barriers to entry, primarily the need to raise large amounts of capital. Markets were thin, there was only room for one or two players in each area, and they were free to operate uncompetitively in such a way as to drive out competition - so they dominated the available market. So the business model of the industrial age, in a thin market like Australia was, get in, dominate, squeeze out the competition obtain a monopoly and then profit take.
Now we're seeing venture capitalism emerge - supporting all kinds of new business, which challenge that traditional market dominance of the established players in many areas. When it's so easy to get in and start a company - what does this mean in terms of changing the corporate landscape?
With information technology - theoretically you have global markets - so they're much bigger and able to support more players. You then get the companies trying to find niches in the market - so instead of having three big players offering the same bland product or service, dominating 90% of the market, you're more likely to get a plethora of business trying to segment the market and meet the needs of smaller and smaller groups of consumers. That's what's happening to business on the net, everybody's trying to niche market, or narrowcast - the segments are getting smaller.
Also in the real world, I'm limited by geography, I use a particular bank because it has a branch in my suburb, but on the net I can pick any financial service provider, globally. In the real world I have to spend all day wandering from shop to shop to find the best deal - on the net I can simply find a site that offers product reviews and price comparisons - I have much more power as a consumer - and I'm freer to find a provider that offers the service that I want. Consumers will become a lot less tolerant of bad service or uncompetitive pricing.
Evidence does show that the average size of the firm is declining - and has done since the early eighties, the start of the information revolution when the invention of the fax machine made dealing with an outside organisation simpler and cheaper - because technology enabling interaction between organisations is getting simpler. But that's not the whole story, there are a range of factors, not related to technology that limit outsourcing, these include control, trust, available competition, organisational politics and culture. Not all of these other factors are related to technology. Nevertheless the effect of email will inevitably be profound.
In business each player in the chain of production is taking a thinner and thinner slice. Companies are getting smaller and monopolies are coming under pressure. Workforce statistics suggest that the chain of production is getting longer, companies are outsourcing all but their core competencies, big players are employing fewer staff, preferring to contract out. Although in many cases this is driven not by a need to deliver better services to customer and clients, but to satisfy the prejudices of the Share Market -- there is still an underling trend.
There is a premium associated with interacting with an outside organisation - but in many cases IT is lowering those costs, making it easier, resulting in a narrowing of the band of core competencies which means that no one company is ever delivering anything on their own - businesses are hollowing out. There's electronic procurement and billing software - automating the supply of goods and services. This smooths the interface between a business and a contractor. In fact, it is pushing procurement back to the individuals desk --for example, I want a ream of paper, I look on my Intranet, I order my paper, it goes through some automated systems typically requiring a very few number of steps by anybody else, is pooled with a whole lot of other requests and automatically the supplier is selected.
The New (Economy) Tax System
Venture capitalists would argue that the Australian taxation regime, as compared with international standards, is punitive on venture capital because of the capital gains provisions. As a result we don't get much overseas institutional investment. In contrast Israel is seen as a winner in the IT and Internet stakes. Their regime is that they'll match the investing countries capital gains tax regime.
It's difficult for the Labor party to confront this issue because that rationale in the eighties, when the tax was introduced, is that, if you're earning money as a capitalist, why should you be taxed less than if you earn the money as a worker - why does this augment no longer apply. But there is a philosophical difference between the knowledge and value creation in a venture capital investment as opposed to investing in say property, which just accumulates value as the market inevitably rises.
There's a thing called the innovation investment fund which is two thirds funded by government where the venture capitalist places an investment based on a fund that was contributed two thirds by government - but it's only for approved organisations, so they have to be early stage, less then four million dollars turnover, in approved innovation activities like the high tech, IT sector and then they are able to access this fund.
At the same time Australian Super funds do not invest anything in innovation because of the risk profile. In contrast, up to five percent of the money invested in American pension funds now goes into this area. At the same time Austrialian super fund trustees would like to get in and invest in this area but they are required to follow the advice of their investment managers, who are very conservative.
The Role of Government
The intersection of physical space with cyberspace is really interesting. The question is: do Nations compete in the corporate landscape? Answer: It kind of depends. For Australia we have to continue to be think about national interests because if you take the Australia's total R&D expenditure, it's still smaller than Seimens R&D budget.
There is value in Australia thinking of itself as a company in some sense given the size of the players. If we use the information economy as a reason for dismantling National boundaries you run a risk that some of the things that it offers Australia by getting over tyranny of distance might be lost - because we'll end up just getting swamped So it is important for governments to have an information technology strategy for Australia as a nation.
The bigger question is: what is the role?. It must intervene by offering programs that address the fact that, by definition, in the new economy, innovation has a higher level of risk associated with it than for proven activities or proven investments. The way in which they need to intervene is to provide programs that tend towards self administration by people utilizing those programs, rather than administration.
The problem is you've got the eighties experience in Victoria where the government was investing heavily in entrepreneurial activities and got it's fingers burned very badly. How does one go about assisting start ups, assisting the new economy to grow, without having to go in and start picking winners, putting government money behind risky ventures. The question is: what kind of programs can a government put in place to avoid this trap?
There are more innovative areas for government involvement as well - like getting long term unemployed young people trained in IT and promoting hi-tech (information worker) communities in rural areas. Ultimately, the best industry policy may be to address the absolute fundamentals by investing in people, culture and education. What is irrefutable is that we need to promote some experimentation with new ideas rather than return to debates of the past.
This chapter is based on discussion with net entrepreneurs Peter van Djlk, Richard Weatherly and Kris Gale held in early 2000. Yes, the world has changed since then - but perhaps some of the analysis still holds.
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