Chapter 2

At odds with the conventional world

 

Four important questions

In chapter one, it was explained that the idea behind this book is to use the concepts described in the previous two books of this trilogy to create an e-business and write about the experience as it happens.

A few of the readers of were asking for specific business ideas to concentrate upon. As one reader put it, "You seem to be dancing around the fire rather than getting on with the job of creating a real e-business".

Another frustrated reader wrote:

Peter's feeling is that "going into the details of a particular business at this early stage of the book will slant the content in a narrow direction." But, it is precisely when he decides to go in a narrow direction that he'll get our support and experience. In wanting to stay with the concepts he prevents me and maybe other sympathisers contributing in a meaningful way.

<snip>

Without some element of governance from the top, bottom-up control will freeze when there are too many options. Without some element of leadership, the many at the bottom will be paralyzed with choices. Numerous small things connected together into a network generate tremendous power, but, this swarm power will need some kind of minimal governance from the top to maximize its usefulness.

These expressions of exasperation are typical of many who have yet to come to grips with a bottom up approach to creating e-business systems. They feel moribund without any central idea or business plan to focus upon: incapable of taking action without guidance or direction. Oddly enough, people often dogmatically maintain this attitude even when they agree that ideas, guidance (management) and business plans are of very little value in a highly volatile and unpredictable business environment.

The way to get over this conceptual hurdle is to think of the strategy used by Sherlock Holmes when he was faced with seemingly unsolvable problems. He would conclude that if an explanation could not be found through rational reasoning then rational reasoning had to abandoned because the answer must lie within the realm of the irrational.

In the context of e-business, this would mean abandoning the rationality of using initial ideas, management and planning and looking for a different kind of strategy that doesn't require them. The eureka moment comes as soon as it is realised that there are such strategies available – and that they are extremely efficient for creating robust e-businesses suitable for an unpredictable and highly competitive environment.

It is just such a strategy I'm pursuing here. No preconceived ideas, no business plans: I'm simply starting with a blind search in a solution space until a viable e-business opportunity emerges.

To the mind set of the Industrial Age, this will evoke four questions:

1) How can you start to create a business with no initial ideas?

2) What is a solution space?

3) How do viable systems emerge without planning?

4) With no visionary idea, with no business plan and no strong management: how can you possibly attract investment funding?

Over the course of the next few chapters I'll attempt to provide answers to these four questions. Only then will it become clear that the apparent vagueness of this approach to establishing an e-business is a necessary requisite that will avoid the problems that have been encountered by most of the early dotcoms who failed to survive.

 

Anyone can have a great idea

Most successful e-businesses appear to have succeeded through someone having a great idea and then following through with it. But, during the dot-com boom at the turn of the century, it seemed that just about everybody had a great idea for an e-business. In almost every office in the world, people were plotting and planning Web sites. Not only was this happening in business offices, it was happening in all kinds of social gatherings, pubs and clubs, universities and colleges and even school playgrounds. Even people who hadn't used a computer before were suggesting ideas for e-businesses.

With millions of people coming up with ideas, it is a statistical certainty that some of them will succeed, just as it is a statistical certainty that someone with a lottery ticket will win the lottery. And, just like having a lottery ticket, a good idea may get you into the game, but, it doesn't guarantee success.

With so many people and businesses coming up with ideas, it is pretty hard to come up with something completely original. Anyone who has made any serious effort to follow through with an e-business idea will soon tell you how true this is. A quick search around the Web will almost certainly uncover somebody already working on any good idea you can come up with, however original it might appear to be.

If it really is a great idea, then there is likely to be many different people working on something similar; maybe even e-mail discussion forums discussing its implementation in various different forms. This can be very disconcerting and depressing for newcomers to the world of e-business.

It might seem that the key to success is in putting an idea into operation faster than anyone else: by being the first to market. However, this is a fallacious argument because if an idea is seen to work, others are likely to copy and improve upon it, leaving the originator disadvantaged because they will have carried the cost of the pioneering and the test marketing.

Common sense tells you that with millions of people trying to think up great ideas for e-businesses, and millions of others looking for ideas to copy, it's no good relying on originality as being a key ingredient of an e-business formula for success. There will almost certainly be many others with similar ideas that you will have to compete against.

This puts the emphasis on the competitiveness of the position, not on the idea itself. Any idea must be accompanied by circumstances that provide a strong competitive advantage. Without this, a great idea is about as useful as an arrow without a bow.

 

The business idea has to emerge later

A business idea has the best chance of being brought to fruition if it is born into the right environment (where a suitable infrastructure and the necessary contacts are in place). Surely then, it would make sense to wait until these conditions are in existence before firming up or going ahead with any specific e-business idea?

The situation can be likened to a game of poker. Does it make any sense to have a plan or an idea to win a game of poker before the cards are dealt? Isn't it more sensible to wait and see what cards turn up before making any play decisions? In this way, you wouldn't be forced to play with a weak hand: you could wait for a really good set of cards to come along before making any strong bets? The play would then be determined by the emergent situation: responding to what is, rather than what might be.

This is what e-business should be about, waiting until you have developed a competitive position with a strong hand. Then, like a poker player, you make opportunistic plays according to a developing situation. In other words, setting up a position of strength before deciding what business moves to make.

With this mind set, it becomes pertinent to think about the timing of the main business idea. Should the idea come before or after a position of competitive strength has been established? This order is vitally important because it determines the whole nature of the e-business strategy.

The intuitive assumption is that the main business idea would have to come first because otherwise you wouldn't know which infrastructure to design or what appropriate contacts to make; you wouldn't know the kind of Web presence that is needed or staff to employ.

Stop to think about this for a moment. You are going to enter a fast moving, highly changeable, competitive environment. Would you have the time to set up contacts, hire and train staff, arrange associations of cooperation and collaboration, design a Web site with all the necessary backend organisation – before the idea goes out of date or the competition moves on to something better? What if the idea goes stale before the business infrastructure is fully operational? Wouldn't it mean much of the custom made preparation work is wasted, losing time and haemorrhaging capital?

If anything is predictable about the e-business environment it is the certainty of continuous change. No ideas are viable for very long. This means that if a competitive position is constructed according to the demands of a business idea, the infrastructure would have to be continuously changed and updated. This would see the business spending more time working on the infrastructure than implementing the idea.

Here is where a conventional business mind set has to make a large conceptual leap because in a volatile business environment it would be necessary to arrange for the infrastructure to be a solid, stable base and view any business ideas as transient and changeable (a nightmare scenario for a managed team with a business plan).

This is counter intuitive because it would seem that building an infrastructure before any definite business idea had been decided upon would be hopelessly inefficient. Surely, it must seem, much of the work would be wasted if you didn't know how the infrastructure was going to be used?

However, in a fast changing, competitive environment this strategy makes a lot of sense because from the position of a stable infrastructure, you can wait for an opportunity to emerge that exactly matches the facilities and skill sets at your disposal. Instead of having to have a delay between having a business idea and being able to put it into operation, it would be possible to act instantly, capitalising on an idea while it is still hot.

It would seem then that the most efficient strategy will be to create and maintain a position of competitive strength and search for suitable business ideas that can be handled from that stable base. It is for this reason that "dancing around the fire" is a necessary first step in the creation of an e-business. Core strength, credibility and appropriate contacts have to be established first. Only then, when these cards are in your hand, can you start to look for ideas or opportunities that match the cards. This situation is illustrated in figure 2.1

 

Figure 2.1

An e-business venture should start by establishing a core strength, acquiring contacts and establishing credibility before even contemplating a business idea. The business idea should then be selectively chosen to match these assets

 

By using this strategy of establishing a stable base first, it is possible to be able to act immediately and efficiently when any opportunity presents itself because you don't have to change your contacts and rebuild your infrastructure.

Naturally, the contacts, the infrastructure and the assets to hand will limit the number of opportunities that can be taken advantage of – but, these are some of the parameter that help define the boundaries of the search space when looking for e-business opportunities.

 

Two different mind sets

The concept of the business idea coming last is not easy for Industrial Age business strategists to get their heads around. Their mind set is to work out what is wanted and then to organise a way to get it. They need to have a target or goal to aim for: this provides the focus for their strategy. Without this goal or target they are lost.

In the Information Age, a completely different mind set is required. Instead of having a business idea and creating an organisation to carry it out, you start with the organisation and then search for a business idea that is ideal for the organisation to handle.

The situation is illustrated in figure 2.2 where the conventional, Industrial Age business strategy is shown at the top, with the bottom up strategy necessary for a highly volatile environment shown underneath.

 

Figure 2.2

Summary of the two different approaches to e-business. The conventional approach aims at planning a solution. The bottom up approach aims at searching for a solution

Industrial Age business thinking would expect a business to descend into total chaos and gross inefficiency if there is no planning or guidance. However, the overwhelming evidence seems to suggest that it is the conventional approach that is more likely to go off course and become unstable. This is because goals and plans seldom survive for long in the harsh realities of the information environment.

Unpredictable events are constantly occurring, necessitating plans having to be altered. As fast as contingency plans are drawn up, new technology, a change in customer expectations or surprising competitor innovations throw any new planning into total disarray. Frequently, this results in the rapid burn up of investment capital – killing an enterprise stone dead before it has achieved either stability or viability.

Perversely, when e-businesses fail through using an outdated Industrial Age approach, the Industrial Age mind set seldom recognises that it is the approach that is wrong. Nearly always the blame for failure is placed upon the Industrial Age methods not being applied strictly enough.

To understand how conventional Industrial Age strategies can produce spectacular failures it is worth looking back at the history of some of the early dot-com startups that came into being at the end of the last century.

 

A little bit of history

The Internet revolution couldn't have arrived at a more appropriate time. Not only was it at the end of a century, but it was at the end of a millennium. This allows history to place a nice neat date on the start of a new period in the history of civilisation ­ the year 2000 ­ the beginning of the third millennium, the end of the Industrial Age and the start of the Information Age.

Decades from now, this revolution will be seen as an instantaneous transition, from one system of civilisation to another. Few will dwell on what happened during the transition itself. It will be treated more like the metamorphosis of a caterpillar into a butterfly ­ a mysterious transformation, where the details of the transition processes are far too complex to be explained.

However, science does have some idea as to how these complex system transitions occur. They may not know every detail of a transition – such as the exact sequence of chemical events that occur when a caterpillar changes into a butterfly - but, the generalities of the process can be explained it terms of a mathematical concept known as Chaos Theory.

This theory explains how complex systems can self organise and then, perhaps through a seemingly trivial event, become totally disorganised and then spontaneously reorganise themselves into a completely different state of organisation. It happens when a caterpillar changes into a butterfly. It happens when a revolution overtakes a civilisation. It is happening now as the Industrial Age gives way to the Information Age.

Observing and experiencing the rapid changes that are taking place, as the Industrial Age gives way to the Information Age, is the business world equivalent of being present in the cocoon of a caterpillar while the mysterious events – which turn the caterpillar into a gooey mess and then turn that gooey mess into a butterfly – are occurring.

At the turn of the century, the caterpillar was the social and business organisation of the Industrial Age. The butterfly is the new kind of business organisation that is emerging in the Information Age. The gooey mess in between is epitomised by the failures of hundreds of early dot-com startup companies as they struggle to cross the divide between the Industrial Age and the Information Age – handicapped by knowing only the methods and strategies appropriate for the pre transition age. These pioneers were the first to be exposed to the unprecedented changes brought about by the new communication technologies.

It is easy to put the failure of the early dotcoms down to poor management, unrealistic business plans and lack of proper control and organisation – as so many business commentators did at the time of their demise. But, this is to ignore something more probable: the use of totally inappropriate business strategies?

Consider for a moment the decision making of the various funding bodies responsible for providing the billions of dollars of venture capital to all those hundreds of failed dot-coms. Wouldn't the financiers have critically assessed the ideas, looked carefully at all the business plans and made sure that the principals had suitably impressive track records. Upon what other grounds could they have justified the handing over of billions of dollars to those early pioneers?

There were so many errors of judgement, on such a grand scale, that it was unlikely to have been a result of incompetence alone. It is much more probable that the criteria used for making investment decisions was at fault. This calls into question the value of basing investment decisions upon the quality of ideas, plans and managerial competence.

 

Calculating the value of a dot-com

Most of the early dot-com startups, that met a rapid demise during the era of the dot-com bubble, probably started out with great visions, detailed business plans and impressive management teams. Yet, the reality was that they had been brought to market on the basis of speculative ideas, which were given unrealistic prospects for successful profitability. Even respectable brokers had been presenting IPOs (Initial Public Offerings) based upon self-fulfilling speculations.

By concentrating upon ideas, business plans and management skills, the fundamental wisdom that value is based upon assets, earnings and dividends was pushed under the carpet. Traditional concepts of discounting for risk were forgotten as brokers rushed companies with unproven ideas to market. All emphasis was placed upon scaling factors: the reasoning going something like this:

The world wide market for widgets is 100 billion dollars. If half of this can be expected to migrate to the Web, a company with a ten percent share of this market would generate sales of 5 billion dollars. A bricks and mortar company with this order of turnover would be valued at 10 billion dollars. As the efficiencies of trading on-line would be expected to halve sales costs, the profits should be double. This would value the company at 20 billion dollars. Even discounting this value back through a build up time of five years, would still see a present day value of 15 billion dollars, so, the valuation at the time of the IPO will be a bargain at 12 billion dollars.

These calculations assumed that a sound management would be able to capture and retain ten percent of the market, perhaps even more if the company is a first mover. This gets investors falling over themselves to invest in such IPOs, pouring millions of dollars into the hands of "sound management" (but, who had never before been exposed to the unpredictable and chaotic world of e-business).

With the comfort of knowing that the startup is not expected to make profits from day one, most managements looked to the future and set their goals on market share and maximum revenue instead of profits and dividends. Attracting Web traffic and directing customer eyeballs became the sole focus of strategies.

A madness crept into e-business equity markets: an on-line, airline ticket ordering company, saw its equity value rise at one time to a point where it was worth more than the value of United Airlines, American Airlines, British Airways and KLM put together. Investors were pouring money into dot-com companies without any idea of what the basics of the business were, let alone the technology involved.

Companies were being floated on the basis of creating some kind of portal (an entry point on the Web for customers to link to a range of products or services) and these portals were being sold as dot-com businesses on the strength of the future purchases that would be made by the people using these portals. Yet, in essence, these were no more than glorified mailing lists ­ with each name being valued by as much as a thousand dollars each. In such crazy times, free computers were given away, just to get a name on a list.

At the time, I spoke to a friend of mine who was an analyst for one of the big London brokers who had brought many of these dotcoms to market. He had the job of calculating the launch price of shares when the equity of a company is first offered to the market. He told me that these valuations were based upon the discounted value of the profit that can be earned from customers over a period of several years.

When I raised the point that these customers would have many different alternative ways to spend their money on the Internet and would have the choice of an almost unlimited number of alternative portals and places to buy, he told me that these calculations were made on the basis that most people have a reluctance to change from a familiar source once they have become customers.

Unfortunately, like so many other people involved in these kind of calculations and valuations, he had very little experience of being on the Internet himself. If he'd had, he would have known how easily and quickly people can chop and change around. This tendency to stick with the familiar is a characteristic applying specifically to the world of bricks and mortar and isn't valid in the fast changing world of e-business. It is a world where change is familiar and frequently rewarding.

On the Internet, as soon as people learn from others where they can get a better price or a better service – just by making a few clicks with the mouse – they start to shop around and the concept of customer loyalty becomes redundant. In this situation the only justification for expecting to retain a customer base is by providing exceptionally competitive products or services. This thought didn't seem to enter the calculations of many of investment advisers and analysts.

The discussion got around to a recent dot-com offering, where the IPO equity share price had valued the dot-com higher than the current valuation of the huge multiple retail business of the bricks and mortar company that had initiated it. The dot-com was providing little more than a "free" connection to the Internet, something any other company could do (and subsequently did). How could the equity in this new dot-com business, with virtually no assets, be worth more than that of a long established, successfully trading company which had stores in nearly every town in the country?

My friend pointed out that the company had more than just this list of customers, it also had the vast sum of money that it had gained by selling its equity shares (less the not inconsiderable costs of the launch and the broker's fees). "They will be able to buy out the shares of other dotcoms", he explained.

This conversation then opened my eyes to what the dot-com boom was really about. It was a gigantic zero sum game, winners winning only what the losers were losing. It was all smoke and mirrors. It was almost as if they were all sophisticated scams that were dragging in investment funds to create more scams with the scams feeding off of each other ­ with the poor investors, who were financing this free for all, getting sucked in deeper and deeper.

It wasn't that most of the people involved were dishonest (although frauds and deceptions abounded), the main fault was that it was a totally new business environment, which nobody understood and where traditional valuations and business practices couldn't be applied.

 

The strategy of a venture capital company

At the peak of the dot-com boom, there was a much publicised national competition being run in the UK by a major venture capital company. The winners – who would be judged as having the best e-business proposition - would be financed with up to two million pounds (about 3 million dollars) of capital, with the venture capital company taking only twenty-five percent of the equity in return.

It sounded like the venture capital company was being altruistic and supportive of entrepreneurs – benefactors, who were helping young hopefuls to get a start. But, after working with financiers and investors in the City of London, my reaction to this competition were perhaps somewhat more cynical: I presumed they were running this competition to make a profit.

As venture capital companies make their money from capital gains rather than income, it is reasonable to assume that their primary interest is in what is going to look appealing in the documents for an IPO (Initial Public Offering) when they take the company to market. In this respect, convention holds that you need an experienced management team and a detailed business plan before offering equity to investors. Investors will expect this. This is what they will want to base their investment decisions upon.

It was only to be expected therefore that the judges were said to be looking for "strong management teams and realistic financial projections as well as products that have sustainable growth possibilities and the chance of competing in the global market place". The big question though was whether or not these requirements actually had any relevance to the eventual success of the company that would be financed. Strong management with business plans seemed to me to be a handicap rather than an asset in the volatile e-business environment and the idea of "realistic financial projections" totally ludicrous.

The competition reminded me of an experience I'd had a couple of years previous, when I'd received a telephone call from a venture capital company. They'd been told, by one of their associate companies, that I might be someone who could have some good e-business ideas - this was on the strength of two books I'd written on computer programming and intelligent systems.

I was invited to the venture capital company's offices for a discussion. When I arrived, I was somewhat surprised when the first thing the interviewer did was to have me sit through a computer presentation showing me how great their company was.

When it was finished, I started to explain my idea of a strategy to create an e-business but the interviewer wasn't interested. He wanted to know what fully developed products I had (none), what patents I had (none), what management structure I had (none), what my business plan was (vague). At that point, a secretary came over (probably at a pre arranged signal) and told the interviewer his next appointment was waiting for him.

However, during the interview, I'd managed to get in a few questions myself and discovered that the interviewer, who was a principle of the firm, had originally been a pop record producer. I'd asked how much he used the Internet and he'd told me he didn't have time to use it himself. Then I clicked. He wasn't interested in my ideas, he was only interested to know if I had anything that would look good in a prospectus for a flotation on the Stock Market.

The whole thing rung a bell with me. I'd had a similar experience when I'd applied for a patent on a method for mixing different types of secure information on a CD-ROM. Soon after the application had been applied for, I'd had a phone call from a company claiming they could market my patent for me.

Full of hope and excitement I went to their smart offices in central London and was surprised to find that they had no interest in the details or potential of my product whatsoever. All I got was a computer generated description of how good their company was and a hard sell to get me to part with seven hundred and fifty pounds for them to act as agents for me. It didn't take much figuring out that they weren't interested in selling my product at all: only in the fee that they could get out of me.

As a postscript to the interview I had with the venture capital company, it was only a year later that I read in the press that the company had grouped together a promising looking selection of start ups and gone to market with a valuation of three billion dollars. Out of curiosity, a year later I looked at the price of their shares after the dot com bubble had burst - they'd fallen to less than a tenth of their initial offer price.

 

The dilemma

Here is my problem then. I want to create a business but my whole approach is at odds with the conventional requirements for obtaining funding. I don't want to start with a great idea, I don't want to have a detailed business plan. I can give no realistic financial projections.

There is also a paradox to be resolved. How can I create a business with a stable, base when the need will be for a very flexible base, which can adapt and evolve in response to continuous technological developments and constant competitive initiatives?

 

Entrepreneurial businesses

Businesses created by entrepreneurs have to be generated from business ideas that come from within a solution space the entrepreneurs create for themselves: a short list of ideas that match the resources available to the entrepreneur. To be worth pursuing, these ideas must have a realistic chance of creating and maintaining a profitable income even if the intention of the entrepreneur is to make a capital gain.

It is common to think of these ideas as arising through an entrepreneur's imagination or from the shrewd reading of a market's needs. These will certainly be factors in the creation of an e-business, but, the most dominant influences will be the ability to put ideas into practice and the capital investment needed.

As soon as investments come into the picture it becomes pertinent to start thinking about the returns that would be expected by the investors who make these investments. This puts the spotlight on the financial gains that an idea might be expected to produce. In other words, ideas will have to be given a value to determine whether or not they will justify the amount of investment needed to turn them into reality. This should be the overriding consideration in determining whether or not an idea is allowed into an entrepreneur's solution space.

Obviously, the value of any idea in the solution space would have to be greater than the amount of capital needed to finance it. Additionally, the activity of putting the idea into effect will carry a minimum overhead – due to the running costs – which will set a minimum value for any of the ideas that can go through the gate. This scenario is illustrated in figure 2.3.

 

Figure 2.3

The ideas within an entrepreneurial business's solution space are limited to those that the business is capable of carrying out – and by the value of the idea in relation to the investment needed to put it into operation

 

From this view point, the boundary conditions of the business idea solution space can be defined as:

1) The idea must be within the capabilities of the business

2) The value of the idea must be greater than the amount of capital needed to finance it

3) The idea must have a minimum value determined by the running costs of the core business (or the running costs of a section of a large business if the idea is assigned as a project).

What is not always obvious is that a similar model is used by funding bodies. They will also have a solution space where they have gates designed to let suitable application proposals in and keep unsuitable application proposals out. However, most funding bodies will have traditional attitudes towards funding and their solution space will almost certainly be static and top down. This is illustrated in figure 2.4.

 

Figure 2.4

Funding bodies have a static, top down solution space that contains only proposals that meet certain criteria. It is only these that are given serious consideration

 

Funding bodies will not want to waste their resources on investigating every proposal that comes along (most funding bodies receive forty or fifty times as many proposals as their analysts can handle), so, they use a series of tests that eliminate all but the most promising. It is the funding body's skills in constructing such tests that determine the success or otherwise of their own business strategy.

Any sensible applicant for funding will make sure they know what tests are being made on the proposals they submit to a funding body to ensure that their proposal get through the gates. This raises a number of important questions:

1) What are the tests that funding bodies apply to proposals?

2) What if the tests are not compatible with the proposer's business strategy

3) What if the funding body's tests are wrong, such that the most promising business proposals are excluded and the least promising included?

To answer these questions, we'll need to know some of the technicalities involved in financial and investment valuations.

 

Current price versus fundamental value

In the early 1970's, I wrote a course on investment strategy for a London firm of investment advisers who were setting up a college to teach students the art of investment. The approach I took was to start by explaining to the students how to calculate fundamental investment values so that they could use these theoretical values to make judgements on current market prices of stocks and shares.

This technical method of valuation involved calculating expected future earnings and comparing the value of those earnings to the current price of annuities (fixed incomes that continue into perpetuity).

Note: The value of any income is calculated by discounting all future income payments back through time to the present day. It's like compound interest in reverse where each payment in the future is given a value according to what sum today would reach that payment amount through compound interest at the time the payment is made.

By suitably discounting for risks and inflation, this appeared to be a logical approach to investment valuations because it was comparing like with like, i.e., one income stream with another. However, when I came to apply this valuation to current equity prices at the time I wrote the course, I found it gave answers widely off the mark. Equity share prices were two or three times the value my calculations were indicating they should be.

At first I thought I'd made some silly mistake in my formulae or missing some important factors, but, despite a month of going over the calculations and methods I could find no obvious errors. So, with great trepidation I let my recommended calculations stand, fearing that as soon as the course went out to the students someone would spot the fault and expose me as a charlatan.

Much to my surprise, I had no adverse comments even though the valuations remained way out of line with current prices for four years. Then, in 1974, the Arab oil crisis occurred. Within a few months there was a stock market crash, prices on the London stock exchange fell by over seventy percent. When the market eventually recovered, the equity share prices recovered only to their fundamental values: the values calculated by the methods I'd proposed in the course.

What I hadn't realised at the time I'd written the course was that it was at a time of a stock market boom. Illogically, the equity prices of all shares had risen to unprecedented levels, way beyond their fundamental values.

I never did get to understand how the prices could have been out of alignment with fundamental values for so long, or, why it had taken a special event to bring them back into alignment. However, the experience gave me a healthy respect for fundamental valuations and a lack of trust in current market prices.

 

Fashion trends in Stock Market valuations

Logically, equity stock market valuations should always be based upon fundamental reasoning and calculation, but, the way these calculations are made can be greatly influenced by currently fashionable trends in business strategy.

Until the late 1950's, equity valuations were based upon the actual returns a company was likely to provide in the way of dividends to the shareholders. No account was taken of profits used for future business. Equity share prices were based solely upon the discounted value of actual incomes with allowances made only for any risks that dividends might not be maintained.

This put the onus on the directors and executives of a company to do everything in their power to maintain the profitability of the company to the extent that dividends were fully supported by earnings and with sufficient reserves to give confidence that dividend payments would be maintained every year into the foreseeable future.

This worked fine while dividend yields from equities were greater than the yields from fixed interest bonds but then IBM came along. The price of IBM shares started to increase substantially without the company paying any dividend at all. This shocked investors into realising that the value of a company was not based solely upon what it was paying in the way of dividends in the present, but, also account must be taken of the potential for increased dividends it may be able to pay at a future date.

This realisation totally transformed the model for evaluating businesses. No longer was the emphasis put on a company's ability to maintain a steady and reliable dividend payout; instead, valuations were based upon an assessment as to how successful a company might be in finding and developing new projects where the results would realise a substantial profit over the expenditure.

This changed the emphasis of company management from that of preservation to that of expansion. The payment of dividends became of lesser importance than the ability to invest earnings into new projects. This trend eventually reached a stage where the payment of dividends was seen almost as a sign of failure by the company to find new opportunities to expand.

This change in the investment model made the dividend yield an irrelevant ratio for estimating equity share values. Accountants decided that the true value of equities needed to be based upon the bottom line: the net profit that a company was making. This was known as GAAP (Generally Agreed Accounting Principles), which saw earnings per share as the principle basis of a company's true value.

The problem with GAAP though was that any investments in future projects would be deducted from the bottom line: effectively writing them off as if the projects were doomed to failure. It allowed no valuation for the effects of strategic marketing plans that gave long term benefits; it attributed no value for expenditures on research and development and it placed no value on branding or good will. In effect, the GAAP valuation of a company was the liquidation or breakup value.

The smarter investors soon spotted these anomalies and there were many highly profitable takeovers before accountants woke up to the fact that they were undervaluing their companies in some way..

To compensate, the accountants started to add a nebulous component to a company's value – known as "intangible assets". This figure included all the expected future benefits that could be realised through current advertising and marketing; employee training; good will; branding; research and development, etc. No provable evidence could be supplied to support the valuations given to these intangible assets, but, their addition certainly provided a more accurate valuation of a company as a going concern.

The problem, however, was that this nebulous asset allowed all manner of discretionary additions to be included in company valuations. It led to much "creative accounting" where a company could be given any kind of value according to how the directors and accountants measured the intangibles and the elements of risk associated with them. This led to the bizarre situation where companies could continue to show continuous losses on their balance sheets while their equity share prices continued to rise.

Until the advent of the Internet and the World Wide Web, intangible asset values, although not precise, were usually based upon some kind of generally accepted, common sense reasoning. Most of the factors and their consequences were more or less understandable; outcomes and risk were predictable within a reasonable degree of accuracy.

The coming of the technological and communication revolution threw these valuations of intangible assets into confusion. It involved dealing with a technology that few if any of the investment analysts, accountants or investors understood. Valuations involved unknowns and unknowables, unpredictable events and technological changes. Effectively, this made the valuation of intangible assets a matter of total guesswork: allowing the imagination to run riot.

The problem was that the promise of potentially huge profits that might be made in a massively connected world had fired the imagination of investors. The potential for profit seemed to be without limit. Fantasy started to creep into the valuations of intangible assets. All common sense was thrown to the wind with equity share valuations changing rapidly from being based upon earnings per share to being based upon dreams per share.

The most surprising feature of the dot-com boom was the way in which many respectable and long established stockbroking firms subscribed to the dreams per share method of calculating values. They could almost have been prosecuted for fraud and misrepresentation for some of the IPOs they put together. However, allowance has to be made for the fact that stockbrokers are in business to give clients what they want and, with such a huge demand for technology stocks, they had to provide them.

The buying and selling of equities is purely a zero sum game where winners win what the losers lose. As such, there is no strong pressure to keep prices at fundamental levels. There is no convincing argument that an equity price is too high if somebody is willing to buy it at that price.

If some stockbrokers were basing IPO prices on dreams, others had to do the same to be able to maintain their share of the new issue market. Although traditional methods of evaluation indicated these valuations were incredulously large, there were so many takers of the equity offerings coming onto the market that IPO equity prices expanded beyond all reason.

When these initial public offers were being bid up as much as several times their offer price by the market , the brokers assumed that they must be doing something right and continued to value IPOs at increasingly unrealistically high values.

But, of course, it couldn't last.

 

The pricking of the dotcom bubble

In the first few months of this century, the shrewder investors began to realise that all was not well with the dotcoms (the name given to the Internet startups that were being rushed to market after receiving massive amounts of venture capital funding). After a few spectacular failures, analysts began looking more closely at the accounts. What they found was truly alarming.

Most were burning up capital so fast that they were almost certain to run out of cash before reaching profitability. Advertising and marketing wasn't working for them. They could get the eyeballs, but it wasn't translating into profitable income. It wasn't uncommon for marketing costs to be multiples of the profits on sales and in some cases even multiples of the gross sales revenue itself.

One company, Pets.com, had to fold even though it had received 85 million dollars of funding and had acquired a customer list of 500,000. Conventional marketing strategies had produced totally unexpected poor results. This was a situation that had no parallel in the Industrial Age world.

Analysts started to look more closely at the accounts of the e-businesses. They found many irregularities and misleading accounting practices. For example, where a company had low or non existent trading incomes, it could find ways to create artificial sales or assets to falsely boost the apparent value of the company. One such trick was where companies exchanged banner advertisements with each other: back to back arrangements where each charged the other the same huge sum of money for running the other's banner advertisement on their site. This can artificially boost the sales revenues of both companies, to make it appear in the accounts that they had large turnovers.

Although this does not generate any real profits, the accounts of the companies involved in these back to back arrangements can be made to show a net gain because the payments (by each company) for the banner advertising is charged to marketing instead of writing these costs off against profits. In this way they can legitimately (but falsely) claim these costs are additions to the intangible assets of the company: on the basis that marketing usually leads to increased value of a brand name and to future sales.

Similarly, many companies were selling goods at huge price discounts, but, entering the sales into the accounts at full retail values. This allowed them to treat the discounts as marketing expenses that could boost the intangible assets valuation of the company, on the pretext that the discounts were being employed profitably to build a customer base.

Without being aware of such tricks, it is easy for an investor to see what appears to be a healthy balance sheet that, although not showing a trading profit, is reflecting the results of a rapidly expanding business with a growing potential to become profitable.

Trying to ascertain a "true" value of those early dotcom companies was fraught with many such difficulties. Web sites, some of which had cost millions of dollars to build, were being treated as if they were permanent buildings in the world of bricks and mortar. Site building costs were being included in the accounts as assets, even when it was patently obvious that the sites were transitional and temporary structures, often failing at what they had been designed to do and proving to be more of an expensive liability than an asset.

Complicating and clouding the valuations was the question of where corporate incomes and expenditures were booked. A company could be set up anywhere in the world, it's Web sites could be distributed all over the planet. Product design, and manufacture could be fragmented and outsourced to a variety of different contractors and sub-contractos in a variety of different countries. If the product was software is could be dispatched from anywhere. It was impossible for even professional investment analysts to discover where profits were being taken or removed. Sorting out such accounts and investment valuations can be impossibly complex.

Perhaps the biggest conundrum for investors was in puzzling out the meaning of a dot-com's burn rate (burn rate is the term used to describe the haemorrhaging of capital as a company spends money in its efforts to become profitable). Burn rate, or negative cash flow, is not alarming in itself as most dotcom companies were set up with the expectation that real trading profits will not materialise immediately. Nearly always, the startups had business plans that indicated profits would appear only after a substantial infrastructure had been set up and a customer base established – which could be several years away from the date of funding or market launch.

So, in the absence of a conventional profit and loss account based upon actual trading, investors had to work out whether the outgoing cash (the burn rate) was being used by a business:

a) to build a profitable company, or,

b) was merely symptomatic of a company that had lost its way and was trying to spend its way out of trouble?

In most cases, the answer to this question was found out too late – after all the money had gone.

 

Funding problems after the dotcom bubble

After the dotcom bubble burst, the dreams started to be taken out of the valuations for the intangibles added to e-business company accounts. New regulations curbed many of the accountancy tricks. The huge numbers of failures gave an indication of the true risks involved; these were seen to be unacceptably high.

Investors became more sceptical and started to look for real evidence of income and profit. Brokers, fearful for their reputations, stopped bolstering claims and glossing over practical realities: reducing the attractiveness of market offerings. This drastically reduced the number of IPO (initial public offering) opportunities.

Without a large pool of gullible investors and with much stricter conditions being placed upon hi-tech companies coming to market, the venture capital companies ran out of steam. Profitable situations were much harder to come by, more expensive and extensive expert analysis work had to be carried out. With the costs rising and the profit opportunities reducing, the boom times for the capital venture companies was over.

In short, the investing public became disenchanted with dotcom companies when the risks were fully exposed; opportunities for funding were much reduced and, where capital was available, it came only after much closer examination and more stringent conditions

In the wake of the dotcom boom and the drying up of indiscriminate funding, many e-businesses were left floundering. Whereas in the boom times companies could rely on going to the market for new funding whenever they run out of funds, this source dried up as the market became increasingly sceptical of companies that were not showing a trading profit.

With the hazards of speculative risk capital exposed, investors became cautious and started to look at fundamental values such as real assets and actual income and profits. Potential startups stared to find it hard, if not impossible, to raise venture capital and many market flotations were postponed or abandoned altogether.

It is in this post dotcom boom environment that I now have to consider creating an e-business to serve as an example to include in this book.

 

The increasingly difficult problem

The last chapter finished with a problem common to all bottom up business strategies – how do you obtain funding when you have no business idea, no business plan and no management structure? Now the problem has worsened because it seems as if funding has practically dried up altogether.

 

 

### End of chapter 2 ###

Back to index Note: This book lead to the creation of the stigmergicsystems.com website

Copyright 2001 - Peter Small

Peter Small

All rights reserved by Pearson Education (Longman, Addison-Wesley,Prentice Hall, Financial Times for FT.COM imprint