Economic Principles Return circa 2001

Originally printed in one of the boom time internet magazines, one of my co workers from the period saw one of my recent articles and dug this one up and send to me.  I wonder if you could write the same thing today…

Economic Principles Return by Ben Smith Tuesday, May 08, 2001

Not so long ago, venture capitalists were chasing ideas faster than they could be generated and stock prices were soaring. High-flying companies like Onvia, VerticalNet and Ventro promised to change the way business as we know it is done and saw their stocks reach unprecedented highs, commanding a combined market capitalization of $25.5 billion, a value 25 percent higher than that of retail stalwarts Sears, Kmart and JC Penney combined. All of this, from three companies whose 2000 collective losses equaled $715 million on only $48 million in sales. In 2000, Sears, Kmart and JC Penney had total sales of $109 billion and profit of $2.4 billion.

But the financial world, it appears, is still founded on basic economic principles. The harsh realities of business economics have set in and the time-honored principle still stands – cash is king. As most old economy companies and entrepreneurs have known for a long time, without cash flow you can’t pay the bills, let alone, stay in business. This situation has come about because several key issues regarding investment markets and the B2B opportunity have been ignored.

Investment dollars can’t replace revenue

In the past, a viable business leveraged a small amount of equity to get it off the ground and then relied on generating revenue to fund further expansion. The end goal wasn’t attracting more equity, it was making a profit. And, profit was achieved through fiscal constraint, squeezing the most out of every penny the business had. Somehow, as the B2B craze took off, these values were left behind and the “money does grow on trees” mentality took over. However, as most firms have now learned, cash is a vital key to success and equity markets – private or public – are not meant to replace the classic enterprise software model of using customer revenue to finance product development.

Building a business still takes time

Contrary to what many e-business enthusiasts thought a year ago, “Internet time” did not change the laws of reality that restrict how long it takes to build a business. It just changed the time it took to get one financed – at least temporarily. Now the harsh lessons of those laws are playing out. Companies that once had large bankrolls, but lacked a strong value proposition, competitive advantage, reasonable revenue models and an aggressive “stick-to-it attitude” are closing shop. Founded in 1994, Commerce One has been on the long path to profitability since and is just beginning to see the impact of the well publicized, but rarely realized e-commerce network effect. Rather than simply buy its software, buyers and suppliers are actually beginning to use it, creating near exponential growth. As more and more users have been connected, sales have grown from less than $3 million in 1998 to more than $400 million today. As Commerce One learned, this can’t happen without years of investing in solutions that add real value and establishing a significant customer base.

Value of implementation is often ignored

Traditional project evaluations weigh the true costs and benefits, and evaluate the risks of a project achieving its goals in the scheduled time frame. Such an analysis, which considers a company’s ability to execute, often translates a “great idea” into a negative net present value (NPV), resulting in rejected, delayed or reformulated projects that meet desired financial goals. Over the past couple years, too much value and hope has been put into the B2B solution and not enough into the infrastructure it takes to implement the solution. Further reflecting this oversight, is that too many companies focused on attracting people who could sell and not the people who could do. Even VCs got away from this to a certain extent, and the skills in key areas that would help integrate many of these solutions with prospective customer systems, such as enterprise software skills, were not appropriately recruited or cultivated. As everyone knows it’s impossible to build a company without the right people and by looking at the relatively small number of suppliers that are hooked-up to most e-marketplaces, it’s obvious that software alone is not the answer.

Opportunities to reconfigure the value chain still exist

Disaggregating physical flows from information flows creates significant opportunity to re-define the value chain of an industry. Many companies are now developing the tools to make this a reality, enabling multi-enterprise collaboration across the supply chain, where information and materials are no longer processed in a linear fashion, but in parallel. In such a world, information is processed and transferred instantaneously to all partners in the supply chain following agreed-upon protocols. Suppliers plan production and inventories, while logistics providers are scheduling loads and financing partners are arranging credit or payment. Not only does this reduce the time required to complete a transaction, but the waste associated with things like excess inventories, production changes or half loaded trucks can be eliminated. Such a world is what companies like Converge, e2open and Fast Parts are trying to create in electronic components. The longevity of these companies is unknown but already they have made an immediate impact on the way the electronics value chain works.

Interconnectivity creates liquidity

To avoid leaving customers without product, companies have spent years meticulously engineering the supply chain to ensure inventories are available to meet demand. But what has resulted is an inventory bloat rapped with inefficiency. According to Morgan Stanley Dean Witter, in 1998 alone, U.S. companies invested almost $1.4 trillion in inventory and 40 percent of the cost of carrying it was lost due to obsolescence – goods that never made it off the shelf. When B2B came along and promised to eliminate the bloat by enabling visibility across the supply chain the opportunity for profit was obvious and the free-for-all was on.

Most B2B start-ups believed that by simply bringing buyers and sellers together via the Internet and offering lower prices through online catalogues or auction capability they would create liquidity, the continuous transaction of goods and the life-blood of a B2B. Overlooked in this optimism was the fact that solutions that focus on only one aspect of a transaction, agreeing on a purchase, are not enough. Payment, fulfillment, and return issues must also be handled efficiently in order for an e-commerce solution to be readily adopted.

In addition, companies who have spent years eliminating risk from their supply chains to satisfy their end customers, need significant guarantees before they will willingly change suppliers or adopt new purchasing channels. For these players, guarantees take the form of 100 percent visibility of demand, production and inventory, something only complete connectivity across the value chain can enable. Fortunately, companies like i2 Technologies and WebMethods, an integrated software solutions provider, are beginning to overcome the technical hurdles of linking disparate information technology infrastructures together. Meanwhile companies like SeeCommerce and Harmony are starting to make available supply-chain-wide metrics such as fill rates, percentage of complete orders, turnaround times, forecast accuracy, and inventories at each site.

Federal Reserve Board chairman Alan Greenspan recently addressed the value of B2B in supply chain management functions: “Extraordinary improvements in business-to-business communication have held unit costs in check, in part by greatly speeding up the flow of information. New technologies for supply-chain management and flexible manufacturing imply that businesses can perceive imbalances in inventories at a very early stage – virtually in real time – and can cut production promptly in response to the developing signs of unintended inventory building.” However Greenspan also said such technology advances remain a work in progress. “Our most recent experience with some inventory backup, of course, suggests that surprises can still occur and that this process is still evolving.”

Proper financing will lead to better results

Because of the delirium over IPO riches, for the past few years investors have tried financing all projects as though they were companies, using venture equity to get them off the ground. A better approach to effective financing is determined by evaluating who captures the benefit and how large a network effect is involved. For example, it makes more sense for a consortia such as WorldWide Retail Exchange or Converge, where all the cost benefits are captured by the participants and the network effect is high, to be financed by the participants. Whereas, a multi-enterprise or enterprise software venture in which the revenue and profits can be captured by a single entity is more appropriately financed with a combination of equity and customer revenues. A corporate project such as eSun’s private marketplace is best financed as an information technology investment, allowing the company and its network of customers to capture the benefit of the supply chain initiative. Unlike recent models, such an approach does not rely blindly on an endless flow of capital, but ensures the financial risk is taken on by the entities most likely to reap the rewards.

These opportunities and issues have presented themselves over the past several years and will continue to emerge and evolve for many years to come. However, no matter what happens, one thing is clear: to avoid future meltdowns in the value of investments, investors, and companies alike, must do a better job of evaluating opportunities and matching the appropriate financing options against the financial benefit received.

BEN SMITH is the Vice President, Ventures Development Group, at EDS / A.T. Kearney.

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