Here are excerpts from the remarks of John Sculley, former chairman of Apple Computer and now a partner in a venture-capital firm, to the Chapman University Economic Forum last month. Among other things, Sculley talked about valuations in the so-called “new economy” and sketched the background against which a lot of current merger-and-acquisition activity is occurring.
We are going through perhaps the biggest power shift, the biggest transformation from one way of doing things to a new way of doing things that has ever happened in the history of the world.
In the old economy, producers controlled everything. Producers made the decision of what natural resources would be used in what products, what features the products would have, what channels they would be sold in, what price points they would have. In the new economy, that power has shifted from the producer to the customer and today the important decisions are being made by the customers. And the customers are being enabled with this power by the emergence of the Internet as a commercial infrastructure for the new economy because the Internet suddenly enables consumers and customers to be able to do things that were never possible before.
They can speak as a group, often forming affinity groups in cyberspace. They can interact as individuals back to the companies selling products and services, and they can find the lowest price and they can find the best service and they can demand much more than we ever saw customers and consumers demanding in the old economy.
So the new-economy customer, with this newfound power, is now saying. “What I want is the best quality product and service. I want the lowest possible price. I want it customized exactly the way I want it. I don’t want a mass-produced product anymore. And I want it right now.”
Now there’s no way with the old-economics business models that you can make money and at the same time satisfy those demands. And so what we see is business models are being re-invented and we are going through an amazing transformation in sector after sector of the economy that we have all known for at least a hundred years.
Dot-Com Valuations
I think in general it’s very complex for most of us coming out of the old economy to understand how these new companies are getting such high values so quickly. What is it they are doing to create such market caps when they aren’t showing profits?
And I think one of the best ways to understand this market value creation is to understand that not only has the power shifted from the producer to the customer, but that the economics of measuring success in the new economy are all centered around the metrics of a customer. The return on investment ultimately for an individual customer is going to be the way that most of these new businesses are measured. Which means that we now start to have a whole new set of measurements or metrics than what we were accustomed to before.
The old way of selling, the world I grew up in, was when we sold a bottle of soft drink or we sold a computer, that was the end of the sale. The new way of selling, is that you often give something away in order to establish the relationship with the customer over an extended period of time.
The market value of AOL is 6 or 7 times larger than the automotive part of General Motors. And the way that AOL is measured is on their ability to acquire customers, their ability to retain their customers and their ability to hold on to those customers for a long period of time. For example, AOL has 50% of their customers shop exclusively on the AOL servers. They don’t go anywhere else. Now 80% of them, when they go to AOL, will stay on AOL for up to an hour or more. And its that stickiness and loyalty that are behind the value of AOL. So the value of AOL on a customer basis is about $8,000-9,000 per registered user of the AOL service. If you compare that with telcos they’re about $2,000 per customer. Cable multiple-service operators come out to about $4,000 value per customer. So analysts are now looking more at the value of the customer over the life of that customer being with the service than they are the immediate profits that those companies are making.
So if we jump to a comparison in the retail world, Wal-Mart has $170 billion in sales revenue per year. They also have about $170 billion of market cap. So their ratio is $1 of sales revenue for $1 of shareholder value. Yet if you look at Amazon, which lost $650 million in their last quarter,Wal-Mart makes a profit,Amazon has approximately $2 billion of revenue and $26 billion market cap, so they are trading at 13 times their revenue versus the one time of the revenue of Wal-Mart, a profitable company.
How is Amazon being valued? It’s being valued again on its efficiency in acquiring customers, holding on to those customers and its value per customer comes out roughly about $2,000 per customer, substantially less than the value of a customer for AOL. So some people say, “Well maybe it’s a bargain.” And yet, if you compare it to the traditional old economy world you say, “How could you ever justify a $26 billion market cap?”
So more and more we’re going to be learning about the value of a customer and I think more and more the new economy is going to be expected to show a business model which lead to real profitability, not just eyeballs. But at the moment, everything is focused around the value of a customer.
The New Company Model
Now the model for a new company is dramatically different organizationally from the old economy companies. The old economy companies were hierarchical. So the decisions were made often at the top. So I was often asking myself, “Why are these new young entrepreneurs who are in their 20s and their 30s so much smarter that we were when we were their age?” And I think I know what the answer is. When we were growing up,particularly those of us who’ve come up through big corporations,information was given to us on a need-to-know basis. In the new economy, employees expect to have access to all of the information that they might possible have any interest in. So information is not conserved at the top and dealt out at the choosing of a hierarchical management. Its available instantly to everybody and the employees, whatever level they’re at, get to decide what they think is important.
We are moving into an entrepreneurial age and the entrepreneurs creating these companies are getting a chance to participate in every building block as that company goes up. Those of us who grew up in large corporations took on a job in a function or in an area of specialization and then we worked our way up through function to function. In a new economy company, the entrepreneurs are doing all those different functions at a very early stage and they’re learning in real time. They’re learning on the job.
If you look at the models of a few of the companies we are involved with, one is called People PC. We were, along with Softbank, the founding investors in this company. Now, People PC was built in less than year to a company that now is going to be one of the larger revenue companies in the new economy. And yet it has very, very few employees, because it’s built on a virtual model. And the virtual model means that you focus on what you think your company can be good at, and then you outsource everything else to other business partners who are trying to be best at what they do. And so the important job in a virtual company becomes the CIO (Chief Information Officer) because they’ve got to make it appear to the customer,remember the customer has all the power and they make the decisions on everything,they’ve got to make that experience to the customer be so good, so much better than anything the customers have seen before. And yet a lot of the performance of that service is being done by business partners and so they have to make it as transparent as possible for what’s going on in the background. So the CIO is a tremendously important person in the new economy virtual model.
The other person who is tremendously important is the business development officer, because they are out putting together these business partnerships. Because unlike the old model of business in the old economy, where you would do many of these things yourself, you are outsourcing to the business partners. And of course you want the best business partners and you want a long-term relationship with your customers, so different job functions take on added importance in this new virtual economy model.
Buy.com is a branded service that offers a very wide selection of products to its customers and yet it has transparent technology that lets it integrate with its back-end business partners so that it’s not apparent to the end customer how all of those functions are being performed. All they know is that they’re doing business with buy.com and that’s who they hold responsible for that quality of service. But there are actually many other companies that are involved in delivering that buy.com service. So the buy.com organization is relatively small.
Even Amazon, which would be called a new economy company by I think almost anybody, is actually more of a hybrid because they have large distribution centers with thousands of people keeping inventory in their warehouses. And if you noticed their reports in the last quarter, for the Christmas quarter, they had a substantial write-off for inventory that was obsolete, that hadn’t been sold, and very high returns. In a true virtual model, you have zero inventory risk. So your business models are quite different from what people are accustomed to and it takes awhile to educate people how the new economy companies need to be studies to understand how they build a business model towards long-term profitability. But the virtual corporation is very much a part of the new economy.
The result is that we are seeing that in the new economy. We are starting to get entirely different models of what a corporation looks like. First of all, the valuable resource is no longer the resource that comes out of the ground, you know oil, and coal, and wheat and iron, those are commodities. Of course they are still important at some level, but the really valuable resources are the ideas and information and so it’s the intellectual property that is really valuable. And even more valuable in many cases, is the resource of time, which means that things are done in dog years, seven times faster that normal years.
Incorporating Entrepreneurs
All of this is being created by a new generation of entrepreneurs. And what is missing in the old economy structure is that there was no role for the entrepreneur, who often isn’t even living and hasn’t lived for several generations. And so, the new economy had to find a role for the entrepreneur to be active and vital. And in fact, we even have a term, “serial entrepreneurs,” which means people who aren’t particularly interested in running the companies after they create them, but they start the companies and then if they do that successfully, they find someone to run the company and they go off and start another company and then they repeat that over and over again.
So, in the new economy as it grows so fast and gets so large, you are starting to see a new model for organization and it’s built around a portfolio concept. Softbank, Internet Captial Group, idealab!, Safeguard Scientific, CMGI,these are all examples of portfolio corporations that are either public or are in the process of going public. And they aren’t mutual funds, meaning passive investments, but they own significantly enough ownership of these companies that they can get past the Mutual Fund Investment Services Act. But rarely do you see these portfolio companies trying to own 100% of any one of their businesses. They will try to own somewhere around 30% of a company. Why? Because they want to have enough that they are not a mutual fund, but they don’t want to have so much that there isn’t a role for the entrepreneur and for the stock-option incentives for management teams that are building these businesses. These businesses are being acquired and merged and started and spun out and tremendous dynamism is going on in this new portfolio world.
Institutionalizing VC
What they are doing is they are institutionalizing venture capital. Venture capital was a nice gentlemanly profession in the 1980s. Today, it’s becoming the model of a corporation, so you see incubators, you see early-stage funds, mezzanine-round funds, late-stage funds, post-IPO funds and then mergers and acquisitions after that and partnerships with other portfolio companies around the world, because it’s a global economy.
So, we have an economy that has shifted the power from the producer to the customer. We have an economy that is now measured around the metrics of the customer value and how you monetize that value of the customer. We have an economy that is disintermediating many of the functions that we saw in the past. We are seeing product industries being transformed into service industries. And we are seeing entirely new models of what the corporations in the 21st century will look like.
So now what is the implication of that for economics? I can’t tell you what the value of the stock market is going to be. But what I can say with some confidence is that we have probably 15 to 20 years more to go before this transformation is fully complete. We are just at the very beginning. The Internet as we know it today is about where the crystal set radio was back in the early 20th century. We are back just when the electric ignition is being put into the automobile and the technology is getting tamed where we can start to make it easy enough for people to use. That is why you see the incredible investments and market values being created for infrastructure companies building the real Internet. Right now, the Internet is built on top of a telephone system that was designed for 10% of the population to be on a telephone call at any one point in time for 4 minutes, and it’s obviously inadequate for a world where people watch television 50 hours a week on average. Today the average Internet home uses it about an hour. So as the Internet moves up toward television viewing-type usage we clearly need another infrastructure and that’s why you see the fiber-optic networks and fiber-optic switch companies and companies that are building wireless services. In the next four to five years the Internet that we have today will be part of the history and the legacy, not part of what we all know.
I hope you are getting yourselves into the new economy. It’s going to be around for a long time, so if you haven’t learned much about it or gotten immersed in it, this is definitely the time to start.
Excerpts from the question-and-answer sessions that followed the talk:
Will this go on indefinitely, where companies don’t have to have profits or are they eventually going to have to show that they are real businesses?
I think its going to happen: and a lot sooner than a lot of companies would like in the new economy. We do not invest in anything today, new companies that we’re helping build, that don’t have business models that will get real revenue and real profits relatively quickly, meaning within an 18-month period of time. That was not the model people were using even a year or so ago. And I think that you’ll find we’re pretty typical now.
The era of investing in eyeballs was important,you wouldn’t have Yahoo! and AOL and Amazon and some of these companies out there. But this world shifts the business ground rules about every nine to 12 months. And I’m reasonably confidant that the ground rules are going to say, “OK, where’s the beef?”
And that’s why you see so much interest in the B2B section. Because unless you are already up and running, with big brands like a buy.com or an Amazon or somebody, the cost of building a new consumer brand and then showing profitability in a relatively short period of time is pretty challenging. And in the B2B world, you don’t have to spend as much up front on the marketing and the brand building and you can often find business models that can get the profitability up a lot sooner.
But I would agree with what I think you were suggesting. That profits are going to count and it’s going to be a day of reckoning for the new economy. Just like it always was for the old economy.
What do all of us that are in medium-size businesses have to contend with? How do we cope with all this?
The question is about mergers and acquisitions and consolidations. I think there will definitely be a continuation of mergers and acquisitions. First of all, everyone’s working with a pretty cheap currency because they’re using their own stock and you’re seeing a pooling of interest. And even though the pooling-of-interest rules will change within a year, I think that probably won’t slow down the mergers and acquisitions.
And the new economy doesn’t need as many winners as you had in the old economy. Being No. 1 gets disproportionately rewarded. Being No. 2 gets pretty well rewarded. No one cares who’s No. 4 or 5.
Now what happens to smaller or medium-size companies? Do they go out of existence? And the answer is, I don’t think so. As long as they are playing an important added-value role of some service to customers, because again the customers are going to make that ultimate decision. So you may well see that smaller or medium-size companies will stay independent if they can join into exchanges, if they can leverage the economics of other infrastructures, where they can work together. Trying to go it alone as a smaller or medium-size company with the old way of doing business, I think that’s pretty much over.
