“One shaft of light that shows the way
No mortal man can win this day
It’s a kind of magic”
I once had the unique opportunity to hear Bill Gates, certainly one of the smartest and most successful men alive, describe other people he admired. Topping the list was his Seattle friend Craig McCaw. When asked to describe why, Gates pointed out that McCaw had convinced investors in not one, but two industries to pay attention to proxy valuations as opposed to traditional valuation metrics. In other words, McCaw convinced analysts and investors alike that valuation tools such as price-earnings and price-cash flow were flawed when evaluating early-stage infrastructure plays. As alternatives, he offered up new metrics such as “homes passed” and “POPs.” Don’t look at this, look at that.
Why is instituting proxy valuations a stroke of genius? As early stage infrastructure companies use tons of capital, investors would have a hard time awarding high valuations to companies with huge losses based solely on earnings-based investment metrics. Rather than settle for second best, the early executives in both of these industries created new metrics based on more measurable data by which to judge the valuation of these companies. So even though these companies may have been hemorrhaging cash, investors could now take comfort that a cable franchise was worth $2,000 per home passed, or that a wireless company was worth $30 per POP (percentage of population).
Most people view investment consideration as a bilateral relationship in which the investor gathers as much data as he or she can about a particular investment and then judges that data to make an investment decision. In this simple framework, investors look at data, and executives try to deliver better data–i.e., increase earnings, revenue, and cash flow. However, this simple model ignores the fact that the executive could instead choose to change the investor’s consideration process. Once again, don’t look here, look over there. Why worry about earnings when you could instead convince the world to value your company based on the number of people that live in your service area?
Historically, proxy valuations have helped investors become overly optimistic. Consider the following quote from a 1997 speech by then chairman of the Federal Communications Commission, Reed Hundt: “As the wireless industry goes far beyond its current dimensions, Wall Street analysts are going to have to think about valuation methods. The ‘per POP’ system served its purposes during the salad days of cellular, when we were green of years. But it’s not how Wall Street generally values firms in markets that have the competition coming in to wireless. And I think the per-POP valuation may already be dragging down wireless stocks.”
So are proxies good or bad? The answer to this question depends on who you are. From a societal view, one could argue that they are good, as they facilitate the acquisition of capital that is necessary to build capital-intensive infrastructures like wireless stations and cable plants. That said, there are certainly investors who invested at the height of the proxy usage who have ill feelings about such notions. And there are others who invested early that perhaps bailed as they saw the proxy begin to strain.
The notion that an executive could influence the investment decision process as opposed to simply the performance of his particular company is particularly fitting when looking at today’s highly valued Internet stocks. As most companies are losing money, traditional valuation tools have been rendered useless. In addition, the public markets are quite eager to accept companies at an earlier and earlier stage in terms of both revenue and earnings. The average time from venture capital investment to the year of an IPO has dropped from 6.5 years in 1995 to about 2.5 years in 1999. We even have begun to see an increase in Internet companies going public with little or no revenues (Stamps.com, for example). It’s hard to have even a proxy when your company has no revenues or customers.
As public market investors begin to evaluate younger and younger companies, their valuation tools become limited to subjective notions such as quality of the team and the uniqueness and boldness of the idea. In other words, if there isn’t enough proof that a business already exists, then they must make a judgment as to whether one will. This typically boils down to the executive’s ability to convince the investor community that (1) the opportunity exists, and (2) his or her company will execute against this opportunity. Like it or not, the skill we are talking about here is storytelling, and just as with proxy valuations, the executive is now trying to influence the consideration of the investor.
In today’s unique Internet business environment, the art of storytelling has taken on increasing importance. Because of “network effect” and “increasing return” phenomena, many people believe that first movers (or at least companies that are first to reach a significant scale) will most likely take the lion’s share of an Internet market. So far, in portals, auctions, and book and toy e-tailers, this has proven to be the case. The company that is most likely to move first is most likely the one with the most money, and the company with the most money is the one that has had the proper ability to sell its story to the investment community.
This notion that the ability to tell a good story is a critical aspect of success is likely troubling to many, especially if you replace the term “storytelling” with the more derogatory term “hype.” To keep things in perspective, however, you must recognize the enormous likelihood for self-fulfilling prophecies. Whoever grabs early mind share typically secures strong financing. Strong financing adds to the story, which then may help enable a killer partnership–once again adding to the story. The press writes about the partnership, which adds even more fuel to an already increasing leadership position. Finally, consumers read about this unique leadership company and are influenced to use the product or service.
Consider the case of Priceline.com. When the company first filed to go public, it reported 1998 sales of $35 million with $115 million in losses and negative gross margins. It’s difficult to make that up in volume. What Priceline did have was an extremely convincing spokesman, Jay Walker, who fundamentally believed that his new idea would bear fruit as soon as the company hit its stride. Fast-forward to Q2 of 1999, when the company reported $111 million in revenue with $10 million in gross profit and only $15 million in losses (a $60 million annual loss run rate). While the company is far from profitable, it has made significant progress relative to 1998, which supports the notion that as the model grows, it will have scale advantages.
Will Priceline ever be profitable? It is hard to say, but Q2 numbers seem to imply that things are moving in the right direction. What is more important is recognizing that the ability of management to convince others (including investors) to come along, even against a backdrop of huge losses, has been critical to the company’s progress. As the company raised money and gained influenced, it signed up more airline partners. As the partners came on board, investors were more excited, which made capital-raising easier. As the company’s stock soared, the press commented, and consumers gained more awareness of the model, leading to more business.
As another example, let’s take a closer look at Healtheon. The first line of the prospectus summary for Healtheon’s IPO stated, “Healtheon is pioneering the use of the Internet to simplify workflow, decrease costs, and improve the quality of patient care throughout the health care industry.” That’s a big idea. Health care is unbelievable bureaucratic and paper-laden, and any company that could solve this problem would be unquestionably valuable. However, buried in the same prospectus was the following note: “Healtheon’s limited revenue to date has been derived primarily from proprietary non-Internet network services…” The story involved the Internet–the company’s revenue did not. To focus on this detail, however, is to ignore the importance of storytelling. Healtheon did not go public based on what it was, but based on what it would become.
It is important to note that these ideas are not new. Books like Richard Brodie’s Virus of the Mind and Robert Cialdini’s Influence do a great job of highlighting the importance of information warfare in corporate success (interestingly, Brodie used to work for Bill Gates). Despite this precedent, I still find people are uncomfortable at the notion that good storytelling, the ability to influence and convince through the written and spoken word, is a critical component of start-up success. Rest assured that venture capitalists are hot in pursuit of an entrepreneur or CEO with a thespian bent.
This does not mean to imply that other business principles are not important. Great management, good execution, strategic decision-making, and sound business models–all these things still matter in a big way. However, with the public market acting more and more like venture capitalists, the art of storytelling takes on increasing importance on a relative scale. Pay attention to the man behind the curtain.