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.
This simple model ignores, however, 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 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.