Two students approached a venture capitalist with a concept for a dot-com business. Intrigued by what he heard in the first few minutes of the students' pitch, the VC asked if they had a business plan. Did they? The students flourished a document--all of three handwritten pages--and the VC was sold. A handshake later, he promised cash. Soon the capital was delivered, and a dot-com was born. It was a deal typical of those times.
Today, the fate of that company is unknown, but if its track record is anything like that of many other Internet startups, it is probably dismal. For most of this year, dot-coms once regarded as high flyers have been in trouble. Many have announced layoffs; some have declared bankruptcy; most have stocks that trade substantially below their IPO prices. No longer can a handwritten business plan land an entrepreneur millions of dollars in venture funding. As the survivors have discovered only too well, the Internet is serious business, meant for companies that have a basic appreciation of the laws of economics.
For companies eager to approach entrepreneurial opportunities on the Internet seriously--and with a view to turning profits-a new research paper by Sendil Ethiraj, Isin Guler and Harbir Singh offers useful insights. Singh, who chairs the management department at Wharton, as well as Ethiraj and Guler, two Ph.D. students, provide a conceptual framework to analyze Internet strategies. In addition, the researchers look at business models and examine their components. Ethiraj, Guler and Singh also look into what makes some business models better than others at providing a competitive edge to companies that adopt them.
The Internet has undoubtedly unleashed a wave of entrepreneurial activity, thanks to the enormous amounts of venture capital available to finance dot-com ventures. "U.S. venture capital investment in 1995 was only $520 million," the researchers say. "This figure grew to $31.9 billion in 1999."
These massive capital investments spurred entrepreneurial waves in Web-based ventures in part because Internet technology has three broad effects, note Ethiraj, Guler and Singh. First, it has a communication effect, which means that it dramatically reduces the cost of finding and transferring information. Second, it has a brokerage effect--the Web makes it easy to connect buyers and sellers. And third, it has an integration effect, which is to say it transforms buyer-seller relationships and has a major impact upon supply and value chains.
Anyone who has searched for information on a search engine like Alta Vista or Google can attest to the usefulness of the communication effect. The Internet has made it enormously easy to look for--and find--vast amounts of information, in addition to making it virtually costless to store and transmit it. Take the Encyclopaedia Britannica, for example. Some years ago, the tomes cost $1,600. It is now available free online, in part because of a bruising battle with its rival, Microsoft's Encarta.
Moreover, the Internet makes it possible to find information rapidly in a format that helps decision making. Want to know the best price for an Agatha Christie murder mystery? A Web site like DealTime.com will not only search through the inventory of more than 50 online booksellers for the title, but it will also provide a price-ordered list of stores that have the book.
The brokerage effect is equally powerful. Some analysts compare the Web to a giant market marked by "openness, informality and interactivity." This effect makes it possible for Internet users to access global markets at little extra cost, allowing small businesses to target the same customers as larger organizations.
Jeff Bezos, CEO of Amazon, for example, has described his company's role as a broker that stands between book buyers and sellers. An even more dramatic example is eBay, the auction site, which routinely brokers hundreds of thousands of sales and purchases among its users.
Finally, the Internet has an integration effect. According to Singh, the Internet realigns players in industry value chains as some get disintermediated as a result of the new technology. "When there are changes in the value chain, I see it as an opportunity to create value," he adds.
The researchers point out that the Internet transforms industry value chains--or the sequence of activities involved in the transformation of inputs into outputs--in significant ways. Since the Web makes it easy to search for information and also directly connects buyers and sellers, it can knock entire sections of middlemen out of the value chain by eliminating the need for their participation in transactions. A case in point: online stock offerings. In the past, those who wanted to buy stocks in an IPO had to deal with the investment bank managing the offering. On the Web, sites such as E*Offering.com allow IPO issuers and buyers to deal directly with one another.
The Web evolution
Sometimes, the transformation of the value chain results in the emergence of new intermediaries who step in to replace the old. These so-called infomediaries gain enormous power through the Internet. The reason is that they are able to mine customer transaction data, making so-called mass customization possible. For example, some online stores recommend new books or CDs based on the past purchasing patterns of their customers.
Ethiraj, Guler and Singh show that the Internet creates entrepreneurial opportunities. How, though, should entrepreneurs exploit them? The answer depends in part upon the kind of business models that entrepreneurs develop to gain competitive advantage over the rivals.
References to "business models" are frequent whenever aspiring entrepreneurs pitch their plans to potential investors. While the popular media uses the term loosely and vaguely, the researchers attempt a precise definition: A business model is "a unique configuration of elements comprising the organization's goals, strategies, processes, technologies and structure, conceived to create value for the customers and thus compete successfully in a particular market." In other words, the business model is what allows a company to capture and deliver value to its customers.
Ethiraj, Guler and Singh point out that business models must have four important elements: scalability, complementary resources and capabilities, relation-specific assets, and knowledge-sharing routines.
1.Scalability: Information assets, which dominate the e-business world, have a unique property--they are generally costly to produce in the first place, but once produced, very easy--and relatively inexpensive--to reproduce. As a result, first movers in a market have an enormous advantage. They can flood the market, and essentially create a winner-take-all situation. In order to exploit this aspect of competitive advantage on the Web, it follows that companies must develop business models that are scalable.
2.Complementary resources and capabilities: A company with an innovative business model can initially use its technological prowess to steal a march over its competitors. Entrepreneurs would be wrong, however, to believe that this advantage is long-lasting. The Web sharply lowers barriers to entry, and rivals can soon catch up with the first mover. In order to protect their competitive positions, companies that lead in the digital arena may have to acquire physical assets to keep their competitors at bay. For example, AOL's acquisition of Time Warners' bricks-and-mortar assets may have been driven by this need.
3.Relation-specific assets: No individual firm can hope to dominate the Internet, which is a complex network designed precisely to avoid such dominance. As a result, networks of alliances become increasingly important. Business models on the Web must recognize that competitive advantage in e-business is often based on managing collaborative relationships with key partners well.
4.Knowledge-sharing routines: This condition follows from the previous one, which emphasizes the need for strong collaborative relationships. These relationships can only become truly effective if the collaborators develop mechanisms through which they can share knowledge with one another. Such knowledge-sharing will help the partners to enhance their collective competitive advantage over rivals and their partners.
As companies attempt to develop Internet strategies, they would do well to pay attention to these ideas. If they do, they will avoid the plight of entrepreneurs whose dot-coms develop pneumonia each time that tech stocks on the Nasdaq catch a cold. If they are lucky, they could even ensure that their Internet strategies will help them to gain competitive advantage and build profitable e-businesses over time.
To read more articles like this one, visit Knowledge@Wharton.
All materials copyright © 2000 of the Wharton School of the University of Pennsylvania.