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Claiming Space on the Value Chain

By Adam Dell

Venture capitalists are in the business of enabling revolutions. We do this by providing the capital and company-building expertise that are desperately important to young companies. What do we look for? Great people, large emerging markets, sustainable competitive advantage. These elements of success are not a mystery. Finding them is the hard part.

Which companies will garner the biggest chunk of transaction revenue from consumer and business commerce? Which will deliver content and services that capture targeted eyeballs? And which can most effectively leverage ubiquitous connectivity? As the Internet continues to reinvent nearly every sector of our economy, our mission becomes increasingly complex.

One metric valuable in analyzing the labyrinth is the value chain. Coined by Harvard University Professor Michael E. Porter, the phrase "value chains" was first used to describe a management approach to the supply chain. But value chain management has some analogues to the Internet. Value chains can represent the components of any given transaction, where the customer sits at one end and the product or service sits at the other. The components in the middle-the route that leads the customer to the end point-define how value is derived from the transaction and split among the parties contributing to the chain.

Chain Gang
The Internet itself is one big value chain. The pieces that make up that chain-browsers, servers, connectivity, content, traffic, services, advertising, commerce, and entertainment-also represent distinct value chains. Servers, for example, are comprised in broad strokes of components, manufacturing, sales, and marketing. Further, each piece of the server value chain is represented by an additional subset of value chains. For instance, processors, storage, and memory are subchains of components. And so on, ad infinitum.

Within each chain exist multiple parties and competitors, complex overlapping partnerships, and the answer to the most crucial question that a business focused on the Net can ask: Where is the money? By analyzing which chains represent the greatest value to the Internet and its constituent parts, we can begin to find the best investment opportunities.

On the Internet, where companies are driven to razor-thin margins, it is imperative to understand how these value chains fit together and how the transaction revenue generated from them is sliced up among the players.

Looking at the Net as a whole, some obvious areas jump out as important value chains. Namely, commerce, connectivity, and content. But of these chains, which pieces are important to own and why? Let's look at the consumer commerce value chain and the proverbial example of buying a book online: The ISP Earthlink provides connectivity to the Web; Yahoo! delivers content through a homepage; NetGravity's ad serving technology delivers the banner advertisement for bookseller Amazon; Net Perceptions' predictive collaborative filtering engine recommends a book; Amazon sells the book; and UPS delivers it to the customer. In a 12 percent gross margin business like books, why do Yahoo!, Amazon, and UPS garner most of the value out of the transaction, while companies such as Earthlink, Net Perceptions, and NetGravity get squeezed out of the resulting revenue?

Value Is Relative
Consumer commerce value chains reward brands that own the customer and eyeballs that can be converted into transactions. Companies that promote and facilitate commerce fall behind in relative value. I have seen several business plans from upstarts who believe the bell or whistle they plan to add to the consumer commerce value chain will give them title to extract a piece of the transaction stream. Unless they add enough to the value chain to call the customer or traffic their own, they are mistaken.

But let's dig a bit deeper into our example by looking at Net Perceptions' contribution to the value chain in terms of not just one commerce Website but hundreds. Imagine if Net Perceptions-which provides personalized recommendations to commerce sites based on past customer activity-could build a knowledge base about shopping preferences among all consumers. What then happens to the relative value of its contribution to the value chain? How unique is that data?

Indeed, value chains must be analyzed in the context of the overall makeup of the Web, and with an understanding of how the many value chains are interconnected. In other words, Net Perceptions' value chain must be viewed not just horizontally across one transaction, but vertically, looking at all transactions on the Net. From this perspective, Net Perceptions' knowledge base of consumer preferences is a pretty valuable piece of the chain.

We need only look at the relative market caps of Yahoo! ($31.9 billion), Amazon ($23 billion), NetGravity ($600 million), and Net Perceptions ($522 million) to get a sense of which part of the chain is most valuable to own. With so much of the Internet not yet claimed, startups should ask themselves just one question about the markets in which they plan to compete: What do you want to own?

Adam R. Dell (adell@crosspointvc.com) is associate partner at Crosspoint Venture Partners, which holds no stakes in the companies mentioned.

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