It began as change often does, with fear. In February 1999, Rick Schnall was a master-of-the-universe in training. Three years earlier, he had graduated from Harvard Business School and had joined Clayton, Dubilier & Rice, one of the world's preeminent leveraged-buyout firms, as a finance associate. By age 29, he was making a generous six-figure salary as a finance principal, taking equity in CD&R's funds, traveling around the world, and working with executives who had also attained the highest reaches of corporate America.
Schnall's day job was to provide financial investment and management support to new and existing portfolio companies. A veteran of the corporate-finance departments at both Smith Barney and Donaldson, Lufkin & Jenrette even before he went to business school, Schnall helped analyze and price acquisitions, corral financing, and, when the time came, prepare the firm's properties for sale through public offerings.
That was his day job. What kept him up at night was something entirely different: the Internet.
Schnall tracked the explosion of electronic commerce, marveling at the way newly hatched companies were changing the face of the economy. He had close friends working at Yahoo! and America Online, and he knew a half-dozen of his Harvard classmates who were launching their own Net ventures. "I saw what was going on, and I thought there had to be some applications for our portfolio companies," Schnall says. "How could we protect our core businesses so that someone else wouldn't come in and steal them away?"
He had been raising such concerns since joining CD&R. It was not that no one would listen. But the Net represented an almost incomprehensibly different world to the company, which was rooted in old-line industries and block-and-tackle management. As one of the youngest professionals amid a crowd of veteran heavy hitters, Schnall was only slowly acquiring the credibility and influence he needed to push his agenda. So mostly he laid low. Until the Piper Jaffray meeting.
It was a routine get-together with outside investment bankers. But when Schnall casually mentioned his interest in Internet initiatives, one of the visitors asked whether he knew about Instill Corp. Instill, which Piper Jaffray's venture arm had helped bankroll, was an online procurement service for the food-services industry. It linked restaurant buyers with distributors, and food manufacturers with customers. And it was growing rapidly.
Schnall, who had never heard of Instill until then, was shocked. This news gave shape and form — a competitive name — to his vague fears: Out there, in the Net ether, someone had brought forth a new business model that directly threatened one of CD&R's biggest investments. "We have to move fast, or we're going to be blown out," he thought. He fidgeted anxiously as the meeting came to a close, then bolted to his office.
And there, he set out to fix Alliant.
Can Bigco Become Netco?
It is the most urgent, most difficult question in business today: How do you move a big, old-line enterprise onto the Net?
The question is urgent because the Internet has so rapidly broken down traditional barriers to entry. Established companies enjoy powerful brands, huge revenue streams, lots of customers — decisive competitive deterrents in the real world. Yet in industry after industry, in the space of just a few years, Web-based upstarts have come up with new business models to wrest market share from much bigger rivals. Amazon.com in books is the most familiar story. But there's also eToys, E*Trade, and Pets.com. There's good reason for Barnes & Noble, Toys 'R' Us, Merrill Lynch, and Petsmart to rush frantically into the online fray: They're late; they've lost customers, market share, mind share, and market value — and they risk losing even more.
The question is difficult because established companies don't easily confront revolutionary new technologies. And big companies are simply not built for speed — at least not for Internet speed. Product cycles in typical manufacturing companies can stretch for years; in Silicon Valley, ventures go from notion to market in a matter of weeks. New Netcos and ".coms" are populated by entrepreneurial risk takers who will accept low pay and ungodly hours in exchange for the thrill of the hunt, a lockbox of options, and the whiff of a big payoff down the line. And they're sustained by venture capitalists, lawyers, and public-relations executives who, for the same thrill, the same lockbox, and the same whiff, are ready and willing to offer aid and support.
How do you compete with that? What large businesses can safely pursue are transitional strategies that employ electronic commerce to sustain existing operations. But big companies can't change the rules. Inventing and enacting a completely new business model, one that takes full advantage of the Internet to revamp the way the company relates to its customers, its suppliers, even its competitors, and to change the way it makes money — that just hasn't been done. The only way for an established business to pursue a revolutionary Net strategy is to create entirely new organizations — ones that will compete with, and perhaps replace, what already exists.
This is the story of one big company's attempt to become a Netco — to remake itself on the Web. Alliant Foodservice Inc. is a $6.1 billion distributor of food and supplies to restaurants, hotels, hospitals, and other institutions. Its network comprises warehouses, trucks, and call centers in 39 U.S. markets. Until 1995, it was Kraft Foodservice, a division of Philip Morris Co.; then Clayton, Dubilier & Rice purchased it for $690 million. Under CD&R, Alliant's revenues have grown by 17% in each of the past two years.
Alliant's effort to change is a work in progress, an example of a real-time transformation. Born at Schnall's meeting last February, the Alliant story won't fully be revealed until the end of the year. Even half-finished, though, it makes an intriguing tale. In short order, the company is introducing a transitional Internet strategy that could win new customers even as it profoundly reduces selling expenses. At the same time, CD&R — itself a bastion of the dirt world — is leveraging Alliant's existing assets to fashion a completely new, transformational Net startup, building it from the digits up. Its accessory: Diamond Technology Partners Inc., a hot e-commerce consulting firm based in Chicago that will take an equity stake in the new company.
For all three, the partnership represents a fundamentally different undertaking, one that requires wholesale changes in thought and strategy. Will it succeed? None of the three partners knows for sure. On one thing, however, Alliant, CD&R, and Diamond agree: It must be done.
Trucks and Warehouses
At 6 am, six days a week, supplier trucks start backing into the 34 bays at Alliant's cavernous distribution center north of Albany, New York. Workers unload vegetable oil, potatoes, and 10,000 other products, and stack them five stories high. When they're done, the night shift begins weaving forklifts through the aisles, assembling pallets of outgoing goods to match the orders that have been entered by some 90 sales reps earlier that day. Starting at midnight, those pallets are loaded onto Alliant trucks for delivery across New England and New York State. Each year, Albany's 65 rigs deliver more than 9 million cases of food to 3,800 restaurants, hospitals, and universities.
Trucks and Warehouses. It's not too complicated. Get some trucks and a warehouse, and you can play in the food-service - distribution business. "This industry hasn't changed very much," says Michael J. Mulhern, the 38-year-old president of Alliant's Albany market. "For 50 years, it has accepted mediocrity. Customers have tolerated it. It is an industry just waiting for someone to do things differently."
The industry is classically fragmented. Its biggest distributor, Sysco Corp., controls just under 10% of total sales; together, the top five, including Alliant, account for about 20%. Most smaller players have little grasp of professional management skills or advanced technology. And since margins historically have been quite narrow — around 2% to 3% before taxes — distributors have tended to pay more attention to managing working capital than to meeting customer needs. True, the logistics are complex: Orders received one day must be processed and delivered by the next. Yet even the big players provide service that is abhorrent by the standards of most businesses. Industrywide, 2% of every customer order goes unfilled, often because items are out of stock. Procurement errors average close to 1%. "Why do we have to have that?" Mulhern wonders. "Why can't we give customers exactly what they want?"
Here, then, is part of Alliant's opportunity. It can employ technology to improve customer service, to reduce errors, and to cut costs. Online purchasing systems, for example, allow restaurant owners more flexibility in how and when they order, while diminishing the possibility of data-entry errors. It represents just one way in which technology can change the job descriptions and tasks inside the old organization, freeing reps from taking orders and allowing them to spend more time selling — pushing more of Alliant's high-margin house brands, for example, or offering some value-added services such as inventory control or menu planning.
Alliant, in fact, already has an online purchasing system. That system, called Alliant-Link Direct, today handles orders that account for 40% of revenues. It is a powerful resource — yet it is a proprietary system, one that requires Alliant to install dedicated PCs and software at each customer site. The expense is justifiable for large regional and national accounts — but it makes little sense for independent restaurants.
Earl L. Mason understands that a Web-based ordering system can address those shortcomings. He also comprehends the risks of standing still. He became Alliant's CEO in May after resigning as CFO of Compaq Computer, just before the Compaq board of directors deposed CEO Eckhard Pfeiffer. "The discussion at Compaq was always about not switching distribution so fast that you lost the existing customer base," Mason says now. "But you can't afford to get stuck in the middle. You go ahead and make the move. You don't worry about cannibalization. You change in the way the market wants you to change."
Buy It and Fix It
The offices of CD&R are exactly what you'd expect of a big-league LBO firm: Dark wood, blond carpeting, hushed voices, and an 18th-floor view of Manhattan's Park Avenue. These are the trappings of an investment partnership that, in its 21-year existence, has bought 29 companies, sold 18 of them, and realized a 45% average internal rate of return on those 18.
Like other LBO firms, CD&R raises big pools of money from big investors — its most recent fund totaled $3.5 billion — against which it borrows to buy businesses, with the expectation that it will sell these businesses at a profit within two to eight years. Unlike most of its rivals, though, CD&R takes a more active role in managing the companies it buys. The spectacular returns on its funds come not only from financial maneuvering, but also from operating partners' efforts to make their companies more profitable.
CD&R follows a formula. It buys "carve-outs" — businesses hidden deep in bigger corporations that are starved for resources and management attention. It figures out beforehand how performance can be improved and offers a price that will allow its fund investors at least a 30% net rate of return if the plan works. When the deal is done, the operating partners push ahead aggressively. They drive for new sales initiatives and creative distribution strategies. They work to shorten product-development cycles and to boost manufacturing productivity. They hone working capital and, not incidentally, cut costs.
Jim Rogers, 49, is the prototypical CD&R operating partner — a proven big-company guy. For 26 years, he toiled at the General Electric Co., eventually running one of its biggest businesses and landing on the shortlist of possible successors to CEO Jack Welch. But in October 1998, after his Industrial Control Systems unit deflated, Rogers realized that his run for the roses was over. His next move: signing on as one of 12 partners at CD&R.
Rogers took over as chairman of Alliant, serving as CEO until he hired Mason. CD&R had already made progress toward its goal of taking Alliant public by 2001. It had encouraged the distributor to make seven acquisitions and had developed strategies to attract national accounts. And in December 1998, Rogers oversaw a broad restructuring plan that implemented several hard-hitting productivity initiatives designed to reduce overhead.
But Schnall's February alert changed the game — and Rogers recognized immediately what was at stake. Instill's threat was genuine. Just six years old, it already claimed 7,500 accounts nationwide — a small but not insignificant piece of a universe of 750,000 U.S. food-service operators. Although it didn't operate warehouses or run trucks, Instill's operation reflected a keen understanding of the food-service value chain: The company that controlled the front-end purchasing system also controlled the customer relationship. Instill's strategic locations, wedged between distributors and their customers, gave it first crack at selling value-added services that distributors otherwise might deliver.
More worrisome to CD&R was the risk that Instill might someday offer restaurateurs the ability to compare distributors' prices online, essentially commoditizing — disintermediating — the entire channel. Other startups, such as PurchasePro.com Inc. and Ariba Inc., were eyeing the same turf. What's more, Sysco already had converted 5,000 of its biggest accounts to a Web-based order system.
At root, Net technology was imminent enough and powerful enough to disrupt Alliant's profitability and, in the process, CD&R's return on investment. On the other hand, there was the possibility of an immediate payback if Alliant acted quickly. Online order entry, Rogers reckoned, could save Alliant as much as five cents on every dollar in revenue in some segments — part of that from reduced sales costs and part from lower back-office transactions. "You can view the Internet as a threat, or as an opportunity, or as both," he says. "There's the threat that if we don't do anything, we could be disintermediated by an Internet company that does something. But we also view it as an opportunity to improve internal productivity."
Rogers and Schnall knew they needed a short-term strategy to meet the looming online competition. They also sensed the opportunity for something bigger, a way to use the Net to transform the food-service business — but they didn't know what that was. They needed help, and they needed it fast. So they went shopping for consultants. And they came up with Diamond.
Food and Time
There are two ways to learn quickly about restaurants. The more fun method involves eating a lot of food at a lot of joints. The other requires working at those joints. This is why, in late June, Rik Reppe, 36, found himself waiting on tables at the Rocky Cola Café in Los Angeles. Forget about the glamorous life of high-priced consultants: This was market research. For about six weeks, six Diamond consultants got their hands dirty. They worked deep fryers, rode in delivery trucks, and tolerated lousy tips. They infiltrated the industry — and they came up with a plan.
Diamond Technology Partners isn't your garden-variety consulting firm. A scant five years old, it has grown to approximately 300 consultants, $82 million in revenue, and a $600 million market cap by marrying business strategy and information technology. Its teams work with big companies to analyze and to identify electronic commerce opportunities. In a short time, Diamond has become a big draw at MBA placement offices — in part because of the white-hot market niche it inhabits, but also because it offers stock options to all consulting hires.
The Diamond partners leading the Alliant engagement were John Sviokla and Peer Munck. Sviokla, 42, had arrived in 1998 from Harvard Business School, where he had coauthored an influential 1994 "Harvard Business Review" article called "Managing in the Marketspace," a seminal work that predicted the dislocation and commercial opportunities of the online world. While at Harvard Business School, he developed its first course in electronic commerce, and Rick Schnall had been one of his students; so when CD&R decided to seek consulting services, Schnall called Sviokla first.
Munck, a 43-year-old Norwegian, was a career consultant, a10-year veteran of Strategic Planning Associates before he joined Diamond. Munck's passions were as various as the Net itself: Grateful Dead devotee, composer, and keyboard player, his band jammed all night at one of Diamond's quarterly staff meetings. He held a patent for an "antiswing stabilization unit" to counter the pendulum motion of cable-suspended cargo; Munckloader Engineering, a company he cofounded, supplied cargo-handling equipment to bulk vessels. And he had traveled the digital world widely: Alliant would be his fifth big e-commerce gig.
Munck and Sviokla joined their Diamond colleagues in the institutional kitchens of America. This is what they learned: The restaurant business isn't really about food. That's what ends up on dinner plates. But the food itself isn't that big a deal for the restaurant owner. "What these guys really need," Munck says, "is more time. They deal with 100% annual staff turnover. They work 70- or 80-hour weeks, and they don't take vacations. They have no time to plan menus or to target new customers, which is where they really should be spending time. All that for a 5% profit margin."
Diamond believed that the Web offered a solution. A Web site would allow owners to buy food and supplies online from many distributors; they would get Alliant's price lists, along with catalogs of competing local and regional providers. Customers could use pull-down menus to modify set orders by week or by season. They could rate distributors' wares and services, much as readers do at Amazon.com. And food suppliers could buy intelligent ads to sway order decisions at the right moment.
The new company would take a cut of purchasing transactions. It also would use the aggregating power of the Net to give restaurants more buying power in other areas. Together, restaurants could negotiate priority service with heating and air-conditioning contractors, or get better rates from communications vendors. As the community of restaurants expanded, so would the opportunities for partnerships.
It was all doable, Munck and Sviokla decided. And it could be done fast. But it couldn't be done by Alliant. For one thing, the venture had to appear independent: Restaurant owners had to feel comfortable that they were getting independent advice and the best possible prices. Other participating distributors had to be convinced that Alliant wasn't getting preferential treatment. Alliant, for that matter, would have to compete on the same site with direct rivals — something it likely wouldn't allow on a proprietary system.
More daunting, though, were the cultural barriers within Alliant. "In a $6.1 billion company that's been in business for a long time, you don't have the culture that allows you to fail or to take risks, that allows you to make decisions in hours instead of weeks, that has no bureaucracy," Munck says. "A startup operates at a completely different pace — you work nights, you work weekends. Alliant won't tend to hire the sort of people who want to do that."
There's also an understanding gap, Sviokla argues. "For traditional managers, understanding virtual space is a nontrivial task. The Internet is a rapidly changing technology; we're in the early color-TV days, and most managers are still radio listeners. The skills and approaches to the business are very different. Add to that the need to make decisions much faster, and it's like taking a boat pilot and putting him in the cockpit of a plane. You tell him, 'Practice landing this thing five times, then we're putting you into combat.' "
Diamond's solution: a two-pronged plan. Alliant would proceed internally with the migration of its proprietary purchasing system onto the Web, aiming to launch a beta version within six months. Separately, CD&R would start a new company that would be largely independent of Alliant. Sviokla and Munck called this new venture TheSauce.com.
Recipe for a Startup
On July 19, two months after retaining Diamond, Rogers and Schnall flew to Chicago to hear the consultants' recommendations. Earl Mason joined them. The three immediately liked the idea of an independent startup. For one thing, they agreed with Sviokla and Munck that the Net business would require talent, experience, and culture that Alliant didn't have. They also believed that this was a way for Alliant to lift revenues quickly. As the "corner tenant" on a site that offered restaurateurs value-added services, they thought, Alliant would win crucial first-mover advantage in the independent-account segment.
There also was an investment rationale for launching a separate entity. The venture would require substantial funding for two to three years — enough to dilute Alliant's earnings significantly. Because CD&R wanted to take Alliant public by mid-2001, it had to build a financial track record that would impress prospective shareholders. Alliant couldn't fund a new business and still make its financial targets.
Over dinner that night, Rogers and Schnall agreed that they would present Diamond's strategy at the CD&R partners' meeting in August. They had considered buying an existing online operation like Instill's, but decided the valuations were too high. (Instill, in any case, says that it didn't want to sell.) Instead, they would ask their partners to seed TheSauce.com with $25 million — with more money available, if needed. For that, CD&R would take a 50% interest in the venture. Alliant would take about a 20% share in return for the intellectual rights to its Alliant-Link.com system. Diamond, in lieu of cash payment for its services, would get about 12%.
This was not immediately familiar territory for CD&R. Next to its typical $200 million investments, $25 million was chump change. But the firm had never actually started a company before. Its expertise lay in productivity enhancements and financial discipline, not in the screwball world of the Web and venture capital.
On the other hand, Rogers says, the partners had their own moment of Web-based truth. "We have to adapt," he says. "We owe it to our investors to make sure that our portfolio companies are taking advantage of the Internet. With Alliant and TheSauce.com, we're acquiring a new skill set that we can use in the future transformations of other large companies."
Think of it this way. CD&R brings a certain management toolbox to its investments. Its partners calculate that if they increase inventory turns or improve sales velocity — just as Alliant's Michael Mulhern is doing in Albany — they can expect a certain return on their funds. Now the Internet is presenting them with the possibility of a powerful new tool for the kit. CD&R can join its transformational expertise and capital with Diamond's digital strategy and technology people, and apply that to other old-line properties with physical assets, brand names, and fulfillment capabilities. In theory, it's a powerful combination — one that could justify investments CD&R otherwise would not have touched, or that could lift the returns on acquisitions it would have made anyway.
Or so the pitch went when CD&R's partners bought in on a $25 million venture investment on August 10. By a unanimous vote, TheSauce.com was born.
If You Can't Stand the Heat
The plan relies on three linked sites. TheSauce.com, the core site aimed at restaurant owners, is scheduled to debut this month on a small scale in Los Angeles, the city with the nation's highest number of restaurants, with as many as 10 other markets targeted by June 2000. FlyInTheSoup.com, targeted to restaurant workers, was launched in October, and EatingOutLoud.com, the consumer site, is expected to follow by mid-2000.
Sviokla and Munck had been impressed by CD&R's agility: In about 60 days, they had gone from an idea to a $25 million business, with no business plan and no product. CD&R's affirmation and promise of capital, though, still left Diamond the "small" matters of creating a product, a plan, and a company. Over the next two months, the new company and its owners would have to work out governance issues, refine its product-market orientation, and write a formal business plan. All at once.
First, TheSauce.com needed a CEO. CD&R asked Munck if he would leave Diamond to take the job. Rogers and Schnall liked Munck's deep understanding of technology-based solutions, of what the Web was all about. For his part, after 14 years of consulting Munck was ready to lead a business full-time. "It was an exciting prospect to be walking the talk," he says. "And here, I was dealing with beautiful material, Brave New World stuff. There weren't the same problems of cannibalization and bureaucracy that we had faced with other clients."
Within Diamond's office atop the gleaming John Hancock Building in downtown Chicago, Munck reproduced the zeitgeist of a hungry Los Gatos, California startup. And he began hiring. He recruited Rik Reppe from Diamond, borrowed Diamond partner Scott McMillen as his chief technology officer, and brought aboard Steve Strasser, an Alliant sales representative, and Jeff Sturgeon, who had helped build Alliant-Link Direct. Within a month, TheSauce.com had 10 employees.
The new venture kept Silicon Valley hours — seven days a week, 16 hours a day. "The pace is the hardest thing, running everything in parallel all the time," Munck says. "Everything all the time, everywhere." Munck's new crew returned to restaurants in Chicago and Los Angeles to test and to refine the original concept. They started jawboning eateries and distributors about joining the network, and launched a sweepstakes to attract visitors to FlyInTheSoup. com. At the same time, they approached likely content providers, such as Cornell University's School of Hotel Administration, about building online continuing-education programs.
Back at Alliant, the transitional Web site went into beta test in September, as planned. The move to an open system already was bearing fruit. Alliant had brokered a deal with Premier Inc., a purchasing group representing 1,800 hospitals and already Alliant's biggest customer, to integrate its electronic commerce systems. Alliant customers who are Premier members will order from its online catalog through Alliant-Link.com, getting immediate confirmations and feedback on availability. Mason expects the deal will help lift Alliant's revenues from Premier from $500 million this year to $700 million in 2000.
But if fear is the first motivator for change, it also serves as a deterrent. There's still resistance to electronic commerce among some Alliant middle managers who fear the new order system — not to mention TheSauce.com — will cannibalize existing operations. "It's taken me a fair amount of time to explain to the marketing and sales- people why opening up to the Net is a smart thing to do," Mason says. "If you're a sales rep, you're worried about being displaced. If you're a market president, you're worried that we're going to be competing with ourselves. It's classic market conflict."
They're right to worry. At best, the Net will fundamentally change the nature of their work. At worst, their work will go away. Web-based ordering will allow rivals to match pricing and promotions as never before, even as it gives Alliant the opportunity to pursue new markets. It's hardly clear whether TheSauce.com will fly — but if it does, it someday could supplant a big chunk of Alliant's traditional business.
The alternatives, though, are far worse. Instill, already several steps ahead, is moving aggressively, acquiring new accounts and adding features to its system that, for example, help chains monitor their local purchases. "I tell people here that the customer is number one, and that our job is to serve them," Mason says. "If the customer wants to buy through the Internet, we have to make that happen. If we don't, someone else will. And we'll lose."
Keith H. Hammonds (firstname.lastname@example.org) is a Net Company senior editor. learn more about Diamond Technology Partners (www.diamtech.com), Clayton, Dubilier & Rice (www.cdr-inc.com), and Alliant (www.alliantboston.com), on the Web.
Sidebar: How to Make Your Oldco into a Netco
Seven rules for making the move from the world of old companies to the world of Net companies.
Learn by doing. You can't remake your business into an online wonder overnight. So it's important to seek out a few quick hits — easy chances to improve your operation and to learn about the Web. The Internet does offer opportunities for companies to create efficiencies — with order-entry systems or inventory management — in little time, without massive investment.
Invent a new sandbox. Building a truly revolutionary new Net company from within is usually impossible: The human and institutional barriers are too great. To enact a transformational online strategy, you'll probably have to create a new company, with separate people, offices, and funding.
You have money? Good. Spend it! Big companies typically have access to more capital than startups do. That's a key competitive edge in the online world. Intelligent spending can put you in the fast lane to the Net.
Eat your own — or be eaten. Any new Net venture will likely cannibalize all or part of your existing business. Your choice: Stick to the old model and risk having 100% of an obsolete market, or make your own operations obsolete. It is better to eat than to be eaten — even if you're eating your own.
Speed rules. (No, faster still!) Get used to it: The Internet moves at a much faster pace than your old-line business is used to. New products appear and die in a heartbeat. Strategies collapse overnight. Be prepared to think fast, to act on little information, and to change all the time.
Seek out new life forms. The Net will require skills and capacities that your old company doesn't have. Be prepared to hire new people, enter into partnerships, strategic alliances, joint ventures, and investment relationships with organizations that you've never considered working with before.
Failure is not an option. (But it is a distinct possibility.) The Net is a high-risk game, in large part because no one is sure what the rules are. Play to win — and be prepared to fail.