Read the Sidebar: (No) Exit Ahead?
Dan Case has learned to think like a prospectus. That would be a terrible insult to most sensible people, except that Case personifies the best attributes of those sometimes-dismal (and these days, hard-to-find) guides for investors — sharp and comprehensive analysis, an ability to see the broadest business landscape, a deep grasp of financial logic — and leaves the boilerplate behind.
Daniel H. Case III has spent his career working the intersection where fast-moving startups and big, established companies cross paths. A Rhodes scholar, Case was 34 when, in 1992, he became CEO of the fabled San Francisco-based technology investment bank Hambrecht & Quist, where he presided over some of the Internet economy’s most efflorescent IPOs, including Netscape’s and Amazon.com’s. In 1999, in a deal valued at $1.35 billion, he steered H&Q into the arms of financial-services giant Chase Corp., and he has managed to keep the investment bank’s interests front and center through the recent merger of Chase and J.P. Morgan.
Case recently stepped down as CEO of J.P. Morgan H&Q, though he retains his chairman’s title and continues to work part-time as he undergoes daily radiation therapy, following surgery to remove a malignant brain tumor on March 23. Three J.P. Morgan H&Q executives have assumed some of the responsibilities of the indefatigable Case.
In the interest of full disclosure, Case also happens to be the brother of another guy named Case, who is no slouch himself when it comes to innovation and value creation. Indeed, AOL founder and CEO Steve Case pulled off the biggest merger in history when his company acquired Time Warner in a deal valued at $104 billion. Dan plans to introduce his brother on May 3 as the luncheon speaker at J.P. Morgan H&Q’s annual technology conference in San Francisco.
In the prospectus that follows, Dan Case provides an intellectual public offering on strategy, growth, technology, and innovation.
Discussion and Analysis of Financial Condition, containing forward-looking statements that involve risks and uncertainties about whether the new economy is really linked to the old economy and just what is meant by the “real economy.”
I think that if you step back and look at which companies have grown fastest in the past five years — which ones climbed into the ranks of the largest in the world — the biggest single group is technology-related companies. The second-biggest group is companies that have done a good job of applying technology for competitive advantage. Those two groups will still be the top two contributors during the next five years. But the second group, the appliers of technology, is where I expect to see the biggest liftoffs occurring.
The new economy and the old economy are converging into what, for lack of a better phrase, we’re calling the “real economy.” The convergence is one of the major motivations for all sorts of strategic combinations and partnerships lately, including the deal between Chase H&Q and J.P. Morgan. We still think that technology is a growth business. We’re just saying that there will be more Wal-Marts this time around — companies that are brilliant at applying technology — and fewer pure-technology, mega-billion-dollar companies.
Every now and then, you get a significant structural change, such as the rise of the Internet. For all of the excesses of the Net, for all of the boom and bust, we still have value creation and company creation happening at twice the rate that those things happened when the PC industry took off. Use any kind of weighted average you want, but the chart for the Internet is still way ahead of the chart for PCs, and the chart for PCs is the biggest chart since semiconductors hit the same inflection point.
The following discussion sets forth the circumstances surrounding the mercurial nature of venture capital to fund innovation and asserts that there are still big opportunities in a downturn.
Lots of entrepreneurs are bitter about what they see as the spigot of venture capital shutting off in the past 12 months or so. But they’re assuming that the conditions that existed prior to the correction were appropriate — and they weren’t. So the bitterness may be easy to understand, but it’s probably misplaced. Let’s face it: The structure of the venture-capital financing process is more broken than it has been since 1984. And interestingly, the venture-capital problems in 1984 and 1985 came from excesses in PCs and semiconductors.
The mania around technology by financial markets is a time-honored American tradition that has been repeated with every major infrastructure wave in our history. A lot of money gets wasted, but America becomes a stronger place every time this happens. Think back to 1985. Sure, the failure rate among startups went way up. But some of the most important companies scaled fastest in that same period of time too. AOL, Microsoft, and Oracle broke away from their competitors when a downturn gave them a little bit of an edge in competing for people and money. There was less competition for talent and capital, and a less noisy market in which to send messages.
I think we’ve entered that phase again. Most industries, when they mature, become places where the middle dies. You either want to be at the top, as a full-service global provider, or you want to be a niche player — which can still be profitable. You just don’t want to get stuck in the middle. That will be even more painful in the next five years than it was in the past five years.
We went through that very phenomenon at H&Q, by the way. We made a series of strategic decisions in our firm in 1994. We believed that technology, innovation, and macroeconomic factors such as globalization, demographics, the spread of free markets — as well as the maturity of the entrepreneurial base — were all going to create a “cycle-skipping opportunity,” a period of prolonged entrepreneurial value creation and productivity gains, which has in fact happened. So we basically made a decision to bet our firm on the intersection of entrepreneurial activity in the capital markets, in areas characterized by innovation and structural change. And that has been an exciting, profitable, enduring — but also humbling — experience.
It’s humbling that the world of entrepreneurial finance outgrew one of the fastest-growing investment banks. It’s humbling that for all we were able to achieve, we did not have the global reach, the products, the capital, or the scale to grow with our great companies. So many companies, ones where we had a huge advantage of understanding them, their origins, and their people, needed to move on — or thought they needed to move on — to larger financial firms. I think that’s humbling.
Risk Factors I: If any of the following risks occur, involving people or leadership but not technology or capital, then business and financial conditions would likely suffer.
The most important constraint over the next five years isn’t going to be a slowdown in innovation or the absence of a big structural change like the Internet. The constraint is going to be people and their experiences and values. That’s where veteran entrepreneurs and angel investors have a very important role to play. And it gets even more important as venture-capital firms become larger and larger and lose their ability to work on small transactions.
The risk is that a generation of great technology leaders have never been this big before. They’ve brought their technologies this far, but now they have to build foundations for endurance. We call it “wind sprints in the marathon,” which means that sometimes you have to speed up, but you can’t ever slow down. The most important quality we look for as investment bankers is whether a company has a long-term, sustainable advantage and whether it has people with the will and the skill to execute against that.
Risk Factors II: That’s not all. There’s another big challenge.
The catch-22 that early-stage companies always face is that they must weigh the advantage of time to market against the risk of not building a strong enough foundation. The situation gets played out in almost every decision made: product completeness versus product breadth, distribution strategy, capital structure, geography. Entrepreneurial companies have to fight that trade-off all the time.
Risk Factors III: If you thought that was bad, read this — especially if you want to build a great company.
I worry that the Lego-construction-set approach to companies has gone too far and that human ability to adapt and change and build teams and own a culture — and to do that again and again, disconnecting and reconnecting — is reaching some kind of limit. If you look at the people who built great companies over long periods of time, they usually had great products and a great ability to spot the market. But what really made them scale was their unending commitment to finding and hiring great people who could work together — and their ability to take the long view.
There’s a generation of entrepreneurs that have made a lot of money, and we need to see how many of them will be motivated to contribute meaningfully in the period ahead. Basically, some of them have grown up in great times. We’ll have to see how many from that generation can endure. They may be too spoiled. I’m more optimistic about the ability of successful, older, rich guys to contribute than I am about the skills of the nouveau riche to endure. It’s like raising kids: If you spoil them early, it lasts for a long, long time.
Special Note Regarding Backward-Looking Statements
Certain events in the past, including but not limited to such milestones as the IPOs of Amazon.com, Apple, and Netscape, provide valuable perspective on how circumstances have changed. (NB: In the interest of full disclosure, Hambrecht & Quist served as lead underwriter for each of the aforementioned IPOs.)
Apple was the entrepreneurial leader of a new industry. The company was brilliant and early, but it forgot to broaden its markets and open up its technology, and it never got a leadership position in the corporate market. And, obviously, the guys who did that better — Microsoft on the software side, and Compaq, and later, Dell, on the hardware side — those guys won, while Apple failed to leverage its lead and entrepreneurial premium. It’s no mistake that the return of Steve Jobs brought entrepreneurial spirit, vision, charisma, and improvements to Apple’s products and marketing. It’s also no mistake that those weren’t enough in the long run.
Hardware companies can grow rapidly in a critical period of time, but over the longer term, particularly when standards emerge, value migrates to software and services. Any hardware provider who fails to understand that shift generally gets turned into a commodity — as happened in semiconductors and PCs. The next place it’s going to happen is in remote devices — personal digital assistants, cell phones, the stuff we carry around. Unless you’re always on the bleeding edge of hardware, the one who captures the software-and-services part of that trail is going to win. And when a standard emerges, that will be the catalyst for changing your game or being commoditized.
Netscape burst onto the scene and created not only a new industry but a new understanding. It became the vanguard, as Apple had done for desktop computers. Netscape did a brilliant job getting to the maximum number of people as quickly as possible. It had entrepreneurial vision and management skill, and it built a scalable business more rapidly than anyone ever had before.
Longer term, Netscape probably tried to do too many things. It tried to compete with Microsoft, and that is definitely a contact sport. It’s interesting that one small part of Netscape’s business — the membership community — turned out to be incredibly valuable to AOL. Even so, Netscape had all of this entrepreneurial capital. If it hadn’t had Microsoft gunning for it, it could have been far more successful. The lesson there is that if you are playing in the big leagues, you’d better finish first or second. The middle’s a lousy place to be.
Amazon had a clear understanding not only of a new industry and a new application but also of the changing capital markets that would fund a leader with a different model for profitability. And Jeff Bezos is a brilliant guy. He understood that doing one important thing well would let him do a lot more later — and history will soon judge whether or not he tried to do too much more later. He also understood, partly because of the early evidence that we showed him, that the ability to get big fast required a capital advantage.
But Bezos basically built the business model predicated not on short-term profitability but on long-term or terminal value. That was a huge advantage. Maybe Amazon stayed with that model a little too long. But I put myself in the category of people who think that B2C got overhyped and is now in the process of being overcriticized. I think the ultimate value of Amazon and other B2C leaders will be higher than conventional wisdom suggests today and lower than it suggested last year.
Use of Proceeds
The amount and timing of expenditures will vary depending on a number of factors, including whether big companies can avoid complacency and whether they can genuinely embrace change.
Clearly, there’s been way too much easy money and way too much value created that wasn’t going to endure, and the hangover that we’re going through will cause a serious headache, which won’t go away quickly. But it’s just a hangover. The level of innovation and value creation in the next up cycle will surpass what happened in the last one. But we’ll probably see fewer IPOs.
To the great legacy companies of the world, and to the more mature tech leaders, I would say this: Here is your big opportunity. Now that the stocks of new entrants are no longer shooting up, you have a cost-of-capital advantage again. And you have a treasure chest of innovation, both inside your company and available through partnering — if you can get at it. But history shows that most big companies are incapable of exploiting an opportunity this large. Their biggest problems often come from within. The only thing I can guarantee is that the entrepreneurs will be getting smarter, so you’d better get smarter too.
Read the Sidebar: (No) Exit Ahead?
Paul C. Judge (firstname.lastname@example.org) is a Fast Company senior editor. Contact Dan Case by email (email@example.com).