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 / Summer 2011 / Issue 63(originally published by Booz & Company)


Focus and Scale on the Internet

The next wave of online business models must focus narrowly, rather than blindly pursuing scale.

During the early days of the Internet, popular wisdom highlighted the power of the new virtual business model that could reach a mass market without the bricks-and-mortar constraints of the “old economy.” Venture capitalists threw money at the lucky startups and encouraged them to get big fast before competitors could gain a foothold. Operating strategies were all about “scalability.” Although that model worked fine for a few companies, like Amazon and eBay, it proved a dead end for most. Today a simplistic approach built around mass markets and scalability is a near-certain recipe for failure.

That’s not to say that we won’t continue to be amazed by growth phenomena — like Facebook and Google — that expand quickly by creating fundamentally new business models. But most Internet businesses are simply offering a new twist on an old business idea and, accordingly, seek to displace existing companies. No longer expecting every new idea to transform the old economy, entrepreneurs (and even venture capitalists) are beginning to realize that scale is the result — not the cause — of business success.

A careful look at some past successes and failures as well as a few emerging Internet stars reveals that a clear focus on distinct capabilities has led to success. And, perhaps surprisingly, the old model of mass-market scalability is being turned on its head by a new local focus. Instead of using the virtual nature of the Internet to reach a geographically unconstrained mass market, new companies are building distinct capabilities at a local level to attract loyal customers. Those capabilities — not scale — provide the barriers to entry that allow these companies to outperform their competitors. Much as in the old economy, leading Internet businesses are gaining scale by replicating their success rather than pursuing scale as the key to success.

The Fallacy of Scale in B2B

An examination of “B2B e-marketplaces” — a class of early Internet companies that sought to transform business-to-business transactions — demonstrates the fleeting value of scale and the virtual enterprise. Consider FreeMarkets Inc., founded in 1995, which offered to save companies up to 15 percent on their purchases through the use of online auctions. FreeMarkets used the Internet to help its clients tap a broader range of suppliers and create more competitive market dynamics through real-time feedback showing the latest price reduction. Over the course of a few hours, the clients confidently discovered the absolute rock-bottom prices by pushing every supplier to its “walk away” point. The traditional methods of issuing requests for quotes, then conducting multiple rounds of negotiations with a narrow list of candidates, took far longer and often left money on the table for the supplier to claim. The success FreeMarkets achieved led to a December 1999 initial public offering (IPO) that raised nearly US$200 million at a stock price of $48 per share. By the end of the opening day, the price had skyrocketed to close at $280 per share, which valued the company at a staggering $8 billion, despite its having revenues of only $13 million in the first nine months of that year.

Not surprisingly, the big industrial customers using the online auction services of the startups concluded that owning a B2B e-marketplace could be worth even more than the savings from the auctions. General Motors Company, which had accounted for 17 percent of the revenues earned by FreeMarkets during the nine months prior to the IPO, announced a consortium with rivals Ford Motor Company and Daimler-Chrysler AG just months later, in early 2000. The new entity, Covisint, would offer online auctions to its members and would also automate information sharing and a host of transactions among the Detroit Three automakers and their suppliers. The virtual scale of FreeMarkets was quickly trumped by the actual scale of existing players.

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