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


Focus and Scale on the Internet

But the massive complexity costs of collectively redesigning the critical interfaces among all the vehicle manufacturers and hundreds of suppliers swamped the anticipated benefits of economies of scale. As the Internet bubble burst, the auto companies realized that each of them worked with suppliers in different ways and had little desire to standardize, especially because each had the scale to develop its own Internet software tools independently. FreeMarkets then acquired the auction services business line of Covisint in 2003 before being subsumed under Ariba Inc. in 2004. Also in 2004, the collaborative software tools developed by Covisint were sold to the Compuware Corporation, which repurposed the software for a broader set of smaller companies that lacked the scale to develop their own tools.

So much for using the Internet to fundamentally transform the staid industries of the old economy. Maybe scale was not all it was cracked up to be.

Scale in Internet Retailing

But perhaps FreeMarkets and even e-marketplaces in general were simply flawed business models. Or maybe the business-to-business market suffers from too much inertia to allow a startup to succeed. After all, Amazon and eBay offer great models of success in the business-to-consumer (B2C) market, even though B2B mostly offers Internet failures.

True, Amazon, a “pure play” startup founded in 1994, has come to dominate online retailing. With $34 billion in 2010 sales, Amazon is 2.5 times bigger than the second-largest online retailer and more than 70 times the size of the 50th-ranked one. Although a powerful example, Amazon’s success needs to be put into context: Online retail sales account for less than 4 percent of total retail in the United States. So Amazon may appear to be a big fish, but it is really just a medium-sized fish in a relatively small pond compared with the ocean of total global retail. The next 10 companies on the list of the top 500 Internet retailers as published by Internet Retailer magazine all existed well before the World Wide Web came to our offices and homes, and have more sales in total than Amazon. Big-box office-supply retailers Staples, Office Depot, and OfficeMax take up three of those 10 slots. And although the online channel accounted for less than 1 percent of its total sales, Walmart garnered sixth place. Even the perennially troubled Sears made the top 10 by channeling 6.3 percent of its $44 billion in sales through the Internet. You have to drop to 12th place to find another pure-play online retailer, Newegg, a purveyor of computer hardware and software that was founded in 2001. Netflix, founded in 1997 and 14th on the list, offers another example of a company launched on the promise of the Internet. However, Newegg, Netflix, and Amazon are the only three nontraditional retailers in the top 25.

The vast majority of the pure-play startups that sought to dominate the mass market proved to be spectacular failures. One of the earliest flameouts, Value America Inc., offers a classic case of unbridled pursuit of scale. Founded in 1996 and funded by such heavyweights as FedEx founder Fred Smith and Vulcan Capital (the venture company of Microsoft cofounder Paul Allen), the company sought to sell anything and everything online. Value America used the deep pockets of its investors to buy full-page advertisements in USA Today. At the end of its first day of trading as a public company in April 1999, the company achieved a valuation of $2.4 billion; it filed for bankruptcy a mere 16 months later, in August 2000.

Webvan Group Inc. similarly sought to be a one-stop shop by delivering everything to the consumer’s door. Funded by a record-breaking $400 million in four rounds of venture capital financing, Webvan launched operations in Oakland, Calif., in June 1999. By the end of the year, it had raised another $400 million to initiate nationwide expansion in the form of 26 additional distribution centers, each carrying a price tag of $35 million. But revenues did not come as quickly as expected. Rather than meeting the projections to generate positive cash flow in five quarters, the Oakland facility was operating at less than 30 percent capacity utilization at the end of 2000. By the spring of 2001, Webvan was losing $100 million per quarter and its stock price had dropped from a high of $34 at its initial public offering to less than 30 cents. It shut down in July 2001, just over two years after it began online operations.

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