The legendary investor, Warren Buffett, once reportedly said that he would ask in an exam (for a business valuation course) how much an Internet company is worth - and then flunk anyone who gave him an answer! Because according to him, there was no logical answer! So he and his funds have kept away from the dotcom world of investment. Perhaps in hindsight, after the massacre of the Internet stocks at Nasdaq and their plummeting valuations one would tend to agree with the philosophy of this savvy investor.

The past couple of years had seen the dizzying "dot.com" valuations. It was normal for dotcom's to go in for a first round of venture capital funding of $400 million to be topped off with $2 billion as in the case of Webvan, the online grocery store, with no practical revenue channels. Currently, the market cap of this company falls far short of $2 billion. Same is the case of Peapod where investors have pulled out of their plan to provide $120 million to back it. Closer at home the acquisition of IndiaWorld, an Internet portal company, by Satyam Infoway at Rs. 499 crores. Considered a watershed in the history of acquisitions in India this investment decision is expected to brew trouble in the long run as valuations were not based on tangibles and is almost entirely based on expectations about the future.

Infact in India, with dotcom (Internet) companies adopting different valuation practices, the Securities and Exchange Board of India (Sebi) has referred setting out accounting standards for the valuation of dotcom companies to a sub-committee of the regulator's Accounting Standards Committee. The committee is expected to study three dotcom related issues gross or net revenue to be given final accounting, basis for revenue recognition (particularly things like mutual promotional tie-ups) and pre-paid/intangible assets vs period costs. The focus is to be only on the accounting aspects of the dotcom companies and the financial disclosures to be made. Recognition of revenue and whether it is to be on gross or net basis is a major area which will be focussed on, as at present valuations of these companies' shares depend a large extent on their revenue models and streams.

So what was the rationale of these sky high valuations and how come this rationale does not seem to work today? Valuations of traditional companies is based on tangible assets. The valuation methodologies were based on factors such as discounted cash flow, price earnings multiple and market value to book value. Then came the age of intangible assets with things like brands etc, being valued. So one included intellectual capital (intangible assets), brand equity and the like in the valuation exercise. But then came along a company which had no factory, no distribution, no product-just that BIG IDEA?! So how did one value him? And why did one lend him a ear?

The why part is easy to answer- The market viewed the new internet technologies as a completely new infrastructure -- perhaps the railroads of the 21st century which would redefine the way people bought, sold, lived, worked etc. There was a clear consensus that digital technology is here to change the way we conduct business and the way we live. The importance of the digital revolution could not be undermined. It redefined consumer power who could , at the click of a mouse, access information for decision-making and interact easily. The new economy with no clear rules or leaders saw one thing definitely, that intermediaries who did not reinvent themselves would perish. So the result was unpredictable the promise was alluring. But then why such high valuations? The new "big Ideas" did not lend themselves to classic models of valuation with discounted cash flows based on risk, balance sheets, assets and liabilities. The emerging world of Internet-enabled business was so nascent that it was inherently difficult to predict the timing and quantum of future cash flows.

So the new age "dons" simply invented new formulas based on which they sold their web dreams. Eyeballs, page-views, hits, mindshare, number of ad impressions, presence of a subscriber base and potential e-commerce related revenue streams were the new bewildering formulas on which valuations were to be based. The high market capitalization of these ventures was justified on the basis that potential revenues were higher than projected due to were more visitors than predicted. These mistakes were further compounded by valuation of e-commerce sites and portals deriving its value by comparison with other Internet ventures, through the use of multiples such as price/revenue, price/unique visitor or revenue generated per unique page view. What everyone forget in their frenzy was the fact that the Internet is only an enabler.

The impact of the Internet is more on business processes rather than on the objective of business itself. Simply put, buyers need goods or services and the Net serves as an alternative medium for them to communicate between the buyers and the market. They also forgot the basic laws of greed which say that a winning formula will be replicated and replicated and replicated………… Barriers to entry in cyberspace are very low. What these dotcoms did not pay much attention to was the distribution and logistics angles of business - which are important at least for delivering goods and products, if not services. Here the brick-and-mortar companies had an advantage with distribution infrastructure in place.

So think of the net from two angles, one as a medium of distribution and secondly as a medium of information disbursement-like the TV, magazines etc. So where did the revenue generation fit in. Traditionally information disseminators like magazines and TV draw revenues from advertising, so that was one revenue generating area. But then the old economy information disseminators are very focused and address select audiences who are clearly defined, constantly researched, and communicated to media buyers. But the websites seemed to try to appeal to all at one time, thereby losing their focus. Also the differentiation levels were very low and unlike in print media, content had not become king. As a medium of distribution, it was the case of who would bell the cat first. With everybody providing everything free who would be the first ones to charge for a service. Plus the service back ups in terms of product, availability, distribution, technical glitches sorted out etc. all had to be put into place, before a clear leader emerged. Simply a vast subscriber base is no indication of a leader-the loyalty of that base, plus the ability of a website to shield against potential replicators would indicate a leader in the making.

A research report in the US revealed that only only 40 per cent of the dotcom companies break-even in the third year. This basically means that 60 per cent of them do not even meet their expenses even after three years of commercial operations. So finally when the "potential" revenues did not change into actual –the investors got jittery. Now the market has progressed to a second generation of valuations where the markets are expecting finer justifications --revenues to be generated, revenues to be translated into profits. The venture capitalists are now redefining the formulas to separate the men from the boys. Performance pressure is now the mantra that is being chanted by the start-ups and their funding partners and unless the promoter shows that he is able to cope with it there is no moolah for him. Now the matrix for success is not just based purely on ideas. The spirit of entrepreneurship blended with business acumen is the grid-work on which valuation is based. The entrepreneur in a promoter is still valued, but what is valued more is the fact that he should be capable of executing it - with revenue generation playing a key role.

Perhaps with the internet now being a little more clearly defined in terms of its end use the dotcom valuations will be forced to incorporate some formulas of traditional valuation like discounted cash flows, intrinsic strength or exclusivity of a website leading to intellectual or proprietary service rights. And the brand value of a website. Although Internet economy companies such as Amazon.com, America Online Inc, Cisco, eBay Inc, Yahoo Inc, Realnetworks Inc, ETrade group are still registering phenomenal CAGR's and Yahoo finding a place in Standard & Poor's 500- the question is now loud and clear-"Show me the money"-as said by Danny De Vito.

Aru Srivastava

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