The <I>TSC</I> Streetside Chat: Bill Ford of General Atlantic Partners - TheStreet

William E. Ford, 38, is a general partner at General Atlantic Partners, one of the most respected and profitable venture capital firms in the U.S. General Atlantic, founded in 1980, has a $6 billion portfolio of about 80 public and private companies, including stakes in online broker E*Trade (EGRP) and priceline.com (PCLN) , the well-known e-commerce company. The firm has been fabulously successful; its $14.4 million investment in E*Trade garnered about $500 million, and its $30 million ventured in priceline.com is valued at about $1 billion. Based in Greenwich, Conn., the firm is in the midst of a growth spurt designed to transform it into a global player. It has recently added several new general partners and one huge limited partner, insurance giant American International Group (AIG) - Get Report, which has committed $1 billion over five years to GA. AIG will aid GA's expansion in Asia. Ford joined GA in 1991 from Morgan Stanley Dean Witter, where he was an investment banker specializing in technology. He chairs AG's investment committee, which currently has $4 billion of capital to invest in the next five years; he also sits on the boards of E*Trade and priceline.com. He sat down recently with TSC Chief Markets Writer Brett D. Fromson to chat about the investing landscape from the vantage point of a VC. They discussed E*Trade and the online brokers, priceline.com, the recent technology IPO boom and bust and the roles played in the melodrama by Wall Street and VCs.

Fromson:

What does the stock market look like from your point of view as a venture capitalist?

Ford:

I think you have to start with the backdrop -- instead of the benign interest-rate environment we've had for years, we are going to have an environment where we're not necessarily going to have flat-to-down rate moves. I think

Alan Greenspan

has a real commitment to slowing down the economy. That's a very different backdrop than we've had for four or five years, where there's been some rate increases, but they've been modest. They've been sporadic; they haven't been consistent. That changes the whole equity market landscape.

Number two, in the realm of technology companies and growth companies, what's gone on over the last 90 days is very deceptive for two reasons: one, the big-cap names -- the

Nasdaq 100

(QQQ) - Get Report

, the

Ciscos

(CSCO) - Get Report

, the

Oracles

(ORCL) - Get Report

-- they're down, but they're not down a lot. So it seems calmer on the surface. But it's turbulent underneath if you look at the smaller-cap stocks. If you look at $10 million caps and under, $5 million caps and under, $1 million caps and under, you're talking about a 50% to 75% decline. So, most portfolios out there have been ravished. You've seen the business-to-commerce and the B2B down 70% plus. And so I think that

TheStreet.com's

public and

The Wall Street Journal's

public might not fully understand how deep the damage has been to the mid-cap and smaller-cap names.

"It was a market that was so excited about the prospects of the Internet and the 'New Economy' that it was not selective in terms of business models, management teams or valuation."

Fromson:

What do you think that damage means for investors in tech going forward?

Ford:

In a very, very short and collapsed period of time, you had a dramatic downward revaluation of the Internet stocks, and a lot of the exuberance or excitement is gone. But I think it sets up, in a very positive way, a much more selective market.

What we had really for two years at least -- 1998 through March of this year -- was a nonselective market. It was a market that was so excited about the prospects of the Internet and the "New Economy" that it was not selective in terms of business models, management teams or valuation. What has happened in the last 90 days is the washing out of that. Going forward, we will return to a lot more of the investment fundamentals we've always thought about, which is how good is the management team, is there a business model and when will they be profitable?

There is no question that the public market was effectively investing in venture capital-stage companies for the past 12 months. The rules of proven business model, revenue traction, even a quarter or two of profitability, all those standards that set the bar for a company being ready to go public, dropped dramatically. It reached its low early this year when companies you could only characterize as early-stage venture capital risk-type companies -- with unproven models, barely at revenue, significant operating losses and without any clear path to profitability within the next two to three years -- were taken public.

Traditionally, in venture capital-stage companies, only two out of 10 get to go public. Instead, we were seeing eight to 10 of those companies going public. That was the danger for the public investor. There were venture capital-type risks being placed on the public investor. The danger for the public investor was if you tried to select a single company, it was very easy to get it wrong.

Fromson:

Is the bar being raised back up?

Ford:

Yes, definitely. And it's about time.

Fromson:

Let's talk about one of your company's biggest IPOs in recent years, E*Trade. What's the outlook for a company like that, particularly since we've seen a decline in trading volume since the crash in tech stocks?

Ford:

We understood that the stock was always going to be a leveraged play on the market because its business relies on a strong equity market and strong retail investor confidence to drive its trading activity. And so it's always been a leveraged play. But the company is doing extremely well in that it had a great quarter last quarter. The online banking business is starting to really gain ground.

Fromson:

What is the nature of its online banking?

Ford:

It's consumer banking. They bought

Telebank

, a unit of

TeleBanc

(TBFCP)

. We bought, for 13% of E*Trade, Telebank, which was the leading online banking company in January. What we want to be able to do is offer a consumer brokerage and a consumer banking business, so that customers can move their financial assets between the two. Then E*Trade went out and bought the largest independent ATM network -- 9,000 ATMs -- and that will give them 15,000 ATM machines, which are now going to be branded

E*Trade Bank

. It becomes the mortar for their strategy -- not to buy any branches, but

for customers to use E*Trade ATMs to make deposits, and use their E*Trade bankcards.

Fromson:

To switch money between bank and brokerage accounts?

Ford:

To switch money, or access the ATM network if you just need to get cash. But it's a reason for you to put more of your assets in the E*Trade family. Right now, if you've got a

Chase

(CMB)

bank account, you'll pull money out of E*Trade and put it in the Chase account. But not for long. And, by the way, our rates on bank accounts are literally twice the national average. We can afford to do that because there's no cost structure. It's all electronic.

Fromson:

Is this FDIC insured?

Ford:

Yes, it's fully insured. Telebank was a fully functioning regulated bank. I mean, we had to go through the OTS

Office of Thrift Supervision to get approved. The whole thing is a fully regulated, fully insured bank.

"If we start seeing a six-month, nine-month down market, you will start to see more washing out of the retail investors in the marketplace."

Fromson:

Getting back to the brokerage business, what kinds of declines have you seen in trading by your customers?

Ford:

Volumes are down. There have been about three dips since the company went public in '97. Basically, volume in a down market is roughly two-thirds of volume in an up market. You might think that people trade in up and in down markets, but the reality is not even close. If the average volume was 200,000 trades a day in a steady market, which is about what it is, in a down market there'll be two-thirds

that number. In a market that's trending down for a successive period, it'll be two-thirds. If the decline goes longer, volume might be half of the steady-state volume. If we start seeing a six-month, nine-month down market, you will start to see more washing out of the retail investors in the marketplace. I think right now they're still active, but less active.

Fromson:

How do you manage the business then, when, on the one hand, you have to be able to handle massive volume when people want to invest, and on the other hand, you don't want a giant cost structure in slow markets that's just going to eat you alive?

Ford:

Well, this is the power of doing it electronically. The cost structure is all just boxes; it's computers. The only cost you have to add on is for customer service. But the rest of it, you can scale up and scale down pretty quickly.

Fromson:

So is E*Trade currently scaling down?

Ford:

Senior management has been paranoid for a long time about this kind of environment. They've been through it in a smaller way. Only half the company's revenues are from transactions. They make a lot of money on interest on cash balances. So the strategy has always been that we have to get ourselves away from being 100% reliant on trading activity.

So the first thing you do is broaden the services you provide customers in such a way that you're more insulated. Now, about 50% of revenue comes from customer trading, which is down from two years ago, when it was 70% to 80%. There is a corporate services group, which is basically stock option administration, and other things like that to create more recurring revenue to balance what we knew would always be a very volatile revenue stream. The second thing they've done is to be tougher on costs. Looking at an environment where B2C companies were rewarded for running losses and building market share, we were able to scale the market with $100-plus million per year in advertising. We can scale that down.

Fromson:

You look for them to cut their ad budget?

Ford:

Yes, I do, and I think they'll do it because you don't want to be aggressively advertising for an online brokerage account in a very negative environment. Why waste the money? People aren't going to react to it. In a bull market, they're highly reactive to it.

Fromson:

How is the company doing on a reported basis?

Ford:

On an operating net income basis, they broke even last quarter. In the second quarter of '98, E*Trade did roughly 55% gross margins and 15% operating margins. I've said all along, I think that it can generate 50% to 60% gross margins, and 15% to 20% operating margins with a steady-state cost structure.

At that point in time,

E*Trade CEO

Christos Cotsakos

came to us and said, "The competitive intensity is picking up, and now is the moment we need to go for market share. And be much, much more aggressive working on our marketing budget." And number two, he said, "We're being penalized by the public market by virtue of having profits right now. We're not perceived to be a growth B2C company, so we're going to literally change our operating strategy to go for market share and trash our operating model."

This was 1998. General Atlantic made this investment in E*Trade in '95. We've worked years to get ourselves to this target operating model -- 50% gross margins, 15% to 20% operating margin. We worked really hard to get it there. We got it there, and we're growing 50% a year. We went from roughly 12% to almost 16% market share.

Fromson:

Who are your primary competitors?

Ford:

Schwab

,

TD Waterhouse

,

Datek

, a little bit of

Fidelity

, and

Ameritrade

. But Schwab's the number one player. Schwab is low 20s in market share. We have gotten to a place where we have almost 3 million customers, where we can turn down the ad budget and get back to 15% operating margins. And growth will probably slow back down to 35% to 50%, and that's pretty darn good. Over top-line growth has been 50% to 100%.

Fromson:

And top-line growth?

Ford:

Last year, we did something like $700-$800 million of revenue. We did over $400 million in Q1 this year. I think we'll do $1.2 billion this year. The stock has been hit hard, however.

The stock corrected really late last year and early this year, and it's been in a $20-$30 range for almost six months. Down from an all-time high of $47.

"What we tried to do with E*Trade was to scratch, claw and gain market share into the critical mass so we would have a brand, customer service and scale to survive when the inevitable shakeup came post-bull market."

Fromson:

What is the future for E*Trade? Will it remain independent? Won't we see consolidation in the industry? Do you expect consolidation?

Ford:

Yes, we do. In the big picture, what we tried to do with E*Trade, and I think we just barely got there, was to somehow scratch, claw and gain market share into the critical mass so we would have a brand, customer service and scale to survive when the inevitable shakeup came post-bull market. We always assumed that the major competitors were going to be the off-line branded financial services --

Merrill Lynch

, Fidelity,

Vanguard

,

American Express

and

Citigroup

-- the brand names in financial services who could come into the market, leverage a huge existing brand, and, for those bold enough to cannibalize part of their existing business, be formidable competitors and take a big share of the market. I'd even add Chase to this.

The only firm that did that was Schwab, and Schwab, by aggressively being willing to cannibalize the traditional phone-based business model and put at risk an $80 trade for a $30 trade, reinvented their business, took the number one market share position, and they're an extremely formidable competitor.

Fromson:

So where does that leave E*Trade?

Ford:

I think we are there now that we have a billion-plus of revenue, 3 million customers, a more diversified revenue stream, a very strong brand.

"... companies like Ameritrade, Datek and others don't have a chance. There's going to be a huge shakeout. They'll be merged either into off-line players ... or they will be merged into other online competitors like E*Trade."

Fromson:

You think you can hang on?

Ford:

I think we have a shot. Having said that, I don't feel like we've made it by a mile. I think we just made it. I think the companies like Ameritrade, Datek and others don't have a chance. There's going to be a huge shakeout. They'll be merged either into off-line players, who want to get online accounts, or they will be merged into other online competitors like E*Trade. There are some decent market share points floating around. I mean 8 to 10 share points for Ameritrade. Even Datek is 5 to 7 share points.

Fromson:

Why should an off-line player buy? Why not just build an online presence themselves?

Ford:

I think two things. First, the cost of acquisition is high. It's anywhere from $250 to $500 per customer. E*Trade's got a very effective customer acquisition capability, roughly around the $250 level. New entrants have come in and routinely had to pay $500 to $1,000 per customer, and they've had to establish credibility with their online offering. Second, what's the value of time and marketing? I think you will have people come in and say, "Hey, I'm better off buying XYZ competitor for $1,500 an account because I get the market right now, and for me as a noncredible Net player it's $1,000 bucks anyway to start acquiring accounts." It's also acquiring accounts in critical mass.

Fromson:

Could you have a hostile bid, or would these have to be friendly deals?

Ford:

Most of these companies are so closely held I think it would be virtually impossible to do a hostile deal. Ameritrade is closely held. Datek is a private company. And the others have a huge percentage held by insiders. So I think they're going to be friendly deals, but I think what could easily happen is that some of those who don't have the scale of an E*Trade or the brand of an E*Trade may start saying, "We need to sell. And we're going to have much more realistic expectations on valuation."

Fromson:

How can E*Trade do an acquisition with the stock price having been cut in half?

Ford:

It will be tougher. When we had the

high stock price currency, we were able to buy Telebank by only giving them 13% of our company. And that was because we were operating with a $35 to $40 stock price and trading at somewhere around, I think, five or six times revenues. We used that high-priced currency to do a number of acquisitions that diversified the revenue stream. Today, we trade at roughly three or four times revenue, and we don't have the currency we once had. Having said that, I think seller expectations have come down, as well.

"I think that the traditional brokerage firms are hamstrung by their retail brokers."

Fromson:

And what about the traditional brokers whose stock prices have not been cut in half?

Ford:

If I had to handicap it, I would still say I think that the nonbrokerage financial services firms are the more likely to buy into online brokerage space.

Fromson:

Meaning who?

Ford:

The

American Expresses

, the Chases. I still think that the traditional brokerage firms are hamstrung by their retail brokers. If you look at the

Dean Witter

organization, if you look at the

Smith Barney

organization, all of them are just absolutely panicked about alienating those retail brokers who have been the source of profitability for this whole up-cycle in the stock market. And I still think that's the case. And so they all understand the importance of doing it; they've all taken defensive steps. Morgan Stanley has

Discover Brokerage

.

Merrill Lynch

has announced an online offering. It's the ones with the big armies of retail brokers that have been defensive. The senior managements know they needed to go up and talk to them, but they have felt that they just can't do it.

Fromson:

Their brokers would be up in arms.

Ford:

Up in arms, and their brokers are the source of huge profitability for them. The brokers are the ones who are still foisting $500 trades on the retail customer.

"Basically, the entire institutional base is gone, sold out and replaced by online e-tail. And so there's no real mass behind the shareholder base."

Fromson:

Let's turn now to priceline, another one of General Atlantic's companies.

Ford:

There's an interesting story. priceline went public at $16 a share just over a year ago. Within 60 days, it was trading at $140 a share. And

some very negative consequences came from that. The stock was propelled there very quickly after the offering. The stock traded at $60 a share, I think, by the first day closing, or something in that range. But from that point, online retail carried the stock to $140. Basically, the entire institutional base is gone, sold out and replaced by online e-tail. And so there's no real mass behind the shareholder base.

Fromson:

No big institutions?

Ford:

No.

Fromson:

They flipped it?

Ford:

Yes. So, what ends up happening is the stock rides its way down literally from $140 through a couple of successive plateaus, down into the mid-50s. The decline

occurred entirely on the basis of not having any institutional shareholder base and having relied on online retail and not being a well-understood company.

Fromson:

And obviously, not a load of support from the underwriters?

Ford:

That is correct. The underwriter was

Goldman

. They did not do a great job.

Fromson:

Because?

Ford:

They took their fees and just didn't support the stock in the aftermarket. This is the story of Wall Street today. No longer is it the old model of, "I'm an agent who advises the company in a long-term relationship, where the investment bankers are trying to help build a company and help it succeed." It's, "I want to hook this stock, get my 7% underwriting fee, get my league table credits and move on."

That's the reality. There's very, very little aftermarket support, aftermarket capital commitment, aftermarket research sponsorship. Look at the economics of the investment banking business from their point of view. They get 7% investment banking fees, say $7 million on a $100 million deal. They make a fortune trading the stock in the first year. If you look at who's the primary

Nasdaq

market maker on the stock for the first year, he's making a fortune trading the stock. He's likely going to pick up some M&A business because there are so many small, fractionalized companies that have been taken public and will need to either merge with someone else or do a secondary offering to survive.

Fromson:

Let's get back to priceline.

Ford:

So priceline goes down during this time period. We make every quarter. We introduce rental cars -- we're about to add

Avis

(AVI)

and

Hertz

(HRZ)

, too. I mean the business is performing well. We make every quarter. We add

Dan Schulman

, who ran the consumer business for AT&T, to the management team. We add

Heidi Miller

, from

Citigroup

(C) - Get Report

. This company is doing well. So anyway, they announce fourth-quarter results that were literally 40% ahead of Wall Street expectations, and the stock climbs back up to $90 at the peak in March, the Nasdaq peak. A lot of good institutional names come back into the stock. People are finally starting to understand the uniqueness of the business model and that priceline will be one of the clear leaders. We will be profitable by the first quarter of next year. All that stuff is understood.

Then, what ends up happening is the stock market goes into its tailspin, and the stock gets crushed from $90 back down to $50. This is despite a lot of institutional interest, despite the fact that the company had a great March quarter, and despite

that fact that their telecom product, which they launched in Q1, is also booming.

Fromson:

That's the name-your-own-price for long-distance service?

Ford:

Yes. It seems like it would be a strange product, but listen to this: You take some lower general demographic customers who spend an hour a month calling Colombia to call their family, or calling Mexico, and they're getting absolutely ripped off by AT&T. You go to priceline and say, "I want to pay 10 cents a minute to call Mexico and I'll buy 60 minutes." We're saving consumers a ton. They're lining up and we're making 40% gross margin. So it's a great product for the consumer and a great product for us. We're just going out to the vendors -- and there are hundreds of telecom vendors -- and saying, "Wanna do business? Line up." They all have excess capacity. They all have to compete for the business. They're simply not willing to stand aside and let someone else take market share.

Fromson:

What's the future for priceline?

Ford:

We are leveraging the supply of new customers in all of our companies. priceline is the one I feel -- five years from now, when the dust settles -- will be among those left standing.

Fromson:

As a big, profitable giant?

Ford:

A big, profitable, successful Internet business, and I would

say it has a unique business model that was not possible without the Internet. In terms of new commerce models, it's more in the customer-management category. Like

eBay

(EBAY) - Get Report

, priceline is a business model that was entirely enabled by the Internet, and I think those are the ones that are going to be interesting in five years.

"Well, there are two comments: One's motherhood and apple pie, and one's maybe more self-serving."

Fromson:

If you are a VC, which you are, and your base in the stock of the companies you take public is pennies, do you really care how the stock does after the IPO? After all, you have already made a fortune.

Ford:

Well, there are two comments: One's motherhood and apple pie, and one's maybe more self-serving. The motherhood and apple pie is that at the end of the day what gets us all jazzed and out of bed in the morning is not just making the money. What excites us is helping participate over the long term, helping build a market leader. We start from the view that if we help them achieve that, our returns will take care of themselves. Just like if I was fortunate enough to have invested in

Microsoft

(MSFT) - Get Report

at pennies a share and I participated in building it, then I'd want to own that stock for a long, long time.

Fromson:

Now give me the more self-serving rationale for caring about how the stock trades in the aftermarket.

Ford:

It's virtually impossible to get significant liquidity quickly in these stocks. You're locked up for at least six months post-IPO. Volume limitations effectively cap the amount of shares you can sell in any given quarter. If you have someone on the board, which we always do, you are subject to these 144 limitations on insiders. Your windows of opportunity to sell are extremely limited. And so, though it may seem like VCs can liquidate instantaneously, at the

expiration of the lockup, the reality is it takes many, many quarters even if you want to get out.

Fromson:

I've heard that when the lockup period expires some VCs get out ahead of the crowd by a back door, by distributing shares in the company to their limited partners at the very time they are selling theirs.

Ford:

We do not distribute shares back to our LPs. What some other firms do is, instead of having to sell the shares in the open market, they distribute the shares, instead of cash, back to the limited partners.

Fromson:

So, if I'm a somewhat cynical and greedy VC, the lockup ends, the stock is at $60 a share, that night I send a letter to my LPs saying that I'm making a distribution. I could have carved it all up, maybe even sold my 20% portion of the investment and given the other 80% back to the LPs in the form of shares?

Ford:

You could. We don't. It doesn't mean we don't sell -- we've been very smart about getting our capital back to our LPs and managing the risk -- but we don't do it in a way that damages the company. We do it slowly.

Fromson:

I can see how it would be tempting to do that. I sell my shares today and give you stock. And then when you sell over the next week or whatever, the stock gets hammered and I am long gone.

Ford:

Those kinds of games can be disastrous for a company because instead of a coordinated process of selling, managed by one firm, working through several brokerage firms, you probably sent stock out to hundreds of pension funds.

Fromson:

And no one wants to be the last guy to sell.

Ford:

They sell immediately in a panic. It's extremely destructive to the companies, because they can't control it, and the Wall Street analysts are saying, "Why aren't you managing this? What's going on? What's the bad news?" And they have no control.

Fromson:

But this kind of stuff does go on.

Ford:

It does. It's a dirty part of the business.

Fromson:

Are VCs required to disclose their policy on this?

Ford:

No. It's one of the reasons why people who read

TheStreet.com

play these lockups. They know what can happen when the lockups expire.

Fromson:

What do you make of Wall Street "buy" recommendations made just as lockups are expiring?

Ford:

This is often research to help get investment banking business. These recommendations are often inversely correlated with what is really going on. They're at maximum bullishness when a company has produced great results looking backwards. And they're at maximum bearishness when a company's stock has gone down.

"The institutional investors are now sophisticated enough to know ... when they are getting really good information, helpful information, and when they're not."

Fromson:

How do you view Wall Street research?

Ford:

It's part of the investment banking business. Why is

Mary Meeker

at Morgan Stanley paid $7-$8 million a year? She's paid it because she brings in investment banking business, not because she's made institutional investors a lot. I mean, the institutional investors are now sophisticated enough to know, to filter through, when they are getting really good information, helpful information, and when they're not.

They listen to Mary Meeker on, say,

Amazon

(AMZN) - Get Report

, because she's got a great in with

Jeff Bezos

, and she's going to get tipped if the company is going to beat the quarter. They want to have a good relationship with her to get that shred of information, not because they need her judgment on whether to buy, sell or hold. But I do need her judgment if she gets a whiff of a quarter that's going to be missed, or some change in the business. I want to be the first to know. So I'm going to pay her trading fees to make sure, because I know on some set of companies, she is the ax.

Rick Sherlund

at Goldman was always that way on Microsoft. He always had the inside word from

Bill Gates

.

Fromson:

Who is the ax on priceline?

Ford:

Mary Meeker would be one.

Fromson:

How many of the Internet plays survive and prosper?

Ford:

One weekend, I sat there and looked through a list of 400 to 500 publicly traded Internet companies -- B2B, B2C, infrastructures, services, the whole ball of wax -- and literally all of them have gone public during the last three years. I wanted to see how many really good businesses there were.

Fromson:

What did you find?

Ford:

Being fairly liberal, I'd say there's probably 50 to 75, maybe 15% that are really quality companies that have outstanding prospects for the next three to five years. Not a lot of them. There are just so many that had no business going public. We had this incredibly ebullient market. The bankers showed no discipline, and the venture capitalists were funding anything that moved and shoveling it into the public market.

Fromson:

What are some of the names you spotted? Let's exclude the ones General Atlantic owns.

Ford:

Right. Well, I think

Inktomi

(INKT)

is a great Internet infrastructure company. It's embedded across most of the different Web sites and search engines.

DoubleClick

(DCLK)

is another. It has leadership technology, strong management and a unique business model.

Proxicom

(PXCM)

and

Sapient

(SAPE)

are two strong companies -- Internet professional services firms with strong management teams, global position, and they have executed well over many quarters. eBay. I think very highly of eBay.

Fromson:

Amazon.com?

Ford:

I've gone through multiple full circles on Amazon. The reason I like it is that Amazon is the premier customer management company on the Internet. They provide the best customer experience. They've set the bar in terms of how to manage customers, how to interact with customers, and they've leveraged their 13 to 15 million customers across multiple product categories. I still have some issues around their gross profit structure and their business model, but I think they can solve all that. I think they can outsource big chunks of their operation and focus more on how to create the premier Web experience for 15 million people.

Fromson:

Now what happens to the other 85% of Internet companies?

Ford:

I think that there's going to be significant merger and acquisition activity. There were far too many companies created by our venture business.