The New VCs

Just what the impact of such liquidity will be on industry is considered by a growing number of economists to be one of the great mysteries in economics today. Whatever their hypotheses may be, no one doubts that the economy's abundant cash flow is bringing vast changes to American business.
And no sector, perhaps, already bares a deeper thumbprint than consulting, where the internal mechanisms are being forever altered. The traditional time and materials model, where consultancy cash flows trot along a linear path — cash in as receivables, cash out as salary and bonus — is history. The allure of equity has cast a furious spell on the profession, causing firms that only six months ago operated as single integrated entities to quickly morph into multiple ventures all or partly owned by the partnership — with each partner angling for their share of IPO riches.
"If you look at [how we're] creating new operating companies that are focused on a certain part of technology, and what we have done with AC Ventures — consulting hardly describes what we do anymore," says Joe Forehand, CEO of Andersen Consulting, the '90s consulting juggernaut that now appears to be morphing into a band of jointly owned companies.

So, just what has Andersen been up to? First, there was Avanade, the Internet services company jointly owned and operated with Microsoft Corp.; then came ePeopleserve, a human resources technology company jointly owned with British Telecom. Next came an "eProcurement" venture with Sun Microsystems, Inc., whose goal is to conduct more than $200 billion of indirect procurement business by 2004.
Later this year, look for the creation of a giant application services provider (ASP) in partnership with another giant telecom player, followed by the formation of a new Web design and creative services firm — the culmination of multiple AC Ventures transactions and investments.
So, how many ventures does that make? Would you like Andersen to draw you a picture? Using a pen and a sheet of lined paper, Jack Wilson, the partner in charge of AC Ventures, sketches the firm's morphing consulting model using clusters of small and large circles. The biggest one, located in the center, he labels AC.
"The vision that we had was to really try to expand the footprint of Andersen Consulting in the market, and the question was really whether we can change and adapt to a new workstyle and different way to motivate our people," says Wilson, who left Andersen's mother ship late last year to head up a fund that's now expected to be bumped up $500 million from its original $1 billion allotment. (See Wilson Q&A, page 21).
When asked about the future, George Stalk, a senior vice president with the Boston Consulting Group, spends little time discussing the performance of the firm's various current practices.
"Next year, you will see multiple entities all or partly being owned by BCG, and there will be fairly intimate relationships with industry participants like banks and technology platforms. There will be new relationships among BCG and clients and other people — so it operates more like a keritsu," says Stalk.

Have Andersen and BCG been drinking each other's Kool Aid? Maybe, but Booz-Allen, Bain, Mercer Management, and Deloitte Consulting appear to have enjoyed a sip or two as well, as have smaller consulting outfits such as The Parthenon Group.
Asked to describe what he envisions his firm will look like in the future, Parthenon CEO William Achtmeyer draws a sketch remarkably similar to Wilson's. "Years from now, I would hope that you find Parthenon with a very strong and healthy advisory business, but also owning several entities with a hold in a variety of markets," says Achtemeyer, who describes one of the inked-in circles as a joint venture with a U.K. merchant bank.

The game begins with a question

Welcome to the crowded world of venture consulting. No longer satisfied to be hobbyist investors, consultancies are vastly enlarging their venture funds, opening business incubators in all parts of the world, and taking stakes in giant joint ventures — all measures destined to make them powerful new players in the equity game.

It's a game that routinely begins with consultancies asking themselves an age-old question.

"As part of our planning process this year, we actually did a serious evaluation of the question as to whether we wanted to go public or not, and the answer was 'No'," says Booz senior partner Chuck Lucier, touching upon a subject Booz management has until recently minced few words about. "We don't want to service outside shareholders," is the pat answer the consultancy's management has routinely dispatched to investment banks ever since the mid-1970s, when it went private after seven bumpy, publicly traded years.
Last year, when the market capitalizations of various little-known but fast-growing e-consultancies soared beyond anyone's wildest expectations, Booz management, along with that of most every other strategy firm, decided that it was time to revisit the question.
"If the valuations for these firms held up, there was some concern that they could well do [in the consulting sector] what AOL did to Time Warner," explains Booz's Lucier. "Ultimately, we couldn't see the game-changing acquisition of a Scient that would [put us at risk] in the marketplace," he says, naming the e-consultancy perhaps more responsible than any other for driving the bifurcation of the consulting sector. Once Scient's market capitalization reached the lofty multiple of $10 billion, consulting firms suddenly found themselves being relegated to New Economy and Old Economy encampments.
BCG's Stalk says that an "AOL Time Warner" type of deal became more believable when a number of e-consultancies began shopping for strategy capabilities.
"Some were rather frank about the fact that they had tried to build a BCG-/McKinsey-like strategy capability and just hadn't been able to scale it up fast enough to keep up with the [Web design] part of their business, and so one of the reasons they were interested in speaking to us — and I'm sure they were speaking to McKinsey as well — was that we were already scaled up," says Stalk, who indicated that the discussions never advanced very far.

Old Economy strategists at risk

In the meantime, Booz, Andersen, BCG, and others have all quickly assembled Web services units with the idea that they could someday soon be spun out and subsequently cashed in by selling shares to the public.
Asked about the risks associated with spinning out a Web services venture now that Wall Street no longer seems as enamored with the e-consultancies, Lucier replies: "If the market goes down, it's conceivable we'd buy the whole thing and bring it back in, because at some point market value is going to be made on much more of an earnings basis like a normal firm, and you lose the advantage of having the venture valued as a huge growth property."

Not unlike so many of their Old Economy clients, the profession's most prestigious strategy firms have often appeared at risk because they continue to be associated with the Old Economy — where more often earnings, not growth, determines market value.
"If you look at the Ford Motor Company stock price, it is really a function of the Old Economy, and the fact is that the idea is to move way from the public model, because there are parts of Ford that should be public and parts that should be private, and in today's economy the parts that should be public are high growth areas. The same goes for BCG, where the mother ship should benefit from any New Economy valuations of its ventures, and the position of those ventures in the stock market becomes the currency we use to attract new talent," explains Stalk.
To get a better fix on its own market valuation, BCG in the last year retained an investment bank to look at IPO possibilities, but determined that such a transaction would fail to generate a high enough stock price to adequately reward the firm's partners.
Booz's Lucier concurs: "To do an IPO well, consultancies can't just share the proceeds with the partners. You have to hold a lot of the shares for those people who are three to four years away from making partner, and when you do that, it's obvious there isn't going to be a big windfall for today's partner."

As for BCG, the firm's best-paid partner owns only about 1.7 percent of the firm, according to a number of the consultancy's senior partners. Shares of ownership have traditionally been directly proportional to a partner's accumulated income divided by the accumulated income of all partners.
In the course of the firm's history, certain BCG partners allegedly saw their shares peak at about one percent, but the ownership stakes on average now fall well below that as the consultancy continues to add new partners.

A suite of equity offerings

To help create more financial instruments, certain firms have recently begun looking to distribute shares of ownership to consultants other than partners. In fact, at Booz, the firm's CEO, Ralph Shrader, has vowed to rework firm by-laws that currently limit ownership of Booz stock to the firm's partners. Meanwhile, to help better motivate and manage its people, Booz earlier this year introduced a shadow stock program.
"At our recent partner meeting, we started the process of beginning to change the way our people think about their annual compensation, because our expectation is that a significant chunk of their compensation going forward will be dealt in the form of stock and equity positions much more than it is now," says Lucier, who explained that although Booz's partners had rejected the idea of taking the firm public, sharing equity is now paramount at Booz.

In the future, Booz partners and staff will enjoy not only equity in their own firm, but what Lucier calls "a suite of equity offerings," including participation in IPOs from future spin-offs (such as the firm's Web services group) and options granted to the firm by clients in exchange for fees, plus equity inside some of the firm's newly incubated businesses. So bullish is Lucier on the outlook for equity-based programs that he predicts that before the close of the decade, half of the wealth Booz partners generate for themselves will be tied to equity.
In addition to taking equity in lieu of fees, consultancies are exploring or have already begun investing a percentage of their partners' income. "While the IPO numbers aren't very attractive unless you got a very high sustained growth rate … we discovered that if you play with consultancy cash flows a little, you can excrete quite a bit of facile capacity," explains BCG's Stalk.
More to the point, Stalk says: "If 300 partners take a five or ten percent cut in pay, that's a lot of money to play with."

The intersection of consulting and venture capital

Just where consultancies are now investing that money varies from firm to firm, and while rewarding their best people with equity may have initially been the primary purpose, it's clear that recent market developments led consultancies to make investments design to expand and protect client relationships. Nine months after Nasdaq's tumble helped close the e-world saga's first chapter — one in which money was cheap and dot-com start-up opportunities plentiful — chapter two is now being written by the global 2000 — the big corporations that have long been the bread and butter of consultants.

To move their fortunes into the e-world, the large corporations (often dubbed the "incumbents") have been pursuing various transactions, including spinning out their Internet assets into stand-alone ventures and acquiring dot-com pure plays — some of which, perhaps, are presently being nurtured within consultancy incubators. It is this flurry of activity that has led the VC community to extend its reach beyond its cartel of dot-com pure play companies and grasp a more sizable chunk of the incumbents' mushrooming business ventures.
In the last year, as more consultants discovered VCs walking the halls of their largest clients, it became clear that the worlds of consulting and venture capital had finally intersected. But not everyone was certain how the two worlds would come together, and incumbent clients have sometimes needed to learn the limits on the different services VCs provide.
Today, consultants and venture firms appear to be working closely together on two fronts. The first is in incubating new businesses, and the second is in the area of corporate spin-outs, where incumbent companies have sometimes looked to move their Internet assets into stand-alone ventures — sometimes called "carve-outs." In both areas, the territories of the new partners appear to be only roughly defined, causing some overlap of services between the two and at times a sense of competition.

The incubation opportunity

"These VC firms and incubators are pretty small companies, but they get huge play in the press, and people started to think that these companies, which have only 100 people or 200 at most, were somehow starting to compete with McKinsey. That's fine, but we hire more people a year in our New York office than some of these companies have in total," says McKinsey senior partner Dick Foster.
For its part, McKinsey has already opened close to 20 incubators that are designed to turn what McKinsey calls "cocktail napkin" concepts into operational businesses. The incubators, dubbed "accelerators" by McKinsey, are today an estuary where the ideas of bootstrapped entrepreneurs and creative incumbent clients find nourishment. McKinsey is not alone. Andersen, Bain, Booz, BCG, and almost every other top consultancy have over the last year made a mad dash into the incubation business, opening centers in all parts of the world.
Numerous venture firms and digital incubators, such as Internet Capital Group (ICG) and CMGI, have already scored big dollars by incubating businesses that can be sold to the public in half or even one-third the time it normally takes a typical VC firm. In exchange for a stake in a venture, incubators normally provide a roster of services that might include anything from technology development to office space to legal and accounting services.

Given their strategic planning capabilities, access to talent, and an army of incumbent clients eager to spin off fledgling ventures, the consultancies at first glance appear to be well suited for providing menus of start-up services. But the entry of consultancies into the incubation business may have been ill-timed. Incubators that went public before 2000, including CMGI and ICG, have seen their stocks slide as much as 80 percent from their highs, and Wall Street is now feeling the pinch of taking companies public before they're ready. With more start-ups running out of cash, big losses and write-offs seem inevitable.
The downturn may be making certain consultancies look to share the risks. For instance, while Andersen has tentative plans to own and operate incubators jointly with Softbank Venture Capital, Booz plans to partner with different venture firms in each quadrant of the world.
"We talked to nine or ten VC firms, and we liked Softbank the best. First, because they have already run incubators. Second, because we liked their people, and third they have a lot of money, and they saw we have a lot of deal flow and money — but not quite as much as they have," says Andersen's Wilson, who describes AC Ventures itself as a spin-out from Andersen — one that after only 11 months appears to have found it legs in an increasingly competitive market.
"One of the questions our partners are now asking is, 'Why do a deal if we can't put $10 million in it?'," says Wilson, who admits such thoughts would not have occurred six months ago. He adds: "I don't want to spend my time with a company where we own .04 percent of it — it's not worth it. I'd rather spend our time where we own ten percent."

A new brand of capital

So far, the venture community seems very willing to welcome consultancies into their deals, given the menu of services they can offer their clients, but there are limits.
"I think there is a place for consulting firms here, and it's one that we value. But if they were to go off and try to lead deals to the exclusion of venture firms like ours, I think they'd find that they just don't have the experience needed, and they'd find themselves less welcome into our other deals," says David Cowan, a managing general partner at venture firm Bessemer Venture Partners.
The entry of consultancies into the venture business is not necessarily all good news for VCs, however. The valuations of many start-ups have remained high due to the mushrooming amounts of money that continue to chase deals, and naive investors end up jacking values up for the smart ones. Conventional market wisdom states that the last ones into the VC craze will likely be some of the first ones pushed out. But the consultancy "newcomers" offer that which is normally only available from top-tier VC firms: branded capital.
"Our capital says something very different from that of a top-tier VC. Our brand endorsement says that there's a fundamental business rationale here," says Bob Bechek, a director at Bain & Co., who today heads up Bainlab,  the consultancy's incubator.
"Since this role is so new, people do not always perceive the different nuances. This is not advisory, and it's not venture capital. It's something in the middle, and it's about bringing our value-add to bear on venture-stage companies," says Bechek, who believes that the "branded capital" which consultancies bring to venture stage companies vouches for the integrity and economics behind the business plan, while a VC's capital says that the management team is top-tier and the valuation is savvy.

"It's more important than ever to try to engage outside experts in crafting the strategy of these companies, because it's no longer the case where a venture investor is sitting only on two or three boards and can spend all day long working with entrepreneurs directly," says Bessemer's Cowan.
McKinsey's Foster concurs: "There's some law of nature that says if you are sitting on a dozen boards, they will all meet the same Wednesday afternoon. Some people have thought that this system would allow for the ultimate self-generation, but I don't think that's case. I think there are real limits — VCs do have limitations."

The carve-out competition

More of those limitations have become visible, perhaps, as the VCs dedicate a greater portion of their business to working with the incumbents or Fortune 1000 businesses.
One short-lived partnership that underscores the challenges VCs face when working with large corporate clients was between Toys"R"Us and venture firm Benchmark Capital. When announced in April of last year, Benchmark hailed it as the first in a new type of venture that would allow traditional corporations to tap into the magic of Silicon Valley entrepreneurism. Under the terms of the deal, Toys"R"Us spun out its on-line business into a stand-alone venture partly owned and operated by Benchmark. The deal fell apart only four months later, with both partners resorting to finger-pointing.
"What we can't afford as VCs is to be a consultant to large corporations," Benchmark general partner Robert Kagle told The Industry Standard upon the deal's demise.
"It turns out that consulting firms have a lot more experience and much deeper networks in their circles than venture firms do, and so we find a lot of value in keeping up with the management consultants who have that rich background in advising Fortune 1000 companies," says Bessemer's Cowan, who expects that his firm will gain some added strategic muscle later this month, when it expects to announce a far-reaching agreement with a large management consultancy.

Bessemer had better not hesitate. A variety of alliances among venture capital firms and management consultancies have already been struck. While Bain & Company hooked up with venture firm Kleiner Perkins Caufield & Byers and a number of partners from buyout firm Texas Pacific Group early last spring, Boston Consulting Group elevated the partnering concept to the next level, perhaps, when this June it formed a company with venture firm General Atlantic Partners and investment bank Goldman Sachs. All three partners own equal stakes in the $300 million venture that is today known as iFormation and is led by the former head of BCG's e-commerce ventures, David Pecaut.
"It's interesting that we've been searching for what the correct word is here, and we still need to find the language — it's really a New Economy booster or a general contractor for the New Economy," says Pecaut.
Meanwhile, venture firm Accel Partners and Kohlberg Kravis Roberts & Co. (KKR) this summer convinced McKinsey to join their jointly owned company as a "strategic advisor." Among their early quarry is none other than McDonald's Corp.
"There has been a tremendous amount of work going on now on the incumbent side over the last year, and while KKR certainly has access to capital, what we bring to this relationship is deep global vertical knowledge of the different industries. … Neither KKR nor Accel have what we have," says McKinsey's Foster.

Still, consultancies are not taking a singular path.  McKinsey's venture dealings appear limited to its consulting-for-equity practices, and the firm's management says its efforts are designed to serve only as an "enabler" to its advisory. On the other hand, BCG and its new partners appear ready to blaze a trail that could redirect the flow of opportunities for both the consulting and the venture worlds.
"With a partnership, there is a limit to how much capital consultancies are going to be able to raise from their partners, and we saw this opportunity getting bigger, not smaller. And so the thought was, how do we do this on a bigger scale?, and, how do we do this in way that would be commensurate with what we do in the consulting business?", explains Pecaut.

The pendulum of liquid rewards   

Back at Andersen, William Shipley expects his first allotment of e-units to show up any day now. Having changed jobs within the firm nine months back, he is now involved in the day-to-day operations of one of the firm's 24 "accelerator" launch centers.
"Given where I am now in the firm, I spend a lot of time with start-ups, and I actually have tried to introduce a few companies to AC Ventures," says Shipley, who views his career now as having a foothold in two worlds — consulting and venture capital.

Sidebar: PowerPoints:

• Last year, as market capitalizations for upstart e-consultancies soared, BCG, Booz, McKinsey, and others explored the idea of selling shares to the public.
• The traditional time and materials business model has been cast aside by most consulting firms as they look to augment their employee earnings with new, equity-driven rewards.
• Many firms are quickly morphing into multiple ventures all or partly owned by the firm's partnership, with each partner angling for their share of IPO riches.

Anderson's Venture Lord

CM: Why was it important that AC Ventures be a stand-alone business?
Wilson: Andersen had been in consulting for 25 years, and at the first meeting we sat down and we purposely told everyone that we are not a global consulting company — we were not going to have that overhead structure or the business processes — AC has a 75,000-member workforce, we have 35 people. We had to consciously be very careful not to take the business processes of a very large business consulting firm and smother a little tiny VC start-up fund.

CM: How is Andersen's approach to taking equity different from other consultancies?
Wilson: People who do consulting for equity, their primary motivator is moving forward in their core business, and that's what McKinsey is talking about. AC Ventures invests cash — we have a ton of money, much like a venture firm, so that's a very different thing. I think both of these things are here for the long term. On the venture investing side, everyone wanted to get in the VC game because it looked so lucrative, but what they don't realize is that everything runs in cycles. You don't have to go back very far to find a time when the venture capital guys were making a reasonable income, but it wasn't about getting a Ferrari a month.
 
CM: Did Nasdaq's March tumble impact your investment strategy?
Wilson: As far as the impact of Nasdaq goes, what we see is that midpoint valuations for start-up companies have gotten more reasonable — that's good for us, because that's where we invest. So, you look at the correction, and what I think came out of that is that the appetite for good, solid companies is even higher now, because the market is trying to differentiate them. Now, we've had three of our companies IPO since the correction. The least successful of them doubled in three weeks. Blue Martini was priced at 20, closed the first day at 54. So we are lucky, and now that some of the clutter is gone, we expect they'll be performing even better.

CM: How quickly are you advancing your investment strategy?
Wilson: Prior to last November, we invested about $33 million, and then from November to August 31 we moved about $175 million. We started out with a target of $100 million, and that took us only about six months — that's really not that fast
compared to how some of the VC firms move money, but they move it in big bites — bigger than ours. So, we increased our target, and September 1, we took the next slice of our available $275 million. We're probably growing faster than the total VC market is growing.

CM: How much are you looking to liquidate relative to how much you plan to invest?
Wilson: We liquidated more last year than we ever invested, so we're operating cash-flow-positive. This year, we're liquidating 3.5 times what we're investing. So the impact on the partners is substantial, and as far as I can see it, we'll be cash-positive forever now. And where did we start? Well, we started with Siebel, where we bought ten percent of the company for a clearly modest amount. It's been public for a number of years and we can now liquidate pieces of our Siebel investment and generate lots of income.

CM: What's the average-size investment you make in a company?
Wilson: One of the things that we'll be doing this fall is taking a bigger bite out of these companies. Our average investment when we first rolled this out was about $1.5 million. We're now beyond that because we've been doing $4 million and $5 million and even $10 million. So, the average is now up to $3.5 million and pushing $4 million. We are going to have to work very hard to get the average to $10 million. We have about 40-something-odd investments today of $3.5 million average. So, to get to an average of $10 million is going take some hard work.