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Case Study: The rise and fall of Digital Disrupters

Case Study: The rise and fall of Digital Disrupters

FRAMINGHAM (01/17/2001) - At 2:30 p.m. on Thursday, Aug. 17, Mohnish Pabrai, smartly dressed in a black pinstriped suit with a blue-on-blue striped shirt and a solid blue silk tie, entered the Norcross, Ga., headquarters of CheckFree Corp., a provider of electronic billing software. In the previous 11 months, Pabrai, the founder and CEO of Digital Disrupters, had visited countless corporate headquarters and had given dozens of presentations about his business. By now, his delivery was flawless. He was passionate about what he was doing. He believed in his company, his business model and the future of the Internet. But today, he seemed dazed. This morning, he had found out that the presentation he was about to give in CheckFree's boardroom would be an exercise in futility.

Pabrai was in Georgia to try to sell CheckFree on an idea for a startup that would send bills to customers' e-mail addresses so that they could pay online. The new company would be synergistic with CheckFree's software business. That was what the 11-month-old Digital Disrupters did: It came up with ideas for new Internet businesses and then partnered with existing brick-and-mortar companies to bring them into being.

Pabrai was accompanied by Tammy Jo Long, Disrupters' vice president of partnering. Long noted that her boss seemed oddly subdued. What she didn't know was that while awaiting their delayed flight to Atlanta that morning at Chicago's O'Hare International Airport, Pabrai had received a voice mail message on his Nokia from Stephen Ricci, a venture capitalist with Cambridge, Mass.-based One Liberty Ventures. Ricci had called to inform Pabrai that One Liberty, an early-stage VC company that manages US$500 million in committed capital and has 50 companies in its portfolio, had decided not to fund Digital Disrupters. Pabrai had been counting on One Liberty for US$6 million, which had been contingent on him finding another US$6 million elsewhere. He hadn't been able to do that.

From O'Hare, Pabrai had called his assistant, Kim Felix, at their office in Downers Grove, Ill., and told her to schedule a staff meeting for 10 a.m. the next day.

In minutes, Long, sitting next to Pabrai in the terminal, got a call on her Sprint PCS from her assistant, Kathleen McLean, informing her of the staff meeting. She turned to Pabrai and asked him what the meeting was going to be about. "You'll find out tomorrow," he said.

He considered cancelling the CheckFree presentation but decided that would raise too many questions before he was ready to answer them. He needed time to collect his thoughts. So, with the shades drawn, Pabrai and Long plowed through all 20 slides in their PowerPoint presentation. When they finished an hour later, CheckFree's COO and its vice president of corporate development politely informed Pabrai and Long that the company was not interested. Pabrai apologised to the two executives, folded his laptop and left.

A(nother) Dotcom Is Born

Digital Disrupters wasn't the first company that Mumbai, India-born Pabrai had started. In 1990, he quit his job working as an engineer for Tellabs in Chicago and abandoned his master's thesis at the Illinois Institute of Technology to launch TransTech, a systems integration company. Pabrai funded TransTech with US$30,000 from his 401(k) and US$70,000 from credit cards. By 1999, it had grown to 200 employees and US$30 million in revenues. But after nine years with TransTech, the thrill was gone. (Pabrai sold TransTech to Kurt Salmon Associates, an Atlanta-based management consultancy, in October 2000.) What he really wanted to do was work for investment guru Warren Buffett at Berkshire Hathaway, the gazillionaire's holding company that operates Geico Insurance and See's Candies. He wrote a letter to Buffett and asked him for a job. Buffet turned him down, saying he didn't need anyone; Buffett liked to work alone.

To stave off ennui, Pabrai took a class in February 1999 at the Harvard Business School. The class was taught by Clayton Christensen, author of the business bible The Innovator's Dilemma. "It was very interesting," says Pabrai of Christensen's theories on disruptive innovation (simply put, companies should invest in technologies that threaten their current business models), "but I put it in the back of my mind. At the time, this whole e-business thing was happening. There was a lot of talk about the new economy and startups, and I decided to get involved."

That spring, Pabrai set up TransTech's e-business practice. One of its clients, Chicago-based Cole Taylor Bank, was struggling to understand the Internet. While explaining how the bank could take advantage of the Web, Pabrai recalled Christensen's advice and advised the company to spin off a separate Internet bank. So intrigued was Cole Taylor with Pabrai's proposal that the bank's CEO asked him to help set up the new company.

"This wasn't a problem that TransTech could solve," Pabrai says. "It wasn't an IT problem; it was a strategic problem. I knew we needed to set up a new company that could help old-line businesses start new [Internet-based] companies."

Digital Disrupters was born.

Pabrai dove into his new business. He funnelled US$1.8 million of his own money into Disrupters. While searching for a CEO to replace himself at TransTech, he also set out to find a CEO for Cole Taylor's Internet play. He thought of Craig Dean, who worked in the Bank of America's private equity group. The two were members of a networking association, the Young President's Organisation (Pabrai is 36 years old; Dean is 40). In May 1999, they met for lunch where all of Chicago's traders eat, at the Rivers Restaurant in the Chicago Mercantile Exchange. Over mahimahi, potato soup and salad, Pabrai asked Dean for his insights on the banking industry.

The two men met again in Pabrai's office at TransTech and spent a few hours hashing out the business plan for the first new company Disrupters would launch: Thebizbank.com, an online bank that would serve the needs of small, local businesses. Pabrai asked Dean if he wanted to be CEO of the new bank. Dean accepted and began working full time in August 1999.

Meanwhile, Pabrai hired a strategic consultant for Disrupters and recruited three TransTech employees who he thought had good business instincts.

"The work was very exciting and very high energy," says Pabrai. "We were trying to figure out where to go next, how to scale and how to hire a bunch of people. People would work until 10 or 11 o'clock at night."

In September 1999, Pabrai refined the business plan. Disrupters would make its money when the Internet company it helped launch became liquid. In other words, either when the company went public or was bought or acquired. Given the hot IPO market and the general e-euphoria in the autumn of 1999, Pabrai figured he'd be able to get liquidity on these new companies within six months of their inception.

That same month, now with eight employees, Digital Disrupters moved to the third floor of 1901 Butterfield Road, a spacious, elegant building in the commercial suburb of Downers Grove.

In this swanky new office, with its trendy furniture, Disrupters launched an aggressive direct-mail campaign targeting the CEOs of Fortune 1000 companies with its message: You need to invest in disruptive innovation, and we're just the ones to help you.

Pabrai and Long began crisscrossing the country, meeting with two or three companies every week, spreading Disrupters' gospel of disruptive innovation and "driving them through the funnel," as Pabrai describes the process of transforming leads into partners.

One such lead that blossomed into a partnership was with Itasca, Ill.-based insurance brokerage Arthur J. Gallagher & Co. Gallagher was interested in using the Internet to find new ways to sell insurance and open new markets, according to Michael Cloherty, the company's executive vice president. Disrupters and Gallagher partnered to develop BigCover.com, an online insurance broker for small businesses. BigCover.com launched on April 3, 2000.

Disrupters also set up a partnership with Appleton Papers, a paper manufacturer based in Appleton, Wis., to develop an online exchange, PaperHub.

Pabrai's team was constantly coming up with new ideas for e-businesses, but the company's reserves were dwindling. Even with the assistance of Disrupters' partners, it was taking an awful lot of cash to start and sustain these companies. It was time for Pabrai to put his business plan to the test and canvas the venture capital community in search of more money to create more new e-businesses.

Nothing Ventured

In March 2000, Pabrai's goal was to raise US$10 million in funding. He thought it would be easy. After all, he had three Fortune 1000 companies backing his ideas; the VC money was flowing (from January 1999 to September 2000, venture capitalists had invested more than US$73 billion in 4,727 Internet startups, according to San Francisco-based venture capital research company VentureOne Corp.), and startups, especially those with funky and unusual names, were still hot.

Indeed, Pabrai had a lot of interest from investors. Between February and June, five venture capital companies signed tentative agreements to back Digital Disrupters. Things were looking good.

Then things began going bad.

The Nasdaq came to a screeching halt in April and again in May as investors began to evaluate the inflated valuations of tech stocks vis-à-vis their actual performance-just as Pabrai was trying to line up meetings with investors.

"A year ago, the world was so enamoured of new business models and almost any manner of new dotcom offering. But since April [2000], the tide has been going out. Investors' first response has been to put capital aside to protect those entities that are already up and running before they think of funding something new," says Ricci.

Udayan Gupta, editor of Done Deals: Venture Capitalists Tell Their Stories, a compendium of essays on the VC world, says that before the crash, entrepreneurs didn't have to translate their ideas into value in order to get funding. The VCs were backing innovation rather than execution. But the Nasdaq correction changed all that.

Gupta says VCs are being more diligent about what they put their money into. And that's why they didn't put it into Disrupters.

"If VCs are not investing, it's because they aren't convinced there's a way for them to achieve a certain kind of return," says Gupta. "Disrupters got hurt because people started scrutinising their investments a lot more."

When Pabrai's plan came under the VC microscope, investors had trouble understanding what Digital Disrupters was all about. Was the company an incubator or accelerator, like Andover, Mass-based CMGI or Englewood, Col.-based ICG? Or was it an e-business consultancy, like San Francisco-based Scient or Boston-based Viant? The truth is, Digital Disrupters' model contained elements of both.

It didn't help that incubators and accelerators fell way out of favour after the Nasdaq nosedive. ICG and CMGI, Digital Disrupters' closest public proxies on the Nasdaq, saw their shares topple from highs of US$165 to US$35 per share and from US$200 to US$131 per share, respectively.

The consulting models also took serious beatings. "[The consultancies'] initial growth was incredible," says Gupta, "but when they didn't deliver, and when people started seeing chinks in their armour, investors said that they would stay away from any model that looked like that." And of course, Digital Disrupters did look like that.

Another problem with Digital Disrupters' model, at least in the eyes of investors, was that it wasn't truly unique.

"There's nothing distinctive about what it did," says Gupta. "What was it providing that's different? A consulting business-isn't that what it boils down to?"

Ricci, on the other hand, believes that what distinguished Digital Disrupters from other incubators were the services it provided, the innovative thinking. "The value that it was creating was almost purely from the intellectual side, whereas many incubators create value through the expeditious delivery of real estate, legal services or recruitment services," says Ricci.

Further validating Pabrai's basic idea were the partnerships recently announced between Accel Partners, a major Palo Alto, Calif.-based venture capital company, and KKR, a giant New York City-based private equity company, and between Kleiner, Perkins, Caufield & Byers, Menlo Park, Calif.-based venture capitalists, and Bain & Co., a Boston-based management consultancy. Like Digital Disrupters, these alliances created new e-businesses through partnerships with Fortune 500 companies.

Even Gupta agrees that the idea of partnering with an existing brick-and-mortar company was smart. "A strategic partnership means [to VCs] that someone has looked at your product, that someone has looked at your strategy and that someone has validated it," he says.

But in spite of the strength of Digital Disrupters' ties to Cole Taylor Bank, Arthur J. Gallagher and Appleton Papers-all established companies-other flaws besides its lack of a defined model made VCs wary of Pabrai's enterprise.

Pabrai's most problematic assumption, as it turned out, was that he would be able to take these new companies public within six months of their creation and would therefore need only about US$500,000 each to sustain them until that happy day. But once the IPO market dried up, liquidity became an ever-retreating mirage. The cost of keeping these businesses going began to approach US$5 million to US$10 million each.

By the beginning of August, four of the five investors who had signed term sheets agreeing to fund Digital Disrupters had pulled out. The only one that remained was One Liberty.

Certainly, investors had backed out before then, but Pabrai says he persisted because someone else was always interested and ready to put up money.

"I thought, once this money came in, we would have time to go to another set of investors to get the additional money we needed," says Pabrai. "I assumed the capital was going to come in, so I executed full blast. I shouldn't have done that."

Endgame

On the flight home from Atlanta, Long brooded over CheckFree's dismissal of their proposal while Pabrai pondered the fate of his company.

By the time he got home, he had made up his mind. He drafted a letter to his shareholders and to The May Report, an online bulletin featuring news about Chicago's technology sector. After 11 months, Digital Disrupters was shutting down.

On Friday, Aug. 18, Pabrai held his last staff meeting at Digital Disrupters. He explained to his 20 employees the core flaw in his business model: The new companies needed a lot more money to start than he had thought. Digital Disrupters, he said, had only US$600,000 in cash left-not enough to sustain itself for another week. Not enough for even another day. Effective immediately, the company was closing down. He told "the best, most talented group of people" he had ever worked with that they would be paid only through the end of the day. There would be no severance. Then he apologised.

And that was that.

Pabrai says he was extremely disappointed and depressed. He felt like a failure. He felt badly for his staff. He felt that he had "taken their stability away." He posted their résumés online, Asked if he'd ever invest his or his client's money in Internet startups, Pabrai says, "Never." connected them with head-hunters and let them use the offices at Digital Disrupters to make phone calls and type up their résumés and cover letters.

Pabrai turned to the Young Presidents Organisation for advice. The members encouraged him to play to his strength. So these days, Pabrai is working out of Digital Disrupters' old offices on Butterfield Road doing what he loves most: investing.

Through the Pabrai Investment Funds (www.pabraifunds.com), he is working hard to become a billionaire by the time he's 60 (he's already worth north of US$10 million) and make his clients equally rich. He has 22 clients and manages more than US$5 million in assets.

Asked if he'd invest his or his client's money in Internet startups, Pabrai says, "Never. It's a gamble, and I don't want to gamble."

After the Fall

The dotcoms that Digital Disrupters started and how they're doing now Thebizbank.com. If it doesn't get sold, the first company that Digital Disrupters launched with Cole Taylor Bank will likely be shut down because of complicated regulatory issues governing online banking.

BigCover.com

Arthur J. Gallagher decided not to go forward with the venture after the CEO Digital Disrupters found for BigCover.com had to quit after back surgery. According to Michael Cloherty, Gallagher's executive vice president, the dotcom did not further the company's strategic goals.

PaperHub

The online exchange formed by Digital Disrupters and Appleton Papers has raised US$1 million in seed capital and is pursuing another US$6 million in its first round of pre-IPO funding. This may become Digital Disrupters' only viable startup legacy.

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