Reputation Building and Performance: An Empirical Analysis of the Top-50 Pure Internet Firms
Suresh Kotha Shivaram Rajgopal Mackenzie Hall, 353200 University of Washington Business School Seattle, WA 98195 Tel: 206-543-4466 Fax: 206-685-9392 Email:
[email protected] and Violina Rindova Robert H. Smith School of Business University of Maryland Van Munching Hall College Park, MD 20742 Email:
[email protected]
April 2000
_______ All authors contributed equally to this paper and are listed alphabetically. We thank our research assistant, Anu Wadhwa, for assisting us with the data collection.
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Reputation Building and Performance: An Empirical Analysis of Top-50 Pure Internet Firms ABSTRACT This study examines the relationship between three types of reputation building activities-marketing investments, reputation borrowing, and media exposure--and firm performance using a sample of Top-50 pure Internet firms. The study addresses a question of paramount practical importance about how the strategic choices of Internet firms affect their performance in both financial and product markets. The finding suggests that reputation building activities may be one of the key determinants of competitive success for Internet firms. At the same time, it raises questions regarding the longevity of the impact of such activities.
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Reputation Building and Performance: An Empirical Examination of Top-50 Pure Internet Companies The Internet has emerged as a new medium of economic and social exchange. It has sparked a variety of new business models for offering products and services that rely on interactivity, direct exchange of information between sellers and vendors, and virtual co-presence. These novel business models have led experts to argue that the Internet will become so pervasive that in the near future every business will be an Internet business (Grove, 1996; Economist, 1999; Hamel & Sampler, 1998). The market valuations of Internet companies seem to be aligned with similar visions of the future: Companies such as Amazon.com are valued in multiple of their revenues despite the proverbial absence of profits. The absence of profits invites critics who warn that the Internet has provided the basis for relatively few sustainable businesses (Gates, 1995). Both the optimists and the skeptics have good reasons: The Internet has created a new opportunity set for attracting customers and delivering to them products and services. It is also riddled with uncertainty originating in the novelty of the medium, and the changes in information flows it enables (Hof, 1999). Novel customer interfaces and distribution mechanisms require that consumers learn new behavioral patterns or that they, at least, adapt their existing ones to the new Internet medium. Previously non-existent types of businesses (e.g., reverse auctions by Priceline.com and Mercata) have emerged and have profoundly altered the boundaries of industries (Economist, 1999; Hof, 1999). The lack of physical constraints intensify the rate of competitive entry and with it, the proliferation of technological and consumption choices. Under conditions of such uncertainty, potential exchange partners experience greater transaction risk with regard to the actual quality of the product or service that is being exchanged (Akerloff, 1970; Klein & Leffler, 1981).
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Firm reputation is an important uncertainty reducing mechanism in such environments. A firm’s reputation summarizes its past strategic actions (Weigelt & Camerer, 1988), and enables other market participants to assess its strategic type (Weigelt & Camerer, 1988), or identity (Fombrun, 1996). Based on these summary beliefs, market participants feel less uncertain about the future actions of the firm, and are more likely to engage in resource exchanges with firms with established reputations. Due to this effect of reputation on market behaviors, various researchers increasingly view reputation as a valuable asset (Barney, 1991, Fombrun, 1996; Shapiro & Varian, 1999). For example, Dierickx and Cool (1989) and Barney (1991) point out that corporate reputation are among the few resources that can give firms sustainable competitive advantage. It is a source of competitive advantage because it is non-tradable, non-substitutable, non-inimitable, and rare (Barney, 1991). Reputations are rare because they are unevenly distributed. Unlike standard measures of performance (e.g., ROA and ROS), reputations include implicit comparisons between a firm and its rivals or of the firm with a general standard (Goode, 1978). Reputations are imperfectly imitable because firms acquire them through socially complex interactions (Rao, 1994).
Reputations are also non-
substitutable. Some economists (e.g., Klein & Leffler, 1981), however, argue that firms can provide "product guarantees" as a substitute for reputation. Although product guarantees reduce the risk of a specific purchase, they do not remove the risk of the overall exchange relationship with the firm. Finally, reputations are non-tradable, i.e., they cannot be bought and sold in the external markets and must be developed through the actions of a firm. How do firms build reputations? Economists emphasize the importance of signals – actions or statements that seek to reveal to the market a firm’s true strategic type (e.g., as a highquality producer or as a tough competitor) (Shapiro, 1983; Milgrom & Roberts, 1986).
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Advertising is one such signal that firms send in an effort to build reputations for quality (Nelson, 1974; Shapiro, 1983; Allen, 1984). In addition, advertising builds reputation by communicating specific information either about the firm’s products (Nelson, 1972), or about its identity (Olins, 1990), which increases awareness of and interest in the firm. Strategy researchers have demonstrated the importance of the institutional contexts, within which firms’ reputations are constructed by multiple actors (Rao, 1994; Fombrun, 1996; Rindova & Fombrun, 1999). One central actor in the institutional environment is the media, which disseminates information about various aspects of social life (McQuail, 1985). Mass communication research has documented that the media influences public opinion by “setting the agenda,” i.e. focusing public attention on specific issues (Katz, 1987). Similarly, we expect the media to focus attention on some firms more than others, and thus, to be an important factor in building reputations. Finally, the value of reputations to observers derives from the summary and synthesis of the past behavior of firms. Thus, observers need time to arrive at such synthesis, and firms have incentives to compress this time. So, they may engage in activities that enable them to borrow reputations form others. Newly public firms borrow reputation form their underwriters (Beatty & Ritter, 1986); and established firms enhance their reputations through strategic partner selection. Thus, associations with highly regarded actors can also help firms build reputations. Drawing on these approaches to reputation building, we explore the question of how three reputation-building mechanisms -- marketing investments in reputation, reputation borrowing from the firm’s venture capital firm, and media exposure -- affect the performance of Internet firms in both product and capital markets.
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We chose to investigate the relationship between reputation building and performance of Internet firms for several reasons. For one, the performance of Internet firms is much debated but poorly understood (Vickers & Weiss, 2000). Traditional valuations models cannot account for the valuations of retailers like Amazon.com, which have negative earnings but higher market value than the entire downstream industry, which supplies them; or for those of a broker like Priceline.com with a higher market value than the combined value of several leading airlines, whose tickets it sells. Thus, our paper seeks to assess the relationship between market performance and both traditional accounting measures, as well as reputation building mechanisms. We focused on the reputation building by pure Internet firms because building reputation is one of the most important success factors on the Internet (Baker, Warner & Dawley, 1998; Kotha, 1998). The reason for this is that Internet firms create value by providing information and reputation is a primary mechanism for ascertaining the quality of information goods (Shapiro & Varian, 1999). Additionally, the poverty of attention associated with the information-rich and competitor-cluttered environment of the Internet suggest that reputation building is likely to have significant impact on the performance of Internet firms (Barker, et al., 1998). The primary contribution of the research described in this paper is to demonstrate the importance of reputation building activities for competing in the information economy. In doing so it underscores that building intangible assets may indeed be among the key competitive behaviors of Internet firms. At the same time, the research highlights the time-bound nature of such intangible assets, and suggests some important managerial implications of these findings. The paper proceeds as follows: First, we develop the hypotheses; second, we discuss the data collection and analysis; third, we present the results; finally, we conclude with a discussion of the implications of our findings for theory and practice.
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THEORY AND HYPOTHESES Marketing investments in reputation The Internet is a communication technology, which since 1995 has been deployed in numerous commercial applications (Evans & Wuster, 1998). These commercial applications are products or services that leverage the new technological capabilities for sending and receiving information. Thus, in general, Internet companies tend to be providers of information goods, i.e. products or services, for which the delivery of information to buyers is either as primary source of value, or as a differentiating feature. Our definition of information follows Shapiro & Varian’s broad definition that “anything that can be digitized – encoded as a stream of bits – is information.” (Shapiro & Varian, 1999: 3). Information goods are experience goods, that is users can recognize their value only after they have used them (Shapiro & Varian, 1999). Thus, one of the primary problems for buyers and sellers of information goods is to ascertain the underlying quality of the product or service. Since this is impossible before the use, buyers seek, and sellers send credible signals of quality. To communicate effectively to market participants, who are likely to maintain an attitude of skepticism (Milgrom, 1981), signals must be costly; otherwise, they will be discounted as “cheap talk” (Porter, 1980). Economists have long identified that advertising is a costly signal of quality that can be viewed as an investment in reputation building (Shapiro, 1983). Shapiro (1983), in what is now considered as classic article, argued that high-quality producers have more incentives to incur the costs of investing in reputation building through advertising because they are more likely to generate repeat purchases. Providers of traditional information goods, like the publishing or broadcasting, continuously make intensive marketing investments in reputation building – from
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the creation of distinctive identity as in the case of The Wall Street Journal (Shapiro & Varian, 1999), to use of elaborate ratings and awards as in the case of the movie and broadcasting industries (e.g., the Oscar Awards). On the Internet, the problems of creating awareness, acceptance, and perception of quality for the products and services offered by Internet start-ups exacerbates. The “infinite shelf-space” of Internet lowers the barriers to entry and increases the competitive clutter. Under those conditions many have suggested that reputation building is the "the one plausible defense against competitive attacks" (Baker, Warner & Dawley, 1998: 48). Therefore, although such expenses depress profitability, we expect that higher levels of marketing investments are likely to be positively associated with high market valuations. Therefore, we suggest that: Hypothesis 1a: The more an Internet firm invests in reputation by committing resources to marketing and advertising, the higher will be its market value. The primary function of reputation, however, is to reduce the risk of transacting parties. In product markets a firm’s reputation (Fombrun, 1996) and its product brands (Aaker, 1992) enable customers to interpret, process, and store information about the firm. By doing so, they increase customers' confidence in their purchasing decisions (i.e. reducing risk) and, at the same time enhance, post-purchase or post-use satisfaction (Aaker, 1992: 16). Importantly, such effects enhance the growth possibilities of a firm: Yoon, Guffey and Kijewski (1992), for example, found that firms with favorable reputations enjoyed faster adoption of their new product introductions than firms without such reputations. Thus, investments in marketing are likely to lead to higher sales growth rates. Therefore, we suggest that: Hypothesis 1b: The more an Internet firm invests in reputation by committing resources to marketing and advertising expenses, the higher will be its sales growth. Borrowing reputation
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Reputation is a valuable yet costly asset: It takes both financial investments and time to develop. Time-dependent assets, like reputation, exhibit diminishing returns to the investment over fixed periods of time, i.e. time-compression diseconomies (Dierickx & Cool, 1989). The time necessary to develop reputations is fixed to the degree that other market players need some minimum duration of time over which they can observe the consistency and consequences of the actions of a new player (Weigelt & Camerer, 1988). Indeed, research has documented that new ventures suffer from the 'liability of newness' (Stinchcombe, 1965). Their lack of performance history deprives them of reputations, which in turn limits the number of potential exchange partners they have access to. This phenomenon is more acute in the context of Internet firms, where Internet startup firms are going public at an earlier time in their life cycle and with shorter performance histories, than their traditional brick-and-mortar counterparts (Meeker, 1999). To compensate for the initial lack of performance history and the time compression diseconomies of building reputations through marketing investments, new firms often seek to borrow reputation by association with a powerful actor in a transaction network (Larson & Starr, 1993). The phenomenon of reputation borrowing is well documented in the IPO market where new ventures undergoing IPOs borrow reputations from the underwriters (Beatty & Ritter, 1986), who intermediate between the new venture selling its stock and the investing public. Whereas past research has studied the effect of underwriter’s reputation on IPO performance (Beatty & Ritter, 1986), the effect of the reputation of the venture capital (VC) firm, which finances of the new venture in its early stages, is less well researched. Technically, VCs invest in a new venture capital in exchange for a percentage of the ownership of the firm, which will provide VCs with certain level of expected returns to VCs (Sapienza, 1992). However, in
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reality VC firms also help new ventures fill in gaps in managerial competence by providing advice or helping recruit additional top management team members (Fried & Hisrich, 1995). Fried and Hisrich (1995) argued that VCs are “relationship investors” because they provide their investment firms with contacts with potential stakeholders, including additional investors, seasoned managers, and high-caliber employees. Further, they highlighted two relational resources that VCs lend to new ventures – access to networks and reputation.1 Thus, borrowing reputation from a VC firm may enable a firm to overcome earlier the credibility problem of all new ventures. According to the Wall Street Journal (1999, p. C1): "In some cases, the presence of a brand-name anchor [venture capital firm] reassures the prospective shareholder that the technology works and has a strategic niche." [ital. added]
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Thus, reputation borrowing
from the VC firm begins to build the visibility and the reputation for the new venture itself. In addition, it may create an advantageous position for the new venture relative to key stakeholders and may improve its access to resources. In turn, superior access to resources is likely to positively affect the market value of ventures that are backed up by highly-regarded VC firms. Based on the above discussion we suggest that: Hypothesis 2a: The more reputation an Internet firm borrows from its VC firm by obtaining financing from a more prestigious VC, the higher will be its market value. Although seldom recognized, the effect of VC reputation may also enhance the performance of a new venture in product markets. For example, Fried and Hisrich (1995) suggested that highly-reputed VCs firm connect firms to key customers and strategic partners. 1
Using case-based research they showed that access to networks and reputation were closely related but not identical: VC reputation had a positive effect on access to resources even with resource-holders outside the VCs’ network (Fried & Hisrich, 1995). 2 An example of this effect is described in the Wall Street Journal: "Traders say the involvement of successful Silicon Valley venture-capital firm Kleiner Perkins Caufield & Byers in the IPO of Martha Stewart Living
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Such superior access to critical resources (e.g., key customers) early in the life cycle of the venture may position it better for rapid growth. Although it is difficult to separate the effects of reputation borrowing from a highly-regarded VC firm and the effects of leveraging its management expertise, the association with a highly-reputatble VC firm is likely to have a positive effect on a firm’s growth. To investigate the effect of reputation borrowing from VCs on new ventures’ performance in product markets, we suggest that: Hypothesis 2b: The more reputation an Internet firm borrows from its VC firm by obtaining financing from a more prestigious VC, the higher will be its sales growth.
Media Exposure Marketing investments in reputation and borrowing reputation from providers of capital signal the intention of the firm to produce high-quality goods and to achieve superior returns. However, they do not automatically create a reputation for a firm. Market participants form reputation beliefs on the basis of information transmitted by information intermediaries (Griffin, Babin, & Attaway, 1991; Fombrun, 1996). Mass communication research, however, has demonstrated the influence of the media over the general public opinions (McQuail, 1985, Katz, 1987). This research has found that rather than shaping how we think, i.e. “in favor of” or “against” something or someone, the media influences what we think about, i.e. it allocates our attention (Katz, 1987). Thus, the findings in mass communication research suggest that, contrary to popular beliefs, the coverage itself, rather than its positive or negative tone, affects the process of forming opinions and judgements. The directionality of the judgements themselves is usually shaped by more direct, interpersonal sources of reference (Sheingold, 1973).
Omnimedia Inc. created a great deal of the buzz that helped propel the stock almost three times last week's offering 11
Thus, media exposure, is likely to contribute to reputation building by focusing attention on the firm. The tremendous attention given by the media to Internet firms has been documented: According to Vickers and Weiss (2000: 114) noted: “…never before have the media joined quite so willingly as cheerleaders and stock-pushers.” The authors also argue that the media attention to Internet stocks is of one of drivers underlying the bull market. Therefore, we expect that media exposure will have significant impacts on stock market performance and suggest that: Hypothesis 3a: The more media exposure an Internet firm gets in the form of articles published about it in the media, the higher will be its market value. Since media exposure provides information to all stakeholders of the firm, we expect that higher levels of media exposure will enhance the performance of Internet firms in both capital and product markets. Stakeholders vary in the degree to which they rely on information provided by the media to make their assessments of firms. Marketing researchers have pointed out that consumers rely on media information in developing interpretation frames, within which they can make sense of their consumption experiences (Hirshman & Thomson, 1997). Also, on the Internet the focus of consumer attention helps generate traffic to a firm's website. Unlike the traditional brick-and-mortar firms, who are constrained by geographical location in reaching a larger customer pool, customers on the Internet are more likely to surf and examine a website that because they are aware of it (by virtue of its media exposure among other things).3 On the Internet traffic is related to sales growth in two ways: Though direct consumer purchases from e-commerce sites and other vendors, and through advertising revenues, paid by
price. “ 3 An interesting example how media exposure generated traffic for Amazon.com was seen during the classic confrontation between Amazon.com and Barnes and Noble during 1997. The legal issues that Barnes and Noble raised about Amazon.com's positioning (i.e., Earth's Largest Book Store) in the book retailing industry, the more media visibility Barnes and Noble lawsuit generated in the media. Most importantly, as media visibility increased so did the traffic to Amazon.com's website.
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third parties seeking to gain exposure to the traffic, which a Web-site generates. In either case, the media exposure is likely to attract user and advertiser attention to a site and to be positively associated with sales growth. Therefore, we suggest that: Hypothesis 3b: The more media exposure an Internet firm gets in the form of articles published about it in the media, the higher will be its sales growth.
METHODS Sample and Data To undertake the study, we collected data on the Top-50 publicly traded pure Internet firms
listed
on
NASDAQ
and
New
York
Stock
Exchanges.
Internet
World
(www.internetworldnews.com) publishes the list of the Top-50 firms. The magazine, published by Meckermedia Corporation, is available in print and online versions. The Top-50 list, based on revenues for the previous 4-quarters, was first published in September 1998 and subsequently made available on the Internet. The list focuses on "pure" Internet companies and provides the first panoramic view of industry leaders and their financial performance (Internet World, 1998). We focused on the Internet World Top-50 firms for the following reasons. These firms capture 82 percent (50/61) of the "pure" Internet firms that were public by the 3rd quarter of 1998, when the list was published. These firms are likely to be watched more closely by the financial markets, and to have their reputation building activities -- the variables germane to this study – noticed and interpreted. Our preliminary analysis indicated that these Top-50 firms were not homogenous along the dimensions of interest to this study.4 Finally, our this approach is
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For example, the inter-quartile range on market-to-book ratio, an important proxy for future growth prospects for a firm, varied from 4.1 to 9.7. Further, the median firm in our sample has just three media citations a quarter, whereas a firm such as Amazon.com (also found in our sample) got more that 300 citations per quarter (see the descriptive statistics provided in Table 1 for more details).
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consistent with the focus of strategy research on relatively successful and established firms (e.g., Fortune 500). We matched the data from Internet World with financial data from the Compustat Database. We also downloaded each firm’s S-1 document from the EDGAR Database to collect information on venture-capital backing and the lead IPO underwriter for each firm. The final sample consists of a total of 41 firms. Nine firms were dropped because complete accounting data about them was unavailable.
Together, the 41 firms amounted to 397 firm-quarter
observations used in our final analysis. Theoretically there could 1148 firm-quarter observations (41 firms x 28 quarters). However, very few of the Internet World Top-50 firms were publicly traded before 1996. We pooled the quarterly observations on the 41 firms to increase sample size. Appropriate controls for serial correlation, cross-correlation and heteroscadasticity were considered before interpreting the results from the pooled data set. Several sensitivity tests (reported later) were conducted to control for within-firm correlation and omitted variable bias. The data collected for the study spans the period between 1992 and 1998. We chose 1992 as our starting year because, by that year, firms in the sample, such as AOL, were becoming established as providers of online access via proprietary systems. Variables Independent Variables. Consistent with the theoretical discussion on reputation building activities, we operationalized three types of activities: marketing investments in reputation, reputation borrowing, and media exposure. Marketing investments in reputation was measured by the sales and general administration (SGA) figures.
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To opertionalize reputation borrowing, we identified the major venture-capital firm backing each firm in our sample. Using the reputation rankings of venture-capital firms provided in Fortune (Warner, 1998), we created a dummy variable called VCDUM that accounted for reputation differences among venture capital firms. Internet firms funded by the three first-tier firms according to Fortune’s rankings -- Kleiner Perkins, New Enterprise Associates, and Sequoia Capital -- were assigned a value of 1, and the rest a value of 0. Media exposure was measured by the total number of articles published about the firm in the "Major Newspapers" database of the Lexis/Nexis electronic database for quarterly periods for each firm starting from January 1992 to December 1998. We selected this database because it includes daily newspapers that reflect the focus of the current media and general public attention. Although it is possible that the tone of each media article be positive, or negative, or both, we measure only the total level for exposure. Theoretically, as discussed earlier, mass communication research has demonstrated that the media allocates attention, rather than shaping positive or negative opinions. Methodologically, since we hypothesized a positive relationship between media exposure and our dependent variables, negative exposure would work against finding a positive relationship between media exposure and market value or sales growth. Our approach was very conservative and biased against finding the hypothesized results. Pragmatically, there were over 7768 citations for the firms in our sample, which would be impossible to categorize as positive or negative unambiguously. Dependent Variables. We use two traditional measures of firm performance --market value (MV) and sales growth. The MV measure is operationalized as the share price of the firm in question for the last date of the quarter multiplied by the number of outstanding shares at that time. Growth in sales is the firm sales at time 't' controlled for lagged sales at 't-1'. Traditionally,
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one would define growth in sales with respect to seasonally lagged sales (i.e., salest minus sales t4
). However, all firms have experienced rapid growth from quarter to quarter. Hence, we define
sales growth with respect to sales for the lagged quarter (i.e., salest minus sales t-1). Control Variables.
Since we were interested in exploring the effects of reputation
building strategic flows on market performance, we controlled for the effect of accounting measures that financial theory has posited as explanatory of market value (Ohlson, 1995). We used book value of the firm’s equity and net income before taxes and extraordinary items as control variables.
The values for these items by quarter were obtained from Compustat.
Alternate measures of performance such as present value of future earnings, return on total assets (ROA) or return on sales (ROS) were not employed because 75 percent of firms in our sample incurred losses. Quarter-identifying dummies are also included to control for unmodeled time-constant factors that may affect the performance variables. Finally, industry-specific dummies are included to control for inter-industry differences in our sample. The Internet World categorizes the firms into nine industry segments, including Internet service provides, Internet-content providers, Internet software providers, portals, ecommerce infrastructure providers, Internet-security software and hardware, Internet advertising, and miscellaneous. Models Modeling Firm Value. To model the impact of reputation on market value of the firm, we employed the following detailed specification: (1)
MVE/TAit = ã0 + ã1 BVE/TAit + ã2 EARN/TAit + ã3 SGA/TAit + ã4 MEDIA EXPit + ã5 VCDUMit + ã6 Time dummiest + ã7 Industry dummiest + errorit
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Book value of equity and earnings information are often used in the accounting literature to control for accounting information (Ohlson, 1995). In the equation above, MVEit captures the market value of firmi equity at timet; BVEit the book value of equity at timet; and EARNit represents the net income earned by the firmi for the period ended at timet. The quarter-identifying and industry-specific dummies are also included as control variables. The reputation related measures in the specification above are SGA expenses (our proxy for marketing investments in reputation), MEDIAEXP (i.e., our proxy for media exposure), and VCDUM, our dummy variable for effect of the venture capital firm. To address heteroscadasticity concerns, the financial measures were scaled by total assets, and heteroscadasticity–consistent variance covariance matrix was used for hypotheses testing (White, 1980). Modeling Growth in Sales. To model the relationship between reputation building and growth in sales we use the following detailed specification: ∆Sales/TAt-1 = ã0 + ã1 lagged (∆Sales/TAt-1) + ã2 SGA/TAt + +ã3MEDIAEXPt + ã4 VCDUM t + ã5 Industry dummiesi + ã6 lagged error termst +errort
(3)
The dependent variable, ∆Sales/TAt-1 was measured as change in quarterly sales [(SalestSalest-1)/TAt-1]. Industry dummies control for omitted variables that vary by industry. ANALYSES AND RESULTS Analyses Descriptive Statistics.
Table 1 provides the descriptive statistics and zero-order
correlation among the dependent and independent variables. The descriptive data presented reveals interesting regularities: the mean (median) firm in the sample incurs quarterly losses of
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$6.17 million ($1.74 million). Book value of the mean (median) firm is $84.91 million ($47.13 million) compared to market value of $794.76 million ($295.37 million). For the median firm in the sample, the SGA expenses accounted for 65 percent of the sales revenues. Also, the median firm in our sample gets media exposure of three mentions compared to the mean of 25 citations per quarter. Clearly media exposure is not uniformly distributed among the sample firms. Approximately 25% of the sample firms were funded by the top -rated venture capitalists (not reported in Table 2). Insert Tables 1 and 2 about here Table 2 presents the correlation matrix between the dependent and independent variables of interest. Market value of equity (scaled by total assets) is positively associated with media exposure, reputation of VC firm, and marketing expenses scaled by total assets at p
