Critical Issues for Digital Exchanges.

They're anything but conventional, yet DMPs are following the classic business cycle - innovation, rapid growth, investor euphoria and shakeout. Poised to shake up the global B2B arena, DMPs first have to survive.

No question about it: digital marketplaces (DMPs) -- also called digital exchanges -- are poised to shake up the global B2B arena. They've got everything competitive businesses are after: dramatically streamlined supply chains, reduced costs and shortened business cycles and buyers and sellers globally connected in real-time. But before they can lead any B2B revolution, DMPs will have to survive their own major shakeout. And 2001 promises to be a defining year.

DMPs are Internet-based market places that enable buyers and sellers in specific industries (vertical exchanges) or across multiple industries (horizontal exchanges) to con duct business in virtual, online environments. This direct B2B commerce is designed to lower transaction costs for buyers and sellers, thus reducing the buyer's effective costs to acquire goods and services while increasing the seller's exposure to new buyers.

DMPs are anything but convention al. Yet, they're following a familiar path, well-worn by many ventures before them, such as the automotive and at-home shopping industries. The classic business cycle -- innovation, rapid growth and proliferation, investor euphoria and shakeout -- is at hand for DMPs, too.

During 1995-1996, a number of DMPs were launched by small entrepreneurs. By 1999, major B2B players like VerticalNet, Internet Capital, Ven-tro, Ariba and Commerce One led the initial wave of IPOs, triggering virtualeuphoria in the sector. Between March and June 2000, an array of DMP initiatives were launched, including numerous exchanges hosted by industry focused consortiums. Marketplace expectations soared and subsequently fell as enthusiasm dampened for all things tech. And now: the shakeout.

Tricky Business?

No matter what the Federal Reserve does or doesn't do, it's clear that the days of euphoric market capitalizations and easy access to capital are history for most DMPs. But, make no mistake about it, DMPs are smart business. Leading analysts -- including Forrester Research and the Yankee Group -- have projected that digital exchanges will host nearly $3 trillion in B2B transactions by 2004. And B2B infrastructure investments are expected to top $80 billion by 2005, according to Jupiter Research. Traditional supply chains will continue to be revolutionized by the Internet and e-commerce. That's not to say, however, that every digital marketplace will survive.

Succeeding as a DMP is tricky business and many are finding out the hard way. In addition to the battering that the technology sector has taken recently, DMPs and the B2B sector have suffered tremendously; some major players have seen their stock values drop by 70 percent, 80 percent -- even 90 percent. As a result, many DMPs are taking steps to protect and rebuild their value through strategic acquisitions and partnerships. Converge recently purchased NECX from VerticalNet; Global Healthcare Exchange acquired CentriMed from Internet Capital; and Transora and GlobalNetXchange (GNX) launched a "megahub," in which they have invited other major exchanges to participate.

Announcements of B2B mergers and consolidation continue at a fairly steady pace. DMPs are recognizing the significant advantages of alliances and acquisitions: accelerating revenues, gaining critical technology infrastructure, evolving business models and expanding their customer base.

Success in the B2B arena depends on many factors surrounding the way in which the inherent challenges are identified and managed. Based on experience working with DMPs of all sizes and across several industries, there are 10 fundamental issues that will determine the survival and long-term profitability of companies in the DMP arena.

The Ten Critical Issues

1. Time to Market

DMPs are still in their infancy, which means speed is essential. Since a few exchanges can feasibly serve an entire industry, early movers will secure a dominant market position. Such speed will hinge on a DMP's ability to manage the array of potentially thorny issues posed by this new business model. One of the fast movers, Freemarets, is capitalizing on quick time-to-market efforts. This B2B leader in industrial parts, raw materials and commodities has evolved from a start up in 1995 to having a worldwide presence today, serving Global 1000 companies and generating $100 million in revenues and $14 billion in transaction volume.

2. Start-up Challenges

A strong business launch requires the right management team, as well as an organizational structure and business culture aligned with the corporate growth goals and mission. Thus, DMPs need to be easily scalable, both from a technological and organizational perspective, and they require a rapidly executable plan for equipment and facility needs.

The challenges for today's digital exchange start-ups include maintaining the momentum of a successful launch, which generally requires enough capital to cover an 18- to 36 month start-up period (typically with in the range of $50 million to $150 million.) While there's no shortage of market opportunities and high-tech solutions to begin a business, venture capital is no longer flowing as freely as it was in the "heyday" of the technology boom. Thus, start-ups should be primed to encounter some initial hurdles in raising capital.

Another challenge is finding top talent, despite new hiring opportunities created by the technology sector shakeout. To maintain momentum and sustain a viable start-up, stick with a clear, value-based business plan that effectively addresses all of these issues and is carried out by a credible, aligned management team and workforce.

3. Strategic Mergers

DMPs are realizing that it takes a combination of industry expertise and technology know-how to build a winning exchange. They will need to closely examine the potential advantages of teaming with other DMPs or acquiring emerging technologies to achieve maximum efficiency and effectiveness. For example, Converge recently purchased VerticalNet's subsidiary NECX, a global trading exchange that matches buyers and sellers of electronic components and computer systems. Through this acquisition, Converge -- itself a leading high-tech DMP -- gains a significant volume of participants and transactions, creating a critical mass to jump-start its own business.

4. Delivering Value

Speed is essential, but it should not be achieved at the expense of quality. The marketplace has made it clear: To secure wide participation, sufficient investment capital and a profitable future, DMPs must deliver a variety of value-added services that appeal to their customers. Ultimately, providing value through a DMP means going beyond the "matching" of buyers and sellers, and extending to other facets that will prove essential to a successful transaction. Some value-driven elements include facilitating timely delivery of goods, ensuring an efficient settlement mechanism and providing an attractive pricing arrangement to both buyers and sellers.

5. Revenue Model

Like many technology-based services, digital exchanges will be quickly commoditized. Already, DMPs are discovering that transaction fees alone will not generate the revenue necessary to be profitable. As a result, they'll need to explore revenue sources beyond transaction or membership fees. As noted in KPMG's recent publication, Defining the Digital Future: Business and Accounting Issues, such ancillary services may include data mining, logistics services, advertising, insurance, order management, bonding and credit checking services and others.

6. Neutrality/Security

DMP participants need assurance that their pricing and other proprietary information won't be shared with competitors also doing business via the digital exchange. A recent Forrester Research report found "market neutrality" to be the number one issue affecting decisions by buyers and suppliers to participate in a DMP. The neutrality of a DMP must also pass muster with antitrust authorities, which are increasing scrutiny of DMPs' objectivity. This scrutiny is particularly intense in industries dominated by only a handful of competitors. Anything less than complete neutrality and airtight security means limited credibility, limited participation and limited revenue and growth potential.

7. Corporate Governance 

Rapidly launching a digital exchange that's owned by a consortium of competitors with equal decision-making authority and equity ownership is particularly tricky. Typically, equity owners will each have their own chain of command, funding issues and vision for the venture. A streamlined corporate governance and organizational strategy is critical to an exchange's speed-to-market, agility and long-term success. Covisint, the Big Three automakers' consortium DMP, recently moved to strengthen the objectivity of its board of directors by appointing 12 members. It's a strategy that DMPs will increasingly have to consider to help ensure effective decision-making.

8. Taxes

Addressing tax issues early on -- before technologies, organizational structures and business processes are in place -- can mean the difference between competitive tax advantages and serious handicaps. As e-businesses, digital exchanges face the universe of tax compliance issues that include: sales and use tax implications for buyers and sellers; nexus; customs; Value-Added Tax (VAT) and foreign income tax hurdles; even managing the tax liability of savings secured through digital exchange-based efficiencies.

A host of non-compliance-related tax issues also can be essential to competitive strength, including capitalizing on tax incentives, attracting and retaining top talent through tax-focused compensation strategies and building enterprise value.

9. Technology

As the lifeblood of the exchange, the technology infrastructure has to clear some high hurdles. Participants must be able to easily access the exchange via a common platform, and the technology must integrate seamlessly with disparate legacy systems maintained by the exchange's various participating organizations. Exponential growth potential -- in transaction volumes, new participants and new markets -- means an exchange's technologies will need a high degree of scalability. And any significant online failures will alienate participants, who can easily move to a competitor's site with the ease of a few mouse clicks.

Indeed, the vital role and significant complexities of DMP-related technologies have spawned an industry of software and network technology vendors specializing in solutions. The technologies of Ariba, CommerceOne, Vertical-Net Solutions, i2 Technologies and others -- together with traditional providers of enterprise resource planning technologies like SAP and Oracle -- will play a critical role. Seamless integration and reliable online performance will be essential to attracting and retaining participants.

10. Going Global

The digital exchanges that offer the most value and efficiency to buyers and sellers will have global reach. As with any global expansion, that means accommodating multiple languages, dealing with foreign business cultures and managing a host of logistics and infrastructure challenges that include regional hubs, business agents and distribution.

In the global arena, companies like GlobalNetXchange (GNX), the worldwide B2B online marketplace for retailers, are taking steps to expand their reach. GNX's original founders -- Sears, Carrefour and Oracle -- were joined by eight additional equity partners, enabling GNX to establish itself on the international stage. While presenting organizational, technological and even cultural challenges, going global offers the benefits of wider participation and critical mass -- elements central to growth and profits.

The DMP arena is in a critical period, as companies both large and small grapple with the challenges of conducting business in a digital world. There are more challenges to face -- including some that haven't yet emerged. But companies have clearly seen the potential benefits of DMPs and the ways in which these virtual environments can help businesses succeed on an array of levels -- from cost cutting to competitive gain. By effectively anticipating and managing the critical business issues associated with doing business in this evolving market place, DMPs can be strongly positioned for long-term survival and success.

Jerry Maginnis is KPMG's National Director, Digital Marketplace Practice based in Philadelphia.