The Knowledge Web: People Power – Fuel for the New Economy pot

Evolutionary Phases of e-BusinessB2C Commerce: Amazon.com B2B Commerce: VerticalN et, CommerceO ne e-Knowledge Growth of Internet Market 1992 1994-5 1995-6 1998-9 2000 Source: Merrill Ly

(1) 212 449-0773henry_blodget@ml.com

The Knowledge Web

Part 1: People Power – Fuel for the New Economy

Highlights: Technology is the Driver of the New Economy and Human Capital is its Fuel

The Internet’s Capability to Deliver a Total Human Capital Solution Creates a Powerful Investment Opportunity

Merrill Lynch & Co

Global Securities Research & Economics Group

Michael T Moe, CFA

Director of Global Growth Research

henry_blodget@ml.com

Kirsten CampbellAssistant Vice President(1) 212 449-3113kirsten_campbell@ml.com

Knowledge Enterprises Group

"Albert Einstein"™ Licensed by the Hebrew University of Jerusalem,

Represented by the Roger Richman Agency, Inc., Beverly Hills, CA 90212 www.albert-einstein.net"

The new economy moves at a pace never seen before The new

economy is a knowledge economy based on brainpower, ideas

and entrepreneurism Technology is the driver of the new

economy, and human capital is its fuel The knowledge

economy is people-centric Our economy has evolved from

manufacturing-intensive to labor-extensive Fundamental to

success in the new economy is how companies obtain, train and

retain knowledge workers The knowledge enterprise industry

is over $2.2 trillion We expect the online component to grow

from $9.4 billion to $53.3 billion by 2003, a 54% CAGR

Ubiquitous PCs and high-speed bandwidth will facilitate access

to knowledge anytime, anywhere The Internet democratizes

knowledge, increasing access to it, lowering its cost and

ultimately improving its quality We believe combining the

“richness” of an offline experience and the “reach” that only the

Internet provides creates a network effect that allows scale

knowledge enterprises to be born Moreover, we see significant

potential advantages that offline operators can achieve by

leveraging their experience and brand online

e-Commerce has forced all traditional businesses to

compete at Internet speed In a 4% unemployment

economy with 65% of all the new jobs created requiring

skills, 70% of Fortune 1000 CEOs are saying that finding

qualified workers is a major issue for growth

“Time-to-competency” is a bottleneck or a strategic advantage

depending on how effective an organization is at finding

and training knowledge workers Domestic online

corporate learning is expected to grow from $1.1 billion in

1999 to $11.4 billion in 2003, a 79% CAGR, and online

staffing and recruiting, critical functions of human capital

management, is projected to grow from $5.8 billion in

1999 to $28 billion in 2003, a 48% CAGR

The information revolution that began with the birth of the

PC is really the knowledge revolution e-Commerce is to

the knowledge revolution what the railroads were to the

industrial revolution We think enterprises building

“knowledge tracks,” or infrastructure, into the corporate

market, K-12 community, and higher education spaces are

poised to enjoy explosive growth

Integrating quality educational content with

testing/assessment and certification programs is the new

education paradigm for the 21st century In the knowledge

economy, assessment is the currency with which all skills

are valued The four engines of the new economy –

computers, telecommunications, healthcare and

instrumentation – employ approximately 50 knowledge

workers per 100 employees and are growing These

technology-intensive industries are growing 3-6 times as

fast as economy-wide job growth Career vortals,

providing continuing education, employment opportunitiesand relevant information, will be knowledge nerve centersfor vertical knowledge communities

Colleges and universities are the most wired community

on the Web, with over 90% of college students accessingthe Internet, 52% of them daily Students spend nearly 19hours per week on the Internet, 84% of the time pursuingacademic activities College students currently spend $105billion annually, with $1.5 billion of that online Higher edhubs provide educators and e-commerce companies access

to this very compelling demographic

The Internet creates one economy and one market Aslarge as the online higher education market is in the U.S.,the global opportunity is significantly greater Unlike theU.S where post-secondary education is relativelyavailable, access to world-class post-secondary institutions

in many parts of the world is limited Currently, there are

84 million students enrolled in higher educationworldwide Global demand for higher education isforecasted to reach 160 million by 2025 − if onlinelearning captures even half of this growth, there would be

40 million students for online education We predict that

in the next five years, there will be global virtualuniversities with potentially millions of students enrolled

We project that the online higher education market willgrow to $7 billion by 2003 in the U.S alone

The number of K-12 schools connected to the Internet hasclimbed from 35% in 1994 to 96% today Today’s kids arethe Internet Generation − Generation i − and are as

comfortable on a computer as on a bicycle With 53 millionschoolchildren, three million teachers and 23 millionfamilies, the K-12 marketplace encompasses a huge number

of potential users The Internet is the world’s greatestlibrary and gives a student in Minot the same access toknowledge as a student in Manhattan Key for improvement

in learner outcome is getting parents involved − the school connection − and email has already proven to be aneffective communication tool between parents and teachers.The Internet is all about disproportionate gains to theleaders of a category The gigantic opportunity has notbeen lost on investors, with over $3 billion in venturecapital funds flowing into knowledge enterprises in thepast fifteen months alone By focusing on knowledgeenterprises that contain the 4 P’s (People, Product,Potential and Predictability) and other key differentiatingfactors, notably the network effect outlined in this report,

home-we hope to identify the Yahoo!s from the yahoos andprovide outsized investment returns for what we see as anoutsized opportunity

Introduction to the e-Knowledge Industry

Fast Facts: The New Economy

• The pay gap separating a high school graduate from a

college graduate was 50% in 1980 Today, it has

reached 111% Looked at another way, a 30-year-old

male with a high school diploma earns just two-thirds

of what he earned 25 years ago Even so, only 21% of

American adults over the age of 25 have a bachelor’s

degree or better

• In 1980, the price-to-book ratio of the ten largest

publicly traded companies in the U.S was 1.2x

Today, the price-to-book is 12.1x, or ten times greater

This multiple expansion correlates directly with the

increased productivity of a company’s intangible

assets – its human capital

• On average, each employee at the leading “New

Economy” companies is “worth” $38 million based on

market cap-per-employee In contrast, each employee

at the leading “Old Economy” companies is worth

about $689,000, or less than 2% of employee value at

the New Economy companies

• Venture capital funding in knowledge enterprises

amounted to over $3 billion since January 1999, or

about triple the total invested in the previous 9 years

• At the end of 1999, more than 196 million people

were using the Internet worldwide The number of

global Internet users is expected to more than triple to

638 million by 2004, a 27% CAGR

• The “free agent” mindset of today’s knowledge worker

is evidenced by the fact that the average person entering

the workforce today will work for between 8 and 10

different employers versus 4 to 6 a decade ago Only

15,000 businesses currently recruit online, but this

figure is expected to increase to 124,000 by 2003

• Worldwide, the Internet economy is expected to

mushroom from $361 billion in 1998 to more than

$2.8 trillion in 2003

• In 1999, nearly 720,000 IT positions went unfilled

Today, one of every five IT jobs remains unfilled, and

nearly 75% of new openings fail to receive interested

and qualified candidates

• Worldwide business-to-business (B2B) commerce

dwarfs B2C commerce in both size and growth Total

B2B Internet revenue is expected to top $2 trillion in

2004, up from $80 billion in 1999, a 91% CAGR

• Firms are stepping up their e-commerce outsourcing

initiatives as they move from building stand-alone

sites to Internet-enabled supply chains and customer

service systems The result is a rising median

outsourcing budget, from $750,000 in 1999 to a

projected $1.5 million in 2001

• At the end of 1998 there were approximately 88Internet stocks Currently, there are approximately

400 with nearly a half trillion dollars of market cap

• Approximately 50% of the total Internet market cap isaccounted for by the five largest Internet companies,providing evidence for the belief that, on the Internet,the winners “take all.”

• Studies have shown that effective management ofhuman capital can improve shareholder value by up to30%

• By our estimates, the e-knowledge market will reach

$53.3 billion by 2003 from $9.4 billion in 1999,growing at a CAGR of 54%

• Reflecting the transformation of technology in oureconomy, in 2000, skilled jobs will represent 65% ofall jobs This is expected to expand to 85% by 2005,

up from just 20% in 1950

• Knowledge Services – education and corporatelearning for the new economy – is a $740 billionindustry in the U.S and a $2-trillion industry globally

• Web-based corporate learning should enjoy explosivegrowth, measuring $11.4 billion by 2003, up from

$550 million in 1998, an 83% CAGR

• By 2002, technology-based training will capture themajority of dollars for IT training, at 55% versus the45% share captured by instructor-led methods

• In 1996, 44% of students enrolled in higher educationprograms were adults over 24 years of age, up from28% in 1970

• The ratio of students to computers in our nation’s

K-12 schools is rapidly improving, falling from 16-to-1

in 1992 to approximately 6-to-1 in 1999

• Nearly every K-12 school in the country (96%) has atleast one Internet-linked computer To date, 51% ofclassrooms have Internet-connected computers

• The number of K-12 students with Internet access hasgrown from virtually zero in 1994 to 10 million in

1996 and is projected to grow to 40 million by 2002

• 47% of 16-22 year-olds are on the web and control

$37 billion in spending 40% have bought and paidfor something online By 2003, 62% of 16-22 year-olds will be on the web

• College students spend nearly 19 hours per week onthe Internet, with 85% of their time spent on academicpursuits

• The domestic broadband market will expand to 2.3million homes this year, up 200% from approximately

4. Mind Over Matter: Human Capital in the Knowledge Economy 31

18. Linking Homes and Schools – The Next Online Land Grab For e-Portals & Hubs

107

Part 4: Corporate e-Learning –

Feeding Hungry Minds

225

n Section Page Part 5: Human Capital

Management – People Power

291

Introduction to the Knowledge Economy

1 Executive Summary and Thesis

“Take our twenty best people away, and I can tell you that Microsoft would become an unimportant company.”

– Bill Gates

When the puck goes in the net, all the sticks go in the air Likewise, attributingwhat or who deserves the credit for the incredible economic boom we areexperiencing is a crowded stage Silicon Valley, Alan Greenspan, the fall of theBerlin Wall and, of course, the Internet are all lead actors amongst the cast ofthousands in the New Economy script

Technology is the driver of the New Economy, and human capital is its fuel Intoday’s world, knowledge is making the difference not only in how an individualdoes, but also in how well a company does and, for that matter, in how well acountry does While the future possibilities of the knowledge economy look bothexciting and, at the same time, daunting, the transformation to a knowledgeeconomy is now evident

• Most striking—the dramatic pay gap between those with education andthose without has more than doubled in less than 20 years Looked atanother way, the purchasing power of a 30-year-old man with a high-schooldiploma has dropped by over one-third over the past two decades

• Also significant—our analysis illustrating a seismic shift in how themarket values companies, discounting traditional analysis of earningsderived from physical capital and replacing it with analysis of earningspower derived from human capital

• Finally, the structural changes that have occurred in our economy meanthat the new jobs being created today are service and skill-based jobs ratherthan manufacturing jobs In 1950, unskilled jobs constituted 60% of alljobs, with professional and skilled jobs representing the remainder Fastforward the clock to today, and it is expected that 65% of all new jobscreated will be skilled jobs and that by 2005 skilled jobs will represent 85%

of all new jobs created Fundamental to the investment opportunity is thesignificant demand imbalance for knowledge workers versus the supply ofskill-based jobs

In today’s knowledge-based global marketplace, human capital has replacedphysical capital as the source of competitive advantage A key result of theconfluence of technology and the Internet Economy is the need for better, fasterand smarter workers The reality of a 4% unemployment rate in the U.S., the “freeagent” mindset of the most talented workers, and the fact that only 21% of theU.S adult population has a college degree is making this task more difficult thanever before e-Commerce forces even traditional businesses to operate at Internetspeed, with “time-to-competency,” now a major factor determining the

competitiveness of all companies

The truly revolutionary impact of the Internet is just beginning to be felt In theold economy, geographic distance needed to be mastered to shop, be serviced or tolearn In the new economy, distance has been eliminated We are rapidly

evolving into one economy and one market

We see the e-knowledge market being the next major growth phase of the Internet,following huge business and investment opportunities in business-to-consumer(B2C) e-commerce and business-to-business (B2B) commerce and services

Technology is the driver of the

New Economy, and human

capital is its fuel.

In today’s knowledge-based

global marketplace, human

capital has replaced physical

capital as the source of

competitive advantage.

The truly revolutionary impact

of the Internet is just beginning

to be felt In the old economy,

geographic distance needed to

be mastered to shop, be serviced

or to learn In the new

economy, distance has been

eliminated We are rapidly

evolving into one economy and

one market.

Evolutionary Phases of e-Business

B2C Commerce: Amazon.com

B2B Commerce: VerticalN et, CommerceO ne

e-Knowledge

Growth of Internet Market

1992 1994-5 1995-6 1998-9 2000

Source: Merrill Lynch Global Growth Group

At no previous time has human capital been so important, meaning finding, developing and retaining knowledge workers will be mission-critical functions – and high growth sectors – in the new economy Accordingly, we

look at the continuum of human capital solutions holistically – a Knowledge Web– and believe the most important companies will have an appreciation for and/orinvolvement in a comprehensive solution We believe those companies that canlink different elements of the human capital value chain – stretching fromrecruiting to assessment to training and through retention – while leveraging theInternet’s capabilities to deliver a total solution, will be the big winners

The Knowledge Services Continuum: The Human Capital Value Chain

Find &

Source: Merrill Lynch Global Growth Group

Unleashing the Killer App

The death of distance and the compression of time have powerful implications inthe knowledge-based economy The biggest investment ideas are often wherethere is a problem – and the bigger the problem, the bigger the opportunity There

is no bigger problem in the global marketplace today than how to obtain, train andretain knowledge workers Seventy percent of Fortune 1000 CEOs cite the ability

to attract and keep adequately skilled employees as a major issue for growth andcompetitiveness Given that essentially all of the 20 million net new jobs that werecreated in the past 20 years were from small and mid-sized companies, obtaining,training and retaining talent is even more critical to what has become the growthengine of the new economy

At no previous time has human

capital been so important,

meaning finding, attracting and

retaining knowledge workers

will be mission-critical

functions – and high growth

sectors – in the New Economy.

“The killer app for the next decade is talent acquisition and retention.”

— John Doerr

Kleiner, Perkins,Caufield & Byers

“The next big killer application for the Internet is going to be education.”

— John Chambers, CEO, Cisco Systems

Nowhere is the importance of people more evident than with technologyprofessionals, or “techies.” Techies are the heroes of the New Economy: theyinfluence the spending of $1 trillion of annual purchases; they are mission-criticalfor any organization; and they are in extremely short supply In fact, there arecurrently 700,000 open IT jobs, or one-third of the total of all IT jobs, with theshortage expected to more than double in the next five years Compounding thecomplexity of dearth of IT professionals is that Moore’s Law is alive and wellmaking IT skills obsolete at the blink of an eye

Fast-forward the clock five years and, unfortunately, the supply of studentscoming out of America’s schools doesn’t promise much relief Twelfth-graders inU.S schools in the most recent international comparisons finished dead last andnext to last in the key new economy subjects of math and science, respectively.Hence, the fundamental and massive problem of global competitiveness andobtaining knowledge workers reaches all the way down to the K-12 level As thehuman capital demand funnel is triggered, global corporations need to moreeffectively recruit knowledge workers and provide lifelong learning for theiremployees and create supply for the future by improving the K-12 educationsystem The Internet acts as a major enabler linking corporations to people,providing management systems, anytime/anywhere learning and a catalyst to helprevolutionize a failing primary education system

Techies are the heroes of the

New Economy: they influence

the spending of $1 trillion of

annual purchases.

Twelfth-graders in U.S schools

in the most recent international

comparisons finished dead last

and next to last in the key new

economy subjects of math and

science, respectively.

The Human Capital Demand Funnel

Global Corporations

Demand for Knowledge Workers

Internet-Based Employee Solutions

E-Cruitment

E-Human Capital Solutions

E-Corporate Learning

Better K-12 & Higher Ed Solutions

Source: Merrill Lynch Global Growth Group

What’s a Mother to Do?

The Information Revolution is really the Knowledge Revolution, and the Internet

is to the Knowledge Revolution what the railroad was to the Industrial Revolution.The Internet has the potential to “democratize” knowledge and learning,

increasing the access, lowering the cost and improving the quality

Communication of rich information has historically required proximity ordedicated channels Key to realizing the potential of the Internet is toreconceptualize how knowledge is obtained and leverage the advantage of themedium By combining “richness” and “reach,” e-knowledge enterprises can driveutilization, leading to a network effect and monetization

“A high growth strategy for the New Economy needs to create more inclusive politics, a new learning society and opportunities available to all.”

– The Long Boom Peter Schwartz, Peter Leyden and Joel Hyatt

Online Human Capital Solutions – Combining Richness and Reach

Optimal Monetization

=Local

PhysicalOne-to-OneInteractivity

GlobalVirtualMass MarketIsolated

Source: Merrill Lynch Global Growth Group

Enormous Market Opportunity

Add it all up, and we see a gigantic opportunity for companies that provide scalesolutions to the most vexing problem facing our global economy The ubiquitousnature of PCs combined with the power of the Internet are both catalysts andenablers revolutionizing what is already a $2 plus-trillion market Currently there

is approximately $14 billion of market capitalization for the “born on the web”knowledge enterprises and $20 billion of market capitalization when we include

“clicks and bricks.” Our estimates are for the U.S online market opportunity forknowledge enterprises to grow from $9.4 billion in 1999 to $53.3 billion in 2003representing a CAGR of 54% Providing additional fuel, venture capitalists haveinvested over $3 billion in the knowledge enterprise industry since January 1999

Huge and Growing Market Opportunity

U.S Online Market Size Human Capital Solutions

U.S Addressable

CAGR: 1999E-2003E Learning Sectors (excludes Pre-K)

K-12 $375 billion $1.3 billion $6.9 billion 52% + Higher Ed $250 billion $1.2 billion $7.0 billion 55% + Corporate + Gov’t Learning $110 billion $1.1 billion* $11.4 billion* 79% Total Learning Sectors $735 billion $3.6 billion $25.3 billion 63% + Recruiting & Staffing $75 billion $5.8 billion $28.0 billion 48%

Total Human Capital Solutions $810 billion $9.4 billion $53.3 billion 54%

Source: Merrill Lynch Global Growth Group, IDC, Forrester, Jupiter, Training Magazine

*Online figures include corporate learning only They exclude the government learning market.

Given the size of the problem, the necessity to solve it, and the momentum of theworldwide web, we see the e-knowledge industry having explosive growth Theaggregate market growth of the learning sectors is estimated to grow from $3.6billion in 1999 to $25.3 billion in 2003, or a CAGR of 63% Representing evenmore potential for growth, the corporate learning market is expected to grow from

$1.1 billion in 1999 to $11.4 billion in 2003 or a CAGR of 79%

Companies providing online

human capital solutions have

the potential to bring together

both richness and reach,

creating a powerful and

revolutionary user experience.

The ubiquitous nature of PCs

combined with the power of the

Internet are both catalysts and

enablers revolutionizing what is

already a $2 plus-trillion

market.

Our estimates are for the U.S.

online market opportunity for

knowledge enterprises to grow

from $9.4 billion in 1999 to

$53.3 billion in 2003

representing a CAGR of 54%.

Publicly Traded e-Knowledge Enterprise Companies

% Price

B2B eLEARNING

CTRA Centra Software 03-Feb-00 Corp Learning $7.69 $178.7 (45.1%) $16.1 $28.3 11.1x 6.3x CLKS CLICK2LEARN.COM 12-Jun-98 Corp Learning 12.00 176.6 9.1% 42.8 59.7 4.1 3.0 DTHK DigitalThink 25-Feb-00 Corp Learning 24.75 813.0 76.8% 19.1 37.0 42.6 22.0 ECLG eCollege.com 15-Dec-99 Higher Ed 4.88 67.6 (55.7%) 15.3 NA 4.4 NA ELOQ Eloquent 17-Feb-00 Corp Learning 8.13 137.5 (49.2%) NA NA NA NA RVDP RiverDeep 09-Mar-00 K-12 26.00 709.3 30.0% 22.0 45.0 32.2 15.8 SABA Saba Software (D-1-1-9) 07-April-00 Corp Learning 18.75 804.5 25.0% 28.9 63.6 27.8 12.6 SKIL SkillSoft Corporation 05-Feb-00 Corp Learning 13.50 169.9 (3.6%) 16.2 42.5 10.5 4.0 SMTF SmartForce plc (D-1-1-9) 13-Apr-95 Corp Learning 43.13 2,328.8 978.1% 152.5 255.8 15.3 9.1

B2C eLEARNING

LTWO Learn2.com, Inc 20-Oct-94 Corp Learning $2.28 $116.3 (77.2%) $50.0 NA 2.3x NA SKDS SmarterKids.com 23-Nov-99 K-12 2.63 50.8 (81.3%) 40.0 91.0 1.3 0.6x NETS YouthStream Media Networks 03-Apr-96 Higher Ed 7.06 189.4 (41.3%) NA NA NA NA

EDUCATION TECHNOLOGY / INFRASTRUCTURE

LSPN Lightspan 10-Feb-00 K-12 8.06 349.0 (32.8%) 62.9 88.9 5.5 3.9 NTWO N2H2, Inc 30-Jul-99 K-12 $4.44 $98.3 (65.9%) $24.3 NA 4.0x NA NLCS National Computer Syst (C-2-1-7) 15-Apr-86 K-12 51.19 1,638.3 485.0% 748.8 861.1 2.2 1.9x SCIL Scientific Learning Corp (D-1-1-9) 22-Jul-99 K-12 16.13 169.2 0.8% 26.2 65.5 6.4 2.6 IZAP ZapMe! Corporation (D-1-1-9) 20-Oct-99 K-12 2.91 127.1 (73.6%) 36.0 123.7 3.5 1.0

ECRUITING / HUMAN CAPITAL SERVICES

CBDR Careerbuilder 12-May-99 Human Cap Serv $2.34 $55.5 (82.0%) $31.0 $60.9 1.8x 0.9x EWBX EarthWeb, Inc (D-2-1-9) 11-Nov-98 Human Cap Serv 14.88 145.2 6.3% 64.0 102.0 2.3 1.4 HHNT HeadHunter.NET 19-Aug-99 Human Cap Serv 11.50 123.9 15.0% 25.1 NA 4.9 NA HOTJ HotJobs.com Ltd 10-Aug-99 Human Cap Serv 7.50 237.9 (6.3%) 46.3 70.2 5.1 3.4 KFRC kforce 15-Aug-95 Human Cap Serv 12.38 577.9 295.4% 901.2 1,141.3 0.6 0.5 NIKU Niku Corporation 29-Feb-00 Human Cap Serv 22.75 1,570.8 (5.2%) NA NA NA NA OPUS Opus360 Corporation 07-Apr-00 Human Cap Serv 4.50 224.0 (55.0%) 11.1 33.0 20.2x 6.8x TMPW TMP Worldwide (D-2-1-9) 13-Dec-96 Human Cap Serv 58.81 5,287.1 740.2% 881.0 1,023.1 6.0 5.2 TJOB topjobs.net plc 28-Apr-99 Human Cap Serv 5.88 47.0 (51.0%) 7.8 21.9 6.0 2.1 HIRE Webhire 23-Jul-96 Human Cap Serv 6.00 87.1 (45.5%) 26.6 NA 3.3 NA

CLICKS & BRICKS LEARNING AND HUMAN CAPITAL SERVICES

APOL Apollo Group (C-1-1-9) 06-Dec-94 Higher Ed $27.56 $2,076.1 1,591.0% $652.9 $783.5 3.2x 2.6x

DV DeVry (C-1-1-9) 24-Jun-91 Higher Ed 27.44 1,909.2 2,095.0% 562.5 646.9 3.4 3.0 HSII Heidrick & Struggles International 27-Apr-99 Human Cap Serv 41.00 788.4 192.9% 523.0 659.0 1.5x 1.2x KFY Korn/Ferry International 11-Feb-99 Human Cap Serv 22.00 810.6 57.1% 568.7 625.6 1.4x 1.3x LTRE Learning Tree Int’l (D-2-2-9) 06-Dec-95 Corp Learning 49.06 1,062.0 513.3% 216.8 242.8 4.9 4.4 POSO ProsoftTraining.com 06-Dec-96 Corp Learning 15.06 277.4 653.1% 22.4 24.6 12.4 11.3 POVT Provant (D-3-2-9) 29-Apr-98 Corp Learning 5.06 106.2 (61.1%) 217.0 NA 0.5 NA SLVN Sylvan Learning Syst (D-2-1-9) 15-Dec-93 K-12 12.50 636.9 155.6% 356.1 391.7 1.8 1.6

PUBLISHERS

H Harcourt, Inc May-69 Education Publish $37.00 $1,913.6 702.6% $2,329.5 $2,562.5 0.8x 0.7x HTN Houghton-Mifflin Sep-84 Education Publish 39.81 1,209.6 451.4% 947.3 1,089.4 1.3 1.1 LSE:PES Pearson plc NA Education Publish 33.00 20,136.6 NA 3,725.0 4,083.0 5.4 4.9 SCHL Scholastic Feb-94 Education Publish 46.69 754.7 107.5% 1,248.9 1,373.8 0.6 0.5 TOC Thomson Corporation NA Education Publish 33.29 20,725.8 NA 6,327.2 6,959.9 3.3 3.0

Total w/o Clicks & Bricks or Publishers: 11,193.6 (5.7%) 4.9x 3.2x

2 Price-to-Opportunity:

The New Valuation Metric

We have watched in awe and delight the unprecedented velocity of market valuecreated by the Internet economy Five years ago, the Internet didn’t even register

as a blip in terms of market value in U.S capital markets Today, Internetcompanies represent a combined half trillion dollars out of $15 trillion withcorresponding valuations at stratospheric heights

In this report, we introduce a new valuation metric – price-to-opportunity – that

we believe makes Net valuations more comprehensible, at least in the framework

of three of the primary forces driving the new economy The first of these is theunprecedented improvement in and adoption of technology and the Internet, bestcaptured by Moore’s Law The second force is dictated by Metcalfe’s Law.Companies leveraging the power of the Internet, with its anytime, anywhere,anyone access, have the opportunity to expand at exponential growth rates as usersbuild Third is the winner-take-all environment that provides disproportionategains to category killers in their respective segments

We believe that e-knowledge enterprises that successfully leverage thisopportunity and receive these outsized valuations will possess certain keycharacteristics:

• An ability to capitalize on Metcalfe’s Law, the Network Effect;

• A service based on the unique advantages of the Internet − or made possibledue to the Internet − to deliver knowledge For example, given that we learnmost through highly interactive experiences, successful companies will notsimply repurpose educational content, but re-think the entire delivery ofeducation;

• A service that expands both the reach and richness of learning and humancapital solutions through the Internet’s capabilities;

• A business model based on recurring revenues, low customer acquisitioncosts or high lifetime customer value (or both), revenues from multiplesources and high gross margins;

• A strong management team and backers, able to function at the rapid fire pace

of the evolving Internet economy

The network effect is all about rapidly building utilization by the delivery ofhighly relevant content and services to accessible markets

An Instant History of the Internet Business:

1996: Great profits propheted 1999: Great prophets profit 2003: The great profit, greatly

– Po Bronson, author

Five years ago, the Internet

didn’t even register a blip in

terms of market value in U.S.

capital markets Today, Internet

companies represent a combined

half trillion dollars out of

$15 trillion.

The Internet will “democratize”

knowledge, increasing access,

lowering the cost and

improving the quality.

e-Knowledge Network Effect

E -K now ledge N etw ork E ffect

*OREDO

&RUSRUDWLRQV

.QRZOHGJH : RUNHUV

Source: Merrill Lynch Global Growth GroupThe correlation between the productivity of a company’s intangible assets – itsintellectual and human capital – and the need to pay those assets a competitivewage is clearly illustrated by the close relationship between rising price-to-bookratios and the rising income gap The market perceives the value of human capital,assigning significantly greater value to knowledge workers than others

The Internet is all about disproportionate gains to the winners in each category.For example, the five largest Internet companies ranked by market cap account fornearly 50% of the half trillion dollars of total Internet-company market

capitalization The ten largest Internet companies account for 62% Clearly, themarket believes the Net is a “winner-take-all” playing field

Pre-Net, it took a company decades to reach a $1-billion market value, if it everreached that milestone In startling contrast, Yahoo! went public in 1996 with amarket cap of $347 million, and today it is $66 billion; Amazon.com had its IPO

in 1997 with a market cap of $366 million, and currently its market cap is $18billion; AOL went public in 1992 with a market cap of $62 million, and today it is

at $137 billion Internet Capital Group, with a market value today of almost

$11.5 billion, did not exist five years ago

New Economy Companies

Year Founded

Value at IPO ($M)

Number of Employees

Market Cap / Employees

Market Cap ($B)

2000E Price / Sales

2000E Price / Book

Yahoo! 1994 $347 1,992 $32,932,099 $65.6 63.7x 73.3x Amazon.com 1995 $366 7,600 $2,378,616 $18.1 7.0x 42.6x Priceline 1998 $2,277 373 $29,818,961 $11.1 10.4x 44.4x Ariba 1996 $983 386 $41,829,016 $16.1 92.9x 56.6x CMGI 1996 $23 1,594 $10,125,025 $16.1 21.3x 4.0x Internet Capital Group 1996 $984 70 $164,736,813 $11.5 N/A 26.5x Commerce One 1994 $471 594 $13,367,778 $7.9 52.7x 32.0x America Online 1985 $62 12,100 $11,314,552 $136.9 20.3x 21.9x

Average: $38,312,857 38.3x 37.6x Median: $21,593,370 21.3x 37.3x

The Internet is all about

disproportionate gains to the

winners in each category The

five largest Internet companies

ranked by market cap account

for nearly 50% of the half

trillion dollars of total

Internet-company market capitalization.

Another stunning contrast between old and new economy companies is thecomparison of market cap-per-employees and price-to-book ratios New economycompanies enjoy phenomenal valuations based on these metrics Each employee atYahoo!, for example, is “worth” nearly $33 million Each employee at Priceline is

“valued” at $30 million On average, each employee at the leading new economycompanies in the table above is worth $38 million The best companies are in awar for talent, realizing that brainpower drives market value in the new economy

In contrast, each employee at Disney is valued at $743,530, and each employee at

GM is valued at just $141,682 On average, each employee at the leading oldeconomy companies is worth “only” $689,020, or less than 2% of employee value

at the new economy companies

Old Economy Companies

Year Founded

Number of Employees

Market Cap / Employees

Market Cap ($B)

2000E Price/Sales

2000E Price/Book

General Electric 1876 340,000 $1,531,351 $520.7 5.9x 13.0x Wal-Mart 1962 910,000 $282,542 $257.1 1.4x 10.6x General Motors 1908 388,000 $141,682 $55.0 0.3x 2.7x McDonalds 1955 314,000 $154,062 $48.4 3.3x 5.1x

Exxon Mobil 1882 120,000 $2,289,025 $274.7 1.3x 4.4x Disney 1918 120,000 $743,530 $89.2 3.6x 3.8x Phillip Morris 1854 137,000 $360,945 $49.4 0.6x 3.2x Boeing 1916 197,000 $176,687 $34.8 0.7x 3.1x

“WE ARE IN A GREAT WAR FOR TALENT Century 21: Age of the Great War for Talent Talent = Wealth Period It’s the word – according to Tony Blair And Cisco CEO John Chambers He is in the talent acquisition mode ALL THE TIME Says he buys companies – typically start-ups – to get the best talent at a price of $2 million or so per employee Just like the NBA! The Blair-Chambers dogma will rule! Talent is a fabulous word – a million miles from employee.”

—Tom Peters, Forbes ASAP, February 21, 2000

In 1980, the price-to-book of the ten largest companies in the U.S was 1.2x.Today, the price-to-book is 12.1x, or 10x greater One could argue that this is aclear sign of a wildly inflated equity market; we believe, however, that it’s morereflective of the fact that, in the knowledge economy, the key asset drivingcorporate value is intangible: Intellectual and human capital These starkcontrasts are summarized in the following table

Two Different Worlds

In the old economy,

price-to-book was a useful valuation

metric, as it was physical

capital that companies

leveraged into earnings power.

What matters in the new

economy, however, is human

capital.

The correlation between the productivity of a company’s intangible assets – itsintellectual and human capital – and the need to pay those assets a competitivewage is clearly illustrated by the close relationship between rising price-to-bookratios and the rising income gap The market also perceives the value of humancapital, assigning significantly greater value to knowledge workers than others.

Human Capital is Replacing Physical Capital as the Primary Productive Asset

Median Price-to-Book for 10 Largest Companies

Source: U.S Census Bureau, Compustat, Merrill Lynch Global Growth Group

n Evaluating the Valuations

The speed at which market value has been created and the valuations associatedwith many Internet companies (i.e., 20x price to sales for a leading Internetcompany is fairly normal, versus 20x earnings in the Old Economy as represented

by the Dow Jones Industrials) are unparalleled in history Many market punditscall this “a bubble ready to burst,” speculating that perhaps 75% of today’s publicInternet companies will be out of business in five years

While we are in the camp that agrees that there is speculative excess reflected inthe market valuations of many Internet companies (with a correspondingobliteration of capital being a reality if business performance does not pan out),

we also believe that changes in the global marketplace are unprecedented in speed,scope and significance The resultant opportunities are extraordinary, in ouropinion To put some figures behind this powerful tailwind to the Interneteconomy, business-to-consumer (B2C) Internet opportunities are expected to grow

at a 55% CAGR from $31 billion in 1999 to $274 billion in 2004 business (B2B) activity is projected to dwarf this total, rising from $80 billion to

Business-to-$2 trillion during the same period, a 91% CAGR

“To swim a fast hundred meters, it’s better to swim with the tide than to work

on your stroke.”

— Warren Buffett

e-Commerce Projected to Explode

Source: Merrill Lynch, IDC, Forrester Research, Jupiter Communications

Due to the unique disproportionate advantages a leading Internet company has inits category as a result of the network effect, operating leverage, global reach andviral growth, the valuation metrics used to determine current share price arenecessarily different However, these valuations ultimately reflect how allcompanies are valued by discounting future cash flow to the present Hence, in thesame way that growth companies are based on “futures,” the most appropriatemetric for evaluating a dominant Internet company, in our opinion, is price-to-opportunity rather than the conventional metrics of price-to-earnings or the newer– but too simplistic – price-to-sales

“In investing money, the amount of interest you want should depend on whether you want to eat well or sleep well.”

– J Kenfield Morley, Some Things I Believe

In a simplified top-down analysis of an old economy company, investors look atboth the size and growth rate of the industry in question, as well as the company’smarket share and operating margin They then calculate a future earnings streambased on their assumptions and discount it back to the present using an appropriaterisk-adjusted rate, thus deriving the company’s theoretical market value

New View of Human Capital and Learning in Our Knowledge-Based Economy

Four-Year Degree Forty-Year Degree Learning As Cost Center Learning as #1 Source of Competitive Advantage Help Wanted Talent Needed

Learner Mobility Content Mobility Distance Education Distributed Learning

Physical Capital Human Capital One-Size Fits All Tailored Programs Geographic Institutions Brand Name Universities & Celebrity Professors Just-in-Case Just-in-Time

Source: Merrill Lynch Global Growth Group

The most appropriate metric for

evaluating a dominant Internet

company is price-to-opportunity.

In the new economy, education

has become critical for both

individuals and employers.

The Internet alters this analysis, ultimately leading to a theoretical market valuebased on the size of the opportunity Here, investors calculate the size of theindustry and estimate its growth based on industry factors, as well as account forthe growth of the Internet – the “Net Effect” – which is a powerful megatrendcutting across all industries.

A primary “Net effect” is disintermediation – the virtual elimination of time anddistance between buyer and seller Coupled with disintermediation is a tremendousopportunity for scalability, where one company can seize control of a market inless time than ever before Both of these forces are rocket-fueled by the networkeffect, as dictated by Metcalfe’s Law, inherent in some Internet companies’

business models Combined, these three “Net effects” – disintermediation, scalability and the network effect – create a winner-take-all competitive environment in which speed kills.

“Speed is God, and time is the devil.”

– Silicon Valley saying

In this environment, gross margin becomes an even more important metric, as theNet affords tremendous operating leverage to the winner All this leads to the size

of the opportunity, discounted back to today, from which current valuations can beapplied Hence, “the new new thing” in many respects is “the old old thing,” thevalue of an enterprise is its future cash flow discounted back to the present.The outsized nature of a category killer’s market share opportunity creates awinner-take-all environment on the Internet The global reach afforded by theNet, coupled with the viral potency of Metcalfe’s Law, fuels the race to marketdominance at speeds never seen before

“Price to Opportunity” is the Appropriate Valuation Metric on the Internet

Operating Margin

Future Earnings Stream Discounted

Disintermediated:

Winner Take All

Gross Margin

Size of Opportunity Discounted to Today

Based on Discount Rate

O pportunity

D iscounted at 35% Back to Today

Market Value Market Value

Source: Merrill Lynch Global Growth Group

Net/e-Commerce Market Caps

“The new new thing” in many

respects is “the old old thing,”

the value of an enterprise is its

future cash flow discounted

back to the present.

We have already seen this valuation metric applied to category killers on theInternet, which enjoy premium multiples vis-à-vis their trailing competitors.Yahoo!, for example, is priced at 59x its 2000 sales estimate, or at a 474%

premium to other aggregators/portals Likewise, EBay is priced at 48x 2000estimated sales, or at a 1425% premium to its peers

The Internet is All About Disproportionate Gains to the Leaders

Leader’s Price/2000E Sales

Leader’s Premium to Comps

Online Aggregators/Portals Yahoo! Goto.com, Lycos, ivillage.com, theglobe.com, women.com 58.9x 474% Online Service Providers AOL Juno, Earthlink/Mindspring, Prodigy, Concentric Network, Excite@Home 13.6x 294%

Internet Software Ariba Net Object, Net Perceptions, Sterling Commerce, Backweb, Marimba 83.5x 598% Commerce – Principal Model Amazon, Priceline Barnesandnoble.com, beyond.com, Cdnow, Cyberian Outpost, Egghead,

Onsale, Value America, uBid

7.3x 1405% Commerce – Agent Model EBay Autobytel.com, Autoweb.com, Cheap Tickets, Preview Travel, Rowecom,

Ticketmaster Online-City Search, Tickets.com

48.0x 1425%

Source: Merrill Lynch Global Growth Group

“We are drowning in information and starving for knowledge.”

— Rutherford D Rogers

3 The Four P’s

To try to determine which Internet knowledge enterprises will be the categorykillers in their respective areas, we have created an analytical and conceptualframework, starting with the Four P’s, to evaluate attractiveness This frameworkreflects our belief that there are certain key fundamentals critical to identifying thepremier e-knowledge enterprise companies To this end, we focus on four

principles of growth stock investing, which we call the Four P’s: People, Product,Potential and Predictability

People

More than half of our investment focus is on the people running the business.There is no shortage of interesting business ideas, particularly on the Internetwhere barriers to entry have been considerably reduced Therefore, the ability toexecute is the key Obviously, no Internet company has a long history, but theirmanagement teams or advisors usually do Netscape changed its business modelfour times in four years and still wound up a phenomenal success The reason, inour view, was extraordinary leadership able to adjust on the fly at Internet speedand make the right decisions

Whether in a country, a company or even a sports team, one “world-class”

individual with vision and leadership skills often makes the difference

Amazon.com, Yahoo!, Starbucks, AOL, EDS and Wal-Mart are but a fewexamples of the truly great business success stories that were largely the result ofthe dreams, skills and leadership of one entrepreneur: Jeff Bezos, Tim

Koogle/Jerry Yang, Howard Schultz, Steve Case, Ross Perot and Sam Walton,respectively

“The thing that has constrained us for the last fours years has always been people bandwidth Just having enough smart, hard-working, talented, passionate people to execute against our vision.”

– Jeff Bezos, CEO, Amazon.com

The premium placed on strong management is greater in the New Economy thanever before, while the evaluation of management has increased in complexity Webelieve the new economy “Kingmakers” can provide a beacon to investors seekingstrong management teams As discussed later in this report, Kingmakers arepowerful partners who can lend credibility, experience and relationships tonetrepreneurs Potential Kingmakers include venture capital firms, Wall Streetinvestment banks, management consulting firms and other enterprise-widerelationship managers, technology companies, partners and customers Thesupport of these constituencies can make or break the future of an Internetknowledge enterprise

Product

There are Internet companies, and there is an Internet economy, but the Internet isnot an industry It’s a megatrend that cuts across all industries We search forcompanies holding leadership positions within the segments of the e-knowledgeenterprise industry, proprietary products, services, technology or niches that setthem apart from the competition or, better yet, “one-of-a-kind” businesses thathave no real competition

More than half of our

investment focus is on the

people running the business.

We search for companies

holding leadership positions

within the segments of the

e-knowledge enterprise industry,

proprietary products, services,

technology or niches that set

them apart from the

competition or, better yet,

“one-of-a-kind” businesses that have

no real competition.

Having a “claim to fame” is critical to us because we believe that the Internet doesnot allow for “me, too” companies to be relevant for very long We also look forcompanies that leverage the full power of the Internet, which are often “born onthe web” companies built with the Internet in mind as a growth platform Wefurther believe that significant opportunities exist for “clicks and bricks”

companies if they can operate with the mindset and speed of an Internet company

and also leverage the assets of their historical business Leading New Economyventure investors such as Accel Partners, Benchmark Capital and Kleiner, Perkinshave seen this opportunity and made significant investments to leverage offlineassets online

In today’s world of innovation supernovas, big-bang-business ideas and light information flow, we need a telescope to measure the future potential andnew growth perspectives to project the rate at which these universes will expand.Our philosophy of trying to identify the ultimate winners may cost us some short-term opportunities because we ignore companies that temporarily are in a voguespace Net Darwinism, however, shows that only the fittest ultimately survive, and

speed-of-we want to invest in companies that not only survive, but will also thrive duringtheir corporate evolution

To determine if a company has a leadership position in its space and really has a

“claim to fame,” we analyze various metrics These metrics serve as bothmeasurements to market position as well as “signs on the highway” to helpcorrelate critical milestones for success The key metric, which is driven by many

of these other metrics, is the Network Effect Once the Network Effect kicks in,market leadership is magnified, as are barriers to competition

Internet Human Capital Solutions Company Scorecard

Metcalfe’s Law:

The Network Effect

Each new member, supplier, and user of the network adds exponential value.

20

essential to being the leader.

10

your partner; make more by giving it away; business is 24/7.

10

Customer Acquisition Cost

& Lifetime Value

Obtaining users of the network balanced against lifetime value

of that user.

10

business around like a battleship New economy: need to be able to turn like a jet ski.

10

One Market (Reach) Time, space and distance are eliminated; think one economy,

one market.

10

assurance Brands are everything in the e-Knowledge space and the Internet.

The Internet is quick, interactive and collaborative Creating

an offering tailored to the Internet is key Just reading a bunch of text or a book online doesn’t work.

5

Source: Merrill Lynch Global Growth Group

Favorite Bookmarks of James W.

Breyer, Managing Partner, Accel

ideas and speed-of-light

information flow, we need a

telescope to measure the future

potential and new growth

perspectives to project the rate

at which these universes will

expand.

In the old economy, turning a

business around is like turning

a battleship In the new

economy, one needs to be able

to turn it like a jet ski.

We want to find companies with a meaningful market potential – smallercompanies that can become big ones “Open-ended” growth stories with longlegs, where there is no real limit to how big a company could become, are

especially attractive to us On the Net, it’s winner-take-all, exponentially increasing the potential of growth companies Potential has been scaled upward, leading to astronomical valuations based on traditional pricing metrics, but which are more understandable when viewed in the context of the aforementioned price-to-opportunity metric.

“I skate to where the puck is going to be, not where it has been.”

– Wayne Gretzky

In The Book of Knowledge, we identified six key megatrends that propelled the

knowledge services market forward Demographics, the Internet and technology,globalization, consolidation, branding and outsourcing are having a significantimpact on how and why we gain knowledge These same megatrends are at work

in the e-knowledge market, creating a powerful tailwind for growth

Six Megatrends Impacting the Knowledge Enterprises Market

Globalization

In te et

Outsourcing

C o so lid a tio n

B ran din g

e-Knowledge Enterprise

Source: Merrill Lynch Global Growth Group

• Internet – The core of e-Knowledge, the Internet, will “democratize”

learning, providing greater access at lower cost, ultimately improving quality.Ubiquitous PCs combined with high-speed bandwidth will facilitate engaginganytime, anywhere learning and human capital management Online learningshould become the new "killer application" for the Internet, providingattractive growth potential for e-knowledge enterprises that can effectivelymarry learning, technology and electronic commerce

• Demographics –In today’s knowledge-based economy, the pay gap between

those with a college education and those without has more than doubled in thelast 20 years Put another way, the purchasing power of a 30-year-old manwith a high-school diploma has dropped by over one-third over the past twodecades Lifelong learning is now required for economic longevity, and thesuccessful e-knowledge enterprise will provide individuals with the ability togain the skills necessary to survive and thrive in the New Economy Today’s

The core of e-Knowledge, the

Internet, will “democratize”

learning, providing greater

access at lower cost, ultimately

• Globalization – Approximately 30% of S&P 500 revenue comes from

outside of the United States The Internet creates one market and oneeconomy In today’s global knowledge-based economy, corporations needconsistent, multi-lingual learning resources that are accessible anywhere,anytime The successful e-knowledge enterprise will provide employees andindividuals with quality education and skills that are universally relevant andaccessible regardless of their time zone, uniquely combining richness andreach Less directly, but perhaps more important for the U.S worker, is thefact that globalization has enabled economic specialization like never before.For the workers of developed nations, this has further heightened the need forcontinuous lifetime learning

• Branding – Brands are key to both the Internet and Knowledge Enterprises.

The winners in the space will build strong brand names known for uniquestate-of-the art learning experiences where individuals can access first ratecontent in an engaging, interactive virtual environment conveniently from thehome or the desktop Established brands – those of prestigious universities,for example – will find both potential in and a challenge from the Internet

“The most valuable Web brands – including Yahoo!, Amazon.com, and E*Trade – are not product brands They are brands for a complex set of services – solutions – that help people cut through the clutter and perform a series of tasks.”

—Evan I Schwartz Digital Darwinism

• Outsourcing – In today’s fast-changing market environment, the corporate

incentive is to focus on core competencies and outsource everything else.Application service providers (ASPs) represent classic outsourcing and areexpected to enjoy explosive growth Customers trade the headache and cost ofpurchasing software and hardware, dealing with implementation and

obsolescence risk and managing internal IT for a single contract and a flatmonthly fee ASPs providing corporations with highly scalable human capitalmanagement services are likely to benefit from the critical solutions theyprovide and an efficient business model

• Consolidation – While consolidation used to be the hallmark of a mature

industry, this is no longer the case, particularly in technology, where smallstart-up companies are acquired for their technology and, as important, fortheir talented people Acquiring a competitor is often faster and easier thanhiring and training scarce computer programmers, sales people and leaders.Being a net consolidator, an acquiror can add value-enhancing features to itsnetwork, aggregate complementary communities and accelerate the networkeffect As niche players find it difficult to access or re-access the capitalmarkets, more consolidation should occur

A company’s ability to “communitize” and then “monetize” users to maximizelifetime value is particularly critical in determining the potential for thatenterprise We look for high gross and long-term operating margins These areindicators of the strength of the business model and correlate to the price-to-salesmultiples investors are willing to pay In general, the higher the gross andoperating margins, the higher the price-to-sales multiples

The Internet creates one market

and one economy.

A company’s ability to

“communitize” and then

“monetize” users to maximize

lifetime value is particularly

critical in determining the

potential for that enterprise.

Correlation Between Revenue Multiple and Gross Margin

ARBA

INKT

YHOO

EBAY BVSN

SCNT AOL VIAN RAZF

Source: Merrill Lynch Global Growth Group

Sustainable competitive advantages, including barriers to entry, economies ofscale and scope, an industry leadership position and proprietary technology andcontent, are the keys to predictable success The ability to exploit the networkeffect is usually a sure way to capture the leadership position in a space Supportfrom strategic partners, customers and financial backers is usually critical to

success, as well The right combination of visibility, scalability and profitability leads to a superior business model which corresponds to outsized valuation of leaders in the e-knowledge enterprise space.

Given the nascent stage of the e-knowledge market, determining the fifth P, Price,

or what the correct valuation should be, is challenging Valuations have been andwill likely in the near term to continue to be driven by the size of the marketopportunity, demand imbalance for stock, sequential growth and sentiment.Historically, great growth stocks, in general, and Internet stocks, in particular,look expensive to start and become even more expensive over time Conversely,mediocre growth and Internet stocks generally start relatively inexpensive andusually get less expensive

Historically, great growth

stocks, in general, and Internet

stocks, in particular, look

expensive to start and become

even more expensive over time.

Conversely, mediocre growth

and Internet stocks generally

start relatively inexpensive and

usually get less expensive.

The Knowledge Web: Unleashing the Killer App

Metcalfe’sLaw

The Network Effect

Transistors per Microprocessor

Source: Merrill Lynch Global Growth Group

Conversation with Gary Becker:

Development of Human Capital and the Internet

Michael Moe: You published your first work on human capital in the early 1960’s Since that time the

importance of human capital and the value of education have only become more pronounced What are some of the observations you could make today about human capital, the knowledge economy and some of the trends that we’re seeing, as well as the importance of education and the statistics behind that?

Gary Becker: Right Well throughout the 20th century, human capital has been important By human capital, I

mean the knowledge and skills that men and women acquire through education, on the jobtraining or other types of schools and other types of learning It can take many different forms Inprevious centuries, economies were based on manpower, strength, some machinery but not really

so systematically on knowledge

That changed in this century and has especially become more and more prominent, I would say, inthe last 25 years One objective measure of that is the earnings advantage of higher education, acollege education in the United States compared to say, a high school education That gap on theaverage for the typical college and high school graduates was about 40% as early 1970’s Itactually was stationary for a while in 1970 and has really exploded in the last 25 years

So the gap between a typical high school graduate and college graduate now is more like 70-75%rather than 40% There has been an enormous increase and the obvious explanation for that hasbeen that while you’ve noticed the supply of higher educated people was growing in the UnitedStates, the demand for people with skills has been growing even faster So the earnings advantage

of this scarce resource namely, educated knowledge, has become greater and greater

That’s the most dramatic feature but it shows up in other ways as well: more skilled people on thejob; their earnings advantage increasing relative to less skilled people; and a recognition bypeople that education is more valuable A larger fraction of both men and women, of differentraces and ethnic groups, has been continuing onto higher education since the early 1980’s,reflecting the fact that they perceive that this is more of a knowledge economy and they have toreally improve their knowledge base

MM: What do you predict looking out over the next 10 to 20 years in terms of the pay gap and the

importance of knowledge and education?

GB: Well, I think there is no evidence that the importance of education is going to decline over this

period If anything, it’s going to continue to increase What happens to the pay gap reallydepends on how rapidly the supply of educated people increases compared to demand If we get arapid increase in supply, that will prevent the pay gap from increasing much if at all

On the other hand, if it increases only slowly, I anticipate we’ll still see a somewhat slowerincrease than we had in the 80’s and 90’s but some further increase

MM: What do you see the Internet’s impact being in terms of increasing the access to education?

The Internet has the potential to be the first major change in this process since Socrates, I believe.What it means is that somebody can be in their office or at their home tuning into an instruction,having a give-and-take with the instructor.

The instructor would give feedback and answers tailored to the individual Even though theywere at a distance and they are not physically interacting with their fellow students, they caninteract with them through the Internet, through chat rooms and the like This provides thepossibility, which is becoming an actuality of enormous increase, in the flexibility of the access

to, not only higher education, but to retraining and additional investment in one’s human capital.People can do that without having to go on-site to some learning center, which may be farremoved or difficult for them to get to from either their home or workplace

Therefore, it economizes on their time It adds greatly to their flexibility – when they can acquirethis knowledge I think it’s going to have great potential, particularly with education of workersand other adults and also for people who want to obtain a higher education degree Also, Ibelieve it already is filtering down to a much greater use to K-12 education, as well

MM: What kind of global impact will this have?

be in Singapore, Zimbabwe, Buenos Aires, Barcelona, as well as in the United States So onceyou go to the Internet, you’re no longer constrained by physical presence Your market is theglobe

These students also have flexibility They can be taking a degree offered at the University ofChicago with some courses taught at Stanford and other courses taught at Columbia put togetherfor their own degree as subject to, of course, the approval of these institutions So it’s going togive both the teacher access to an enormous market and the students much access to a variety toteachers who are not constrained to be at one particular institution

MM: We talk about some of the advantages that the Internet brings What are some of the major

disadvantages of the Internet that need to be solved to really create a value added-learning experience?

obvious one that people always bring up is the fact that there is clearly some advantage to directphysical interaction with instructor and students That is the challenge to the Internet I don’tthink there will ever be a perfect substitute for that, but the challenge is to try to reduce thedisparity by having more direct interaction, not only through video, direct access with instructorsand possibly with other students, but also with ease of communication This way, students don’tfeel that they are sitting isolated in front of a computer They feel they are really part of a class,maybe a class that extends around the world, but a class where they can directly communicatewith other students and with their instructor

MM: You look at the opportunity for UNext and obviously the potential is very exciting What is your

exact involvement with UNext and what do you see the opportunity for it to be?

been of course, Andy Rosenfield, but I’ve been one of the people involved I’m on the board now

of the company I’ve made some presentations on behalf of the company So they have me on avideo and here and there on some things but I haven’t prepared a course or anything for thecompany That may come in the future

I think there is an enormous potential for UNext and for profit-making UNext’s market will betwo-fold I think the first and major part in the beginning certainly will be through companies;employees of companies who sign up with UNext for instruction in a particular type of, say,finance, maybe in options markets or cost accounting or whatever it may be

Ultimately, the hope is that UNext will also be dealing with individuals For this we have auniversity So we hope to be and expect to be a degree granting institution that people, maybestarting out with companies taking these courses, can use toward a bachelors or a masters degree.

MM: What are some things that need to happen for UNext to realize its enormous opportunity?

GB: Well, two things mainly One is to get a bigger portfolio of courses that we have to offer As we

learn more, and as we are in this business longer, we are trying out these courses, but the feedbackthat we will get from the early courses will be enormous in helping us to restructure and to bettermeet the individual needs of different students in the same course Certainly, getting a largerportfolio of courses would be very important

The second thing is essentially that most on-the-job-training or company-sponsored training isclearly taking place on-site at the company A little bit has taken place through companiesfinancing high level employees to go get MBA degrees and executive training programs and thelike What they have to be convinced of is that there are great advantages for them not to bedirectly involved in providing their own courses [for the remaining majority of employees] but tocontract out a much larger fraction of them to a company like UNext who can, by specializing in

it, provide much greater talent Affiliation with major universities can do a much better job inproviding access to their employees, in particular, by having their employees do most of this studyover the Internet so that they can economize on how much lost work-time they incur

I think this is a selling job that we have already started to do, and I think this will be an obstacle toget companies thinking along these lines If we can overcome that obstacle, I think we are well

on our way

MM: My last question, I think you’ve talked about, but how important do you think the Internet is going

to be for the advancement of and the importance of human capital?

GB: I think it’s going to be extremely important as you take a long-run perspective I think its main

challenge, let’s say at the university levels, is not going to be to the Chicagos, the Stanfords, theHarvards, the Yales, the Columbias and other top schools We have 3,000 colleges anduniversities [in this country], and I think the Internet will be a very effective and very toughcombination for the middle and lower tier schools So, I think that’s one direction it’s going tospread

The second role of the Internet, which may turn out to be even more important, would be in aknowledge economy You don’t finish your learning when you graduate from high school oreven from an university, or get an advanced degree, an MBA or Ph.D It’s a lifelong process.Nothing is going to rival the effectiveness, the cost-effectiveness in terms of saving people’s time,for this means of continuing the learning process of individuals, through the Internet I think it’sgoing to capture a good share of that market and a significant share of the education market atlower levels

GB: I’m an enthusiast obviously I’ve not only worked in the area of human capital, I’ve taught for 40

years So, for me personally to see these two interests come together – teaching and theimportance of human capital – by a new technological medium, namely the Internet, is really afantastic opportunity aside from my involvement with UNext I’m really optimistic not onlyabout UNext but with many other companies that will eventually be quite successful at takingadvantage of the fact that we are in a knowledge-based economy People have to continue tolearn Some of it will continue to go on on-site, but with the new technology available there is noreason why we have to any longer think that most of it be on-site rather than through this medium

4 Mind Over Matter:

Human Capital in the Knowledge Economy

Throughout history, whether in pre-industrial or industrial times, great nationsdeveloped based on their access to physical resources or their ability to surmountphysical barriers: England and Spain crossed the oceans, Germany turned coal andiron into steel, and the United States exploited a wealth of agricultural andindustrial resources to become the world’s breadbasket and industrial superpower.The advent of the personal computer, the Internet and the electronic delivery ofinformation have transformed the world from a manufacturing, physically-basedeconomy to an electronic, knowledge-based economy Whereas the resources ofthe physically-based economy are coal, oil and steel, the resources of the new,knowledge-based economy are brainpower and the ability to acquire, deliver andprocess information effectively

“We spend all our time on people The day we screw up the people thing, this company is over.”

— Jack Welch

With some of the greatest developments in new technologies arriving late in the

20th century, widespread optimism surrounding the 21st century has yieldedfuturists predicting a period of rapid growth at the magnitude of the industrialrevolution, if not greater, with the advent of the knowledge-based economy Inthis new economy, knowledge workers form the cornerstones of successfulbusinesses, emerging industries and economic growth In this new environment,however, the labor force is presented with an unprecedented challenge as it mustnow gain and continuously upgrade its skills Companies are increasing R&Dexpenditures, and employees must continue to “upgrade” their skills in order tokeep pace with the innovation Case in point, the number of patents being issued

in the United States is almost twice the amount granted only ten years ago, and thepace of patent applications is accelerating

Patent Applications & Grants in the U.S (000s)

0 50 100 150 200 250 300

1978 1980 1982 198

4

1986 1988 1990 1992 1994 1996 1998

Source: The Economist

The advent of the personal

computer, the Internet and the

electronic delivery of

information have transformed

the world from a manufacturing, physically-

based economy to an electronic,

knowledge-based economy.

In this “new economy,”

knowledge workers form the

cornerstones of successful

businesses, emerging industries

and economic growth In this

new environment, the labor

force is presented with an

unprecedented challenge as it

must now gain and

continuously upgrade its skills.

While the future possibilities of the knowledge economy look both exciting and, at thesame time, daunting, we believe the transformation to a knowledge economy isalready evident.

• Most striking—the dramatic pay gap between those with education andthose without has more than doubled in less than 20 years

• Also significant—our analysis illustrating a seismic shift in how themarket values companies, discounting traditional analysis of earningsderived from physical capital and replacing it with analysis of earningspower derived from human capital

• Finally, the structural economic changes that have occurred mean thatnew jobs being created are service and skill-based jobs rather thanmanufacturing jobs

Growing Pay Gap Rewards Knowledge Workers

In today’s economy, companies’ earnings power rises due to returns on humancapital Companies, in turn, must reward employees with their “productivitywages” or risk losing them to competitors The result is that the earnings power ofknowledge employees rises in the job market Those without the necessaryeducation, however, do not reap similar rewards Accordingly, we have seen theincome gap between those with a bachelor’s or higher degree and those with just ahigh school education widen significantly, and we expect this trend to continue aslong as the marketplace continues to reward knowledge-intensive companies

Widening Pay Gap Between High School and College Graduates

“Capital is accessible, and smart strategies can simply be copied The life of technology is growing shorter all the time For many companies today, talented people are the prime source of competitive advantage.”

— Ed Michaels, Director, McKinsey & Co.

In today’s economy, companies’

earnings power rises due to

returns on human capital.

Companies, in turn, are

rewarding employees with their

“productivity wages”, or risk

losing them to competitors.

In 1980, the pay difference

between someone who had a

high school education and a

college education was 50%.

Today it is over 100% and

growing.

Recognition of Human Capital Driving Market Valuations of Knowledge Enterprises

Growth companies today are dependent on human capital Those companies thathave created growth by leveraging their “off balance sheet” human capital assetshave, in turn, seen their share prices rewarded with higher valuations It isillustrative to look at valuations of the largest ten companies in the old economyand compare them with the largest ten companies in the new economy

Human Capital is Replacing Physical Capital as the Primary Productive Asset

10 Largest Companies by Market Capitalization

Median Price-to-Book

1.2x

12.1x

1x 3x 5x 7x 9x 11x 13x

Source: Compustat, Merrill Lynch Global Growth Group

In the old economy, price-to-book was a useful valuation measure, as it wasphysical capital that companies leveraged into earnings power What matters inthe new economy, however, is human capital In 1980, the price-to-book of thelargest companies in the U.S was 1.2x Today the price-to-book is 12.1x, or tentimes greater

“There is a clear relationship between the effectiveness of a company’s human capital and the creation of superior shareholder returns."

— Watson Wyatt Human Capital Index Study

Growth Jobs Are Knowledge and Service Jobs

During the industrial revolution, the labor force was already equipped with theskills to enter into manufacturing sector employment, where the assembly linemerely required the theory of work organization to be put into practice Workerswere required to do no more than perform specific tasks, and later operatespecialized machinery that performed the actual work Nonetheless, the changesthat this innovation brought were enormous By 1950, 40% of the Americanworkforce was employed in the manufacturing sector and, as a result, productivityincreased fifty-fold Workers accrued the majority of the benefits — half in theform of sharply reduced working hours and the other half in a twenty-five-fold

Those companies that have

created growth by leveraging

their “off balance sheet”

human capital assets have, in

turn, seen their share prices

rewarded with higher

valuations.

By 1950, 40% of the American

workforce was employed in the

manufacturing sector and as a

result, productivity increased

fifty-fold.

Flip-Flop From Manufacturing Economy to Service Economy (% of Total Employment)

13.7%

35.4% 38.9%

50 years ago with roots in the GI Bill, the “Management Revolution” and the rise

of the services sector Since 1950, employment in the manufacturing sector hasfallen from nearly 40% of total employment to less than 18% currently, whileservice sector employment has risen from less than 14% to more than 35%,essentially flip-flopping from where it had been in 1950

During this period, demands for an educated workforce grew Increasedcompetition from abroad, and particularly from emerging economic regions, hasresulted in continued substitution in the manufacturing sector away from workersand toward technology, increasing the productivity of remaining workers

Domestically, the service sector has attracted the more highly skilled workersaway from the manufacturing sector Lower-skilled factory jobs have beenabsorbed by less developed countries

“Today with the emergence of the information age, the strength of a country

is based on knowledge National greatness will arise not from our natural resources or our factories, but from our people – people with new ideas and skills.”

— Michael Milken, Fueling America’s Growth, Education, Entrepreneurship and Access to Capital

Just as gains in manufacturing productivity, greater access to higher education and

an affluent middle-class fueled the transition from a manufacturing to a based economy, the extensive adoption of information technology is now creatingthe need for a highly skilled knowledge-based economy While service sector jobgrowth has been growing overall, the more technology-intensive industries haveexperienced the most rapid growth In fact, traditional services sector

services-employment, retail and wholesale trade, financial services, and leisure services,has experienced slower job growth than the total job market Knowledge jobssuch as IT, health and business services, on the other hand, are growing 3-6 times

as fast as economy-wide job growth

Since 1950, employment in the

manufacturing sector has fallen

from nearly 40% of total

employment to less than 18%

currently, while service sector

employment has risen from less

than 14% to more than 35%,

essentially flip-flopping from

where it had been in 1950.

The extensive adoption of

information technology is now

creating the need for a highly

skilled knowledge-based

economy.

Knowledge jobs such as IT,

health and business services, on

the other hand, are growing 3-6

times as fast as economy-wide

job growth.

Industry Job Growth 1988-1998, CAGR

Educational Services Engineering and Management Services Offices & Clinics of Medical Doctors Child Day Care Services Motion Pictures Social Services Business Services Residential Care Services Management & Public Relations Services

Personnel Supply Services Computer & Data Processing Services

Source: Bureau of Labor StatisticsThe growth of the knowledge workforce heralds the potential for far greateropportunities for today’s workers, companies and the economy The resulting demandfor an educated workforce, however, also presents a sizeable challenge for today’sworkers With rapid technological advances and the continued proliferation ofcomputers and the numerous applications that are required to be mastered, employersare demanding more from their current and prospective employees

Projected Employment by Educational Level Required, 1996-2006

Postsecondary vocational training Moderate-term on-the-job training Long-term on-the-job training Work experience in related occupation Short-term on-the-job training

Master’s degree Work experience plus bachelors or higher

First professional degree Doctoral degree Associates degree Bachelor’s degree All occupations

Source: Bureau of Labor StatisticsThe challenge to workers, companies and economies in realizing this practicallyopen-ended economic growth opportunity (where we are limited only by “greymatter”, that is, brainpower) is in preparing today’s workforce for tomorrow’sjobs Coming generations of workers must accomplish far more in terms ofeducational attainment, and companies will have to invest heavily in training if

“the greatest boom in history” is to become a reality As a consequence, we believethis dynamic will be accompanied by a significant growth in the knowledge servicesindustry, creating tremendous growth opportunities for investors

The resulting demand for an

educated workforce, brought

about by the pervasiveness of

technology in today’s

businesses, presents a sizeable

challenge for today’s workers.

Coming generations of workers

must accomplish far more in

terms of educational attainment

and companies will have to

invest heavily in training if “the

greatest boom in history” is to

become a reality.

5 The Emerging New Economy

We believe the Internet will have a greater effect on the way we do business thananything we’ve seen in the past 500 years Standing on the shoulders of theinventions of electricity, the telephone and the PC, the Internet will advance thepower of the individual to a degree not seen since the invention of the printingpress

This emerging new economy represents a tectonic upheaval in our commonwealth It has its own distinct opportunities and its own new rules Those who play by the new rules will prosper; those who ignore them will not.

—Kevin Kelly New Rules for the New Economy

The Internet – like the printing press – is a Great Democratizer It vastly improvesthe access, quality and speed of information, enabling the individual to developknowledge like never before As with any democratizing force, the Internet willpropel power toward the individual, devolving it away from the institution.Technology platforms and the Internet have created tremendous opportunities fornew business and education paradigms, ushering in a new economy driven byknowledge and access to information

The Emergence of a New Economy

Labor vs Management Teams Business vs Environment Encourage Growth

Job Preservation Job Creation

Plant, Equipment Intellectual Property

Standardization Custom, Choice

Regulation Public/Private Partnerships

Source: John Doerr; Kleiner, Perkins, Caufield & ByersWhere the resources of the physically based economy were coal, oil and steel, theresources of the new, knowledge-based economy are brainpower and the ability toeffectively acquire, deliver and process information Those who are effectivelyeducated and trained will be the ones who will be able to survive economicallyand thrive in our global, knowledge-based economy Those who don’t will berendered economically obsolete

The Internet – like the printing

press – is a Great Democratizer.

It vastly improves the access,

quality and speed of

information, enabling the

individual to develop knowledge

like never before.

Technology platforms and the

Internet have created

tremendous opportunities for

new business and education

paradigms, ushering in a “New

Economy” driven by knowledge

and access to information.

Where the resources of the

physically based economy were

coal, oil and steel, the resources

of the new, knowledge-based

economy are brainpower and

the ability to effectively acquire,

deliver and process information.

What is an “Internet Company”

The Internet is a powerful force – a global “mega-trend” – affecting all commerce

It is more like the emergence of the printing press, the telephone or the computerthan an industry in and of itself In addition to commerce, the Internet shouldcontinue to change the way people communicate, research, shop, spend theirleisure time and learn

A rapidly growing number of companies covering every potential nook and cranny

of the business world operate primarily or exclusively on the Net, but most have

an analog in the offline world For example, Amazon.com is in many ways aBarnes & Noble or Wal-Mart in cyberspace (or at least is becoming so) AOL has

a lot of similarities to cable television, although notably a super-deluxe and highlyinteractive cable offering eBay is essentially an online auction house or fleamarket without geographic boundaries

Since it’s very difficult to be all things to all people, the Internet may be apolarizing force pushing companies to either end of a spectrum and graduallyeliminating companies in the middle On one end of the spectrum will be highlyfocused, premium content and services, while on the other will be all-

encompassing, value-priced content and service

The Internet Metamorphosis Offline Caterpillar The Net’s Metamorphosing Characteristics Dot.com Butterfly

Mail/Fax /Telephone/FedEx Digitization of Information/Convenience Email Junk Mail Customization/Access "One-to-one" marketing Video Rental Zero Marginal Cost, "Byte-Sized" Information Video On Demand Library Info as a Digitized, Accessible Commodity Search Engines Catalog Interactivity Website (online catalog)

Bookstores, five & dimes Anytime, Anywhere/Unlimited Selection Amazon.com Auction houses/flea markets Frictionless, Ubiquitous Commerce eBay National print newspapers Instantaneous/Information Democratizer Drudge Report

Network news Interactivity/Anytime Access to Information ESPN.com, CNN.com Wall Street brokerage firms Power Devolves to the Consumer Merrill Lynch Direct, E*Trade The local newspaper Interactivity/Zero Marginal Cost Content CitySearch/Sidewalk.com

Source: Merrill Lynch Global Growth Group

Corporate America Has Changed Dramatically

While catalyzing a sea change in the way we interact with one another andtransact business, the Internet has at the same time caused an explosion in thegrowth of a new type of company The old rigid corporate structure is anathema inthe Internet Age To compete successfully on the Net, companies must be, above

all things, entrepreneurial to the core They must view change as an opportunity instead of a threat, competition as a potential partner rather than the enemy, and the business plan as a work in progress rather than a ball and

chain limiting choices

It is interesting, but perhaps not surprising, that the changes caused by the Internet

in business, communications, learning, etc., have their parallel in the corporatestructure and culture of Internet companies The Net is The Great Democratizer,devolving power from institutions to individuals The same shift in power hasoccurred in many companies

To compete successfully on the

Net, companies must be, above

all things, entrepreneurial to

the core.

Net companies must view

change as an opportunity

instead of a threat, competition

as a potential partner rather

than the enemy, and the

business plan as a work in

progress rather than a ball and

chain limiting choices.