The incredible returns of bubble companies attracted a lot of money.
The venture capital funds expanded and new venture firms emerged to channel the capital that the existing funds turned away. The public mar- kets also swelled with people putting money into individual stocks, growth funds, and increasingly fast emerging tech funds. This capital found its way into various businesses new and old that were perceived as being on the forefront of the new economy. Connecting young start-ups on the frontiers of new technology to the incredible voltage of public market provides access to vast sums of money. As big as the venture in- dustry has become, it still does not compare to the public market that can channel tens of billions into funds and stocks on a monthly basis.
When venture firms go out to raise money for a new fund, they typ- ically have a cadre of limited partners and others they can call. During the bubble, demand was so high among limited partners who wanted to share in the fabulous returns that most funds had to turn away money rather than actively recruit new investors.
“We’ve been so successful. It was so easy to raise the money,” remem- bered Tom Perkins. “We raised money in days over the telephone from our existing investors. We have been compounding—for 30 years roughly 40 percent. During the bubble, our more recent partnerships were compounding 100 to 200 percent annually. Those numbers were real. The value wasn’t but the numbers were.”93
VCs were increasingly encouraged to make bigger, bolder invest- ments. The flood of money available created distorted incentives and made many investments seem practically risk-free.
Geoff Yang saw a noticeable shift in venture deals that were being funded. “Normally, venture capitalists guide start-ups by saying, ‘Don’t try to boil the ocean, start with something small and manageable and in your control in bite-sized pieces.’”94
By contrast, Yang saw this as a period of time when “if you tried to boil the ocean, it was—the bigger, the bolder [the] idea—the more interesting
it was to investors, to potential management and corporate partners.”95 The shift among investors to maximize boldness as a way to maximize re- turns was based on real experience—real, at least, in the bubble environ- ment. “It started off with a couple of very intriguing companies that would experience rapid success, and every time you stepped out further and further with something that was a little bit more ambitious and a lit- tle bit wilder, it would succeed bigger,” Yang said. “The whole phenome- non fed on itself. The success indicator, initially, was massive growth in users and revenues. And then stock price. That kind of kept feeding itself to more and more intangible metrics. As long as you could tell a story about how this could get big, then people would really get interested and towards the end of the mania—it was big just to be big—without ever thinking about should a stock price have some correlation to the dis- counted value of future cash flows. That kind of went out the window to- wards the end in favor of—just show me how it gets big. There was a feeling that there was a real land-grab mentality that the investors as well as the companies—if we can be the biggest one and fastest growing, we will figure out a way to monetize that position and revenues and subse- quently profits.”96
Furthermore, venture capitalists have a great luxury in the pipeline of money flows. They enjoy remarkable position regarding risk, at least when there is a seemingly endless supply of capital for future funds. To put this in striking context, Benchmark capital’s $3 million investment at the early stages of eBay led to over $4 billion returned in disburse- ments to its limited partners. Certainly, eBay is an extraordinary case, but that single hit would make up for many flops. Indeed, $4.5 billion would pay for 1,333 flop investments of $3 million. The comparison isn’t fair, since VCs do not use those returns for making new investments;
they give them back to their limited partners. But this comparison is nevertheless instructive. Single blockbusters pay for all the other very poor investments in start-ups that go out of business. Every individual investment is extraordinarily risky, because start-ups usually fail. Funds as a whole, which consist of many start-ups, appearto be far less risky than the public markets relative to their high rate of return, certainly during bubbles.
So far, the venture industry as a whole has not had a single year show- ing losses. Compared to the public market for stocks, that is extraordi- nary. Those losses may be fast approaching for the first time and may be large as the Internet bust ripples through their portfolios. Funds that started in the last years of the bubble and invested in the many start-ups that are now out of business or missed out on the IPO window may be- come the first to show loses. For these funds that started in the waning years of the bubbles, all of their companies may have gone out of busi- ness or their stock price dropped to extraordinary lows. This reality of venture risk can drive reckless spending during bubbles when money is so freely available.
It was this risk profile during bubbles that enabled venture funds to invest in start-ups that had slim prospects. Bob Kagle explained the dy- namic this way: “Since capital was essentially free it created this envi- ronment where people were literally willing to throw caution to the wind in pursuit of some collection of metrics which they could promote to the investment community and give them greater access to capital. There was such demand. Anytime you are taking companies public that were less than 2 years old and don’t even have solid revenue models, much less profitability, and you are getting paid 50 times your investment to do that—it would take super-human discipline to say no, thanks. That is more than you could expect from anyone.”97
Funds can do poorly if there are no home runs, and many of the companies that receive funding go out of business during a bust. But during bubbles the opposite is true. Just about any firm seemed to gen- erate fabulous returns. Savvy fund managers saw the public market val- uations of start-ups as excessive and expected a downturn. But even if the valuations dropped by half, they still came out ahead on their initial investments. The big shock to venture funds during the bust was that even their most dour estimates of how far things could drop were not low enough.
“The prices of public stocks were trading up to were too high. The purchase prices by large companies were too high. What we were saying is that we can buy at a deep discount to that so we can make a whole of money. What we didn’t appreciate was the fact that these prices could
come down by a factor of 5 to 10 rather than a factor of 2,” commented a venture capitalist.98
When infant companies growing in bubbles are suddenly able to raise huge amounts of money not just from venture capital firms but also on a far big- ger scale than the public markets, their methods of operation become warped and self-destructive. During normal periods, it typically takes 4 years or so for a company to reach a level at which it might raise additional cash by issuing shares to the public market. At this point in its develop- ment, it is looking to expand its operations in some way and has already gone through several periods of performance that can be analyzed. The management, business model, and market all have some history that can be used and gauged to determine the fair value of the new issues of stock.
Bubbles short-circuit that process, enabling infant companies with no history of performance to draw additional money from the vast resources of the general public. This makes it pretty easy for start-ups to be valued with metrics of enthusiasm rather than realistic future business performance.
Not only does this create froth in the public markets, but it also cre- ates froth within those businesses that become elevated by massive mar- ket capitalization and cash. Even worse, many start-ups have easy access to secondary offerings, creating the perceptions that capital will be end- lessly available. As a result, their approach to the risks of running their own business becomes warped.
Bill Hambrecht bemoaned the corrosive effect this perception of end- less money had on running new businesses: “It was a presumption that if this company has what I think it does technically, they can raise as much money as they need. So people didn’t pay any attention to what was on the balance sheet. It was an assumption that the market would continue to give them the money they needed.”99
As a result of such a seemingly endless supply of money, businesses operating in a bubble are encouraged to create unsustainable strategies and practices. One of the most notable examples of this was Webvan.
Webvan was able to raise $1 billion in venture capital to provide on- line delivery service of groceries. The plan was to build from scratch a na- tional network of warehouses and logistical operations to deliver
groceries from online orders. The core business idea of online orders of groceries was unproven. In fact, experimenting with a similar service in the Midwest, Krogers found that the initiative could not become prof- itable and shut it down.
After the bubble, it seems like insanity that such an unproven idea could have attracted so much money. However, it attracted some of the most sophisticated venture capitalists and business managers. Sequoia Capital and Benchmark were the earliest investors. George Shaheen, for- mer CEO of Anderson Consulting, was recruited to head the start-up.
Benchmark and Sequoia Capital, as early investors, put in only a few million dollars. But excitement was extremely high for the venture and for the stellar team that was assembled. Excitement ran high despite the complete lack of evidence that the business was viable, much less worth the amount invested or capable of demonstrating a notable return. Sub- sequent investors joined on terms far less favorable and far more risky than those enjoyed by Benchmark and Sequoia. It is hard to imagine how the core business of Webvan, delivering groceries, could ever create high returns on the $1 billion that was invested. Bob Kagle explained the logic used by those who invested on riskier terms this way: “You look at the market cap of Wal-Mart and you say why isn’t Webvan the new age Wal-Mart? That can be a very difficult argument to lose in this environ- ment.” Kagle added, “People aren’t forecasting on the risk in that envi- ronment. They are just projecting rosy scenarios, and no one is looking at the thorny scenarios. The notion of a rosy scenario leads you to even further detachment from reality.”100
The sense of endless capital affected every business decision at Web- van, from buying staplers to choosing warehouse expansions to estab- lishing complex logistics support.
Webvan, as could have been expected, ran into innumerable logistical and operational challenges. The managers learned, further, that the busi- ness of delivering groceries is very hard to bring to scale quickly. It needs to grow organically and slowly in order to insure that there are enough customers and deliveries to pay for all those costs. The new CEO who replaced Shaheen, Robert Swan, demonstrated clearly how the warped bubble environment undermined the company’s ability to make sound business decisions. “We made the assumption that capital was endless and demand was endless,” he said.101The firm folded on July 9, 2001.
After the bubble burst, the core idea of Webvan reemerged locally on smaller scales in parts of the country. Now growing organically are Fresh Direct in New York and Simon Delivers in Minneapolis, which serve only a handful of Zip codes. Right now they seem like profitable businesses.
While Webvan represents a single case of these bubble business dy- namics on an extraordinary scale, a similar dynamic affected every Inter- net start-up in almost any decision it made.
“We were a victim of the times,” commented Michael Moritz on the environment. “The world was rewarding us for raising $250 million and penalizing [us for] raising $25 million. Plaudits were given to expanding nationwide rather than regionally. Daring to be great overweighed being cautious.”102
Bubble environments regularly and systematically distort the business incentives for everyone in the market. At the time, a growing number of start-ups were paying for time during the Super Bowl in order to capture customer attention. “If everyone is behaving irrationally by buying Super Bowl ads, then you have to as well,” Peter Sisson, founder of Wineshop- per.com, said. “It’s an unvirtuous circle. Capital was not an issue, there was an endless supply. The only mistake could be not to be equipped to serve customers.”103
Another example of the destructive effects of so much money was that companies sold goods at unsustainably low prices—or even gave it away for free. The idea was that start-ups would keep prices low to at- tract customers at a significant loss in the hopes that companies could turn a profit by raising prices once the customers were “locked in.” Don Valentine lamented that a “group bought into this concept that if you gave it away to enough people, somehow the business model would work. What made it difficult to realize that it wasn’t true was that money was fairly free.”104
For example, OnSale announced in January 1999 that it would launch a service called “atCost,” which would offer a broad selection of computer items at wholesale prices. The company expected to make money from advertising. Buy.com launched a similar effort on a broader array of items from computers to books to music.
Kagle noted that when so much money floods the system, “the need for focus dissipates. You don’t really have to make something work in
order to get the next traunch of capital. All you have to do is promote and create the perception that there is momentum.”105
UrbanFetch and Kozmo.com both planned a service of 1-hour deliv- ery of videos, food, and other goods. They hoped that initial sales of cheap products would lead consumers increasingly to buy more expen- sive products like electronics. To attract customers, delivery was free, tips were not accepted, and for long periods of time, many products were sold at a discount.
These efforts were possible only so long as these start-ups received money from venture capitalist funds because they could not be sup- ported by normal business economics. Both started fairly late in the game. As a result, the slide that began in March 2000 closed for them the possibility of going IPO and getting significant public money to maintain their unsustainable practices. With the IPO window closed, the possibility of future venture rounds also quickly evaporated. Both businesses failed.
“When you are in business at some point the business needs to sup- port its own growth,” commented Alan Patricof. “Here the only thing supporting the company was raising additional rounds of capital. You can’t sustain any company, I don’t care who it is, with continued rais- ing of equity capital because at some point someone wakes up and says the emperor has no clothes on. All I am doing is funding losses.”106