As much as information and analysis can be warped during bubbles, they also typically run on so much enthusiasm that perceived investment op-
portunities contradict basic logic and 2 plus 2 equals 16 becomes ac- ceptable thinking. Despite the difficulty of separating information from noise, many people do not try very hard or simply do not bother at all.
Henry Blodget said bluntly in a report three months before the mar- ket began its collapse, “Valuation is often not a helpful tool in deter- mining when to sell hyper-growth stocks.”
Bad analysis can justify any stock valuation, and bubbles tend to at- tract bad analysis. On the one hand, the bad analysis and new metrics helped inflate the stock prices by creating flawed rationales for their val- uations that nevertheless convinced many investors. On the other hand, to some degree, those new metrics emerged to explain the stock prices observed in the market. The analysis and the prices reinforced each other in an unholy cycle: Bad analysis inflated stock prices, and higher stock prices motivated bad analysis to explain them.
“Values were created out of thin air based on hype and on projections rather than on past records,” said Alan Patricof, an early investor in Apple Computers and Office Depot. “It was multiples of sales that were the measures by which companies were being financed. Companies were bought and sold and merged on these metrics.”63
The idea was that these new companies were competing in a frenzied land grab to capture significant market share. They needed to build fast to get there first. Once there, they would be big enough and have enough customers to start generating real profits. Focusing on profits too early would penalize them inappropriately for the high spending required for fast growth. The logic was that profits would come once they positioned themselves successfully as the market leader.
“There are fundamental principles that VCs must follow and these tend to be common sense,” said Tony Sun. “However, during the boom, many rules were broken and the rationalization is that the new economy dictates new rules. For example, many of the dot.com companies had business plans that made no sense. The more revenues they generated, the more money they lost. However, this was explained by the ‘land grab’
theory and no one wanted to address the business model as long as the stock market was willing to accord such companies lofty valuations.”64
For example, Alladvantage paid people to surf the web. Members downloaded a “ViewBar” program that beamed ads onto the bottom of
their computer screen while they surfed the web. They received 50 cents for every hour logged. More importantly, and more damaging to the company’s finances, if members referred a friend, they received 10 cents for each hour that person surfed. The users didn’t have to click on any ads or buy anything. They just had to allow Alladvantage to beam them advertising at the bottom of the screen.
By the end of the first quarter of 2000, Alladvantage had two million members. The refer-a-friend strategy encouraged some 125,000 members to refer 20 or more friends each.Alladvantage employed 587 people with offices in London, Paris, Tokyo, and Sydney as well as several locations in the United States. It sounded promising—at least by Internet metrics.
Except that their fee structure meant that they paid out $40 million to members leading to a loss of $66 million for that quarter alone. Total loses for the year reached $102 million.
The revenue, and ultimately profit, was supposed to come from highly targeted advertising based on data collected about users’ surfing habits. But the demand for that data was not nearly as high as the com- pany’s leaders fantasized. Between March 1999 and 2000, Alladvantage collected only $14.4 million in revenues.
With economics like this, Alladvantage quickly burned through its
$135 million invested by several VCs. When the IPO window closed in March 2000, so did the company’s potential new source of cash and the willingness of VC to go along with the game. By February 1, 2001, Al- ladvantage shut down.
“Once the greed glands started pumping, there were a lot of disci- plines that fell by the wayside,” observed Bob Kagle of Benchmark Cap- ital, an early investor in eBay. “The discipline of being very methodical in the process of company building went away . . . people slowly lose touch with reality and the measures that in a more rational period are important to determine success like profitability, revenues and things like that fall away to other convenient measures that people can hang things on to—eyeballs, page views. That can give people some false sense of security that there is some sort of rational basis to their behavior—but those are not grounded in firm economic principals. A lot of long-term, tried-and-true disciplines that are constructive in company building process just go out of vogue.”65
Bubbles don’t operate on truth. This kind of analysis created infor- mation that justified high valuations for investment in untested com- panies. The information, moreover, was being developed and reported by the most established organizations in the business. Across the board, the biggest banks were producing glowing reports, the most re- spected media touted them to the public, the venture funds were talk- ing up a storm. If you can’t believe these experts, whom can you believe?
One of the most noted examples of a stock valuation that made no sense was the IPO of Palm on March 2, 2000. Palm’s parent company, 3Com, sold 5 percent of Palm’s shares, retaining ownership of 95 percent of the company for itself. But defying basic logic, the value of Palm be- come worth more than the value of 3Com. On the first day of trading, Palm closed at $95 a share and 3Com closed at $82. Even three months after the IPO, this substantial gap remained. The Palm example has some exceptional features in the sense that short sellers often enter the market during such price discrepancies and drive down the price. But short sell- ers could not find anyone to lend them shares of Palm. As a result, it was- n’t possible to take advantage of this price difference for arbitrage trading purposes.66
By February 2000, the Internet sector equaled 6 percent of the mar- ket capitalization of all U.S. public companies and 20 percent of all pub- licly traded equity volume.67 In 1999, Internet companies had a total market value of over $1 trillion, while accumulating lossesof $9 billion for the same year. Even if you accepted the new metric mania and al- lowed for the possibility that today’s profits could be sacrificed for to- morrow’s growth, these firms had revenues of just $30 billion leading to a price to sales ratio of 33 compared to the broad-based historic norm of roughly 1.68
Mark Walsh was CEO of VerticalNet, one of the first stellar business- to-business performers. He was very early in thinking about the Internet not as consumer media or commerce but as a vehicle to serve businesses and improve purchasing between companies. When he was shopping around the business plan to go public, he described VerticalNet as an In- ternet-based trade publisher. His pitch to investors was that every type of media had been impacted to some extent by the tsunami of the Internet,
except trade publishing. “There was this ‘aha’ moment in every meeting,”
he said. “You would see it every time. They would sit back in their chair and go, ‘makes sense’ and most of these meetings really had a kind of
‘makes sense’ kind of yardstick. The majority concluded to give me a piece of this action.”69“Makes sense” became the only standard for so many start-ups pitching themselves to venture funds or to the public market.
Toward the end, even that flimsiest of standards could be ignored.
Mark Walsh was not a 20-something start-up guy. He was a former executive at AOL and at GE. VerticalNet’s presentations had lots of spreadsheets with sound analysis showing a reasonable growth rate as the company was consolidating online trade publications. Despite that, “the romance took over,” he said. “Our story was fresh and new. No matter what the spreadsheets say, if you’re fresh and new or first, no matter what the industry, there is a certain panache that comes with that.”
Internet Capital Group (ICG), another high-flying stock, appeared toward the end of the bubble. Its plan was to become a holding company of business-to-business companies—a GE for the new economy. At the peak, an ICG stock was trading at $212, representing a market value of
$56 billion—more than the combined value of the “old economy” com- panies Alcoa, Caterpillar, and Eastman Kodak combined.ICG went out of business when the bubble burst.
The market-driven metrics, however, fed on themselves. The decline of analytical discipline was cumulative as the market seemed to confirm its own worst thinking.
“It’s a slippery slope, intellectually,” explained an investment banker directly involved with some of the most prominent Internet IPOs, “once you kind of say, ‘I don’t have any fundamentals to decline this piece of business. I can’t say it’s too early, I can’t say it doesn’t have revenues, I can’t say the management team is not intact, I can’t say it’s not prof- itable.’ Pretty soon, you’ve thrown every rational argument out the win- dow. The only thing left is, well, is this a good piece of business and will they be around in 3 to 5 years and potentially a leader in the space? If your team says yes, and they think the stock will go up, that pretty much became the only basis to judge whether to take companies public.”70
Discipline declines quickly among many investors when market sig- nals are not telling investors who use these valuation techniques that they
are wrong. Even worse, the market prices for stocks sometimes surpass even the most exaggerated claims.
The venture capital industry, “lost its discipline by being co-opted into believing that new business models could succeed,” said Tony Sun.
“Some of these new business models clearly had no economic principles but [were] based on momentum and impression. The trouble is that you get co-opted easily when the market continued to reinforce the idea that your erroneous assumptions can turn into profitable investments.”71
“It’s the fog of war,” said Barbalato, “You’re just in there going to work every day. You get up in the morning, you pack your bag, you go to work, you do your job, you go home. You don’t sit back and pick your teeth and analyze every little thing. You just don’t have enough information.”72
The decline of discipline that occurs during all bubbles means that companies that never should have been created got funded, and many entered the public market sowing the seeds of its own destruction. The enthusiasm of the day makes endless opportunities look probable rather than possible and everything else look easy.
Reflecting on one poor business venture during the Internet bubble, Michael Moritz, a partner at Sequoia Capital and lead investor of Google, bemoaned the sentiment of the time: “The promise of the un- introduced service is infinite. In part you delude yourself. All the risks were spelled out in incredible and graphic detail in all the documents. I think there was enough encouraging stuff happening that people felt the income statements and balance sheets would eventually catch up with the promise.”73
Alan Patricof remembers one investment he considered and was glad he stayed away. Kozmo.com proposed 1-hour online delivery of things like ice cream, videos, and so forth. It was valued very highly. The CEO was just 29 years old. “There was a lot of interest,” Patricof remem- bered, “I tried it out. Ordered three videos. They messed up the order a few times. I started thinking, each delivery, back and forth, the labor, the bill processing, for 3 videos. They didn’t charge for delivery. This is like Chinese food take out. No Chinese delivery company is worth
$200 million.”74
It wasn’t just venture capitalists or overexcited stock investors who let discipline fall by the wayside. Big businesses also suffered from bubble-
thinking. “By 1997, everyone started getting excited about it. And we, like everyone else, got more excited. A certain amount of irrational en- thusiasm crept into the business and by 1998–99 everyone was irra- tionally enthusiastic,” remembers Strauss Zelnick, former CEO of Bertelsmann Music Group.75
He opposed Bertelsmann’s plan to provide Napster a $100 million loan after the bubble burst. Napster was a file-sharing service that en- abled music lovers to trade their favorite songs for free. The courts shut it down for copyright infringement. Despite this, Bertelsmann wanted to keep it alive, use its brand, and convert it into a legitimate service.
After some analysis, Zelnick and others, couldn’t see a path that would ever get Napster to be a viable pay service after being free for so many years. “There was a lot of ‘you don’t just get it.’” In response to Zelnick’s analysis, “They just ignored it and rejected it out of hand. They just said, ‘no, you’re wrong, this is going to work. Because we believe.’ I think Bertelsmann did it bigger and more foolishly than most, but a lot of other people made the same mistake too.”76
Zelnick added, “The disagreement we had was a disagreement be- tween magical thinking and analytical thinking.”
Discipline declines precipitously during bubbles, and as a direct result, the seeds of its own destruction are laid. With each investment that cre- ates or fuels an unsustainable business, the market becomes weaker and weaker, less and less viable over the long term, and thus destined to col- lapse. Each of these bubble start-ups is like a time bomb, ticking away investors’ money, counting down the time to explode and destroy the party that so many investors are enjoying.
The mania for personal computers, automobiles, radio, and railways all attracted poorly thought-through companies if not outright shams.
Investors asked few questions and required little analysis.
During the radio mania, it appears that De Forest was well aware that his business, Wireless Telegraph Company of America, would benefit from and perhaps require overexcited markets. He wrote in his diaries,
“Soon, we believe, the suckers will begin to bite. Fine fishing weather,
now that the oil-fields have played out. ‘Wireless’ is the bait to use at pre- sent. May we stock our string before the wind veers and the sucker shoals are swept out to sea.”77
Like so many Internet companies, De Forest began to generate startling sales figures by charging unsustainable low prices. He was attempting to gain market share, funded by the capital markets, not by customers. For example, in a competition for a contract with the U.S. Navy, he offered prices 80 percent lower than Fassenden’s NESCO and won the contract.
Just as during the Internet bubble, illegitimate shell companies were formed just to be marketed to the public because they seemed to buy anything related to radio, but that had no real underlying business ra- tionale. The American Wireless Telephone and Telegraph Company, for example, was formed primarily to sell stock to the public.78 After in- vestors witnessed Marconi’s first demonstration of the opportunity, this shell company was able to tap frenzied followers and raise $5 million, or about $345 million in 2002.
A sales document promoting De Forest’s company reflects where in- vestors’ mindset was, “There is not enough stock to go around. You have the opportunity. Will you grasp it ‘at the flood tide’ and ride on the shore of plenty, high and dry above the adversities which often beset old age, to land of our dreams, where the wealth is unbounded and every wish gratified. . . . Or will you hesitate and doubt. . . . Think ! It is time for you to decide! Think well! Buy! Do it now!”79
SIMPLISTIC COMPARISONS
The most pervasive graph circulating around the desks of start-ups, venture funds, investment banks, and large corporations was the Internet adoption curve—a fabulously beautiful hockey-stick-shaped line, rapidly sloping up to the heavens. The bottom-line message of the graph to many was that consumers seemed to be signing up for some kind of Internet access at an incredible pace—faster than in any previous technology. This was proof, in the eyes of many, of how transformative the Internet could become and provided some indication of the speed of shifting consumer behavior.
Habib Kairuz, managing partner of Rho Capital, remembered, “The rate of growth of Internet adoption made it convincing . . . so much
faster than any other medium, the slide that everyone was showing was how long it took for cable to get to 60 percent penetration, how long it took for TV to get to 60 percent, and Internet was so much faster. And the application for the Internet was not just media, here you have media, you have commerce, you have business communication, you were looking EDI only serving 10 percent of corporations and this could open it up to everyone else. Whenever you talk about figures like trillion dollar markets, people get very excited. No one questioned those big numbers.”
If all these people were online, then the customer base for various ser- vices and content was large and growing fast. However, for so many firms this line was used as a signal not just for Internet adoption but also adoption of their own businesses. There was an assumption that if the Internet grew this fast, they should too. Business plans were written and funded on this basis.
Several psychological studies show that when faced with uncertainty, people tend to assume that past events will indicate what will occur in the future. People exaggerate the degree to which one event is a good rep- resentation of another event. Psychologists call this a representative heuristic.
This is similar to the mental slip that occurred when investors for- casted that all start-up efforts would follow the same growth path in the future as the Internet adoption did in the past. People overestimate how much past events will represent future events.
In an excellent history of early radio, Susan Douglas captured a cen- tral driver of investor enthusiasm this way, “All the eager dreamer had to do was recognize what giants Western Union, Bell Telephone and Gen- eral Electric had become to calculate where wireless might be in the fu- ture and what fortunes might accrue to those who had had the foresight to invest early.”80Bubbles lead investors to repeatedly project parallels in between the infant companies and the established mega-players to de- lude themselves that they are on the inside track of a great opportunity.
The same dynamic drove some of the highest valued Internet companies:
Internet Capital Group imagined itself to become the GE of the Inter- net, and Yahoo the Disney of the Internet, and Webvan the Wal-Mart of the Internet.