Digital Matters - Issue 37

"The dotcom crash was like a shark attack."

There's no question that what happened on Wall Street on April 14 was a major event. Some called it a "dislocation," others called it a "correction," but it was bigger and more important than what either word suggests. It was the end of the dotcom era — and the beginning of a financial shakeout that continues to roil the markets today.

More than $1 trillion in market capitalization was lost in a wild six-and-a-half-hour stretch. Dotcom stocks of every description crashed. Companies good and bad lost half, two-thirds, or three-quarters of their value — just like that. Great companies like Cisco Systems, JDS Uniphase Corp., Microsoft, and Sun Microsystems got caught in the avalanche of selling and saw their market caps shaved by tens of billions of dollars.

For a while, it appeared as if the dotcom crash might cascade down a mountain of margin debt, crushing both the NASDAQ and the New York Stock Exchange. That didn't happen. But most people acknowledged a scary truth: The dotcom crash was like a shark attack. It brought fear to the marrow of your bones. And it changed the way that everyone looked at the horizon.

The most immediate change could be summed up in what I call the "four strikes of Internet investing" rule. Before April 14, it was possible to get financing for a business-to-consumer Web site. It was possible to get financing for a dotcom company even if that company lacked a seasoned management team. It was possible to get financing for a company that was "all about content." And it was even possible to get financing for a company whose leaders were unclear about when — or if — the company would ever be profitable.

On April 15, all of those things ceased to be possible. Journalists and analysts saw this shift in almost comic terms. The day after the crash, dotcom companies sent out reams of advisories and press releases purporting to show that "previous estimates" had "incorrectly" assessed their "timelines" to profitability. Actually, the companies said, we'll be turning a profit much sooner than previously stated. That was nonsense, of course. Nothing had changed, except the balance of power. But, oh, what a difference that change made.

It's hard to believe, but investment bankers, venture capitalists, and merchant bankers have been suffering from low self-esteem over the past few years. They've been feeling unloved and underappreciated. In their mind's eye, they had done yeoman's work and had made all of these arrogant net-heads rich, and despite their hard work, they were almost universally regarded as parasites and greed-heads, beyond help and beneath contempt. "Suckfish" was Netscape founder Jim Clark's famous moniker for people in the investment community, and it stuck to them like chewing gum.

All of that changed. On April 15, no one called them "suckfish" anymore. And that, more than anything else, is what the dotcom crash meant. Simply stated, the financial community was back on top. The bosses who had become errand boys became bosses again. And they immediately laid down the law.

If some dotcom executive had a "vision" that he or she could scratch out on the back of a cocktail napkin — a vision that would "change the face" of some business sector but that had no realistic business plan — well, that was nice, but it was no longer good enough. Bring the investment boys (they were virtually all male) a business-to-consumer Internet play, and they wouldn't even offer you a cup of coffee. One strike, and you were on the margin. "No management team with proven experience" now meant "No meeting at all." Two strikes, and you were out. With three strikes ("all about content") or four strikes (no sign of profitability), you didn't even get your phone calls returned.

This change in the business pecking order was so swift and so sharp that most of the mainstream media missed it. But you could see it all over the pages of business magazines and newspapers. There were stories about incubators that would no longer consider startups, about IPOs cancelled because of "uncertain" market conditions, about dotcom outfits that had once positioned themselves as titans of disintermediation but were now describing themselves as a "good fit" inside a larger suite of services. Indeed, the most immediate impact was a resurgence of activity in the mergers-and-acquisitions departments of major financial-services firms. Dotcom companies that had only recently promised to reinvent entire business categories were suddenly being appraised as prime takeover targets — at well below book value.

With this change came a return to value investing. Truth be told, Wall Street was never very comfortable with momentum investing, or with so-called concept stocks. Analysts understood that the digital revolution would create enormous value and change virtually everything in its path, and they believed as strongly as any Webbie that the Internet was an unstoppable force. But they still liked to see the money — the black numbers in the earnings report. Most of all, they liked to see customers who paid every month. And, on April 15, they loved those customers as never before.

And so what didn't change after April 14 was the investment community's enthusiasm for dotcom companies (especially those with proprietary technologies) that promised to rationalize and make transparent markets that had long been irrational and opaque. "Create real value for both suppliers and purchasers" was the new mantra — or, more simply, "Show us your persuasive value equation."

Companies that danced to the new music proceeded apace. So, for instance, PrintNation.com got its money. PrintNation.com made sense. Commercial printing accounts for 1% (more or less) of GDP, regardless of which developed or developing country you're talking about. In North America, one-third of all commercial printing is done by so-called "big shops." Two-thirds is done by companies with 10 employees or fewer. Shops with four employees or fewer — many of which are literally mom-and-pop operations — do 40% of all commercial printing in the United States. Most important, more than 75% of small shops are now connected to the Internet.

The big shops, of course, get all of the attention and all of the best deals, while the small shops get nothing but middlemen and markups and just-too-late deliveries. The smaller the shop, the more likely it is to pay dearly for printing products that big shops buy at a discount. PrintNation.com rationalizes this market by aggregating all of the small shops that are on the Internet into one collectively huge shop. The small shops rack up huge savings, their suppliers are satisfied, and PrintNation.com takes a nice fee on every deal.

The investment community loves this kind of business proposition because it's one that they understand. It reminds them of the leveraged-buyout model that proved so successful in the 1980s and early 1990s. By cutting out layers of fat, businesses that follow the market-rationalization model create real value.

The return to value investing explains why Paymap Inc.'s IPO will likely go forward, and why 100 shopping-bot companies will fold. Paymap, which has signed up 7 of the 11 largest mortgage lenders in the United States, offers a value proposition for customers: It will pay their mortgage every two weeks via electronic funds transfer, and in so doing, it will pay off a 30-year note in 21 years. And it offers a value proposition for lenders: It eliminates settlement costs for late payment, overpayment, or underpayment, because payments arrive on time, every two weeks — and if they're not on time, adjustments are made electronically, with no human intervention required. Shopping bots, on the other hand, promise a "rewarding Internet experience." What's the value of that?

Big companies are approaching Internet investments in much the same way — creating auction sites and exchanges to extract value from dysfunctional markets. Fuel and Marine Marketing LLC (a joint venture between Chevron and Texaco), working in concert with BP Amoco and Royal Dutch/Shell, has launched OceanConnect.com, a service that seeks to rationalize the market for fuel oil, the petroleum-derivative product that powers fishing fleets around the world. Major automobile manufacturers are setting up consortiums for Internet-enabled procurement of auto-assembly materials. Enron Corp. is using the Internet to aggregate broadband technology and to broker its use.

A return to value investing was inevitable. So many dotcom companies made so little sense that it's a wonder that they ever got funding at all. Petfood.com and bluejeans.com were never anything more than 800-numbers to begin with. The idea that people would want lots of stand-alone services cluttering up their bookmarks defied common sense. For most consumers, the Internet is a time-and-convenience deal. Its added value lies in getting things done quickly so that you have more time for what you really want to do.

April 14 marked a fork in the road of the new economy. The high road is digital technology; the low road is dotcom. Digital-technology companies get the benefit of the doubt, while dotcom companies are now required to show profitability.

Digital technology gets the benefit of the doubt because of its underlying fundamentals. As Rich Karlgaard put it in a recent magazine column, "Markets may (and did) correct for overvalue, but they can't abjure the laws of physics. Chips will continue to double in price performance every 18 months. Storage of bits will continue to double every 12 months. Communications capacity on fiber optics will double every 6 months." Those laws of physics are not something that you can afford to bet against. They could change the entertainment business, the telephony business, the government business, the health-care business, and hundreds of other business categories in the blink of an eye.

But for dotcom companies, the law of supply and demand now applies with a vengeance. There is no such thing as "monetized eyeballs" — not unless you have Yahoo!-like reach. Relying on banner advertising as your only revenue stream isn't going to cut it anymore. Building to flip is no longer a business plan. And you'd better have some serious people on board to help you build your business.

Just as the digital revolution has transformed traditional business, so the April 14 dotcom crash signifies the end of e-business as a separate entity. The new rules of the road are still digital, but the disciplines of the old economy still apply. This reckoning was bound to happen sooner or later. That it happened sooner (and that it caused a dislocation that was easily contained) will almost certainly prove beneficial to the economy as a whole. That which does not kill the digital revolution makes it stronger.

John Ellis (jellis@fastcompany.com) is a writer and consultant based in New York City.

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