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DECEMBER 10, 1999


Will You Be Holding the Bag When Web Investors Regain Their Senses?
Excerpts from The Internet Bubble: Inside the Overvalued World of High-Tech Stocks and What You Need to Know to Avoid the Coming Shakeout

Will You Be Holding the Bag When Web Investors Regain Their Senses?^Excerpts from The Internet Bubble: Inside the Overvalued World of High-Tech Stocks and What You Need to Know to Avoid the Coming Shakeout ^^Excerpts from The Internet Bubble: Inside the Overvalued World of High-Tech Stocks and What You Need to Know to Avoid the Coming Shakeout ^Will You Be Holding the Bag When Web Investors Regain Their Senses?
The Internet Bubble

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In the last five years, individual investors have poured millions into more than 2,000 Internet startup companies in hopes of striking it rich. Some have cashed in big. The following chart of the top ten performing Internet stocks that went public before May 1999 tells the story. Shown here are the annualized returns for these stocks. The increase in the stock prices isn't even calculated from the IPO price, but from the closing price at the end of the first trading week when normal investors would have been able to buy these stocks.

Company Percentage Return
Healtheon   3339 %
eBay   3269 %
AboveNet   1853 %
AmeriTrade   1105 %
MessageMedia   886 %
Go2Net   872 %
CMG   792 %
InfoSpace   681 %
E*Trade   652 %
Bottomline Technologies   611 %

Manias are nothing new. The classic case is the tulip mania of seventeenth-century Holland. Not just the elite, but artisans, millers, weavers, carpenters, smiths, maidservants, and barge keepers converted their property into cash and invested in tulip bulbs.

There was about a two-year buildup before the tulip market took off in the year 1636, then came crashing down for good in April 1637. When the full panic hit, prices dropped by the hour, and the tulip bulbs became worthless.

More than 200 years later, America had its own version of tulip mania in the form of railroad stock speculation and the Comstock Lode silver rush. The twentieth century has had speculative manias as well, in the Florida real estate boom and the stock-market frenzy of the 1920s. In both cases, stories circulated of fortunes made overnight, and there was constant talk of prime real estate, hot companies, and surefire stock tips.

Veteran technology investor Roger McNamee likes to distinguish between the industrial and technological manias that led to something lasting and mere fads such as the tulips that came to nothing. "There were a whole bunch of industries funded on the backs of gigantic manias, many of which led to great industrial revolutions," he says. "Speculation tends to go hand in hand with entrepreneurship."

But McNamee also explains that during these financial manias, which generally span a three- to five-year period, capital is infused indiscriminately into a new industry. Companies with sustainable business models survive, but the vast majority implode.

INTERNET IPOS. As capital floods the market, companies not only get started faster, but go public sooner. Many have only a vague idea what their strategy is. Says venture capitalist Ann Winblad of Hummer Winblad Partners, which has placed big bets on the Internet, "There are companies where, even if you squint, you can't figure out what their business models are."

So how do so many fledgling Internet companies get public? There is a whole financial food chain that benefits from the process — entrepreneurs, venture capitalists, investment bankers, certain large institutional investors and mutual funds. "To us, going public is just another means of financing the roll-out of a company," explains Don Valentine of Sequoia Capital.

Over the last four years, demand for Internet stocks has been insatiable. As investor demand rises, the quality of the companies generally sinks. Yet investment banks willingly accommodate their investors' desires for technology IPOs so they can collect their 7 percent underwriting fees and sign on new clients to manage their follow-on offerings. The bankers make no apologies about taking fledgling companies public to meet this demand. "It's our job to put food on the stoop," declares Cristina Morgan, managing director at the investment bank Hambrecht & Quist. "If the cat eats it, we've done ourA job."

Investment bankers also make their money by keeping their big institutional clients happy. There are over three-dozen primary institutional investors around the U.S. that favor technology stocks, and an array of specialty mutual funds. That's why few individual investors can secure IPO shares on their own.

Behind the public appetite for these investments is the human desire to get rich without working for it. That's how, in 1920, Charles Ponzi convinced investors that he could pay them 50 percent interest for the use of their money for just 45 days. Ponzi took in $7.9 million. Early investors were paid with funds raised from later ones. The whole scheme collapsed, and the latecomers lost all their capital.

During manias, public investors forget how much time it takes for viable companies to become established and for an industry to mature. Life in the Bubble also encourages the manic speculators to rack up high credit-card bills and other debt. Debt as a percentage of personal income rose from 58 percent in 1973, to 76 percent in 1989 to 85 percent in 1997. Total credit card debt soared from $243 billion in 1990 to $560 billion in 1997. American families carry an average of more than $7,000 in credit card debt. And one American family in 68 filed for personal bankruptcy in 1998, seven times the rate in 1980.

Yet insiders continue to exploit the environment. In a 1996 interview with Red Herring, Michael McCaffery, president and CEO of investment bank Robertson Stephens, spoke bluntly: "You wouldn't find any venture capitalists in Silicon Valley willing to finance these companies with their own money at these prices. The professionals would never do that."

Look at the stock prospectuses of these newly public venture companies — the risk sections are longer than the business summaries. In 1997, about one-third of the Internet companies completing IPOs lost money; in 1999 the same portion didn't even record any sales. Most of these companies have made no profit and have no idea when they will become profitable. Sometimes this vagueness is even seen as a virtue — that it's better to have no revenue than some revenue that doesn't grow very fast.

Part of the rationale for taking unprofitable companies public is to establish brand identity and grab market share. But it's far from certain who the survivors, much less the big winners, will be. So the pressure of the financial food chain comes full circle, with the insiders pointing the finger at each other, even as they all reap the rewards. And the mania builds toward a Darwinian shakeout.

Anthony Perkins and his brother, Michael Perkins, grew up in Menlo Park, Calif in the midst of the high-tech culture.

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