Beyond the Temples
The information sector jumped into the real world with a splash. For a while, though, the real world hardly seemed real. Warnings of irrational exuberance notwithstanding,33 alchemists, charlatans, and Ponzi schemers drove crowd psychology to believe in the New World.
At its peak, a New World company called Pixelon announced that it had cracked some of the toughest challenges in computer graphics. Though the high-profile Pixelon raised more than $20 million in the fall of 1999 and hosted a star-studded Vegas extravaganza, the whole thing was a fraud. Pixelon CEO Michael Fenne was actually convicted felon David Kim Stanley, an old-time con man who realized that Internet investors were even easier marks than elderly churchgoers.34 Something was clearly amiss.It was only a matter of time before investors started to notice that they had been caught in a Ponzi scheme. The network growth pitch had sounded good. Its connection to Microsoft related recent successes to future ones, and grounded the reasons for both in academic theory. Listeners unaware of what constituted a “technology company,” why Internet pure plays weren’t really technology investments, and precisely what network economics established—in other words, most investors—found the argument enticing. It enticed enough of them to get the Ponzi scheme rolling; crowd psychology took over from there. As the bubble grew, the balance between investors seeking a rational explanation and those simply jumping on the bandwagon may have shifted, but the presumption of a plausible justification grounded in cutting-edge economic theory remained critical throughout. And it might very well have worked, except for one tiny problem: the cutting-edge theory was inapplicable to Internet pure plays.
The network economics pitch justifying the bubble had always focused on network growth.
But growth alone is insufficient for a company to exhibit the type of strong network effects that helped Microsoft. In order for even a firm controlling a network to reap monopoly profits, it must have some way of staying a monopolist when it raises its prices; it needs to lock its consumers in and its competitors out. Investors considering an “inevitable” network monopolist thus need to determine whether entry barriers exist. If they don’t, any price increase will anger customers and invite competitive entry. Monopolists unprotected by entry barriers are thus faced with a quandary; they can raise prices and lose their monopoly, or they can keep prices low and remain unprofitable monopolists. Either way, investors would be well advised to consider alternative investments.The key to the bubble was thus that few, if any, Internet companies were able to lock in enough customers to become profitable. Insufficient attention to the actual conditions of entry and the ease of consumer switching led investors to overestimate barriers to entry. These widespread misconceptions created both the tech-stock boom and the New World paradigm—and doomed them both to become merely interesting historical footnotes.
The challenge of locking-in consumers manifested itself as a lack of customer loyalty—even to successfully branded first movers. Con- sumers—many of whom were also the very investors decrying the dis- loyalty—began to compare prices across competing sites, effectively forcing e-tailers to bid away whatever slim margins they may have been attempting to earn. The theoretical predictions of marginal cost pricing and of zero profits throughout the information sector began to raise their ugly heads. Shopping “bots” emerged to help consumers compare prices by accessing the information on multiple sellers’ sites and reporting it back to a consumer accessing the bot site. Some bots even allowed consumers to make their purchases without ever visiting the seller’s site— thereby reducing the number of hits to that site and consequently the seller’s potential to gain revenue by selling advertising space.
Some sellers—or sites representing sellers—responded by posting virtual “No Bots Allowed” signs. E-Bay, for example, hung such a sign, and then (successfully) sued Bidder’s Edge’s offending bot for trespassing.35 While this apparent “disloyalty” was really nothing more than a case of rational consumers availing themselves of the Internet’s reduced information costs and the inherent lack of lock-in and of switching costs, it helped expose the shortcomings of the New World paradigm’s assumption of rampant network effects.When investors began to grasp these issues, they also began to understand that there was no such thing as “an Internet company,” and in particular that it was meaningless to think of a company as “an e-tailer.” Companies simply used the Internet in differing degrees to sell a wide array of goods. Online vendors competed with off-line vendors for the same consumer dollars. This understanding would soon lead to the New Channel paradigm. Before that was possible, however, one other “detail” had to be resolved. Internet investors had to realize the full scope of their error. The first visible sign came when prominent e-tailers’ (also known as B2C, or business-to-consumer, companies), including Toysrus.com, announced days before Christmas 1999 that they could not guarantee delivery in time for the holiday.36 E-tail stocks quickly fell out of favor.37 By the end of January 2000, equity prices had fallen far below their highs, and in some cases below their IPO values. From there, the bubble’s burst spiraled outward. E-tailers unable to pay for Web development and software renegotiated deals with their suppliers or simply refused to pay—at times even suing for breaches of vague contractual responsibilities.38
The combination of unpaid bills and increased skepticism hit hardest at small, highly leveraged service providers. In many cases, the hit came as they were contemplating their own IPOs, giving them the unenviable choice of either stopping work, writing off large portions of their receivables, and risking litigation with deadbeat clients, or continuing work, aging their receivables, and hoping for a B2C upturn.
Accounting conventions made their choice easy. They continued work and hoped that a rapid turnaround would make their aging invoices collectable. Most of them also decided to postpone their IPOs until that day arrived. As a result—and because most of them are still awaiting that day—IPOs were delayed and eventually cancelled, valuations of public companies dropped, and the disillusionment with New World thinking spread from B2C firms to Web developers and Internet-focused software companies.39 The disillusionment spiral continued. It moved horizontally to B2B (business-to-business), vertically to more conventional software firms, and outward into Web-hosting companies, computer hardware, chip and component makers, optical equipment firms, etc.Companies in traditional businesses that had oriented themselves toward Internet and New Economy companies felt the pain as well; Internet magazines folded and law firms with strong technology groups disbanded. By the middle of 2002, the unwind had reached pipeline company-cum-bandwidth trader Enron, and large, debt-laden telecommunications firms like Global Crossing and WorldCom. In all three cases, questionable accounting practices and allegations of outright fraud compounded the issue. The lack of public diligence to the financials of the firms in which we had invested had given their accountants a false sense of omnipotence. We queried their auditors and learned that oversight had been virtually nonexistent. That revelation brought down the once- venerable firm of Arthur Andersen & Co. The “tech wreck” changed the perception of the Internet among investors, analysts, industry observers, and the public at large. It also provided the empirical data necessary to discredit the New World view,40 and to set the survivors on the path towards more realistic New Channel thinking.
In the first true public display of the real world information sector, then, we misconstrued network economics to miscast Internet companies as inevitable monopolists. More significantly, though, we became excited, hopeful, and focused on growth. But while the economy as a whole and the information sector in particular experienced stunning and sustained growth, our portfolios didn’t fare quite as well. The priests had lost control of their creation—and left investors holding the bag—as information products completed their transition from laboratory experiments to major players in the global economy. We the investing public were not alone, it seems, in realizing that we had much more to learn.