Silicon Valley

Introduction

A decentralised networked communication system that would survive nuclear attack? It came to be known variously as the Internet, World Wide Web and Information Superhighway. Given the installed base of personal computers and the invention of a graphical browser, the internet's lightning fast adoption by millions became the citizens' badge for the wired age. Irrational exuberance was everywhere - the medium had become the message. Business and community would never be the same.

Entrepreneurs, venture capitalists, and investors seized on the Internet as the next big thing. Huge amounts of money were invested into what became known as 'dot-com' businesses. Their store front was a website where, unburdened by the cost structure of traditional bricks and mortar companies, they could troll for savvy customers who would value the convenience of shopping from home.

They came, they soared and then in April 2000 valuations and hype collapsed. What has been the impact of the dot-com phenomena? What happened and what have we learned?

In the beginning was Netscape

Ground zero for the Internet explosion was Netscape Communications. The company produced the first Internet browser and then gave it away. The thinking behind this bold move was based on their experience in the software business - i.e. that you could lock in customers to one dominant product - in this case the Netscape Navigator browser. The large captive market created would attract significant advertising revenue which was expected to be much greater than the income lost from the browser giveaway. By the time Netscape went public, its value had skyrocketed even though there was no demonstrated path to profitability. The dot-com gold rush had begun. A new but untested model for valuing companies had arrived.

The inherent risks in the untested model were overlooked because of the large amounts of capital available for investing in the next big thing and an exponentially growing new medium that promised unlimited opportunities for connection.

In addition, entrepreneurs recognised the opportunities for commerce on the Internet and the advantage of bypassing existing customer-business relationships and "going direct". They could remove significant costs incurred by traditional businesses in servicing these same customers. The challenge would be bringing these customers to their website within the new medium. To do this, they needed to brand the company's name to the largest audience possible. The metrics for doing this successfully would in fact be eyeballs and page views at the company's website. It was assumed that if you could attract visitors to the website, they could be converted to paying customers. Branding became an end unto itself. It was even more important than profitability.

The market analysts were influential in communicating market potential and mapping the territory of Internet space. They described the Internet as a huge land grab where the first mover had to sacrifice profits for rapid growth. Everybody – from venture capitalists, money managers, individual investors, entrepreneurs, to executives in traditional companies - wanted in on the action. The early successful IPO's (initial public offerings) certainly rewarded investors, but a huge pyramid scheme had been built that many thought was unsustainable. And it was.

The bubble bursts

April 4, 2000. The Nasdaq Technology Index drops 500 points in one day. The valuations of virtually all dot-coms plummeted and since then have deteriorated further. Investment capital has dried up. Companies that are without venture capital and have no foreseeable revenue are now hoping to be reabsorbed by a traditional bricks and mortar company.

Most dot-coms did not survive. Actual numbers are hard to come by but it is certainly more than the 560 quoted on a Silicon Valley website that tracks such things. 41,200 dot-com jobs disappeared in 2000 and 82,000 from January to July this year, according to a Chicago recruiting firm (Challenger, Gray and Christmas). Forty-seven per cent of a sample of 90 business-to-consumer companies have shifted their focus to selling directly to other businesses (Webmergers.com).

A case study: WebVan.com

Next to Amazon.com, WebVan, an online grocery shopping service, attracted the biggest capital investment in online business: $830 million. It declared bankruptcy on July 9, 2001. The company provides a good example of how assumptions built into the dot-com business model played out.

WebVan took aim at grocery stores in a similar way that Amazon challenged bricks and mortar booksellers —by taking orders online. Within a half hour of ordering, working mothers and fathers could have their groceries delivered to them at home, without having to drag their kids to the store. Millions were invested in automated specially equipped warehouses and hundreds of refrigerated vans to deliver goods to customers in the San Francisco Bay Area, Los Angeles, Seattle, San Diego and Atlanta.

Sounds good so far? Well, WebVan was betting that enough shoppers were willing to give up on their traditional way of buying groceries to create sufficient demand for their service. Unfortunately market surveys revealed that fewer than 1% of the US population bought groceries online. To win over customers, WebVan invested $35 million for each new market they entered compared to $5-$6 million for supermarkets. Obviously the business model was not viable! Established food supermarkets like Safeway are in a better position to incorporate home deliveries into their business.

Another interesting feature of WebVan (and not unusual for dot.coms) was that the key players involved in the company had successful business experience but no grocery industry experience. The founder was Louis Border of Border Books and the CEO they first hired was George Shaheen, a consultant who had been CEO at Andersen Consulting. One of the fastest ways to build credibility as a dot-com was to leverage the credibility of others. While business pedigree is reassuring for investors, being ignorant of the industry in which you are trying to innovate is arrogance.

Operationally many mistakes were made. Those who visited the large distribution centres commented on how wasteful and poorly designed they were. And, as the company was running out of money, management decided to repaint their fleet of delivery vans. The frugal management of investment money was not in evidence.

In the end 4,500 people lost their jobs. The CEO left in April with a retirement package of $375,000 per year for the rest of his life. Is there any wonder that investors and the business community have referred to the dot-commers as the 'ninety-niners' (a reference to the 'forty-niners' of the California gold rush days).

What are the business lessons for the rest of us?

1. Profitability - the first law of business

The dot-coms were an experiment. We now know that the suspension of the first law of business - profitability - in favour of being the first mover in the new market is just plain silly. There were an inordinately large number of companies that went public with no promise of dividends, no profits, no earnings before or after taxes and even no revenue growth projections. It seems the more money that flowed into venture capital funds, the lower was the performance bar for entrepreneurs.

Most dot-coms were unable to estimate when they would break even or become profitable. In many instances companies were unclear about their gross margins. To secure customers, they often waived shipping and delivery charges (Amazon.com) or offered unsustainable delivery times (WebVan). Essentially every transaction lost money. For instance Pets.com spent $185 on advertising to sell $35 of pet food. In many instances the more customers lured to the company's website the more money they lost.

As Brodie Callender, a local entrepreneur noted: "When there's a lot of money about, a lot of things float and if you don't look carefully, they can look like companies."

2. Customer - every business needs them

Many who saw the ads of several dot-coms appearing during the broadcast of the January 2000 Superbowl (at $2-3 million for 30 seconds) were bemused and confused. "What was that about?" The intent of the ads was to draw visitors to the advertiser's site, turn them into paying customers and then figure out how to make a business out of it.

In effect the dot-coms suffered from what some have called a fatal attraction. Huge upfront expenditures lured customers to the site but failed to translate them into initial customers, let alone repeat customers. During the first half of 1999, fewer than 4.5% of site visits resulted in sales and fewer than 10% of visitors who made an initial purchase made a later one. Compare this to the leading successful dot-com companies that have achieved an average of 12% sales from site visits and repeat purchase rates of 60% (McKinsey). Except for some rare exceptions, customer acquisition costs were four times higher than traditional bricks and mortar type companies, i.e. prohibitively expensive.

In many instances, the brand focus of dot-coms and the concomitant emphasis on mass advertising was aimed at Wall Street and investors and not at customers. It was very clear to dot-com executives that their brand's buzz drove high stock valuations and hence the company's ability to raise more capital to finance exorbitant customer acquisition costs. It was only a matter of time before someone blinked and the bubble burst.

3. Possessing a unique competitive advantage is still the ticket

Certainly the Internet has produced some incredible efficiency and cost reduction gains for business and a much greater transparency in the cost of goods and services for consumers. According to Michael Porter of Harvard earning above average profits depends on having a unique competitive advantage - something that creates value for customers and is difficult for competitors to copy. It is clear that many of the dot-com businesses met neither criteria.

Epilogue

It takes a lot more to create a business than just a new technology. "Build it and they will come" works in the movies but not in real life. The Internet will continue to play an important role in our lives, and there will continue to be dot-coms. However, what has survived the burst bubble are established bricks and mortar companies with online capability and some exceptional dot-coms in specialised market niches (e.g. auctions, share trading or media).