The Great Internet Money Game

Techtelligence, screams a two-page advertisement from Merrill Lynch in a
recent weekly trade publication. The ad goes on to praise the capabilities of
the Wall Street firm’s technology group, from the 100
analysts covering 500 companies to the awards they’ve won to Merrill’s
“Internet guru,” Henry Blodget. The firm even proclaims its technology
coverage is “the top tier in research.”

Don’t believe every ad you read. Of the 20 Net companies that Merrill
brought public since the beginning of 1997, 15 are trading below their offering
prices, and two have gone bust, according to Thomson Financial Securities Data.
The stocks of eight of Merrill’s companies, including computer e-tailer
Buy.com and Net advertising company 24/7 Media, have fallen 90% or more from
their IPO prices. Perhaps the biggest fiasco has been pet-food retailer Pets.com,
which took a mere 10 months to go from its $66 million initial public offering
to closing its doors. Byron Gordon, a 33-year-old marketer in San Francisco,
lost $2,000 by buying the company’s stock. “Why Merrill Lynch felt that
was a good company to take public I’ll never know,” he says.

It could have been the sweet smell of money. Merrill took in fees of about
$4.6 million for managing the books for the pet-food retailer’s stock
offering, according to estimates from Thomson Financial. That’s just part of
the $100 million Merrill pulled in since 1997 for taking Internet companies
public.

Indeed, Merrill Lynch has plenty of company. Many of America’s top
financial firms reaped millions in fees from the Internet boom even while the
investing public got burned. How did they do it? They were playing a different
money game than the rest of us. Investors may have depended on Net stocks rising
from their IPO levels to make money, but the finance firms weren’t. Investment
bankers took their cash up front, grabbing a slice of the dough raised in IPOs.
If the stock cratered, they already had their money in the bank. Venture
capitalists had a similar spot in the food chain. In exchange for footing the
early costs of a startup, they got their stock for as little as pennies a share.
Even if shares dove after the offering, they were still ahead. And that’s the
way it has worked for decades.

What changed with the Internet boom was that many financial firms veered from
their habits of the past. For years, venture capitalists declared that their
mission was to build rock-solid, sustainable businesses. They would seed
startups with millions of dollars, betting that two out of 10 would hit it big,
and they would be richly rewarded. When Net mania hit, they abandoned that
approach and began rushing companies onto the public market with the ink barely
dry on the business plans. “Venture capitalists shamelessly took companies
public that never should have been taken public,” says Todd Dagres, a
partner at Battery Ventures. And the old rule of thumb for investment banks? Don’t
take a company public until it has three quarters of profits. That, too, went by
the wayside.

Greed broke the system. With billions of dollars up for grabs, many leading
US financial firms threw out their business standards and started grabbing the
loot with both hands.

Do the financial firms deserve sole blame for the Internet bust? Not at all.
Institutional and individual investors got caught up in the Net frenzy, too. The
conventional wisdom of the time was that companies had to get big fast and
sacrifice profits for growth. Investors were willing buyers of these stocks even
though the risks detailed in their offering documents often included phrases
such as “unproven business model” and “may not continue as a
going concern.” Specialized mutual funds, including Munder NetNet Fund and
Internet Index Fund, were set up to allow investors to put their money in Net
stocks. “We want to be responsible, but at the end of the day investors are
going to make their own decisions,” says Bradford Koenig, who heads the
technology investment banking practice at Goldman, Sachs.

Still, investment bankers and venture capitalists are supposed to be expert
at channeling capital into the most promising companies. Over the past few
years, the brightest minds of American finance sold public investors stock in
hundreds of companies that are proving to be almost worthless. Of the 367
Internet outfits taken public since 1997 that are still trading, the stocks of
316 are below their offering prices, according to Thomson Financial. Only 55
companies, or 15%, have made money for public investors. And a staggering 224
have tumbled 75% or more since their IPOs. A total of $2.5 trillion has
disappeared from Net company market caps since the peak last year.

The real danger is that investors may not be back anytime soon. Innovation is
the engine of the US economy, and it runs on money. Heavy tech investments have
enabled the productivity gains that have turbocharged the economy in recent
years. If investors lose faith in the experts that are supposed to be guiding
them to the most promising businesses, they may shy away from investing in
startups, good and bad. Already, the number of initial public offerings for tech
companies has slowed to a trickle.

By Peter Elstrom in BusinessWeek. Copyright 2001 by The McGraw-Hill Companies, Inc

Size matters

Now, these mini-dots are proving they’re an online force to be reckoned
with. Indeed, they’re teaching their bigger rivals a thing or two–including
the value of common sense. Unlike some dot-coms with inexperienced executives,
the mini-dots are succeeding by employing the same strategies that
small-business owners have relied on for centuries: They’re sticking to niches
they know well. They scrimp on expenses, forgoing expensive portal deals and
using Net resources, from e-mail to customer-sharing arrangements, to save
money. And they’re banding together on the Web, presenting a bigger face to
the online world.

So far, it seems to be working–so well that small businesses appear poised
to play a greater role in the growth of e-commerce than anyone expected. Small
companies will see their online sales grow 336% from 2000, to $120 billion by
the end of 2002, predicts ami-Partners, a New York consultant to small and
medium-size businesses. That will outpace overall e-commerce revenue growth of
249%.

Of course, size matters, even in the New Economy. But in some crucial ways,
the Net helps level the playing field for small outfits. For one thing, the cost
savings of selling online and dispensing with store rents or direct-mail costs
makes some businesses viable that otherwise wouldn’t be–say, a home-based
collectibles business.

Moreover, the global nature of the Web goes a long way toward negating one
key disadvantage of the small fry: geographic reach. Now, even a niche seller of
specialty pet supplies can amass enough customers to be viable. Finally, the
easy communications afforded by the Net may make more small businesses,
especially services such as graphic design, attractive to larger businesses
seeking to outsource jobs.

The impact of a mini-dot explosion could have big implications beyond the
Web. By 2004, even the tiniest of these e-merchants–those with fewer than 10
employees and $3 million in annual sales–could account for as much as 10% of
the US gross domestic product, according to e-commerce researcher Keenan Vision.

Maybe so, but big questions remain about how much the Net will boost the
number of small businesses and what impact they’ll truly have on the economy.
For one thing, says William Dunkelberg, chief economist for the National
Federation of Independent Business, it’s possible the Net is simply shifting
existing sales online, not expanding markets enough to support many new
businesses. He adds, it’s likely that the most successful online businesses
will put the other mom-and-pops out of business, lessening the net gain. Most
traditional small businesses fail, and the same may well be true online.

And for all its advantages, the Internet presents a lot of challenges to the
little guys, too. In many parts of the country, pokey Net connections limit how
many visitors these sites can handle. And it can be tough for traditional
businesses coming online to handle both channels at once. Those factors may
explain why, for all the small businesses that have launched online, many more
have not yet moved beyond sites that are nothing more than online brochures.
According to ami-Partners, 22% of small businesses had Web sites in 2000, but
only 8% were engaging in e-commerce.

Still, none of these challenges has stopped a growing number of small
businesses from embracing the Web as a new sales channel and productivity tool.
Many of the online newbies are longtime Main Street merchants or
industrial-goods manufacturers. There’s also a raft of service providers–computer
programmers, graphic designers, lawyers, and such–who have left Corporate
America to hang a shingle on the Internet.

The Web is spawning new breeds of small companies, too. They include tens of
thousands of people who never ran a business before but now make a living
selling collectible ornaments, antique toys, and other odds and ends on sites
such as eBay. About 13,000 stores have sprouted on the Yahoo! Stores section
alone since June, 1998.

What these disparate businesses have discovered is that the Net is less a
magic carpet to a newfound land of riches than a tool to turbocharge an already
sound business model. “The Internet is what the telephone was when it was
invented–a way to further our reach,” says Wendy Haig, founder of
Washington (DC)-based Global Strategy, which counsels troubled dot-coms.
“With its vast reach, the Internet will enhance any small business that
uses it properly.”

How so? First, they’re using the Net’s access to a global customer base
to zero in on defensible niches, instead of offering all things to all Web
surfers. Pets.com, for instance, went bust in December partly because it tried
to sell all kinds of pet supplies–even huge bags of inexpensive dog food with
high shipping costs and margins under 10%. By contrast, Massachusetts based
Waggin’ Tails sells scarce items such as Provi-Tabs dog vitamins and Hi-Tor
prescription cat food. That allows the Web store to charge high enough prices to
turn a 30% profit margin on well under $5 million in annual sales.

In some cases, the Web’s global reach has allowed entrepreneurs to offer
entirely new types of narrowly focused services. Patti Glick, a San Francisco
nurse trained in podiatry, makes a living speaking at companies on foot health
and safety. Before, she had to do a lot of personal networking, such as mingling
at Toastmasters meetings. Now, by participating in various online podiatric
sites and women’s portals, Glick has drawn corporate customers intrigued by
her screen name, “footnurse.” She expects to earn $30,000 this year
working part-time hours that allow her to spend time with her 10-year-old twins.

Small businesses also are using the Net to save big bucks–enough, in many
cases, to make a pipe dream a going business. Selling Beanie Babies and other
collectibles online out of a bedroom in his Oklahoma home, Perry Calton is
grossing annual sales in the low six figures.

Besides saving money, the Net also provides mini-dots a wealth of new
marketing channels. E-mail and discussion newsgroups can be far less expensive
and more effective than direct mail and print or TV advertising. Carrie Hardy,
founder of Colorado based scrapbook-supply site Scrappin’ Happy, sends
newsletters to 1,100 past customers and posts messages on scrapbooking
newsgroups. Instead of buying $80, three-line ads in trade magazines that never
drove any traffic anyway, she spends nothing and gets a far better response:
After mailing her February newsletter, sales doubled the next day.

No online marketing channel has proved more effective than online auctions,
pioneered by eBay in 1996. Besides spurring the formation of thousands of new
small businesses online, they have prompted existing businesses to branch out.
Some wholesalers are using eBay to go retail:

Andrew Waites took his Mississippi retail overstock business, Inventory
Procurement Services, directly to consumers over eBay–leading to what he hopes
will be a twofold-plus jump in sales this year, to $7 million, and a gross
profit margin online of 50%, 10 times the original business.

Finally, the Net has allowed far-flung small businesses to gang up and pool
their resources against their bigger and louder competition in ways they can’t
do in the physical world. The American Booksellers Association, which promotes
independent bookstores, runs a program called BookSense.com that allows members
to offer amenities only big chains could offer before, such as gift certificates
good at any member store. Moreover, their online customers can order any book in
print from their site, even if they don’t stock it themselves. Kerry Slattery,
owner of Skylight Books in Los Angeles, partly credits the program for a
higher-than-expected 15% rise in her store’s sales in 2000, to $1 million.

Daunting prospect

All that’s not to say the Web can turn any small business into a raging
success. Most entrepreneurs are running into obstacles on the Web that are hard
to overcome with limited staff and resources. One of the toughest jobs:
providing superior customer service. After all, to make up for what they may
lack in product breadth–not to mention customers’ ability to click instantly
to another site–they have to offer much more personal service.

Another challenge is Internet technology itself. Fast broadband connections
are still largely unavailable, especially in rural areas, leaving many small
businesses stuck with snail-like modem connections. And many worry that they
could lose a lot of customers if their connection goes down. Says Deepinder
Sahni, vice-president at researcher ami-Partners: "What we are hearing is
that they are hesitant to put their crown jewels–their companies–on the
Internet."

For many small businesses, the prospect of competing with the online
behemoths is daunting–for good reason. It may be only a matter of time before
the big guys notice how well they’re doing and jump onto their turf. So they
must stay vigilant, even paranoid, about differentiating their offerings.

That, however, is not the main worry of most small businesses that have moved
online. Their problem: too much business. When Jordan Dossett posted her
graphic-design portfolio a year ago on eLance.com, a Web marketplace for
freelance workers, she was buried under an avalanche of work offers from
companies as far away as Russia. So she quit her job as art director for a law
firm and opened The Design Studio in her Washington (DC) home. After hiring
three employees, she expects to rake in $350,000 in sales–and a tidy gross
profit of $250,000. "I had no idea the amount of demand out there,"
she says. "Suddenly, I’m slammed." Now, that’s a problem a lot of
dead dot-coms would love to have had.

Arlene Weintraub–BusinessWeek