How the Internet Bubble Broke Records, Rules, Bank Accounts
By Wall Street Journal Reporters Greg Ip, Susan Pulliam, Scott Thurm, and Ruth Simon
"The world has gone mad."
The thought flashed in the mind of Internet analyst Lise Buyer one morning in November 1998, as she and colleagues at Credit Suisse First Boston stared at a stock-quote machine. They were, Ms. Buyer recalls, agog at the trajectory of the initial public offering of theglobe.com, a collection of community Web sites. Theglobe.com had puny revenues and heavy losses. CSFB bankers didn't think the company was ready to go public. Yet theglobe.com's stock, offered at $9 a share, instantly soared to $97, briefly giving the company a market value of nearly $1 billion.
Crazy -- but there was a message to the madness. CSFB soon scrapped some of the rules it had used to gauge whether a company was ready for the big time, and took public no-profit Internet plays Audible Inc., Autoweb.com Inc., CareerBuilder Inc. and others arguably just as slight as theglobe.com ever was. Today, Audible trades at 54% below its offering price, Autoweb is down 69% and CareerBuilder is off 86%. Theglobe.com closed Thursday at $1.8125, or $3.625 before a split. Theglobe.com declines to comment on its IPO but asserts that the company is "committed to achieving profitability." Its underwriter, Bear Stearns & Co., very much believed in theglobe.com at the time, a spokesman says, noting that it traded above its offering price for months.
The Great Internet Bubble may be starting to fade from many memories, but the fallout blankets the landscape. This craze, after all, ranks among history's biggest bubbles. Investment bankers, venture capitalists, research analysts and investors big and small, through cynicism or suspension of disbelief, financed and took public countless companies that had barely a prayer of prospering. Rarely have so many people willingly put prudence on hold to enter a game most were sure couldn't last. "We all knew we were going to get a big kahuna correction at some point," says Jay Tracey, former manager of the Oppenheimer Enterprise Fund.
Murky Realms
While the Nasdaq Composite Index has clawed back half of its 37% plunge between March 10 and May 23, Internet stocks as a group, valued at $1.4 trillion at their March peak, have lost 40% of that -- erasing almost as much paper wealth as the 1987 crash. Even former stalwarts like Amazon.com Inc. trade at a third of last winter's highs. Though investors are slowly warming again to Internet IPOs, almost half of existing Internet companies now trade below their IPO price.
The question is: What brought on the mania? Some answers lie in the murky realms of mob psychology, the human capacity for denial, the get-rich-quick mentality -- factors in speculative frenzies since the days of the tulip. But to an unusual degree, the Internet bubble was a product of basic avarice and tactics that smacked of the boiler room. From Wall Street pro to fledgling day trader, all joined hands in a giddy game of lowering standards, pushing out IPOs and trumpeting prospects, with little regard for a company's true long-term -- that is to say, more than three months' -- outlook.
"People were throwing money at businesses that wouldn't pass simple due-diligence screens five years ago," says venture capitalist Jim Breyer of Accel Partners. "People overlooked almost all business fundamentals and drove valuations into the stratosphere."
Drenched in Warnings
Many investors have made good money, but many got clobbered. And the pros? They made billions, and most of them wound up winners even after the bubble burst.
People were certainly warned. Every IPO prospectus was drenched in warnings and risk factors, but most investors breezed past them. When the hype crossed the line into manipulation or other wrongdoing, the Securities and Exchange Commission usually stepped in. But most of the time, regulators could only stand by and warn investors about the risks of playing a completely legal game.
There is no denying the enormous business opportunity or the huge changes represented by the Internet and information technology. Some of the companies that emerged from the Internet upheaval will almost certainly mature into enduring, valuable enterprises, as the rebound in a handful of Internet leaders in recent weeks seems to bear out. Yet with the true potential came some truly cynical actions driven by a willingness to see what the market would bear and the investor buy -- i.e., a bubble.
Here's how some of the pivotal players stoked one of the hottest stock-market crazes in history.
These have been heady times for investment bankers. Just since theglobe.com's IPO -- an event many cite as a line of demarcation between raging bullishness and outright bubble -- Goldman Sachs Group Inc., Morgan Stanley Dean Witter & Co. and Credit Suisse Group's Credit Suisse First Boston each pocketed more than $500 million in IPO or secondary offering underwriting fees, according to Thomson Financial Securities Data. It was the most lucrative hot streak investment bankers have ever seen in a single sector.
It wouldn't have happened if bankers hadn't changed their rules. For instance, way back at the beginning of 1999, CSFB had a rule of thumb that a company needed at least $10 million in revenue in the 12 months before its IPO. (Profits were no longer critical; Netscape Communications and Amazon.com, two early IPO meteors, had proved that.)
Flying over Thailand on his way to meet a client in January 1999, CSFB Internet analyst Bill Burnham piped into a regular Monday morning teleconference during which a spirited debate had emerged over whether the rule should be canned. The bank was losing clients -- and fees -- to competitors. "Everyone realized the entire market was doing deals like this," Mr. Burnham, now a venture capitalist, recalls. "Companies we had relationships with but didn't have any intention of taking public anytime soon announced, 'Hey, if theglobe.com can go public, we can.' "
No formal decision on relaxing the guideline was taken at the time, but soon CSFB's bankers concluded that if they really liked a company, they could take it public with $10 million in annualized revenues -- in other words, just $2.5 million in the previous quarter, regardless of revenue in earlier periods. "It was emblematic to me of the competitive devaluation of underwriting standards that went on and reached a crescendo in the first quarter of this year," Mr. Burnham says.
One company that wouldn't have fit CSFB's old standard was CareerBuilder, an online recruitment firm. Before CareerBuilder's IPO in May 1999, its prior 12 months' revenue was just $8.8 million. But revenue in its last quarter was $2.8 million, or $11.2 million annualized. After CSFB took CareerBuilder public at $13, it traded as high as $20 but has since fallen to $4.0625.
Bill Brady, CSFB's head of global corporate finance for technology, says CareerBuilder remains a great company that is meeting expectations. He says he doesn't regret any of the deals CSFB has done in the past 18 months. Some, like Commerce One Inc., didn't fit the old standard either, but were successes. Still, he acknowledges that he thought that the prices many stocks hit after their IPOs were irrational, even as CSFB brought similar companies to market.
Other investment banks were priming the IPO machine, of course. Alan Naumann, chief executive of Calico Commerce Inc., says that for nine months before the business-to-business e-commerce software company went public last October, he had 15 different investment banks courting him with regular phone calls.
"The pitch to Calico was, 'Other companies are going public with smaller revenues and fewer customers -- we think you're ready. You've got $2 million in sales, go for it,' " he recalls. Calico held off and eventually picked Goldman Sachs as its lead underwriter. It went public at $14, shot above $62 on the first day, but have since slid back to $17.375 a share.
Mike Yiu, a software developer in Los Angeles, paid an average of about $58 a share for 1,100 shares of Calico between late October and early January. Mr. Yiu sold about 900 of his shares in April at about $19 a share and the remaining 200 last month at about $16 a share, for a total loss of more than $43,000. The timing of Calico's IPO was "perfect," Mr. Yiu observes. But "we got burned."
The stock price notwithstanding, Mr. Naumann says Calico's business remains on track. Its revenue grew 66% to $35.6 million in the fiscal year ended March 31 -- but its loss widened by 82%, to $27.8 million.
Goldman's Brad Koenig, head of the firm's technology investment banking, says Goldman had good reason to believe early-stage companies could be winners. He points to the debate preceding an early Internet IPO in April 1996. "There were a certain number of people who were highly skeptical of this company named Yahoo! with its yellow-and-purple logos," he says. Even with the recent 51% decline in its price from early January, Yahoo! Inc. is up more than 100-fold since its IPO.
The risks Goldman took on Yahoo went from being the exception to the norm. In 1997, of the 24 domestic companies Goldman took public for which data are available, a third were losing money at the time. Of the 18 it took public this year through mid-April, 80% lose money. A Goldman spokeswoman says this trend reflects the growing number of IPOs of Internet companies, which typically are unprofitable.
Some were companies that its arch-competitor, Morgan Stanley Dean Witter Inc., had decided were too speculative to underwrite. Mary Meeker, Morgan's star Internet analyst, says the firm passed on taking the TheStreet.com Inc., the Internet financial-news site, public because it wasn't ready. (An official at TheStreet.com says Goldman was its first choice.) After Goldman took it public in May 1999 at $19 a share, TheStreet.com shot above $70 on its first day, but has since slumped to $6.
Goldman officials deny that their standards slipped, and contend that the firm also passed on deals that rivals chose to underwrite. Mr. Koenig adds that the criticism of underwriters is off-target. If an Internet start-up with losses exceeding revenue "goes public and goes to a $22 billion valuation, whose fault is that? It's a tough philosophical argument. ... Is it an underwriter's responsibility to determine whether the market is overvalued or undervalued? Investment bankers wouldn't be making a good living if that was required."
The bankers got help in feeding the furnace from a new breed of mostly young securities analysts who presented themselves as pathfinders in the uncharted terrain of the Internet.
The best-known is Henry Blodget, famous for forecasting in December 1998 that Amazon.com would hit $400 a share. At the time, Amazon.com was trading at $240; within four weeks it blew past $400 on its way to a high of more than $600. Mr. Blodget was celebrated as a seer and left his job at CIBC Oppenheimer for Merrill Lynch & Co. Amazon.com? It closed at a split-adjusted $35 Thursday, equivalent to $210 at the time of Mr. Blodget's big call.
Mr. Blodget, 34, has regularly predicted that 75% or more of Internet companies will fail, and he stands by his general belief that Amazon.com and many of his other picks will be winners over the long haul. Mr. Blodget adds, "If AOL, Yahoo, Amazon, eBay, a few others we recommend as core holdings, go down 70% and stay there for four years, I will have been wrong. No argument. But a 50% pullback is still in the line of how this industry performs."
Still, to critics, Mr. Blodget epitomizes the change in the analyst's role during the overheated market in tech stocks: more cheerleader than detached observer. And the buzz -- and career opportunities -- that Mr. Blodget did draw may have encouraged other analysts to make similarly adventurous forecasts, the critics add.
Despite Mr. Blodget's 75% caveat, his recommendations on individual stocks, like those of many Internet analysts, got more bullish even as they led the Nasdaq Composite Index to ever-more-dizzying heights. Today, he rates 12 of the 27 stocks that he follows as "buy" (the rest are "accumulate"), compared with just one buy rating for the 10 stocks he followed a year ago, says Bob Kim, a former Merrill Lynch supervisory analyst whose Web site, Restex.com, monitors Merrill technology research.
Consider Pets.com Inc., which Merrill took public at $11 in February. It slid to $6.125 in a month, when Mr. Blodget initiated coverage with a prediction that it would soar to $16 a share, or 160%, in 12 to 18 months. A major justification: Despite the pet-supply seller's continuing losses, he noted that it was trading at five times this year's estimated revenue, a discount to Amazon.com at eight times revenue. Since Mr. Blodget's prediction, Pets.com has been a dog, falling 70% to $1.8125.
"Out of one side of his mouth, the message of caution," says Mr. Kim, "the other side, buy the leaders." He describes the Blodget message as: "The risk isn't losing 100% of your investment now, it's giving up 10-times gains in the future." But, says Mr. Kim, "it seems that so far, little of that has panned out except for the downside part."
As lucrative as the bubble has been for investment bankers and analysts, their profits pale compared with the money venture capitalists and other early-stage investors have made. The journey of eToys Inc. shows why.
The online retailer went public on May 20, 1999, at $20 a share, and soared to $76.5625 on its first day of trading. On Oct. 11, it closed at a high of $84.25 -- and has since plunged 93%, closing Thursday at $5.625 a share.
A disaster for eToys' early-stage investors such as idealab, an Internet incubator that invests in and nurtures start-ups? Not exactly. Idealab paid just half a cent a share -- a total of $100,000 -- for its eToys stake in June 1997. In late 1999, idealab sold more than 3.8 million shares at prices between $47.50 and $69.58, for a profit of $193 million. It still holds a further 14.5 million shares, so idealab has seen its paper profits dwindle. But even idealab's remaining stake in eToys is still worth roughly 1,000 times what idealab paid for it, while anyone who bought at the IPO price is down 72%. (Idealab, which itself is trying to go public, declined to comment, citing its quiet period.)
And plenty of investors fared worse than that. On Dec. 2, Daniel Sperling, a 35-year-old technology consultant in the Detroit area, bought 200 shares of eToys at $70. "Our goal was to ride the tidal wave of Christmas shopping and get out," Mr. Sperling says. But in early December, it became clear that big Internet sales weren't materializing, and eToys skidded. Mr. Sperling bought more: A hundred shares at $58.50 on Dec. 6. A hundred more at $47.50 on Dec. 14. A hundred more at about $20 in January. Today, his $26,600 investment in eToys is worth $2,800, a paper loss of $23,800.
Some venture capitalists' profits were truly astounding. Benchmark Capital's $5 million early stage investment in eBay Inc. grew to $4.2 billion by the time Benchmark distributed the shares to its investors late last year and early this year. If Benchmark's partners kept a typical 25% to 30% of the firm's investment profits, five of its partners would have split more than $1 billion when cashing in eBay stock.
Venture capitalists say they deserve big rewards because they take big risks. Many investments go bust. During the early stages of the Internet frenzy, however, it appeared that venture capitalists couldn't lose. They threw more money in earlier stages at start-ups than ever before. Often, they pushed the companies to go public as quickly as possible, to cash in on their investments faster than ever.
Even some who benefited from the feeding frenzy agree. "You could invest in a company, take it public and cash out before you proved your business model," says Michael Barach, a former venture capitalist who is now chief executive of Mothernature.com, an online health-products seller. Mothernature.com received its first venture-capital investment in June 1998 and went public last December.
The Internet craze set off an "Oklahoma land rush," says Roger McNamee, general partner at Integral Capital Partners in Menlo Park, Calif., which manages both private and public investments. "In a land rush, you suspend rules because your perception is that time is of the essence."
All told, venture capital invested in start-ups jumped to $36.5 billion last year from $14.3 billion in 1998, according to San Francisco market researcher VentureOne Corp. The number of deals increased to 2,969 from 1,972.
Mr. Barach of Mothernature.com attests to the craziness. Two investors gave him $10 million apiece after hearing him give a speech at an investment conference. Investment bankers told him they could take his company public when it reached $750,000 a month -- an annualized $9 million -- in revenue, and they did. "No one ever mentioned or talked about how much money we'd lose in 2000 to get to that revenue," he says. The company, which Bear Stearns took public, reported a loss of $59 million last year on sales of $5.8 million. Its stock trades at 81.25 cents, down 94% from its IPO price of $13.
IPOs can't soar without big buyers -- and mutual funds are among the biggest.
As tech stocks roared, mutual-fund managers faced powerful incentives to ride the rocket, trying to boost their funds' returns -- which can mean higher compensation for fund managers. Their voracious appetite for tech shares expanded the bubble.
Between Nov. 1, 1998, and last March 31, investors poured almost $72.5 billion into technology and small-cap-growth mutual funds, according to Financial Research Corp., a Boston-based financial-consulting firm. It says that about $11.4 billion of that total flowed into funds specializing narrowly in the Internet. Six of the 14 Internet-only mutual funds tracked by Lipper Inc. had gains of 100% or more last year.
Sometimes the tactics driving the action in mutual funds have raised questions. When business-to-business Internet player Ariba Inc. went public at $23 (pre-split) share last June, it shot to a first-day high of more than $90, thanks to people like Gary Tanaka, a founding partner of Amerindo, a growth-oriented mutual-fund group.
On most IPOs, Mr. Tanaka would get 50,000 to 70,000 shares. On Ariba, he got 100,000, in part because he informed underwriter Morgan Stanley that he would buy an additional 100,000 in the after-market once the company went public. His agreement to buy shares in the after-market "probably helped boost us to the top bracket for allocations," he says. Internet IPO allocations helped juice returns of Amerindo funds; its Technology Fund, for instance, posted a 249% gain in 1999. After-market orders also contributed to a big first-day run-up in the stock price -- more than ever the mark of a successful IPO.
Some market experts say agreements to buy stock -- and thus support the price-in the after-market raise regulatory questions depending on how explicit the arrangement is. Mr. Tanaka says he believes his arrangements are both appropriate and a natural result of his firm's role as "long term investors. If we are buying one million shares, we feel we should get a better allocation." Mark Hantho, managing director of equity capital markets at Morgan Stanley, says the firm doesn't use after-market bids to allocate IPOs, although "it's common to hear feedback as to how investors value the company, ... and we listen carefully to that."
Funds' appetite for IPOs also supercharged the market in another way. "On a hot deal, everyone would put in for 10% and the bankers could tell how hot a deal was by the number of guys who were circling 10% on the deal," Mr. Tanaka says. None of the institutions really expected to receive a full 10% allocation of a red-hot IPO, many of which involved only 10 million or so shares. But the idea was to get a bigger piece of the pie.
The overstated "order book" from institutions, as it is called, was then sent to research firms that rate IPOs based on their interest from institutions. "Sure, that artificially inflates demand. But that's how you rate a deal," says Vinnie Slaven, with Cantor Fitzgerald, whose job it is to rate IPOs based on investor demand. So the process itself helped to create an aura surrounding certain deals of vast enthusiasm among other institutions. This in turn helped to whet the public's appetite for shares of hot IPOs, often leading individuals to buys shares during an IPO's giant first-day run-up.
To catch the Web wave -- and keep up with peers' performance -- many fund managers loaded up on Internet stocks even though many in their hearts believed the shares to be overvalued. Twice last year, Mr. Tracey, until recently manager of Oppenheimer Enterprise Fund, thought a mammoth correction was coming and sold many Internet stocks. Both times he was wrong. So, after the second time, he jumped at the chance a few weeks later to buy into the IPO of an online industrial auctioneer called FreeMarkets Inc. It was valued at $1.8 billion based on its IPO price, despite 12-month sales of just $16 million and steep losses. But Mr. Tracey figured that similar companies were trading at far richer levels, and as to whether those valuations were ridiculous: "I said, 'I'm going to suspend judgment for the moment.' "
That proved profitable for Mr. Tracey, who watched FreeMarkets rocket from its IPO price of $48 in December to $280 the first day of trading. He held on as it roared to $370 in January, then dumped it in February at $215. It now trades at $55.0625 a share. This strategy helped Mr. Tracey's fund post a 105.8% return in 1999, though it's down 4.1% so far this year. Mr. Tracey recently moved to Denver fund manager Berger LLC to become chief investment officer.
The tech bubble had one thing no past manias had: the push from online brokers, who made speculating on stocks easier than ever and advertised heavily to encourage people to chase riches.
In September 1998, employees at online broker E*Trade Group Inc. hit TV viewers with a barrage of commercials in an effort to add one million customer accounts to its total of 500,000 in the coming year. Some ads suggested that trading stocks over E*Trade was a better route to wealth than waiting to win the lottery, others that it was better than waiting for a rich relative to die. All promised a fast, cheap, powerful way to play the stock market.
As new accounts poured in, E*Trade kept upping its ad spending, says Michael Sievert, chief marketing officer. E*Trade spent $321 million on marketing in the fiscal year ended last Sept. 30, and surpassed its goal, with 1.6 million accounts -- but with a loss of $54.7 million. It has already spent an additional $307 million on marketing in the six months through March 31, helping to boost the number of accounts to 2.6 million.
The astonishing growth made online brokers a powerful force in the market, as their customers drove the stocks of newly public and established companies to unprecedented levels. By some estimates, individual investors -- most of them trading online -- accounted at the peak for 65% of the volume on Nasdaq.
E*Trade's Mr. Sievert says the firm's ads tell investors they won't get rich quick, and that they should take charge of their finances. He notes one of E*Trade's commercials warned against getting carried away with a profit that could quickly disappear.
But critics say the Internet brokers did indeed encourage many unsophisticated investors to trade aggressively in the belief they could get wealthy and failed to adequately disclose the risk. "The marketing campaigns by these Internet brokers encouraged novice investors, who had no business trading securities, to short-term trade stocks, and they in many instances ended up losing a major portion of their net worth," charges Douglas Schulz, a Westcliffe, Colo., securities-fraud expert who advises investors with complaints against their brokers.
Jay Kiessling, a physician living near Mobile, Ala., had been trading through E*Trade for about 16 months when he heard about theglobe.com. "I wasn't quite sure if it was a good stock for the long run, but I was almost sure it would have a terrific first day," he says. He put in an order for 5,000 shares, expecting to get the stock at the IPO price of $9 a share.
But because the stock rocketed at the opening, he ended up paying between $84 to $88 ($42-$44 split-adjusted), more than $420,000 in total. He finally dumped most of the stock a few days later at $42 a share, and had to liquidate about two-thirds of his retirement investments to cover the loss.
Dr. Kiessling and his wife filed an arbitration claim against E*Trade, saying it allowed them to "buy an unsuitably over-concentrated position," according to his attorney, James Eccleston, and that E*Trade should have alerted customers that the stock would open up so much higher. In a statement of answer filed last year with the National Association of Securities Dealers, E*Trade said that the Kiesslings "could and should have minimized their risk" by immediately selling the shares and that the couple is responsible for the loss. The case is pending.
Mr. Kiessling hasn't made a single investment since theglobe.com. But though such stories are commonplace, it's hard to say whether the bubble mentality is dead. Just Thursday, two new technology companies went public. Neither is a pure Internet play and one actually is making money. Still, the prices of both more than doubled.
-- Kara Scannell contributed to this article.