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What the Bubble Got Right

[What the Bubble Got Right]

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| September 2004(This essay is derived from an invited talk at ICFP 2004.)I had a front row seat for the Internet Bubble,
because I worked at Yahoo during 1998 and 1999. One day,
when the stock was trading around $200, I sat down and calculated
what I thought the price should be. The
answer I got was $12. I went to
the next cubicle and told my friend Trevor. "Twelve!" he said.
He tried to sound indignant, but he didn't quite manage it. He
knew as well as I did that our valuation was crazy.Yahoo was a special case. It was not just our price to earnings
ratio that was bogus. Half our earnings were too. Not in
the Enron way, of course. The finance guys seemed
scrupulous about reporting earnings. What made our
earnings bogus was that Yahoo was, in effect, the center of
a Ponzi scheme. Investors looked at Yahoo's earnings
and said to themselves, here is proof that Internet companies can make
money. So they invested in new
startups that promised to be the next Yahoo. And as soon as these startups
got the money, what did they do with it?
Buy millions of dollars worth of advertising on Yahoo to promote
their brand. Result: a capital investment in a startup this
quarter shows up as Yahoo earnings next quarter—stimulating
another round of investments in startups.As in a Ponzi scheme, what seemed to be the returns of this system
were simply the latest round of investments in it.
What made it not a Ponzi scheme was that it was unintentional.
At least, I think it was. The venture capital business is pretty incestuous,
and there were presumably people in a position, if not to create
this situation, to realize what was happening and to milk it.A year later the game was up. Starting in January 2000, Yahoo's
stock price began to crash, ultimately losing 95% of its
value.Notice, though, that even with all the fat trimmed off its market
cap, Yahoo was still worth a lot. Even at the morning-after
valuations of March and April 2001, the people at Yahoo had managed
to create a company worth about $8 billion in just six years.The fact is, despite all the nonsense we heard
during the Bubble about the "new economy," there was a
core of truth. You need
that to get a really big bubble: you need to have something
solid at the center, so that even smart people are sucked in.
(Isaac Newton and Jonathan Swift both lost money
in the South Sea Bubble of 1720.)Now the pendulum has swung the other way. Now anything that
became fashionable during the Bubble is ipso facto unfashionable.
But that's a mistake—an even bigger mistake than believing
what everyone was saying in 1999. Over the long term,
what the Bubble got right will be more important than what
it got wrong.1. Retail VCAfter the excesses of the Bubble, it's now
considered dubious to take companies public before they have earnings.
But there is nothing intrinsically wrong with
that idea. Taking a company public at an early stage is simply
retail VC: instead of going to venture capital firms for the last round of
funding, you go to the public markets.By the end of the Bubble, companies going public with no
earnings were being derided as "concept stocks," as if it
were inherently stupid to invest in them.
But investing in concepts isn't stupid; it's what VCs do,
and the best of them are far from stupid.The stock of a company that doesn't yet have earnings is
worth something.
It may take a while for the market to learn
how to value such companies, just as it had to learn to
value common stocks in the early 20th century. But markets
are good at solving that kind of problem. I wouldn't be
surprised if the market ultimately did a better
job than VCs do now.Going public early will not be the right plan
for every company.
And it can of course be
disruptive—by distracting the management, or by making the early
employees suddenly rich. But just as the market will learn
how to value startups, startups will learn how to minimize
the damage of going public.2. The InternetThe Internet genuinely is a big deal. That was one reason
even smart people were fooled by the Bubble. Obviously
it was going to have a huge effect. Enough of an effect to
triple the value of Nasdaq companies in two years? No, as it
turned out. But it was hard to say for certain at the time. [1]The same thing happened during the Mississippi and South Sea Bubbles.
What drove them was the invention of organized public finance
(the South Sea Company, despite its name, was really a competitor
of the Bank of England). And that did turn out to be
a big deal, in the long run.Recognizing an important trend turns out to be easier than
figuring out how to profit from it. The mistake
investors always seem to make is to take the trend too literally.
Since the Internet was the big new thing, investors supposed
that the more Internettish the company, the better. Hence
such parodies as Pets.Com.In fact most of the money to be made from big trends is made
indirectly. It was not the railroads themselves that
made the most money during the railroad boom, but the companies
on either side, like Carnegie's steelworks, which made the rails,
and Standard Oil, which used railroads to get oil to the East Coast,
where it could be shipped to Europe.I think the Internet will have great effects,
and that what we've seen so far is nothing compared to what's
coming. But most of the winners will only indirectly be
Internet companies; for every Google there will be ten
JetBlues.3. ChoicesWhy will the Internet have great effects? The general
argument is that new forms of communication always do. They happen
rarely (till industrial times there were just speech, writing, and printing),
but when they do, they always cause a big splash.The specific argument, or one of them, is the Internet gives us
more choices. In the "old" economy,
the high cost of presenting information to people meant they
had only a narrow range of options to choose from. The tiny,
expensive pipeline to consumers was tellingly named "the channel."
Control the channel and you
could feed them what you wanted, on your terms. And it
was not just big corporations that depended
on this principle. So, in their way, did
labor unions, the traditional news media,
and the art and literary establishments.
Winning depended not on doing good work, but on gaining control
of some bottleneck.There are signs that this is changing.
Google has over 82 million unique users a month and
annual revenues of about three billion dollars. [2]
And yet have you ever seen
a Google ad?
Something is going on here.Admittedly, Google is an extreme case. It's very easy for
people to switch to a new search engine. It costs little
effort and no money to try a new one, and it's easy to
see if the results are better. And so Google doesn't have
to advertise. In a business like theirs, being the best is
enough.The exciting thing about the Internet is that it's
shifting everything in that direction.
The hard part, if you want to win by making the best stuff,
is the beginning. Eventually everyone
will learn by word of mouth that you're the best,
but how do you survive to that point? And it is in this crucial
stage that the Internet has the most effect. First, the
Internet lets anyone find you at almost zero cost.
Second, it dramatically speeds up the rate at which
reputation spreads by word of mouth. Together these mean that in many
fields the rule will be: Build it, and they will come.
Make something great and put it online.
That is a big change from the recipe for winning in the
past century.4. YouthThe aspect of the Internet Bubble that the press seemed most
taken with was the youth of some of the startup founders.
This too is a trend that will last.
There is a huge standard deviation among 26 year olds. Some
are fit only for entry level jobs, but others are

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