The Great Internet Money Game How America's top financial firms reaped billions from the Net boom, while investors got burned
businessweek.com
APRIL 16, 2001
BUSINESSWEEK E.BIZ -- COVER STORY
Cover Illustration by Stuart Bradford
Cover Image: The Great Internet Money Game
Table: How Some Investment Bankers Performed
Photo: Henry Blodget
Photo: Frank Quattrone
Table: How Some Venture Capitalists Performed
Photo: Ann Winblad
Photo: Bill Gross
Photo: David Wetherell
Online Extra: Q&A with Goldman's Bradford Koenig
Techtelligence," screams a two-page advertisement from Merrill Lynch & Co. (MER ) 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 M. 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 Inc., 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. Blodget defends his company's track record. "Investors wanted these stocks," he says. "It's tough to tell a CEO, `We won't take you public' when investors are shouting, `Bring it on!"'
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. "We had pressure from bankers to go public three months after inception," says Julie L. Wainwright, the former chief executive of Pets.com, which went public a year after its founding. "We tried to be responsible."
Greed broke the system. With billions of dollars up for grabs, many leading U.S. financial firms threw out their business standards and started grabbing the loot with both hands. "I think there are lower ethical standards," says Jay R. Ritter, a professor of finance at the University of Florida. "It's no longer a relationship business. It's a transaction business."
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 C. Koenig, who heads the technology investment banking practice at Goldman, Sachs & Co. (GS )
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. "We have never lost so much money so fast for the investing public," says Reid W. Dennis, a longtime venture capitalist at Silicon Valley's Institutional Venture Partners (IVP). "Our whole industry is at fault and the entire underwriting industry is at fault".
The real danger is that investors may not be back anytime soon. Innovation is the engine of the U.S. 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. "This is totally unprecedented," says Garrett Van Wagoner, president of the mutual fund firm Van Wagoner Capital Management. "People got so badly burned that they may never be back."
Looking for the bottom. Never is a long time, but the impending money drought may seem that long. The last protracted plunge in the Nasdaq index was the 31% drop over 13 months in 1983 and 1984. That slowed the flow of offerings through 1985. This time, though, the index has fallen twice as much and it may not have hit bottom yet. "It took about three years after 1983 [to coax investors back to tech offerings] and I think we have hurt investors even worse this time," says Dennis. "I think it'll be at least three years this time."
Worse, the closing of the IPO market is scaring off some venture firms, which will further dampen innovation. VCs cut their investments to $19.6 billion in the fourth quarter, down 26% from the $27 billion average for the preceding three quarters, according to Venture Economics. That's even more startling, considering that venture firms raised a record $92 billion last year. Kathleen Huber, founder of Internet router maker IronBridge Networks Inc., had raised $122 million for her company over the past few years and had won industry awards for her products. In March, she had to shut down her company because she couldn't find more cash. Some VCs are even taking back money they've invested in startups. EPod Corp., an interactive ad company that raised $21 million, closed its doors in February after its venture firms took back $8 million to $10 million. "It was immensely disappointing, especially when you think the company is promising," says Lynda Radosevich, the company's former director of marketing.
The destruction caused by the Internet bust is prompting some soul-searching among venture capitalists and investment bankers. Many vow to go back to their old ways of doing things, trying to nurture lasting businesses. For example, Technology Crossover Ventures adopted a rule last year that a partner could not sit on the boards of more than eight companies. That way, its VCs spend more time guiding entrepreneurs and fine-tuning business models. James W. Breyer, managing partner of Accel Partners, used to spend 75% of his time on new deals and 25% on existing ones. Now it's the reverse. "We dropped the ball on the level of advice and strategy we were providing," he says.
Bankers aren't as publicly contrite. Privately, some admit that they took companies public too soon. Most, however, say that they have always been careful with IPOs and they're tightening their underwriting standards now because investors require it. Michael Christenson, head of technology investment banking at Salomon Smith Barney (C ), says IPO candidates today need to have at least $10 million in quarterly revenues and must be no more than two quarters away from profitability. "We've always strived for high quality," he says. "What has clearly changed is that we've adjusted our screen for the market."
So will the financial firms' newfound restraint hold them back next time? Don't bet on it. Experienced money managers say the lesson to draw from the Net bust is that investors need to do their own homework and not just rely on the experts. "At the bottom of the cycle, they tell you they've tightened their due diligence standards," says Van Wagoner. "At the top of the cycle, they always find a reason to take companies public. You can't rely on them to do the due diligence."
Keeping score. To be sure, not all of the top financial firms performed poorly during the Net frenzy. Some showed restraint in bringing companies to market and succeeded in creating new leaders for Corporate America. As the dust settles from the collapse in Net stocks, it's possible to pick through the wreckage to find out which financiers were behind the biggest successes and which were behind the biggest busts.
Ranking the
Venture Firms
Here's a look at how the companies backed by certain venture investors have performed since their initial public offerings. The period covered is since the beginning of 1997.
Accel Partners 55%
Sequoia Capital 54%
Benchmark Capital 38%
Kleiner Perkins Caufield & Byers 23%
Microsoft -39%
Flatiron Partners -76%
Internet Capital Group -79%
idealab! -84%
Hummer Winblad -91%
CMGI @Ventures -95%
Data: Venture Economics
Money managers certainly are keeping score. Horsley Bridge Partners Inc., an asset management firm based in San Francisco, is cutting back on the number of venture firms that it's giving money to, even though it's keeping the same amount of money in venture capital. "We're going to be more selective," says Alfred Guiffrida, managing director at the firm. "We invested in groups that were newer and less mainstream and we won't do much of that."
First, the successes. Morgan Stanley Dean Witter (MWD ) led the IPOs of many Net companies that have tumbled sharply from their offering prices. It reaped total underwriting fees of $350 million since 1997, according to Thomson Financial. But the firm has a respectable average return of 20% because of big hits with Net security systems developer VeriSign Inc. (VRSN ) and storage solutions provider Brocade Communications Systems Inc. (BRCD ) On the venture-capital side, Breyer's Accel Partners backed 30 companies that have gone public since 1997, and those upstarts have averaged returns of 55% for public shareholders, according to Venture Economics. They include audio and video software provider RealNetworks (RNWK ) and networking equipment maker Redback Networks Inc. (RBAK ) VC firms Sequoia Capital and Kleiner Perkins Caufield & Byers also have strong track records, with average returns of 54% and 23% respectively.
Few on Wall Street, however, have strong returns. While taking public hundreds of Net companies that have proved to be losers, investment bankers took in $2.1 billion in underwriting fees since 1997, according to Thomson Financial. The biggest names in the business led the charge. Goldman Sachs, arguably the most respected firm on Wall Street, reaped fees of $360 million by leading or co-leading the IPOs of 47 Net companies since 1997. Now, 38 of those companies have stocks trading below their offering prices, and two more have shut down. The average return for investors is -16%. Relatively, that's not bad. Credit Suisse First Boston, Robertson Stephens, Bear Stearns (BSC ), Lehman (LEH ), and Merrill Lynch all averaged returns of -45% or worse, according to Thomson Financial's figures. "Clearly, lots of very high-risk companies went public, and the investment bankers didn't show a whole lot of discipline in turning down deals," says E. David Coolidge III, chief executive officer at William Blair & Co., a 65-year-old Chicago investment bank that largely sat out the Net boom.
Some bankers take issue with the numbers. Execs at CS First Boston contend that their track record should be measured only since star tech banker Frank Quattrone and his team moved to the firm in mid-1998. If you measure the years 1999 and 2000 and include the IPOs that CS First Boston considers Net companies, the firm's average return is -55%, which is not as low as the returns they claim that Morgan Stanley and Goldman had. "The performance of Internet stocks has been pretty ugly for all of us," says John Hodge, managing director for U.S. technology corporate finance at CS First Boston. "But we did more deals and our average returns are better."
Lack of insight. If the results have been ugly, investment bankers point out that they were struggling with some of the same issues as investors. Companies were going public so early that Wall Streeters had a hard time differentiating winners and losers. "Because the market was clamoring for these companies, we had to make judgments earlier in companies' life cycles," says Goldman's Koenig. "The market was interested in investing in these companies at a stage when proof of viability was impossible to get."
Ranking the
Investment Bankers
How have investment banks performed in taking Internet companies public? Here's a look at the average returns for the Net companies taken public since 1997 by each bank.
Morgan Stanley & Co. 20%
Salomon Smith Barney -14%
Goldman Sachs & Co. -16%
Deutsche Bank AG -41%
CS First Boston -41%
Lehman Brothers -59%
JP Morgan -59%
Bear Stearns & Co Inc -65%
Robertson Stephens -65%
Merrill Lynch & Co. -82%
Data: Thomson Financial Securities Data, Business Week
The track record suggests some investment banks didn't have any more insight into the prospects for certain companies than the average investor. Lehman Brothers Inc. led the IPO of U.S. Interactive Inc., a Net consulting firm based in King of Prussia, Pa., in August, 1999, at $10. The stock surged to $76.50 in January, 2000, and then began a steady slide. Lehman analyst Karl Keirstead issued buy recommendations seven times between February and early September, 2000, as the stock dropped 92%, to $6.50. Only after the company disclosed on Sept. 20 that it would miss third-quarter financial estimates did Keirstead downgrade the stock--and then merely to "outperform." Since then, U.S. Interactive has dropped to 50 cents a share and, in January, filed for bankruptcy. Sharon Wilson, an accountant in Oregon who's nearing retirement, was one investor who got nailed. She began buying U.S. Interactive at $73.15 a share and ended up paying about $13,000 for 5,000 shares. Now, Wilson is out at least $10,000. "Many of us are ready to shoot most of the analysts out there," she says.
Lehman and Keirstead didn't fare too badly, though. The firm received fees of about $2 million for managing the books for U.S. Interactive's IPO, according to Thomson Financial. Even without U.S. Interactive, its track record isn't one to brag about: For the 15 Net companies it took public that still trade, investors have lost an average of 59% from the IPO price. They include online community developer Talk City (TCTY ) (down 99%), health site HealthCentral.com (down 97%), and ad tech firm Mediaplex (down 95%). Keirstead did not return telephone calls seeking comment.
Other Wall Street heavyweights played the same game. In May, 1999, Salomon Smith Barney led the IPO of Juno Online Services Inc. (JWEB ), a New York company that provided free e-mail service and later started offering free Internet access. In June, Lanny Baker, Salomon's Net analyst, issued a report with a buy recommendation on Juno, and by December, 1999, the stock hit a peak of $87, up from its $13 offering price.
But skeptics saw a classic Net-craze company. "There was no there there," says Steve Worthington, a portfolio manager at Barbary Coast Capital Management who sold Juno's stock short. "Giving away stuff for free never seemed like much of a business." Over the first half of 2000, investors came to agree, as Juno shares slid to less than $10. Even after that drop, Baker issued another report on June 1 that recommended investors buy the stock. While the stock recovered briefly to close at $12.44 on June 7, it then went into a slow, steady slide. On Aug. 2, with the stock again below $10, Baker downgraded the stock to neutral, and it now trades at about $1. Salomon defends its support of Juno. "We believed in Juno," says Christenson. "We were wrong."
Venture-capital firms have sold investors some big losers, too. The venture business has always been a slugger's game, in which a few home runs make up for far more strikeouts. Out of 10 deals, a firm used to expect to lose everything on three or four, make decent returns on three or four, and then have two or at best three huge hits. What changed with the Net boom is that VC firms were able to shift their early risk-taking onto the investing public. Investors, however, were buying individual stocks, not a broad portfolio, so when companies started blowing up, they ended up getting burned worse than most venture firms. "Public investors were effectively making venture-stage investments," says Blodget. "VCs understand the risks of those investments, but I don't think everybody understood."
Some of the most aggressive venture financiers were the incubators that supplied upstarts with administrative support, office space, and other services as well as capital. But incubators have not had much success in building successful companies. Internet Capital Group (ICGE ), CMGI (CMGI ), and idealab! backed companies that have averaged stock declines of 79%, 95%, and 84% respectively.
In some cases, the incubators hadn't gotten very far in building their businesses were sustainable before they took them public. Internet Capital Group, which specializes in business-to-business Internet companies, started and backed about 60 upstarts in 1999 and 2000. One of them was Onvia.com Inc. (ONVI ), a Seattle company that marketed itself as an online marketplace for businesses. The idea was to let small business use the broad reach of the Net to get bids for a variety of services, such as accounting or insurance.
That may sound like a compelling business plan, but Onvia and ICG didn't have much evidence it would work before they took the company public. In 1999, the company cranked up its revenues to $27 million from $1 million the year before, but less than 1% of those sales came from services, according to Securities & Exchange Commission filings.
How the company was able to show sharply rising sales by hawking computer hardware, software, and other products--often selling them below cost. Onvia went public in February, 2000, at $21 a share and now trades at 70 cents. On Feb. 5, Onvia said it would exit the products business to focus on services and, as a result, its sales will fall from $51.5 million in the fourth quarter of 2000 to an estimated $10.5 million in the first quarter of 2001.
A spokeswoman for ICG says the company has helped build some promising businesses, even if that's not reflected in their current stock prices. Onvia President Michael Pickett says the products business was designed to get companies comfortable with doing business on the Net and with Onvia. Later they would be converted to service customers.
CMGI Inc. also backed companies that went public with unproven business plans. Consider its investment in MotherNature.com. The incubator, through its affiliated venture-capital firm, @Ventures, made its first investment in the online health goods site in June, 1998, and took the company public in December, 1999. Yet the company hadn't developed a track record for smoothly running operations. During those 18 months, MotherNature got new top managers, moved from Philadelphia to Concord, Mass., changed its strategy to compete with health-food stores instead of cooperating with them, and was on its way to losing $54.2 million in 1999 on sales of $5.8 million. Ross A. Love, a co-founder who was fired by the board, says the new strategy was untested and he knew it wouldn't work because of his experience in the health food industry. "I totally think [CMGI and the other venture investors on the board] didn't understand the Internet at all," he says.
The company announced plans to liquidate last November, less than a year after its IPO. Kent R. Goff, a 70-year-old retired engineer, lost about $16,000 in MotherNature.com. "I kind of thought CMGI wouldn't let them go down," he says. CMGI execs declined comment.
Taking its toll. Even some traditional venture firms brought companies to market without much evidence that they would fly. Consider Hummer Winblad Venture Partners, a San Francisco firm that invested in Pets.com as well as the controversial music-sharing service Napster. It has backed seven companies that have gone public since 1997, and the average return for investors was -89%, according to Venture Economics.
Pets.com was a prime example. Hummer Winblad invested its first $500,000 in the company in March, 1999, the same month that Wainwright joined as chief executive. Then, with several rivals rolling out similar sites, Pets.com boosted its workforce from four in March to 270 at the end of 1999.
The rapid growth seemed to take its toll on operations. Several goods had the wrong product codes, so, for example, one flavor of dog food would be shipped instead of the proper one. Customer-service reps would routinely let the customer keep the wrong product and reship a new bag, according to Byron Gordon, a one-time supervisor in the department. "It could take weeks or even months [to fix the product codes]," he says. Pets.com lost $61.8 million in 1999 on revenues of $5.8 million.
All this didn't stop Hummer Winblad and Merrill Lynch from taking the company public in February, 2000. Blodget put his first buy recommendation on the stock in March, then reiterated his recommendation three more times before he finally downgraded the stock to accumulate in August. The stock, which had gone public at $11 a share, was then at $1.31. "We were definitely late in downgrading the stocks," he admits. Wainwright says Pets.com was "extremely well-managed" and that its return rate was less than 5% of sales.
Ann Winblad, of Hummer Winblad, says Gordon's description of operational problems is inaccurate and that her firm did not rush companies to market. "All of these companies had complete management teams and solid business strategies," she wrote in an e-mail. She says Venture Economics' figures are not correct and that the drop in tech stock prices contributed to Hummer Winblad's returns.
In March, after another major sell-off in the stock market, Merrill Lynch took out a full-page ad in The New York Times. In somber tones, the country's biggest brokerage firm explained its view on the market with the title, "Where We Go From Here." After the Internet bust, investors may realize that many of the top financial firms aren't the best place to find that out.
By Peter Elstrom
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