The pricking of the dotcom bubble

In the first few months of this century, the shrewder investors began to realise that all was not well with the dotcoms (the name given to the Internet startups that were being rushed to market after receiving massive amounts of venture capital funding). After a few spectacular failures, analysts began looking more closely at the accounts. What they found was truly alarming.

Most were burning up capital so fast that they were almost certain to run out of cash before reaching profitability. Advertising and marketing wasn't working for them. They could get the eyeballs, but it wasn't translating into profitable income. It wasn't uncommon for marketing costs to be multiples of the profits on sales and in some cases even multiples of the gross sales revenue itself.

One company, Pets.com, had to fold even though it had received 85 million dollars of funding and had acquired a customer list of 500,000. Conventional marketing strategies had produced totally unexpected poor results. This was a situation that had no parallel in the Industrial Age world.

Analysts started to look more closely at the accounts of the e-businesses. They found many irregularities and misleading accounting practices. For example, where a company had low or non existent trading incomes, it could find ways to create artificial sales or assets to falsely boost the apparent value of the company. One such trick was where companies exchanged banner advertisements with each other: back to back arrangements where each charged the other the same huge sum of money for running the other's banner advertisement on their site. This can artificially boost the sales revenues of both companies, to make it appear in the accounts that they had large turnovers.

Although this does not generate any real profits, the accounts of the companies involved in these back to back arrangements can be made to show a net gain because the payments (by each company) for the banner advertising is charged to marketing instead of writing these costs off against profits. In this way they can legitimately (but falsely) claim these costs are additions to the intangible assets of the company: on the basis that marketing usually leads to increased value of a brand name and to future sales.

Similarly, many companies were selling goods at huge price discounts, but, entering the sales into the accounts at full retail values. This allowed them to treat the discounts as marketing expenses that could boost the intangible assets valuation of the company, on the pretext that the discounts were being employed profitably to build a customer base.

Without being aware of such tricks, it is easy for an investor to see what appears to be a healthy balance sheet that, although not showing a trading profit, is reflecting the results of a rapidly expanding business with a growing potential to become profitable.

Trying to ascertain a "true" value of those early dotcom companies was fraught with many such difficulties. Web sites, some of which had cost millions of dollars to build, were being treated as if they were permanent buildings in the world of bricks and mortar. Site building costs were being included in the accounts as assets, even when it was patently obvious that the sites were transitional and temporary structures, often failing at what they had been designed to do and proving to be more of an expensive liability than an asset.

Complicating and clouding the valuations was the question of where corporate incomes and expenditures were booked. A company could be set up anywhere in the world, it's Web sites could be distributed all over the planet. Product design, and manufacture could be fragmented and outsourced to a variety of different contractors and sub-contractos in a variety of different countries. If the product was software is could be dispatched from anywhere. It was impossible for even professional investment analysts to discover where profits were being taken or removed. Sorting out such accounts and investment valuations can be impossibly complex.

Perhaps the biggest conundrum for investors was in puzzling out the meaning of a dot-com's burn rate (burn rate is the term used to describe the haemorrhaging of capital as a company spends money in its efforts to become profitable). Burn rate, or negative cash flow, is not alarming in itself as most dotcom companies were set up with the expectation that real trading profits will not materialise immediately. Nearly always, the startups had business plans that indicated profits would appear only after a substantial infrastructure had been set up and a customer base established – which could be several years away from the date of funding or market launch.

So, in the absence of a conventional profit and loss account based upon actual trading, investors had to work out whether the outgoing cash (the burn rate) was being used by a business:

a) to build a profitable company, or,

b) was merely symptomatic of a company that had lost its way and was trying to spend its way out of trouble?

In most cases, the answer to this question was found out too late – after all the money had gone.