I've been spending quite a bit of time reviewing venture capital investments, mostly in the Internet area, and have been chewing over ideas with an old friend. His thoughts about the myths of the Internet opportunity -- and the reality of that opportunity -- are provocative enough to share with you.
I wrote this article a couple months ago, but shelved it when the dot-com stocks blew up. What's the point of closing the barn door after the horse has fled? But, with some speculative excesses beginning to reemerge, I thought now would be an appropriate time to publish this.
First, a bit of background. My friend, who wishes to remain anonymous (you'll see why when you read what he has to say), graduated from Harvard Business School a year ago. He watched as a large number of his business school peers turned down traditional jobs in consulting and investment banking to seek their fortune in the dot-com world. Not surprising, given that many of their predecessors -- including some classmates of mine from Harvard Business School's class of 1994 -- struck it rich.
When my friend graduated last spring, the Internet frenzy on campus was at a peak. But, despite being from Silicon Valley and having an engineering degree, he cast a skeptical eye on what was happening. Unlike most of his friends, he turned down opportunities to work at dot-coms and is instead designing the latest medical devices. But, he's still based in Silicon Valley, so he has his finger on the pulse of what's happening there.
Here are his thoughts, as told to me:
- Huge space = great opportunity.
Reality: The carnage among Internet companies targeting pet supplies and drugstores, among others, put an end to that grossly simplistic notion.
- Many world-class businesses will emerge to become enormously profitable.
Reality: Consumers have reaped an enormous percentage of the value created by the Internet. Of the pure Internet companies, despite their growth, only a few have truly significant sales and even fewer have material profits. Most of the corporate winners are businesses that were successful before the Internet -- General Electric (NYSE: GE), Dell (Nasdaq: DELL) -- and are now using the Internet to connect more closely with customers and suppliers, become more efficient, etc.
- Once you build a brand and get to scale, you'll dominate your sector, have real pricing power, and watch the profits roll in.
Reality: It has proven to be exceedingly difficult to build a brand and get to scale. For the few companies that have done so, it's unclear how much pricing power they have. I admire Amazon.com (Nasdaq: AMZN), but question how much more it can charge than its many competitors -- and we all know the profit story so far. And that's e-commerce's greatest success story! More representative are Pets.com (Nasdaq: IPET) and eToys (Nasdaq: ETYS), both of which arguably established brands (who hasn't seen Pets.com's ubiquitous sock puppet?), but haven't profited from it. With their stocks down 83% and 94%, respectively, from their 52-week highs, do Pets.com and eToys feel like winners?
- Competitors are a good thing because they "validate" the space.
Reality: The laws of economic gravity apply to online businesses too. A flood of well-funded competitors turns the space into a bloody brawl, with more and more value transferred to the consumer and less and less captured by the businesses -- a simple Michael Porter five-forces analysis shows this. Not to pick on Pets.com, but do you think those folks go to bed at night with a smile because their space has been "validated"?
- Companies can be very virtual, easily outsourcing most of the "back-end" tasks.
Reality: Customer service still matters, and it is expensive. Drop shipping from your supplier sounds good until you realize that they aren't set up to do it and, when they do, they largely serve to alienate your customers. Darn. I guess I do have to build the warehouse and carry the inventory and deal with service and...
- The Internet allows you to cheaply acquire customers, who will then spread your service/application to their friends (so-called "viral marketing").
Reality: Acquiring customers is very expensive, and most of these customers never return. The phrase "lifetime value of a customer" begins to look absurd when the reality is often pick-(the $50 first-time freebie)-and-run behavior. Viral marketing is nice when it happens, but exceedingly rare. There are plenty of other applications and companies out there vying for every customer's short and fleeting attention. Most customers are quite skeptical. Try getting and keeping a piece of today's customer's attention.
- "It's really not about selling books or CDs or ___, it is about leveraging those sticky customer relationships to sell an entire wide range of products over the customer's entire life."
Reality: Again, customers are stunningly fickle and opportunistic (just like the venture capitalists and entrepreneurs who pursue them). There are very few examples of companies successfully expanding from one sector to another sector (Amazon.com may prove to be an exception).
- If you get the eyeballs, they can be monetized.
Reality: Sometimes eyeballs can be monetized, but more often than not they can't, or are only monetized at a ridiculously low value. The subject of a recent Dueling Fools, drkoop.com (Nasdaq: KOOP), has amassed plenty of eyeballs, yet it has been nothing but a revenueless rocket ride to the bottom. Similarly (and also a recent Dueling Fools feature), iVillage (Nasdaq: IVIL) has been successful at attracting eyeballs, but has yet to build a business model that could be called sustainable, much less financially successful.
- You only need a few people to set up a dot-com company.
Reality: You need many people to start -- and those people are damn expensive. And, boy do they have short time horizons and low levels of loyalty! Few have any truly relevant experience, and many are very greedy. True, once you get really large, the efficiencies start to show up, but that is farther away than you realize, a place that few companies ever discover. Another thing to remember is that this quest for equity and the almighty cash-out is a powerful motivator until the moment it becomes clearly unlikely. At that point, there is a rapid exodus toward greener pastures.
- Working for a dot-com is fun and people do it for the joy of creating something new and revolutionary.
Reality: With a few notable exceptions, the people my friend knows who work for dot-coms are frustrated, overworked, and cynical. They are less passionate than opportunistic. The overwhelming urge is not to just get rich, but to get filthy rich, very fast, then to exit even faster.
- It is ___ that matters.
Reality: First it was content. Smack! (That's what happened to investors.) Then it was community. Smack! Then it was e-commerce. Smack! Then it was (briefly) B2B. Smack! The time period during which these opportunities are in vogue continues to grow shorter.
- The Internet has resulted in what John Doerr of venture capital firm Kleiner Perkins has called "The largest creation of wealth the world has ever seen."
Reality: It is unclear how much wealth has really been created, but what is certain is that there has been an extraordinary transfer of wealth from gullible investors to venture capitalists, entrepreneurs (the early ones anyway), real estate agents, ad agencies and, most of all, American consumers. For a great book about this, read The Internet Bubble.
I don't agree with all of my friend's points, but most of them are right on. This doesn't mean I don't believe in the power of the Internet -- I do, in a big way. In fact, I own stakes in a handful of public and private Internet companies. But, good investments in this space -- like any other -- are rare and difficult to find. Above all, I try not to deceive myself about the risks and never count on being bailed out by a greater fool.
-- Whitney Tilson
Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous guest columns in the Boring Port and other writings, click here.