Rule Breaker Portfolio
Why Pets.com Died

Dozens of young online-based companies are doomed to fail alongside Pets.com. The companies were rushed to the public market in a system that often makes money for venture capitalists, but leaves shareholders battered. Is the system working as it should?

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By Jeff Fischer (TMF Jeff)
November 14, 2000

My tale was heard and yet it was not told,
My fruit is fallen and yet my leaves are green,
My youth is spent and yet I am not old,
I saw the world and yet I was not seen;
My thread is cut and yet it is not spun,
And now I live, and now my life is done.
--Chidiock Tichborne, c. 1580

After bursting to life to deliver on the promise of e-commerce, Pets.com (Nasdaq: IPET) closed its business the same year that it went public. To quote Tichborne again, "And now I die, and now I was but made."

Pets.com is not alone in falling to an early grave. MotherNature.com (Nasdaq: MTHR), Living.com, Furniture.com, and dozens of e-commerce companies with stocks below $2 per share are destined to share the same fate.

The failure of Pets.com and other Internet-based companies affects us all in obvious if small ways, and also in ways that we'll never know. These failures not only leave us with fewer choices as consumers, but they make it difficult for today's new online-based enterprises to raise capital. Some of today's upstarts have excellent ideas that will never see the light of day because they can't get funding.

Betting it all on the market
Why did Pets.com die? Ironically, the eager venture capital investors who swiftly funded Pets.com might have made the company's failure almost inevitable. Pets.com raised millions with nary a sustainable advantage to its name (it was not a Rule Breaker), and the venture capitalists knew that most of the money would be blown on marketing. Then, Pets.com was able to go public without a penny of value creation, let alone meaningful experience, under its belt. Next, Pets.com was allowed to fail quickly without anyone giving it a long-term chance.

When the company went public on Valentine's Day this year, management knew that very soon it would need more money given its marketing spending plan. Pets.com counted on additional funds, most likely from a secondary stock offering (they were a dime a dozen back then), and the additional funds would largely be spent on still more marketing. They arguably had to be. Even a partnership with Amazon.com (Nasdaq: AMZN) was not bringing the millions of customers that Pets.com needed quickly enough.

Relying on additional public capital to fund the long process of becoming a sustainable business with a meaningful customer base was a big gamble at Pets.com. It lost the gamble. In a different stock market (for example, if Pets.com had gone public in 1997), this bet might have actually panned out, but it didn't.

Shareholders draw the short stick
Venture capital firms made hundreds of new public companies possible over the last three years by providing initial financing. They smelled easy opportunity and leapt. Rather than actually fostering a new company's development, venture capitalists could simply fund almost any online-based company, take it public quickly, and sell into the buying frenzy.

This short-term mentality during the Internet's gold rush led to the following devastating chain of events with dozens of online-based companies:

  1. A questionable business model quickly received millions of dollars in venture capital funds to get started.
  2. When that seed money was spent, typically quickly, another round of financing arrived, mainly to help get the company to the public market.
  3. Within months, the young company wobbled onto the public market, eyes still closed, legs half-buckled, and ears still wet.
  4. Once the company had been public a handful of months, public shareholders shouldered nearly all of the risk, as the venture capital firms bowed out forever. ("Thank you!" they said.)
  5. Many of these companies, not surprisingly, failed or will fail, often by simply running out of money. Since the companies went public too soon and spent money too quickly, we'll never know which ones could have grown to become viable businesses under saner, more patient conditions.

Perhaps it's too easy to get a company listed on the stock market. Perhaps investors deserve more protection and loud warnings. (Investors should always be cautious about what they choose to buy anyway, especially with IPOs.) Or, perhaps the way that the venture capital system works is too often counterproductive to creating long-term shareholder value, especially in hot markets where there are opportunities that the system can abuse for personal gain. Striking while the iron's hot can create great wealth for venture capital firms, but it leaves unsuspecting shareholders much poorer and, arguably, it can end up destroying businesses before they've even had a chance.

Is this a smart, long-term minded system? Is it a fair system?

Whatever your answer (please share it below), the practice of unfit and ill-prepared companies rushing to go public is bound to continue, especially in hot industries. For too many new companies, the prime of their lives will be the very day that they go public, as was true with Pets.com. To recite Shelley:

O World! O life! O time!
On whose last steps I climb,
Trembling at that where I had stood before;
When will return the glory of your prime?
No more -- Oh, never more!

Rule Breaker Exit Poll
Companies now often go public within a few years of getting venture capital funding. It used to take several years. Do you believe that the accelerating stepladder system from venture capital funding to IPO is working as it should? Respond to our poll and then share your additional thoughts.






Rule Breaker Portfolio


11/14/00 as of ~8:30:00 PM EST

Ticker Company Price
Change
Daily Price
% Change
Price
AMGNAMGEN INC1.502.40%64.13
AMZNAMAZON.COM1.134.04%28.94
AOLAMERICA ONLINE0.831.69%49.90
ATHMAT HOME CORP CL A0.697.33%10.06
CRAPE CORP - CELERA GENOMICS GRP0.130.22%57.13
EBAYEBAY INC4.8111.22%47.69
HGSIHUMAN GENOME SCIENCES(4.25)(5.69%)70.50
SBUXSTARBUCKS CORP2.696.06%47.06

  Day Week Month Year
To Date
Since
8/5/1994
Annualized
Rule Breaker2.07%(3.58%)(7.11%)(35.66%)945.75%45.32%
S&P 5002.35%1.24%(3.25%)(5.87%)201.69%19.22%
S&P 500 (DA)2.24%1.19%(3.11%)(5.62%)215.95%20.10%
NASDAQ5.78%3.61%(6.87%)(22.88%)335.76%26.41%

Trade Date # Shares Ticker Cost/Share Price Total % Ret *
8/5/944020AOL0.4549.905520.08%
9/9/972640AMZN3.1828.94846.38%
12/16/981160AMGN21.4464.13199.03%
7/2/98470SBUX27.9547.0668.35%
12/17/991260CRA39.7657.1343.69%
2/26/99600EBAY50.2647.69(5.12%)
9/22/00560HGSI80.0570.50(11.93%)
12/4/98900ATHM28.0410.06(64.11%)

Trade Date # Shares Ticker Total Cost Current Value Total Gain *
8/5/944020AOL1,816.44200,598.00271,374.00
9/9/972640AMZN8,408.4076,395.0093,810.70
12/16/981160AMGN24,875.5074,385.0049,509.50
12/17/991260CRA50,093.0071,977.5021,884.50
7/2/98470SBUX13,138.6222,119.388,980.75
2/26/99600EBAY30,158.0028,612.50(1,545.50)
9/22/00560HGSI44,830.5039,480.00(5,350.50)
12/4/98900ATHM25,236.179,056.25(16,179.92)
 
Cash: 
Total: 
67.51
522,691.14
 

* Our long term totals include both our realized and unrealized gains. For instance, we have sold portions of AOL and Amazon in the past, and those realized gains are included in our total returns for these stocks.



Note
The Fool Portfolio was launched on August 5, 1994, with $50,000. It was renamed the Rule Breaker Portfolio in October 1998. The investing strategy began with the first investments of the Fool Port and has evolved with time and experience. In July 2001, the portfolio began adding $12,500 each quarter (We missed Jan. 2002, so we added $25,000 in April 2002). We skip a quarter if we have enough uninvested cash or cash available in stocks we would prefer to sell to make new investments. All transactions are shared and explained publicly before being made, and returns are compared in each week's column to the S&P 500 (including dividends where noted) and the Nasdaq composite. For a history of all transactions, please click here.