Dotcom Bust 2.0?

For those of us who went through the pain of the first dotcom bust around the start of the millenium this will all seem familiar - huge valuations on companies that are just not making money.

Dot-com fever stirs sense of déjà vu

By Brad Stone and Matt Richtel, International Herald Tribune
Published: October 16, 2007

SAN FRANCISCO: Silicon Valley's math is getting fuzzy again.

Internet companies with funny names, little revenue and few customers are commanding high prices. And investors, having seemingly forgotten the pain of the first dot-com bust, are displaying symptoms of the disorder known as irrational exuberance.

Consider Facebook, the popular but financially unproven social networking site, which is reportedly being valued by investors at up to $15 billion. That is nearly half the value of Yahoo, a company with 38 times as many employees and, based on estimates of Facebook's income, 32 times more revenue. Google, which recently surged past $600 a share, is now worth more than IBM, a company with eight times more revenue.

More broadly, Internet start-ups are drawing investment based on their ability to build an audience, not bring in revenue - the very alchemy that many say led to the inflating and undoing of the dot-com bubble.

The surge in the perceived value of some start-ups has even surprised some entrepreneurs who are benefiting from it. A year ago, Yahoo invested in Right Media, a New York company developing an online advertising network. Yahoo's investment valued the company at $200 million. Six months later, when Yahoo acquired Right Media outright, the purchase price had swelled to $850 million.

What changed? According to Right Media's co-founder Brian O'Kelley, very little, except for the fact that Microsoft and Google were writing billion-dollar checks to buy online advertising networks, and Yahoo felt that it needed to pay any price to keep up.

"I have to say I giggled," O'Kelley, 30, said of Yahoo's acquisition, which earned him $25 million. "There is no way we quadrupled the value of the company in six months."

The trend is described as a return to madness by skeptics or as a rational approach to unlimited opportunities presented by the Internet by true believers. Greed, fear and a desperate rush to pick the next big winner are all adding fuel to the fire that is Silicon Valley's boom. "There's definitely a lot of betting going on, and it's not rational," said Tim O'Reilly, a technology conference promoter and book publisher.

O'Reilly, who is credited with coining the phrase "Web 2.0," said he thought that Silicon Valley was creating a new set of society-altering tools. But that has not stopped him from worrying that the industry is now minting too many copycat companies, half-baked business plans and overpriced buyouts.

When the bubble inevitably pops, he said, "there are going to be a lot of people out of work again."

Putting a value on start-ups has always been a mix of science and speculation. But as happened in the first dot-com boom and the recent surge in housing, seasoned financial professionals are seemingly indulging in some strange instinct to turn away from the science and lean instead on the speculation.

This time around, people indulging in that optimistic thinking are not mom-and-pop investors or day-traders but venture capitalists whose coffers are overflowing with money from university endowments and hedge funds. Many of those financial professionals say everything is different this time.

More than 1.3 billion people around the world now use the Internet, many with speedy broadband connections and a willingness to immerse themselves in digital culture. The flood of advertising dollars to the Web has become an indomitable trend and a proven way for these new start-ups to make money, while the revenue models of the dot-coms of yesteryear were often little more than sleight of hand.

"The environmental factors are much different than they were eight years ago," said Roelof Botha, a partner at Sequoia Capital and an early backer of YouTube. "The cost of doing business has declined dramatically, and traditional media companies have also woken up to the opportunities of the Web. That does open up the aperture for a different outcome this time."

Some trace the start of the new bubble to eBay's $3.1 billion acquisition of the Internet telephone startup Skype in 2005. EBay's chief executive, Meg Whitman, reportedly outbid Google for the company. EBay acknowledged this month that it had overpaid for Skype by about $1.43 billion, and Niklas Zennstrom, a Skype co-founder, left the company.

Google's acquisition of YouTube last year for $1.65 billion, under similarly competitive bidding, may have accelerated the transition to loftier values. Google executives and many analysts argued that YouTube was well worth the price tag if it became the next entertainment juggernaut.

It still might. Over 205 million people visit YouTube each month, according to the research firm ComScore. Still, Citigroup recently estimated that YouTube would bring in $135 million in revenue in 2008. At that rate, the number of videos watched on the site would have to grow 1,642 percent before YouTube accounts for just 5 percent of Google's revenue.

"We are almost going back to year 2000-types of errors," said Aaron Kessler of Piper Jaffray. Internet companies, he added, "are buying users instead of revenue and profitability."

The Skype and YouTube windfalls helped to give the newest batch of Internet entrepreneurs their dreams of improbable wealth. They also brought back practices that were seemingly discredited during the first boom. For example, in the first dot-com gold rush, Internet companies did not have to demonstrate to investors that they could make money. Now that once again appears to be true.

Twitter, a San Francisco company that lets users alert friends to what they are doing at any given moment over their mobile phones, recently raised an undisclosed amount of financing. The company is not focused on making money and no one in the company is even working on how to do so, said its co-founder and creative director, Biz Stone.

"At the moment, we're focused on growing our network and our user experience," Stone said. "When you have a lot of traffic, there's always a clear business model."

That is not necessarily illogical in the current climate. A European competitor, Jaiku, also devoid of income, was bought last week by Google for an undisclosed sum. With the competitive logic that prevails at the major Internet companies, the deal may have further raised Twitter's appeal to Google's rivals.

The high value placed on many startups and minimal requirements for financial performance are raising expectations of other entrepreneurs. Sharon Wienbar, managing director of Scale Ventures Partners, an investment firm, cited the $100 million valuation that investors recently gave to the Internet genealogy site Geni.com, founded last year in Los Angeles by a veteran of PayPal. "Now every entrepreneur thinks he should get that," Wienbar said. "I have a feeling a lot of entrepreneurs are secretly meeting for beers on the Peninsula, saying, 'Hey, look what I got."'

O'Kelley, the Right Media co-founder, said other entrepreneurs had begun to think that the financing game was best played by avoiding actual revenue, since that only limits the imagination of investors. "It's a screwed-up incentive structure, just like you had in the first bubble," he said.

Another company benefiting from the exuberance is Ning, which allows users to create their own MySpace-style, ad-supported social networks. It was recently valued by investors at more than $200 million, mainly because its main backer and founder, Marc Andreessen, has a successful history with the Internet hits Netscape and Opsware.

Andreessen has argued on his blog that there is no bubble and that the high prices represent a rational desire to stake a claim in the potentially huge markets of the future. He also says companies that create mass-market hits always find ways to make money.

But he acknowledges that a seemingly inexhaustible flood of capital into Silicon Valley is helping to power the boom. Venture capitalists are flush with cash from institutional investors, eager for Internet-style returns on their money. That money has to go somewhere.

"The upward valuations pressure," Andreessen said, "is the result of decisions being made by people wearing suits in cities like New York and Boston who would never ever meet with start-ups. If that ever goes away, it will have consequences. But it doesn't look like they will change their minds."