The Dot-com Bubble

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The second half of the 1990s marked the sudden rise of a new sort of economy, one in which stock markets experienced high growth rates under the influence of venture capital and IPO-funded companies in the Internet sector and related fields. Hence, the name ‘Dot-com Economy,’ which refers to the commercial websites that characterized so many of these companies, was born as a term to identify companies featuring internet domain names ending with “.com.” High volume stock speculation was fueled by the fact that this was a novel industry with high potential, but also one where companies were difficult to value. Investors looking for the new ‘hot’ stocks triggered high demand for tech stocks in general, as well as causing the overvaluation of many companies in this field. At its peak, even companies which had never made any revenue were pushed onto the stock exchange and were trading at extremely high values when one looked at the bottom lines of these companies—which were extremely negative in most cases. As early as 1996, Alan Greenspan, the chairman of the Fed at the time, warned against ‘irrational exuberance,’ where rational investing was replaced by momentum investing. On March 10, 2000, the technology stock index Nasdaq peaked at over 5,000 points, the day after a fire sale of tech stocks started marking the end of the rise of the ‘new economy’ (Econport, 2007; Allen & Morris, 2008).

Events Causing the Dot-com Bubble

The invention of the Internet led to one of the biggest economic booms in history. The history of this global network of computers traces back to early research activities in the 1960s, but it wasn’t until the creation of the World Wide Web in the 1990s that large scale adoption and commercialization started to catch on (Internet, 2012).
Once it became clear to investors and speculators that the internet had created a wholly new and untapped international market, IPOs of internet companies started to follow each other in rapid succession. Sometimes the valuations of these companies were based on nothing more than just an idea on a single sheet of paper. The excitement over the commercial possibilities of the internet was so big that every idea which sounded viable could fairly easily receive millions of dollars worth of funding. The basic principles of investment theory with regard to understanding when a business would turn a profit, if ever, were ignored in many cases, as investors were afraid to miss out on the next big hit. They were willing to invest large sums in companies which did not have a clear business plan. This was rationalized by a so-called ‘dot-com theory’: for an internet company to survive and grow, it depended on rapid expansion of its customer base, which in most cases meant huge initial losses. That there is some truth in this is proven by Google and Amazon, two hugely successful companies in 2012, but it took them both several years before they showed any kind of profit.
Many of these new companies spent a lot of money internally as well. Because of stock option plans, the employees and executives of these companies became overnight millionaires after their IPOs, while it was not uncommon for these companies to spend a lot of money on luxurious business facilities, as confidence in this ‘new economy’ was extremely high. In 1999, there were a total of 457 IPOs in the U.S.—most of them internet and tech companies. Out of these, 117 managed to double their value within the first day of trading.
Communication companies such as mobile network operators and internet service providers also started to invest a lot in network infrastructure, as they wanted to be able to grow along with the demands of the new economy. This meant many of these companies took on huge levels of debt in order to be able to invest in new network technology and to acquire wireless network licenses (Investopedia, 2010; Dot-com Bubble, 2012).

Dot-coms Become Dot-bombs

On March 10, 2000, the Nasdaq Composite—the index for technology shares traded on Wall Street—peaked at 5046.86 points, double the value of where it was the year before. The next day, technology shares began to fall as the dot-com bubble burst. One of the direct reasons for the deflation was the finalization of the antitrust case against Microsoft, which was declared a monopoly in early April, 2000. These findings were already anticipated by the market, causing the Nasdaq to lose 10% of its value in the ten days following March 10, 2000. The day after the official findings of the Microsoft investigation were made public, April 4, 2000, the Nasdaq experienced a large intraday downfall, but subsequently bounced back up. This did not mark a recovery; the Nasdaq entered into a freefall the moment investors started to realize that many of the loss-making new tech companies were indeed that: loss-making companies. Within a year after the start of the deflation, most of the venture capital backed technology companies had burned all their funding and many went bankrupt while new funding dried up. Some investors started referring to the original dot-com stars as ‘dot-bombs,’ as they managed to destroy billions of dollars of value in a very short timespan (Investopedia, 2010; Internet, 2012).
On October 9, 2002, the Nasdaq hit a low of 1114.11 points—a whopping 78% loss of value compared to its peak two-and-a-half years before (Investopedia, 2010). Besides a lot of the tech startups, many communication companies also got into trouble, as they had to cover billions of debt they took on to invest in network infrastructure—the return time of which now suddenly was a lot longer than they had anticipated.

On the legal issues side, Microsoft was not the only company that had to appear in front of a judge. Another famous tech company of that era was launched in 1999 and called Napster, a software program which enabled the peer-to-peer sharing of digital music. It was founded by 20-year old Sean Parker and two friends and it quickly rose to short-lived fame. It came under fire from the music business almost immediately because of copyright infringements and eventually ceased to exist (Napster, 2012).
The actions of individual entrepreneurs with regard to the craze of the dot-com bubble can perhaps best be illustrated by Kim Schmitz. This German hacker became a multi-millionaire by launching various internet companies in the 1990s and eventually changed his name to ‘Kim Dotcom’ as a wink to the Dot-com Economy which had made him rich. He famously sold 80% of his shares in DataProtect, a company he founded that provided data protection services, to TÜV Rheinland in early 2000, right before the collapse of the new economy. Less than a year later, DataProtect went bankrupt. In the 1990s he was already the central figure in a number of convictions for insider trading and embezzlement related to his technology ventures. In 1999, he drove a tuned-up Mercedes Benz with a high-speed wireless internet connection, unique at the time, among many other electronic gadgets. He used this car to participate in the Gumball Rally through Europe, where a host of people in expensive cars race around a number of European countries using public roads. When Kimble’s car (‘Kimble’ being his nickname at the time—after the character Richard Kimble from the motion picture ‘The Fugitive’ and a reference to his convictions) got a flat tire in Finland, he had a new wheel flown in by private jet from Germany. He still came through the aftermath of the bubble’s collapse and kept on launching new startups. However, he was arrested again in 2012 because of allegations that he illegally spread copyrighted content through his Mega-companies; he is currently under house-arrest in his NZ $30 million house in New Zealand awaiting trial (The Economist, 2012a, 2012b).

Have Investors Learned Their Lessons a Decade Down the Line?

Of the tech companies which were launched during the buildup to the dotcom bubble, a few have survived and lived on to be technology giants, such as Google and Amazon. However, the majority went under. Some of the entrepreneurs involved in risky ventures stayed active in the technology industry and eventually started new companies, like the aforementioned Kim Schmitz, but also Sean Parker of Napster, who went on to become the founding president of Facebook (Parker, 2012).
After the bubble deflated, investors became more wary of investments in technology companies and started to put emphasis again on realistic plans. However, in recent years, a number of high profile IPOs have made the headlines. When LinkedIn, a social network for professionals, was floated on Thursday May 19, 2011, its shares instantly more than doubled in value, reminiscent of what happened in 1999 (Reuters, 2011a). The company itself cautioned investors not to be too optimistic, quite the opposite from the wild stories tech companies were telling the markets in the 1990s (Reuters, 2011b). When these kinds of companies do an IPO now, they typically have been in business for a few years and have good prospects for profits, if they are not profitable already. Another IPO bound to take place in 2012, and which has been anticipated for years—Facebook—will be closely followed by investors and observers alike. The social network is currently valued at around $100 billion, making the eight-year-old company roughly as valuable as McDonald’s, while it only has 0.2% of the employees McDonald’s has (The Economist, 2012c).

Conclusion

The Dot-com Bubble of the 1990s and early 2000s was characterized by a new technology which created a new market with many potential products and services, and highly opportunistic investors and entrepreneurs who were blinded by early successes. After the crash, both companies and the markets have become a lot more cautious when it comes to investing in new technology ventures. It might be noted, though, that the current popularity of mobile devices such as smartphones and tablets, and their almost infinite possibilities, and the fact that there have been a few successful tech IPOs recently, will give life to a whole new generation of companies that want to capitalize on this new market. Let’s see if investors and entrepreneurs are a bit more sensible this time around.

 

References
Dot-com Bubble (2012). In Wikipedia, the free encyclopedia. Retrieved March 22, 2012, from: http://en.wikipedia.org/wiki/Dot-com_bubble

Econport (2007). The Dot-com Bubble. Retrieved on March 20, 2012, from: http://www.econport.org/content/handbook/Internet-Economics/dotcom.html

Internet (2012). In Wikipedia, the free encyclopedia. Retrieved March 22, 2012, from: http://en.wikipedia.org/wiki/Internet

Investopedia (2010). The Greatest Market Crashes, The Dotcom Crash. Retrieved March 20, 2012, from: http://www.investopedia.com/features/crashes/crashes8.asp#axzz1p1oKrRIP

Napster (2012). In Wikipedia, the free encyclopedia. Retrieved March 22, 2012, from: http://en.wikipedia.org/wiki/Napster

Reuters (2011a). LinkedIn share price more than doubles in NYSE debut. May 8, 2011. Retrieved March 20, 2012, from: http://www.reuters.com/article/2011/05/19/us-linkedin-ipo-risks-idUSTRE74H0TL20110519

Reuters (2011b). LinkedIn IPO price hints at social media caution. May 9, 2011. Retrieved March 22, 2012, from: http://www.reuters.com/article/2011/05/09/us-linkedin-idUSTRE7481NS20110509

Reuters (2011c). Groupon’s IPO biggest by U.S. Web company since Google. November 4, 2011. Retrieved March 22, 2012, from: http://www.reuters.com/article/2011/11/04/us-groupon-idUSTRE7A352020111104

Sean Parker (2012). In Wikipedia, the free encyclopedia. Retrieved March 22, 2012, from: http://en.wikipedia.org/wiki/Sean_Parker

The Economist (2012a). Megaupload goes down. Published in The Economist, January 21, 2012. Retrieved March 20, 2012, from: http://www.economist.com/blogs/babbage/2012/01/online-file-sharing

The Economist (2012b). Dotcom Bust, the arrest of Kim Dotcom has rocked the world of cyberlockers. Published in The Economist, January 28, 2012. Retrieved on March 22, 2012 from: http://www.economist.com/node/21543548

The Economist (2012c). Facebook by numbers. Published in The Economist, February 2, 2012. Retrieved on March 20, 2012, from: http://www.economist.com/blogs/graphicdetail/2012/02/daily-chart-0

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