I think it was Steve Martin who said he knew we might be at a market top
when his wife bought a fur suit. Do you remember two or three things that said
to you things are getting a little far out here?
There were several. I think one of the defining moments was when Jack Welch,
who is arguably the most respected CEO in the business today, decided to join
the board of Idealab. We had spent a lot of time looking at deals that Idealab
had formed, and we had a pretty good understanding of what was going on within
Idealab. It was absolutely shocking to me that someone with a reputation and
the tenacity of a Jack Welch would consider doing that. That was a sure sign
that the end was near.
And then there was March  -- which actually was the precise market top --
at a conference in Arizona, one of the fancy conferences that Esther Dyson puts
on, Whoopi Goldberg was a dinner speaker. And the fact that Whoopi was coming
up and talking about how wealthy these Silicon Valley entrepreneurs and venture
capitalists were and what a great life it was; and she had some ideas as well.
That to me was a sure sign the end was pretty darn close. ... But she was a
great speaker, by the way. ...
At one point, you criticized the [investment] community, and you were
ridiculed. Tell me about that. What did you say? What were people saying about
It was a couple of years ago. It was 1998. We were just at the beginning of
what would be the insane run-up. A lot of these retailing concepts were being
backed, again, by venture capitalists and angel investors who didn't know the
first thing about building a retail business. So that should give everyone
pause, when technology-oriented venture capitalists or private investors are
backing sporting goods companies [and] pet deals on the Web. Everyone should
step back and say, "Run for the hills, these are danger signs." And a lot of
these deals were getting done.
We tried to do our part to run numbers and talk to the smartest people we knew
at companies like Wal-Mart and Home Depot, who really understood retail. And no
one could make out what the numbers were on these e-tailing deals. People who
were the best and the brightest in the retailing world could not show how these
companies would get profitable.
It doesn't take much more than a little common sense to realize that if
longtime experienced, superb executives out of Wal-Mart can't make the numbers
work, there is something flawed with these models. Yet literally billions of
dollars would pump into these e-tailing deals. At that point in 1998, it led to
my statements where I felt that 95 percent of the consumer Internet companies
would be obliterated; they would either go out of business, [or] in some cases
they would get lucky and find potential buyers. I didn't think there would be
more than a handful of companies that would make it as stand-alone companies in
the e-tailing business. In some cases we get it right, and in that particular
thing we did get it right.
I think you were quoted as saying that there were hundreds of companies
being taken public that just should not have been taken public.
Absolutely. Many of these were venture-backed. They were taken public before
any risk was taken out of the business. And the deals -- the pet deals, the
sporting goods deals -- no one that I talked to could make those business
models work when you add in all the customer acquisition costs and what
customers were really worth. These are companies that should never have been
taken public. And, in fact, should never have been venture financed. But there
was momentum investing, and people kept piling on. ...
The analysis we did in some of these companies -- because we kept asking
ourselves are we really missing something, we were criticized in many circles
for missing the consumer Internet wave -- the numbers we ran were just
sobering, to say the least. ... And we realized that eToys had a larger market
cap than the top three or four or five long-time toy companies. That certainly
suggested to us that there would be not just a shakeout, but a massive
obliteration of market cap in areas like toy retailing that are highly cyclical
and very difficult businesses. ...
I think what was so unfortunate about many of the Internet consumer businesses
is there was no business there, period. But on the infrastructure side, you
could argue about the valuations -- the valuations certainly were astronomical
and unjustified, but many of those companies really remained long-term viable
But weren't they taken public too soon?
Absolutely. ... There was so much available capital that entrepreneurs forgot
that the very best enduring companies typically raise very little capital; they
bootstrap along the way. They focus on profitability. And whether it is Dell,
Microsoft, Cisco, Siebel Systems -- I could go on and on. Few of those
companies had to raise more than $20 million or $30 million before getting
profitable. ... A host of companies which could have been real businesses
simply went out and raised hundreds of millions of dollars before reaching
profitability, and very bad things happened from over-capitalization. And
that's what we are seeing, even for companies that I think do have a long-term
chance of real businesses.
How about this phenomenon of the excess of free capital? What was happening
to these companies?
The dangers of over-capitalization are, in many cases, even higher and more
grave than under-capitalization. We went through a period where the badge of
honor for some reason for a lot of entrepreneurs was, one, raise large amounts
of venture capital from the right firms. That's step one. And their idea of
risk reduction was to get a blue-chip venture firm to invest, and get a
blue-chip partner to join the board.
Like a Kleiner Perkins, like a Benchmark.
Absolutely. Secondly, go out and raise mezzanine money from wealthy
individuals, investment banks, other sources of capital, and raise a big slug
at a big valuation; then finally go public.
And in our business, historically, what we've always said was that risk
reduction is all about, in the first 12 months, take out the technical risk; in
year two, take out sales and marketing risk; in year three, build for working
capital and international distribution; year four, take the company public.
That's a classic venture model in terms of how we stage investment. But, in
fact, there was no staging. There was no risk reduction that was occurring,
because the capital was so free, the companies could raise it all at once, and
were simultaneously trying to address all these issues.
You can't address all those issues simultaneously. There has to be a systematic
reduction of risk. And what happened was, companies felt that if they raised
hundreds of millions of dollars, they were off to the races. It was all about
being preemptive, first mover. And of course, the history of technology
businesses, as well as many others, suggests that it's very often the case that
the second or third mover ends up winning. ... Sometimes it really pays to let
someone else create a market and be the second or third entrant. That's true in
the spreadsheet business with Lotus. That was true in the personal computing
business with Dell; true in the router business with Cisco; true in the
operating system business with Microsoft. I could go on and on.
That was lost for a couple of years. People felt there was only one way to
build a business: go after the capital. It was free, so it was available. Spend
like crazy, and use a first-strike advantage to create a defining business. And
that's just not the way good businesses are built.
What was motivating that rush?
I think there were some examples, starting with Netscape, and to a lesser
extent, UUNET in 1995, which changed, I think, the scenery in Silicon Valley
for the six-year period that we're talking about.
Netscape really was a preemptive strike. And the Netscape IPO in August of 1995
in many ways, coming on the heels of the UUNET IPO was very defining. Suddenly
there was a generation of young entrepreneurs who looked at how Netscape
suddenly turned tens of millions of dollars into hundreds of millions or
billions of dollars, and were creating real market share.
People used the Netscape model inappropriately as a model for every type of
technology or Internet business, period. And then we had examples like Amazon,
which were very much following the preemptive strike model as well. So some of
the early successes were really around this model, and it, I think, led to a
lot of lost capital, and a lot of fallacious thinking.
But we moved from a first-strike motive at some point to a stock play
motive, didn't we, at some point?
Oh, absolutely. Part of the thinking was, "get public." Use the capital to
build a preemptive first-strike position. And with the public currency, go out
and make acquisitions, and fill in around the business, and really build
At some point, the value of that Internet currency was just astronomical. You
had Yahoo trading at $100 billion or close to $100 billion, and some of the
other Internet companies trading certainly in the $30 billion to $40 billion
range. That is very powerful currency. And the interesting thing is, if
companies had made the right acquisitions when their stock prices were at those
levels, they might have real underlying businesses.
Like AOL, the defining example. In January of 2000, AOL announced a merger. It
was absolutely brilliant. And in my view, ten years from now, AOL Time Warner
is likely to be one of the most valuable companies in the world. They
structured something exactly at the right time, with the right mix of Internet
and physical world assets. It's still a very big execution challenge. But they
have all the right pieces to build a very deep enduring business. I give Steve
Case enormous credit.
Who's responsible? Who gets the blame now for taking all these companies
No way to blame one constituency. This is a circular process. One day I'm
reading that the blame should be directed at the investment bankers. Another
day, of course, it's the venture capitalists. Some days, it's the
entrepreneurs. In some cases, it's the money management firms.
I think that it's circular. There's no way to point any one finger at any one
constituency. I will say, on the investment banking side, better due diligence
should have been done. I think they are middlemen to some extent. They are in
between the supply and demand equation, if you will. They sit right at the
middle. And people are buying these offerings. Their argument is, we're just
there to make sure that they're high quality offerings and we're getting them
out into the right hands.
But there is no doubt there are a lot of companies that were taken public
simply didn't receive the right due diligence from the investment bankers. And
from a venture capitalist perspective, I am sure that there were cases of
venture capitalists trying to push companies toward liquidity, largely because
of the idea that first strike, and preemptive, really mattered. But again, it's
very hard to say precisely who's at fault. But there are a lot of people who
should raise their hands, including the venture capitalist.
For instance, yourself, you invest in Technology Crossover Ventures, as a
small or not-so-small crossover firm --
-- that was taking companies public very quickly; five-, six-, seven- month
periods of time. You're an investor in that. Should we be saying to you, "Why?"
We started investing in Technology Crossover Ventures previous to its actual
formation. So we were an initial sponsor of Jay Hoag and Rick Kimball. I think
they are really smart investors. They've been at it a long time with a great
track record. I think what TCV was doing was investing in companies where, for
a brief period of time, there was an ability to take a company public and,
within a year or so, get real liquidity.
Do I think we should have continued to caution Jay and Rick and the TCV people?
We should have done more than that. But we have a lot of confidence in the TCV
management team as long-term technology investors. They're really smart, really
So many venture capitalists and entrepreneurs were going public and then,
six months later, selling out their stock, some CEOs retiring, a lot of venture
capitalists getting out altogether -- Rick Kimball and Jay Hoag are good
examples of that with companies like Ariba and CacheFlow -- and doing very well
doing that. What's wrong with that?
First of all, from an investment standpoint, you can't count on it. So anybody
who joined the business thinking that that's the way the business works, I
think, won't be in the business very long.
There was a brief period of time when that was possible. But by and large, in
many of those cases, there are investors who were in there four or five years,
and post lock-up, which is typically six months after the public offering,
distributing that stock to limited partners, which include individuals,
endowments, pension funds, and foundations. There's nothing wrong with that.
The fact is that if there'd been real value that had been created, and the
stock was at a high level, perhaps higher than it should be, we as venture
capitalists aren't the ones to determine what's an appropriate market cap. We
want to get the stock in the hands of our investors and let them make decisions
whether to sell it or not. And that's how we operate our business. We will
distribute stock to our investors, and then everybody makes their own decisions
as to whether they hold it or sell it. We never had a recommendation one way or
That process wasn't going too quickly, in your view? You could almost ensure
that there was going to be a pop, basically, easy capital, and get out. It was
a very short-term kind of investment horizon -- not what I thought venture
capital was supposed to be about.
I can speak for our portfolio. There weren't many one- to two-year terms in our
Maybe not yours, and that's one reason I'm talking to you. But there was a
lot of that going on across the Valley.
I think there was some, particularly in the late-stage environment. And there
were people who certainly started drinking the Kool-Aid and saying, "Boy, I can
turn this in a year and make three or five or ten times my money." But we
certainly stepped back and said, "What are these people thinking? At any
moment in time, this market can come crashing down, and that three times or
five times can turn into a significant loss of capital."
There was a period of time when that was working. But like all mania, there are
periods of time when you feel that it's unreal, you step back, and you just
have to say, "This is going to come to an end." Some people get real lucky, is
how I would characterize it. But that's no way over a long period of time to
operate a venture capital firm or an investment business. It sure helps to get
lucky, but you can't count on it. A lot of people started counting on it.
You were talking about risk -- that the traditional models of venture
capital sort of squeezed the risk out over a period of years. That stopped
happening. What allowed for that to happen? And where did that risk land?
The risk landed with the public investor, unfortunately. The public market
investor who ended up buying a lot of these companies, either at the public
offerings or after the public offerings, ended up assuming a lot of the risk,
and it's a shame.
Why did classic venture capital risk reduction processes stop for some period
of time? By and large, it's impossible to say. There was euphoria. Why were
venture capitalists who were electrical engineers investing in pets deals, or
sporting goods on the web deals? Hard to explain.
And in fact, when you look back at that, or you look at some of the
advertisements that were run by E*Trade and others, you just got to laugh. You
just got to say, what were people thinking?
But the really unfortunate part, of course, is if these companies, as they were
going through their private venture process, were not addressing risk, and not
reducing risk, and not building in the right business processes and
disciplines, at some point they're going to implode. And what typically
happened was that they imploded post public offering. A lot of people who were
buying these stocks ended up holding the bag.
How did it happen that the public came to assume that risk? It's rare that
it happens like that, is it not?
It happens every five or six years; there's some phenomenon, some frenzy, some
trend which captures everyone's fancy. The last time I saw it in a significant
way was the biotech boom, when you had a lot of public investors, a lot of
venture capitalists, throwing money at the latest and greatest biotech company.
I can't believe there were many public investors, and for that matter, many
venture capitalists, who understood the science behind many of the biotech
deals. And there was a boom, a concept, and that came crashing down as well.
I think what typically happens is that you get a real feeling of momentum. What
happened, particularly in 1999, there were some people who were getting in
early in some of these public tech Internet companies. They were making a lot
of money. And what happened was, they were talking to their neighbors. The
neighbors were figuring out, "My gosh, I'm holding on to GE and IBM and all of
these blue chips. Why am I not making money?"
People would stick to their guns for awhile, but as the Aribas and Real
Networks and eBays and Yahoos were going through the roof, I think people
started throwing in the towel and saying, "Darn, I want to participate in some
of this. And if I buy five or ten of these companies, somehow I'm reducing some
of the risk." And of course they all came crashing down, or many of them came
Some will come back: I think eBay, Real Networks, and others. There are some
real long-term phenomenal businesses there. But the valuations that we saw may
not come around again for a long, long time. So I think there was this momentum
building in all circles, whether it was individual investors buying stocks,
whether it was the money management firms.
And we're also in an era where the information flow was coming at us from every
which way. So it was of course the 24-hour chat rooms. There were the news
broadcasts. There was this constant information being thrown at people from all
avenues. And I think that also really affected the emotion as we were moving
the stock up.
What were your returns, at best, on your funds? What was the range of return
that you were getting for your limited partners?
Well, over triple digits annually, after all fees and expenses. We had some
outstanding funds. We were very fortunate. And so the returns were
astronomical. You just can't sustain triple-digit IRRs over a period of four or
five years typically. But in fact, in the 1995 to 2000 period, there were a
handful of venture firms, ourselves included, that were posting those kinds of
Three hundred percent, 400 percent, 500 percent?
In some cases, on an annual basis, we were looking at 300 percent or 400
percent. But if you look at a five-year period, it was certainly over 100
percent a year on pretty big dollars. And every time I would sit down with our
limited, every time we were out raising a new fund, I would start by saying,
"These are not sustainable, and our business over a long period of time, over a
10-year or 20-year standpoint, should be generating 20 percent, 25 percent, 30
percent per deal." That's really outstanding performance.
So what I would typically say is, "If we're generating 100 percent or 200
percent a year for a period of four or five years, this is going to average out
in the long run. Be prepared for some really difficult times." In fact, that's
where we are today. I think over the next several years, we as venture
capitalists need to expect that outstanding performance will be 25 percent to
30 percent per year. That will really be exceptional technology investment
Wasn't the problem in a lot of these spaces that there were just too many
Tell me about that.
... This was a classic exercise, whether it was e-tailing in the sporting goods
or pets area, whether it was CacheFlow like content delivery equipment, in
almost every segment you could think of for about two years there were about
20-30 companies that were being formed. Of course every one of the companies
would talk about a 20 percent to 30 percent market share for that business.
You'd add it up and you'd get 1,000 percent. And I can't tell you how many
businesses were formed around that assumption, when suddenly overfunding
"me-too" projects, a complete lack of discipline around how one really defines
And so we went through a period which was really unfortunate. The one I
remember a long time ago was the disk-drive business and the personal computer
business in 1982 and 1983, where there were hundreds of disk-drive companies,
hundreds of personal computer companies, Eagle and others that no one has ever
heard of, and everyone thought they'd get 20 percent market share. Well, of
course, the numbers don't add up.
This is the excess-of-capital problem?
This is excess of capital, and I think at the same time, the real interesting
balance in Silicon Valley, both among entrepreneurs and venture capitalists, is
the consistent tension between optimism and realism. And if you step back and
you think, how is a Michael Dell, out of his dorm room, ever going to build a
multi-billion dollar, leading PC company? Or how does a Rob Glazer from scratch
perhaps create over a long-term, a leading Internet media company [Real
Networks]? The odds are stacked against these entrepreneurs. So when we're
backing entrepreneurs, we're looking for entrepreneurs who have enormous
optimism and confidence in what they're trying to build, tempered with some
discipline and realism.
What happened in many cases, unfortunately, there was all the optimism, and it
wasn't tempered often enough, and so that led to overfunding. That led to
businesses being formed that never should have been formed. That led to an
oversupply of capital. The realism part of the equation was thrown out. The
optimism always has to be there.
Again, who would out of their dorm room at Stanford believe that they could
create a media company like Yahoo? And Jerry Yang did that. And if one steps
back for a moment, we can argue about whether Yahoo is overvalued or
undervalued; but $10 billion created over five years, that's a really
significant achievement. Jerry Yang is simply a phenomenal entrepreneur. And
yet, there are a lot of people who have lost a lot of money in Yahoo stock. So
there are a lot of really difficult contradictions that people are going to
have to come to terms with.
Did the folks from Mortgage.com come through here?
Mortgage.com came through, as well as I think there were 12 or other
Mortgage.com-like deals that came through, absolutely. We took a hard look at
that particular space. ... We couldn't make any of the math work.
There's just not enough margin. When we looked at customer acquisition costs,
you looked at what it would take to monetize a customer, we couldn't make the
numbers work, as far as a big stand-alone business, whether it was Mortgage.com
or any of its competitors.
We saw a lot of those financial services deals that simply didn't have models
that took into account what the real gross margin would be. And I think that's
the other piece, in particular a lot of the dotcom companies. When I sit down
with the people I know ... at Wal-Mart, you can't get two or three minutes into
a conversation without talking about gross margin.
Many of the dotcom entrepreneurs, and many who took their companies public, you
couldn't ever get them to talk about gross margin. In some cases, I even wonder
if they knew what gross margin was. And if you can't understand the fundamental
profitable drivers of a business, whether it's Mortgage.com, Pets.com ... you
just shouldn't be starting that business. And yet we saw it again and again.
It's kind of the lesson you're supposed to learn with the lemonade stand.
You bet. It's a good time to learn it. And unfortunately, there were a lot of
people who just didn't do the right analysis, around something as fundamental
as gross margins. And a classic retailer, a real top-notch retailer,
understands that in every detail. That's what they live and breathe. The
dotcommers, in many cases who are starting these businesses were living and
breathing, I think, the euphoria, the frenzy and the optimism.
And the venture capitalists and the investment bankers that went with these
companies like Mortgage.com were doing it because it was a stock play?
I think people felt, one, there was a stock play to get behind. But I also
think there were a lot of people who stopped having the discipline and the
psychology and the momentum took over. I think what people really forget is
that investing is very psychological, whether you're Warren Buffett, whether
you're early-stage technology venture capitalists, psychology plays such a
central role. And when you see the eToys and the other companies sporting
multibillion valuations overnight that sure attracted a lot of venture
capitalists, angel investors and entrepreneurs. And it's very, very difficult
to step back.
It seems clear that they were building stocks, and not building companies,
for a period of time.
That's true. But there are some really smart people who understand the
distinction, who took a sabbatical perhaps for three or four months and threw
that discipline out the window.
Well, it was rational. The world was valuing these companies at such prices
that it was rational to make the stock play. Your obligation, it seems to me,
is fundamentally to return money to your limited partners.
In the right way. Over a long period of time.
And for a short period of time, maybe in the wrong way?
No, no. It doesn't pay.
Not for you. But it did happen in the Valley, it just happens.
It does happen. And we don't get everything right. We're in a business where
we're at the highest risk quotient, if you will, of the investment business.
We're there backing three Stanford grads who want to go compete with Cisco or
Microsoft. So there's tremendous risk in our business.
But what we're paid to do is build really good companies. And when we build
really good companies, those typically end up being really good stocks, and we
generate exceptional returns to our limiteds. I can't ever remember a
conversation that we've had where we said, "Boy, we are in the stock-picking
game." There are a lot of deals we have turned down where we left a lot of
money on the table, where we said, "This could be a good opportunistic stock
pick, but there's no real business here."
And for a while, we looked pretty silly. Today, we look at little bit better.
When we started working with the Wal-Marts and the McDonald's of the world in
terms of carving our new businesses, a lot of my buddies in Silicon Valley
would say, "Why are you spending any time whatsoever in Oak Brook, Illinois? Or
Bentonville, Arkansas? It's all happening within a 30-mile radius of Silicon
That's when I knew that, again, we had one more sign that the end was near,
relative to the euphoria. Because why should all the great technology
businesses be formed within a 10-mile radius of Stanford? A lot of them will.
But Silicon Valley, Stanford University, Palo Alto, California, does not have a
monopoly on real investment insight and technology building. For a while, I
think, there was some thinking that perhaps it did.
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