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inside the dotcom ipo game
Why were so many Internet startups taken public before their time? Did Silicon Valley's venture capitalists pass off risk to a naïve investing public -- while they themselves amassed fortunes? And what role did Wall Street play? Should investment bankers have known better than to allow ever-higher IPO price spikes, or "pops," to happen? Here are excerpts from FRONTLINE's interviews with venture capitalist Jim Breyer of Accel Partners, venture capitalists Jay Hoag and Rick Kimball of Technology Crossover Ventures, institutional money manager David Siminoff of Capital Group, veteran investment banker Bill Hambrecht, and Joseph Nocera of Fortune magazine.

jim breyer
Managing partner of Accel Partners, a venture capital firm based in Palo Alto, Calif.

read the extended interview

Describe those heady days in the Valley, what life was like.

Everything was a bit on steroids in terms of intensity, and there were certainly some absolutely insane ideas that were financed. They were a dime a dozen. ...

There was a lot of free spending and a lot of flamboyance in those times.

Oh, there is no doubt.

A lot of fancy conferences. Lots of fancy coming-out parties for companies?

There is no doubt. There was a branding and marketing aspect to company building that was ephemeral. And many of us thought it was ephemeral, but people started drinking the Kool-Aid. ...

At one point, you criticized the [investment] community, and you were ridiculed. What did you say?

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." ...

related links

· An IPO Primer
Don't speak the language? Here's a concise overview of the nuts and bolts of the IPO process, along with links to further reading.

· Chart-Topping 'Pops'
See some amazing statistics about first-day price spikes during the Internet IPO bubble.

· The IPO Investigations: Who's the Victim? What's the Harm?
In this Web-exclusive report for FRONTLINE, Wall Street legal expert John Coffee, a professor of law at Columbia University, offers an overview and analysis of what's at issue in the federal investigations into IPO practices during the Internet bubble.

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. ...

What was motivating [the rush to go public]?

... The Netscape IPO, in August of 1995, in many ways ... was very defining. Suddenly there was a generation of young entrepreneurs who looked at how Netscape 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. ... Part of the thinking was, "get public." Use the capital to build a preemptive first-strike position. ...

You were talking about risk. ... Where did the 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? Hard to explain. And in fact, when you look back at that, or you look at some of the advertisements that were run by eTrade 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.

Jay Hoag & Rick Kimball
Founding partners of Technology Crossover Ventures (TCV), they are among Silicon Valley's most successful, and aggressive, venture capitalists. In 2000, they attracted $1.6 billion to form the largest technology venture capital fund in U.S. history.

read the extended interview

Not long after you start TCV, you see Netscape go public. It's like the Big Bang in conventional wisdom here. ...

Jay Hoag: I think what Netscape triggered was a sense that you didn't have to be profitable to go public. But if you were growing fast enough, at some point in the future, you would grow into profitability. It unleashed a lot of different things, including a huge number of IPOs, a really big up cycle in venture funding -- to some extent, some bad ideas, actually. ...

How do you account for getting into a situation ... where you were rushing to take companies public within narrower and narrower time frames? In the case of Ariba, it's from March of 1998 to June of 1999. In the case of others, it gets faster than that.

Rick Kimball: ... At that point in time, what the market was saying was you should go get, basically, almost free capital in the process of going public. So as a board member, the decision would be very tough to not push a company towards an IPO. ... The whole system kind of got ratcheted up. So, yes, younger companies were trying to go public. ...

I think some of what happened was people confused a financing event with an end result. ... So I think people would start talking about an IPO as a branding event. And somehow, magically, by going public you got all this publicity, all these people would come to your Internet site and the business would boom. That proved to be fallacious thinking. ...

Talk about the kind of money ... that was coming at you during this period of time, once people saw the returns that you were getting. ... People are getting involved who didn't get involved in venture capital in the past?

Jay Hoag: ... Everybody wanted in. Venture funds had returned over 100 percent over several years. And just like any other asset class in the world, including tulip bulbs in Holland and oil in Texas during a certain period of time, money rushed in. ...

Some critics of your industry say that, during this period of the bubble, that risk was transferred to the public, away from you. Is that a fair analysis?

Rick Kimball: Investing in a private technology company or investing in a public technology stock is by its very nature a risky proposition -- always has been. ... It's a winners and losers game. Technology markets are horribly unforgiving. ... So I'm not sure if it was transfer of risk. ...

But what was different here was that the public participated in investments that were risky perhaps like never before. Is that true?

Rick Kimball: I don't believe that day traders or other people jump on technology IPOs and technology stocks because they have a fundamental love for technology. I think they did so just like some people go to Vegas; because they think they are going to come away with more money than they put in. ...

I don't want to belabor this. But do you believe there was inappropriate transference of risk to the public?

Rick Kimball: You know, we can't -- words like "inappropriate," you know, I don't feel in a position to make a value judgment about what is, quote, "appropriate," versus what is "inappropriate." ...

Jay Hoag: Looking back, I think everybody throughout the system -- ourselves included -- made mistakes. ... I think it's worth pointing out [that] where a year ago everybody had rose-colored glasses on in every part of the food chain -- the sky's the limit -- today, everybody has a very dark set of glasses. I won't use any analogies of what's lining them.

joseph nocera
Analyst and portfolio manager for Capital Group, which oversees the American Funds, one of the largest mutual fund families in the world.

read the extended interview

In the times that we went through, where normal bets were off -- how do you make a rational [investment] decision in that environment?

It's difficult. The challenge is finding the truly great companies in all the noise. I think in a four-year period, I saw over 500 IPOs. We probably owned 200 or 250 of them for ten minutes, many of them for ten minutes, where at $8 or $10 a share you thought, "OK, I can understand how this can compound at 20 percent a year if they hit their target." But when the first print of the IPO was $95, it was very easy to sell. ... It no longer made financial sense, so you'd sell the stock and go on. ...

The thing you have to understand historically about IPOs, to place all this in context, is that for decades IPOs were considered very risky -- risky enough that a lot of private investors didn't invest in them. A large percentage of IPOs ended up at half, or worse, of the price they came public at. It wasn't until this very short-lived bubble that an IPO was "found money" and you had to get there quickly. ... So it became a feeding frenzy, something that everyone was caught up in. ...

Were you surprised that that kind of demand was out there in the retail [investment sector]?

... Yes, it was shocking to find companies with close to no revenues who would have $30 billion valuations the first day of their IPO. But the people buying the stock at $130, hoping it would go to $200, were not the wizened, educated institutional investors. I guess at that point for the retail investors buying them, it was like a lottery or a trading scheme to see who was going to play chicken first and leave the game. And that's just not the business that institutional money managers are in. ...

We knew a group of women in North Carolina who had an investment club and talked about various investments. One of them decided to get into an IPO, somehow thinking this was the hot thing to do. So without knowing anything about the company, she jumped in and bought an IPO. It seems like this crosses the line to gambling.

Yes. I agree. It was speculation at its peak. You've labeled many of these things with the tag that people were "investing" in IPOs. And investing, in my mind, is a different thing -- where you put money to work with a long-term perspective. ...

I'm trying to think of anyone who's made a lot of money over a long period of time by trading stocks. I can think of a lot of people who've made real money owning stocks forever. Warren Buffett's the most famous, probably. To my knowledge, he doesn't really trade stocks. He has owned Washington Post and Coca-Cola and a bunch of other companies for really long periods of time, and has done fantastically well. That's what I think of as real investing. What you're focusing on is a different issue.

Bill Hambrecht
Founder, chairman, and CEO of W.R. Hambrecht & Co., which has developed an innovative "Dutch auction" IPO. A highly respected Wall Street veteran, he was the only investment banker who would speak to FRONTLINE during the making of "Dot Con."

read the extended interview

Traditionally, venture capitalists invested in companies for four to seven years before they even thought of taking them public. So before the need for an investment banker, there was quite a bit of money spent and raised privately. And then this changed?

Well, I think what happened in the last -- particularly in the Internet boom -- people were so excited about the possibilities of the Internet that they were willing to buy very early-stage companies. So companies were able to go to the public market ... even if they were only a year or two old. They were not seasoned in the private markets the way they used to be in the past. ... It's very unusual to have that happen. ...

The public during this period of time, 1998-2000, was willing to step in and buy those shares [after] they were flipped [by institutional investors, hedge funds, etc.]. Explain that dynamic.

... It was really fueled by what you would call the "greater fool" theory. In other words, there has to be a greater fool than you that buys it [at an even higher price], or the whole thing collapses. Well, ultimately, you run out of greater fools, and the system has collapsed. You don't get high-flying IPOs now, and you have had markets return to more normal behavior. ...

What happens during an IPO like VA Linux [which had the biggest first-day gain in Wall Street history]? Where does the money go?

First of all, by fiat and SEC law, all the stock has to be sold to public buyers at the offering price. So all the stock is sold at that -- I've forgotten the exact price, but it was $30 some-odd per share, something like that. Suddenly you get this huge surge where the stock leaps seven times, creates a billion dollars or $1.2 billion of market value. That's profit to the person who got the IPO allocation. And if you trace it out, I think you'll find that anything that goes that high, almost all of it is flipped, because it just doesn't make sense not to. So effectively the underwriter parceled out $1.2 billion of guaranteed profit to his clients. As you can imagine, that's a very nice thing to happen. ...

Do you remember the day when Netscape went public, and what were you thinking?

I wasn't working on the deal, so I wasn't intimately involved. But yes, we were just amazed at how high it went. In all fairness to the underwriters, it's pretty hard to predict in the beginning that these things were just going to take off, because it was very hard to justify the price of it on any rational economic benchmark that you usually use. I mean, the values were off the charts. ...

Explain how a Dutch auction would solve the problem of flipping?

Because there's no guarantee of aftermarket profit. ... In a Dutch auction system, there is really no guaranteed profit, because you're pricing it very close to the full demand in the marketplace. And some people might argue it's too close to the demand; you don't even get a little bit of a pop. And we've had to adjust to try and see if we could find a better way of doing it sometimes. ... But as long as you don't guarantee the market, in effect, a profit from underpricing, you're going to discourage the flipper. Then it becomes a decision like any other stock. ...

What about branding? ... What is this branding thing?

To me, it was ridiculous. Guys would say, "I left $200 million to $300 million on the table, but look at all the publicity I got." So we used to calculate how many Super Bowl ads you could buy with $300 million. You can buy a lot of branding for that kind of money. Economically, it didn't make any sense. ...

You were watching all this going on from the inside, as an experienced investment banker. What were you thinking as you saw these IPOs coming to market so frequently?

It was frustrating. ... When it hit a fever pitch, there wasn't anybody truly that really wanted to listen. I kind of felt like the designated driver at a New Year's Eve party, to come in and say, "Hey guys, this isn't going to turn out well." And their reaction was, "What could be better than this? I sell my stock at 10, and it goes to 100, and everybody is rich, and who's lost? And isn't this a wonderful thing?"

And it isn't until the aftermarket phase, and the people who bought it in the aftermarket are left holding the bag, that's when the problem starts. ...

The public was also being seduced with a lot of very fancy advertising, and a lot of media hype.

There was a lot of media hype, but my theory, for whatever it's worth, why this thing took off the way it did and why it seemed to captivate people's imagination, was that for the first time, it was technology that sounded reasonable and understandable. You would go home and you'd say, "Gee, I hear this idea." And you'd talk to your kid who is sitting there on a computer, and he'd say, "Oh, yes, it's a great idea." It just seemed to make sense. I mean, why wouldn't you do these things on the Internet?

I must have seen 5,000 proposals, at least, at one point or another. Every one of them sounded great. The real problem was that for every good idea, there were about 500 people trying to do the same thing. So unless you were first, and unless you got there quickly, and unless you executed flawlessly, it was a very difficult place to build a business, because there was so much competition. ...

With all your experience in investment banking, how does this bubble rank with others?

Oh, it's off the charts. I've never seen anything create value the way it did, nor melt down as fast. The meltdown was incredible. The market for these stocks probably went down 90 percent to 95 percent in a period of six months. These weren't $10 million, $20 million market caps. These were multibillion market caps disappearing.

joseph nocera
Executive editor of Fortune magazine and the author of A Piece of the Action: How the Middle Class Joined the Money Class (1994).

read the extended interview

The [idea] is that the banks are servicing the economy by helping these companies get out there and raise additional capital and stay alive.

If the investment banks had been doing their job the way they are supposed to be doing them, if they really had the best interests of the companies at heart, you would have never seen the situation where IPOs go up 200 percent, 300 percent, 400 percent on the first day. I mean, that is a crime, because that means that price was so badly managed by the investment bank that all this money [was left on the table]. What is the reason that you have an IPO? It's to put money in the coffers of the company. That's the reason you do it.

When you have a situation where it's going up 300 percent on the first day, that's 300 percent that the company is not getting. It's going into the pockets of investment professionals, many of whom have trading alliances and relationships with the investment bank. And they don't care about the company. They don't care if the company goes out of business the next day, as long as they can flip their IPO and take their profit. The dereliction of duty that went on here is just appalling. ...

The job of the investment banker is to price the IPO. That's the real job: to gauge what the market will bear on this stock the first day it comes out. And if you misprice it one way, the stock goes down the first day, and that's bad for everybody. If the stock goes up a little, that's good for everybody; then the company has gotten the majority of the money in its coffers, where it's supposed to be, and the investors have made a little bit of money, which is basically their reward for coming in and taking a risk on this new company.

What happened was that the investment banks basically persuaded companies, these dotcoms -- many of which were run by people who just didn't know any better -- that it was good marketing to have it go up 200 to 300 percent, because they got a nice article in the paper the next day.

A "branding event" -- that was the rationale.

Yes, the famous case is, which I believe went up over 500 percent on the first day. And everybody said, "Oh, my God, look at that, look at that!" Well, if I had been running, I think I would have sued the investment bank the next day. I don't believe exists anymore. And think of all the money that was left on the table by allowing its IPO to be so underpriced that it actually went up 500 percent.

So how did it happen, that they were able to convince these companies to leave so much money on the table?

... When an IPO goes up 300 percent the first day, it's not just the investment banks and their buddies at Fidelity who are making a giant profit. You have to remember that if you're the founder, if you're the VC, you're one of those original investors. Suddenly your personal wealth is up 300 percent. ...

Didn't allocations have a lot to do with it? I'm talking about how the incentive for the banks and all their friends was to keep that share price low so you'd get the big "pop" and you'd get people in on that allocation.

Right. Yes, but my view of this is that you've got the tail wagging the dog here. In other words, what really happened was this: [in 1995], before there was any spinning, before there was any of this sort of legalized (or perhaps not so legal) bribery, in effect, Netscape goes public. ...

Nobody expects what happens at Netscape. It's the first big "pop" stock ... the first great Internet stock. It goes up a couple hundred percent, I think, on the first day. It's this amazing event. It was just, "Whoa! What was that all about?" And after Netscape, it started to happen without there being any scheming or conspiracy or planning. It took a while for the banks to realize that this was what was going to happen with these Internet stocks. So then the thing takes on a life of its own. And suddenly you realize that if you're an investment bank, that this is something that can be taken advantage of. ...

So it was just Christmas?

Right, Christmas. Christmas in July in Silicon Valley.

What about Bill Hambrecht's solution? [The online Dutch auction system?]

He has a market-based solution which would wind up pricing an IPO at what the market will bear, so it's not artificially deflated to create large profits. I actually think it's a very shrewd idea and very worthy.

The problem he has had, and the problem the idea has had, is that there's still so much stature and prestige attached to being taken public by an important investment bank, that even the most adventurous dotcoms which saw themselves as, quote, "thinking out of the box," and all that other baloney, could never bring themselves to use that system. Instead, [they] continued to rely on the Morgan Stanleys and the Goldman Sachses and the Credit Suisse First Bostons.

He told us he felt like the designated driver at a New Year's Eve party.

It's true. He's still at it, though. He hasn't thrown in the towel. My hat's off to him. ...

This seems to be the grandest irony of all. The Internet comes along and it promises democratization. It's all about you and me get equal access to the same information at the same time. That was the promise. And now we're investigating a scandal in which the bankers playing by the old rules decided who was included, who was excluded, who got information, who didn't get information.

Democratization has been going on in this country, financially, since the 1970s. And people do have a lot more information than they used to, and they can make better decisions, and they can trade stock more easily; all of that is true.

But if the events of Internet mania proved anything, they proved that Wall Street is still a club; that insiders still have enormous advantage over the rest of us; and all the technology and all the democratization has simply not been able to trump that one fact.

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