Dot-Com Crash: Causes, Failures, and the Bust of 2000

Introduction: The Scope of the Dot-Com Collapse

Many believe the root cause of the dot-com crash was the overvaluation of stock prices relative to the actual underlying value of the companies themselves. Stocks of Internet companies traded at price-to-earnings ratios higher than 30, buoyed by a speculative bubble. When reality set in, many investors realized that the companies they were so heavily invested in were little more than money-absorbing black holes with no upside potential in the near or long-term future. This triggered mass sell-offs of Internet-related stocks, which soon impacted the market value of many companies associated with computer, networking, or telecommunications industries.

This paper will show that overvaluation was, in fact, more a symptom of the speculative boom and only one of the multifaceted factors that contributed to the Internet boom turning into the Internet bust.

The investment frenzy in Internet-related companies reached a peak almost exactly three years before the time of writing, in the first quarter of 2000. The tech-heavy NASDAQ Composite reached an all-time high, fueled in large part by Internet stocks and the surrounding euphoria. Since that time, the dot-com sector underwent a radical realignment that saw nearly 5,000 Internet companies acquired or shut down.

Some pertinent comparisons illustrate the scale of the collapse:

March 10, 2000: The NASDAQ Composite reached an all-time high of 5,048.62. Selectica, a San Jose maker of e-commerce software, went public at $30 a share — its 92nd IPO in Silicon Valley in 12 months — and shares rose 371%, closing at $141.23. Worried about an overheated economy, the Federal Reserve had raised interest rates to 5.75%. Chip stocks were roaring: Rambus, up 470% over 12 months, closed at a split-adjusted $105.25. The 304 valley companies still trading at that time had a combined market value of $2.9 trillion.

March 10, 2003: The NASDAQ closed at 1,278.37, down 75% from its peak. Selectica shares had plunged to $2.76. Only three local companies had gone public in the previous 12 months. Worried about a flickering economy, the Fed had sliced rates to 1.25%. The chip industry was in its worst slump ever, and Rambus — now facing federal antitrust charges — sat at $12.97. Those same 304 valley companies were valued at $588 billion, down 80%. (Source: Mercury News research, Bloomberg)

The casualty numbers are staggering. In the year following April 2000, the Nasdaq lost more than $2 trillion in value. Once high-flying companies like Excite.com disappeared — bankrupt and out of business. During the 36 months preceding this writing, 93,079 Internet-related jobs were cut nationwide (Cassidy 2002). At least 4,854 Internet companies were either acquired or shut down in the three years since the dot-com investment boom peaked. Of these, at least 962 were substantial Internet companies that either shut down or declared bankruptcy. Unemployment in the San Francisco Bay Area, once the engine driving the Internet economy, hovered around 7% (U.S. Department of Labor).

The many contributing causes of the dot-com collapse are complex, and they can serve as a cautionary tale for investors and aspiring entrepreneurs. Overly speculative investors pushed tech stocks far beyond what their price-to-earnings ratios warranted. Venture capital firms with ready cash threw money at anyone with a "dot-com" idea. Creative accounting practices fueled the boom with inflated earnings estimates while masking true debt-to-income ratios. The burn rates — the rate at which startup capital was spent — of many startups were staggering. Few Internet companies were profitable, but investors did not seem to mind. Many investors looked at the number of customers or subscribers as the basis for valuing Internet stocks. The name of the game became raising capital, not making profits (CNN/MoneyLine 2000).

This paper examines why the Internet boom succeeded and the reasons behind its crash. An examination of one failed Internet venture is presented as a case study representative of why many Internet-based companies failed.

Where Did the Dot-Com Boom Come From?

In 1945, an essay titled "As We May Think," published in the Atlantic Monthly, argued that the biggest problem facing scientists after the war would be information overload. Its author, Vannevar Bush, observed that the more knowledge society gained, the more specialized people became, simply because the breadth and depth of knowledge had grown too great. As a consequence, attempts by scientists to bridge fields of specialization could only enable a superficial understanding of other disciplines.

Bush proposed a solution based on two relatively new inventions: microphotography — the ability to take pictures so small that an entire encyclopedia could be photographed and stored in a matchbox — and the cathode ray tube, which allowed scientists to transmit pictures and text onto a glass screen. He theorized that a device combining the two could revolutionize how information was stored and transmitted. He called his proposed machine a "memex." It would use translucent screens on which material could be projected for convenient reading, along with a keyboard and a set of buttons and levers. All information entered into the memex would be indexed by title and subject, as in a library. Users could move between items of interest by following what Bush called "trails." Each time a user created a new file, it could be linked to a second file of their choosing, which would in turn link to a third file, and so forth. Bush wrote that the great attraction of this filing system would be that it mimicked the human mind, working by "association." The memex was never built, but his "trails" idea was the intellectual predecessor of the World Wide Web (Cassidy 2002).

In the 1960s, an iconoclastic engineer named Ted Nelson realized that the technology for implementing Bush's ideas had arrived. Using the storage capacity and speed of digital computers, Bush's concepts could become reality. Nelson postulated that the world's knowledge could be stored in a giant database and retrieved by anyone with access to a computer. The information would be presented via a method he called "hypertext," allowing users to jump from one file to another. Nelson's idea, called Xanadu, never came to fruition, but his concept of hypertext caught on.

Doug Engelbart developed the first working hypertext program in 1968, after coming across a copy of "As We May Think" while stationed in the Philippines. His program, called "oNLine Systems," allowed users to browse through multiple windows of text using a small block mounted on a ball — a prototype of today's mouse.

It would take another 20 years before the World Wide Web came into being. The web had to wait for the advent of the central processor, the personal computer, and the graphical user interface, developed at Xerox's Palo Alto Research Center.

The central technological development that led to the Internet was the invention of packet switching. The Pentagon had been looking for a way to maintain command and control communications in the event of a nuclear attack. An engineer named Paul Baran conceived of the idea. In order to utilize packet switching, information first had to be digitized, then sent to a receiving station in the form of small pieces called packets. Each packet contains a header — an address that tells routing switches where the packet is supposed to go. When all the packets reached their final destination, software reassembled them into a coherent piece of information.

Using packet-switching technology, the military linked several large research universities together on a network called ARPANET — short for the Advanced Research Projects Agency network — connecting Stanford, UCLA, UC Santa Barbara, and the University of Utah. On October 1, 1969, a researcher at UCLA attempted to send a message across the network to a researcher at Stanford. The network abruptly crashed. The problems were resolved over the following months, and the Internet was born.

Through improvements in hardware, networking, and software, the use of the fledgling Internet grew until it was used by scientists and researchers worldwide. Then, on January 23, 1993, a message appeared on several Internet bulletin boards:

"By the power vested in me by nobody in particular, alpha/beta version of 0.5 of NCSA's Motif-based information systems and World Wide Web browser, X Mosaic, is hereby released. Cheers, Marc." (Cassidy 2002, p. 51)

Marc Andreessen, a 21-year-old computer science major working part-time at the National Center for Supercomputing Applications, had released what would later become the Netscape World Wide Web browser. His browser made it far easier to navigate the Internet. By the summer of 1993, hundreds of thousands of people were using Mosaic, the precursor to the Netscape browser.

Many people credit the start of the dot-com boom to the success of one company: Netscape. In August 1995, a generation of investors had been inspired enough to invest in Internet technology based on the market success of Netscape's initial public offering (CNN/MoneyLine 2000). Many described the Internet as being as transformative as the railroad, the automobile, or the electrification of the nation.

Andreessen graduated and moved to California, where he went to work for a small software company. A few months later, he received an unsolicited email from Jim Clark, the founder of Silicon Graphics, inviting him to join a new company: Netscape. Netscape was listed on the NASDAQ on August 9, 1995, and went from an opening price of $28.00 to a high of $74.00 that same afternoon. That kind of appreciation in an IPO was unheard of. The New York Times wrote the following day that Netscape had the single most successful opening day of any stock on Wall Street. Andreessen and his fellow developers were each worth over $70 million; Jim Clark, the initial backer, was worth over $660 million by the end of that day.

Following the success of the Netscape browser came Yahoo, the web search engine founded by two Stanford students, David Filo and Jerry Yang. They had incorporated their company in 1994 with a plan to generate revenue by selling advertisements on their site. In late 1999, Yahoo joined the S&P 500 and was trading on the NASDAQ at $228 a share (Wang 1999).

In the summer of 1995, Jeff Bezos quit his Wall Street job to found Amazon.com, the first company to use the dot-com suffix so prominently in its name. Amazon launched on July 16, 1995. In its first week, the company received about $12,000 worth of orders. Amazon's 1997 IPO gave Bezos a net worth of $180 million, fueling yet more excitement in an already expanding market.

The creation of the NASDAQ allowed small-capitalized companies to have their stocks publicly traded. The exchange was a magnet for small technology companies seeking to raise capital by going public — companies that often would never have qualified for listing on the New York Stock Exchange. NASDAQ helped fuel the dot-com boom in this way. Like the Dutch tulip mania of the 1600s, the dot-com boom was fed in part by speculative investors looking for the next big score. The "New Economy" helped fuel the national economy and was part of the reason for the largest peacetime economic expansion in U.S. history.

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