What the Bubble Got Right - Insights and Observations on Technology and the Start-Up World: What the Internet Bubble Got Right

Yigit Konur's Curation

"This article written by Paul Graham in 2004 discusses the events during the Internet Bubble and some things that this era got right. Graham points out that despite the exaggerated and misleading aspects of the Internet Bubble, it accurately predicted some significant trends. For instance, he argues that innovation in technology would be fundamental for future success, the value of young entrepreneurs would increase, knowledge and ideas would gain more value, and smaller, more efficient start-ups would rise in place of large companies. Even after the burst of the bubble, he emphasizes the importance and impact of these trends.

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# What the Bubble Got Right (Insights and Observations on Technology and the Start-Up World: What the Internet Bubble Got Right)

September 2004
_(This essay is derived from an invited talk at ICFP 2004.)_

I had a front row seat for the Internet Bubble, because I worked at Yahoo during 1998 and 1999. One day, when the stock was trading around $200, I sat down and calculated what I thought the price should be. The answer I got was $12. I went to the next cubicle and told my friend Trevor. ""Twelve!"" he said. He tried to sound indignant, but he didn't quite manage it. He knew as well as I did that our valuation was crazy.

Yahoo was a special case. It was not just our price to earnings ratio that was bogus. Half our earnings were too. Not in the Enron way, of course. The finance guys seemed scrupulous about reporting earnings. What made our earnings bogus was that Yahoo was, in effect, the center of a Ponzi scheme. Investors looked at Yahoo's earnings and said to themselves, here is proof that Internet companies can make money. So they invested in new startups that promised to be the next Yahoo. And as soon as these startups got the money, what did they do with it? Buy millions of dollars worth of advertising on Yahoo to promote their brand. Result: a capital investment in a startup this quarter shows up as Yahoo earnings next quarter—stimulating another round of investments in startups.

As in a Ponzi scheme, what seemed to be the returns of this system were simply the latest round of investments in it. What made it not a Ponzi scheme was that it was unintentional. At least, I think it was. The venture capital business is pretty incestuous, and there were presumably people in a position, if not to create this situation, to realize what was happening and to milk it.

A year later the game was up. Starting in January 2000, Yahoo's stock price began to crash, ultimately losing 95% of its value.

Notice, though, that even with all the fat trimmed off its market cap, Yahoo was still worth a lot. Even at the morning-after valuations of March and April 2001, the people at Yahoo had managed to create a company worth about $8 billion in just six years.

The fact is, despite all the nonsense we heard during the Bubble about the ""new economy,"" there was a core of truth. You need that to get a really big bubble: you need to have something solid at the center, so that even smart people are sucked in. (Isaac Newton and Jonathan Swift both lost money in the South Sea Bubble of 1720.)

Now the pendulum has swung the other way. Now anything that became fashionable during the Bubble is ipso facto unfashionable. But that's a mistake—an even bigger mistake than believing what everyone was saying in 1999. Over the long term, what the Bubble got right will be more important than what it got wrong.

**1. Retail VC**

After the excesses of the Bubble, it's now considered dubious to take companies public before they have earnings. But there is nothing intrinsically wrong with that idea. Taking a company public at an early stage is simply retail VC: instead of going to venture capital firms for the last round of funding, you go to the public markets.

By the end of the Bubble, companies going public with no earnings were being derided as ""concept stocks,"" as if it were inherently stupid to invest in them. But investing in concepts isn't stupid; it's what VCs do, and the best of them are far from stupid.

The stock of a company that doesn't yet have earnings is worth _something._ It may take a while for the market to learn how to value such companies, just as it had to learn to value common stocks in the early 20th century. But markets are good at solving that kind of problem. I wouldn't be surprised if the market ultimately did a better job than VCs do now.

Going public early will not be the right plan for every company. And it can of course be disruptive—by distracting the management, or by making the early employees suddenly rich. But just as the market will learn how to value startups, startups will learn how to minimize the damage of going public.

**2. The Internet**

The Internet genuinely is a big deal. That was one reason even smart people were fooled by the Bubble. Obviously it was going to have a huge effect. Enough of an effect to triple the value of Nasdaq companies in two years? No, as it turned out. But it was hard to say for certain at the time. [1]

The same thing happened during the Mississippi and South Sea Bubbles. What drove them was the invention of organized public finance (the South Sea Company, despite its name, was really a competitor of the Bank of England). And that did turn out to be a big deal, in the long run.

Recognizing an important trend turns out to be easier than figuring out how to profit from it. The mistake investors always seem to make is to take the trend too literally. Since the Internet was the big new thing, investors supposed that the more Internettish the company, the better. Hence such parodies as Pets.Com.

In fact most of the money to be made from big trends is made indirectly. It was not the railroads themselves that made the most money during the railroad boom, but the companies on either side, like Carnegie's steelworks, which made the rails, and Standard Oil, which used railroads to get oil to the East Coast, where it could be shipped to Europe.

I think the Internet will have great effects, and that what we've seen so far is nothing compared to what's coming. But most of the winners will only indirectly be Internet companies; for every Google there will be ten JetBlues.

**3. Choices**

Why will the Internet have great effects? The general argument is that new forms of communication always do. They happen rarely (till industrial times there were just speech, writing, and printing), but when they do, they always cause a big splash.

The specific argument, or one of them, is the Internet gives us more choices. In the ""old"" economy, the high cost of presenting information to people meant they had only a narrow range of options to choose from. The tiny, expensive pipeline to consumers was tellingly named ""the channel."" Control the channel and you could feed them what you wanted, on your terms. And it was not just big corporations that depended on this principle. So, in their way, did labor unions, the traditional news media, and the art and literary establishments. Winning depended not on doing good work, but on gaining control of some bottleneck.

There are signs that this is changing. Google has over 82 million unique users a month and annual revenues of about three billion dollars. [2] And yet have you ever seen a Google ad? Something is going on here.

Admittedly, Google is an extreme case. It's very easy for people to switch to a new search engine. It costs little effort and no money to try a new one, and it's easy to see if the results are better. And so Google doesn't _have_ to advertise. In a business like theirs, being the best is enough.

The exciting thing about the Internet is that it's shifting everything in that direction. The hard part, if you want to win by making the best stuff, is the beginning. Eve...