We may have gotten a small foretaste last week of the endgame of the Internet investment boom. The hallmark of any boom is unbridled confidence, which conceals and condones practices that--in a less giddy climate--would seem sloppy, unethical or illegal. The Internet has been so profitable for so many that people instinctively confuse economic success with moral infallibility. This can't last forever, if only because human nature isn't perfect--even the human nature of the people behind the Internet and computer booms.
What happened last week provided a cautionary tale. Early Monday, MicroStrategy--a prominent software company--announced that it was revising its 1999 financial results. Sales would drop roughly 25 percent, from $205 million to about $150 million. Profits would change from a reported 15 cents a share to a loss of between 43 cents and 51 cents. The reaction was swift. On Monday, MicroStrategy's stock plunged 62 percent, from $226.75 to $86.75.
Bombarded by shareholder suits, MicroStrategy will have ample opportunity to explain its actions. No one can yet say whether it committed fraud--or was the victim of overly conservative accounting rules. "I don't think we made a mistake," says MicroStrategy chairman Michael Saylor. "The technology has outstripped accounting guidelines." He says the company merely booked revenues it had in hand and that auditors insisted be spread over the life of software contracts. However the episode ends, it suggests that the high-tech frenzy has created an ethical quagmire.
There are huge pressures to project optimism--and prop up stock prices. The line between what people genuinely believe and what serves their economic interests has blurred. Perhaps some people can no longer see the line. Stretching accounting rules (if that is what MicroStrategy did) is a flagrant trespass. But others are more subtle, ambiguous and, possibly, pervasive. Questions abound about underwriting practices, the independence of stock "research" and the use of stock options.
Consider IPOs. These are the "initial public offerings" of stocks by private companies selling their shares to general investors. The business is hugely profitable for the underwriters--the brokerage houses that handle the sales. Suppose that Whoopee!.com has a $100 million IPO. According to Jay Ritter, a professor of finance at the University of Florida, the underwriters typically get about 7 percent (or $7 million). Why would anyone buy Whoopee!.com?
Well, it helps if the Wall Street underwriter has a popular stock analyst whose recommendation will push up the price. The best-known Internet analyst is Mary Meeker of Morgan Stanley Dean Witter. In 1999 she reportedly made about $15 million. (The figure, cited by The Wall Street Journal, isn't denied by the firm.) She was paid so much in part because she helped attract so much underwriting. In 1999 Morgan ranked second in IPO underwritings at almost $14 billion, just behind Goldman Sachs ($14.5 billion), reports Thomson Financial Securities Data.
"The conflicts of interest are immense," argues Ritter. Stock analysts are increasingly "cheerleaders," he says. Their pay depends on the firm's underwriting, which depends on enthusiastic research reports. Glum Internet analysts aren't wanted. (Morgan Stanley Dean Witter has a different view: Meeker does prescreen Internet companies that the firm underwrites, but this review helps eliminate weaker candidates. "There are lots of companies that would like to be underwritten by Morgan Stanley Dean Witter," says a spokesman.)
Capitalism is about risk and reward. If there's risk, some people will lose. Companies fail. Business plans flop. The dot-com phenomenon won't (and shouldn't) be any different. That is not the issue. But to work, capitalism requires reasonably reliable information. If it's skewed, then the risk- reward equation becomes skewed.
Logic suggests that IPO underwriting standards have eroded--and they have. Before Netscape's IPO in 1996, companies going public generally were profitable, says finance professor Jeremy Siegel of the University of Pennsylvania. Now, most run losses. One reason is that they're younger. In 1995 the average IPO firm was 8.1 years old. By 1999 it was 5.2 years.
Of course, this is a godsend for venture capitalists and company founders, who can cash out more rapidly. It's also a bonanza for underwriters. But some companies are--almost certainly--being taken public by promoters who suspect that the firms will never be profitable. Sooner or later, some investors will suffer huge losses. "Fleecing" is the word that springs to mind.
Whose moral responsibility is this? Good question. There are others. For example: are stock options being overused? Critics believe they may hurt shareholders by draining a company's wealth.
These are ethical--as well as business--questions. They are hardly being asked. (An exception: an excellent recent cover story in Fortune magazine.) The answers aren't easy. As Siegel notes, investors clamor for speculative stocks, despite well-known dangers. "It's the gold rush like the 1850s," he says. "There's a tremendous amount of stock envy." Josh Lerner of the Harvard Business School says there have been other IPO eras--say, biotech issues a decade ago--when most companies were unprofitable. It's the nature of the beast.
Perhaps. But qualifications may be irrelevant. While the boom proceeds, almost everyone tolerates its excesses, including moral lapses. Winners outnumber losers. Resentment is muted. But let the boom falter, and the climate might alter. Disappointment and losses mount. Some seem to have profited at others' expense. Recriminations grow. The anger and outrage going down may be as exaggerated as the indifference going up. Other deflated booms have followed this cycle: the 1920s' U.S. stock boom; the S&L scandal of the 1980s; Japan's recent "bubble economy."
In good times, people often do things that--with hindsight--look less than upstanding. The MicroStrategy case may be misleading. Or it might portend a larger reckoning.
