Why do "dot com" companies burn through tremendous amounts of cash early on? In some ways, it makes twisted sense. In others, not.
When I worked at the Very Large Odious Law Firm (very briefly) back during the "dot com" bubble, we catered to a lot of these internet startups, and the way they operated was, to say the least, odd.
"Profits are a thing of the past!" they said, "All that matters is your burn rate - the higher the better!"
Burn rate is how fast you squander investment capital. It made no sense at all!
And the IPO's - they would sell off 5% of the company at $25 a share, only to see the share price rocket to $50 a share within minutes! How was this efficiently raising capital for the company? Again, it made no sense at all.
But in a way it did make sense, I was just looking at it from old school parameters. In the old days, you did an IPO to sell stock, raised capital and build a steel mill or something. You then hired people, bought ore and smelted steel, selling a finished product that was worth more than the cost of materials and labor (and overhead). You made a profit. You paid dividends to your shareholders. Your stock price went up. And you went and made more steel.
Well, steel factories are gone, and today we have bullshit factories, as I have noted in the past. In the 1990's and 2000's it was the "dot com" boom. But today that term is as antiquated as steel mills. Now we are on to the "app" boom - people laying claim to broad swaths of intellectual territory and market share (mostly the latter) with the idea that it will all pay off big someday.
And sometimes it does. Sometimes. A very few of those "dot com" companies of the 1990's and 2000's are actually making money today and some are huge operations now that seem "too big to fail" (but don't count on it!). While there were dozens of auction sites out there, eBay seems to be the big gorilla in that space. PayPal sort of dominated online payment. And Amazon is the big retailer these days online, even as Wal-Mart very quietly under-the-radar has copied their entire business model, often to their detriment (every other week, someone decries "Wal-Mart is selling Nazi T-shirts!" when in fact it is their online retailer site that is doing so, from third parties).
Amazon is sort of just barely making a profit, though, as they continue to "burn" by offering free shipping and whatnot to get more and more market share. The idea is plain and simple: You offer services that are so good and so cheap that people will flock to your "store" and use your service. Over time, you can cut costs and raise prices and make a profit - now that you have captured an audience and effectively excluded others. Uber is using the same tactic, as I noted in a previous posting.
It is the online version of what Sam Walton did with Wal-Mart. Sell like mad, slash prices, live in the margins, eke out a profit, and drive everyone else out of business. Or take Sears - a classic, in every sense of the word, example. In the 1800's, before the Internet (just barely) they put out the Sears Catalog, which offered goods at startlingly low prices. Mark's Grandfather actually built a house in Old Greenwich, Connecticut from the Sears Catalog. They got big pretty fast, and prevented other catalog stores from getting a real foothold (Mongomery Wards notwithstanding). They prided themselves on efficiency, using clerks on roller skates to fill orders (there's an idea for you, Mr. Bezos!). The place ran like a machine.
The Amazon of its day, Sears.
So you get big, and this acts as a deterrent to competition, as you have the cost savings of volume pricing and the infrastructure in place, as well as brand-name recognition and a ready audience. Trying to build growth slowly is far more difficult, as your overhead will be higher and it will be harder to compete with the "big boys" who can plow you under.
And so it goes with the Internet. You need to go big or go home. You can't run a "little shop on the Internet" unless you are selling something unique or different. And odds are, if you are, you probably sell through e-Bay or Amazon anyway. If you have a new app or social network, you need to get millions of users right away - you can't rely on slow organic growth. No one wants to be on a "social network" that no one uses - that isn't social by definition (ask Google Plus!).
So you squander money on advertising and promotion, burning through hundreds of millions of dollars with nary a profit in sight. Maybe someday it pays off, if you get big, quick.
And it is a scheme that works, provided you have enough capital to keep doing it for a good long time. I used the example of pets.com as illustrating this internet foolishness. And maybe they weren't foolish, but just didn't have the dough to stick it out long enough. Maybe if they could keep selling dog food at a loss for a few more years, they would have eventually cornered that market and could then afford to raise prices and make a profit. Maybe, maybe not. The bottom line is, they ran out of capital - suddenly and completely - and could not continue.
And that is how these Internet companies work - they burn through capital and then go bust very, very suddenly. One day there is a website that seems like a permanent part of the landscape, and the next day - nothing.
But with the Internet - and apps - we find other factors involved. You can have an "app" that is quite popular one day, and yesterday's news the next. This is particularly true for apps you are selling to young people, which are more like hit albums than they are business plans. Sure, your record sells millions of copies and goes platinum. That doesn't mean it will keep selling at that rate indefinitely or that it represents a "business plan" (Dark Side of the Moon and Eagles Greatest Hits Vol. I are the apparent exceptions to this rule - they sell perpetually).
So that is the "logic" behind these start-ups in the app world today. They aren't interested in making a profit because they want to build an audience first. Facebook succeeded where MySpace failed in that they were able to capture a far wider audience and become a de facto standard of the Internet, even if you do have to be particularly dense to find it interesting (Most people are incredibly shallow and "socializing" and being popular are the most important things in their lives - Zuckerberg basically tapped into basic human anxiety with his website).
But even if you build an audience, the profits may never come. And eventually, something has to give. We are seeing this with Twitter, which seems to be stuck in terms of attracting new members and attracting profits. Part of the problem is, like Facebook, that nothing ever good seems to come of it. All we hear about are people losing their jobs or being ostracized for comments they make on Twitter. Even the most famous tweeter in the world, President Trump, gets nothing but grief for his ill-considered early-morning tweets.
But then again, the people running these companies are not necessarily worried about whether the company makes money so much as they worry about themselves making money. And this brings us to part two of the dot-com (or app) silliness - the IPO.
Again, I used to wonder what the point of these IPOs was. If you sell the stock at $25 a share and it jumps to $50 a share in seconds, your company just left $25 on the table, so some middle-man could double his money overnight. This puzzled me until I discovered that was the point.
The insiders who get the blocks of shares early on are the investment banks and "analysts" who go on the road shows and hype the stock, so schmucks like you and me will buy. These folks double their money selling their shares to us.
And the founders of the company and the early investors now have a means of cashing out of their investment, by selling stock in a money-losing company (or a company with a P/E ratio of 600 or more) by selling shares to schmucks like you and me. It turns out the Ferrari dealer won't take "dot com" stock in payment, and those luxury villas don't come cheap - these folks need cash.
And like with the Groupon CEO, once you cash out, well, who cares what happens to the company? Groupon was a fad - a one-trick pony that was copied by many others, such as "living social" which recently went bust as well. The founders are laughing all the way to the bank, of course. The shareholders? Not so happy.
And sadly, the media, after nearly three decades of this nonsense, gleefully reports on it as if it were some big deal and good bargain, because the share price went up. A school made millions the first day! You could too! If only you'd play IPO roulette too! But for every person who "cashed out" there are ten schmucks like you can me who bought at the peak, only to find out later on, the party was already over.
"But," you say, "this has to be a good deal! All the media channels are covering it! All the financial guys are shouting about it! They even redecorate the exchange with the logo of the company! The CEO gets to ring the trading bell on the exchange! It's a big deal, these IPOs! Why would the television lie to me about it?"
And that is the deal, right there. Just as there are tons of check-cashing stores and title pawn loan shops in every town, and just because lots of people patronize these places doesn't make them good deals.
And eventually, people realize this. But a new generation comes along and bites on this hot-dog and the whole process starts over again. It is like the evangelical church - 1/3 of members are joining, 1/3 are in, and 1/3 are leaving. It is a turnover process. A sucker is born every minute.
That is what it takes, I guess. People lose money on a few IPOs and then realize they are doing little more than gambling and making someone else rich. They give up and give their seat to the next guy. But a few core believers go right back and put their hand on the hot stove. Don't believe me? Go to the track or the casino and see the people who have been gambling (and losing) for decades. They're hooked.
Today, it is the Snapchat IPO, another in a long line of dot-com or app type stocks that are losing money and show no signs of being profitable. Often these are trendy things which are more style-based than real business plans. They may even be physical products that are little more than stylistic trends - like Croc sandals.
Snapchat is popular with the kids today. So was Farmville - whatever happened to that - and its IPO? The problem is, kids are fickle, and they will move on to the next big thing or next popular thing in very short order, particularly if their parents get on snapchat. So the "big" audience could disappear pretty quickly.
But the other problem is profitability. Facebook is one of the few of these IPOs to figure out how to make a profit, but even then, only with a P/E ratio of about 50. You have to hope Facebook gets more profitable (at least by a factor of two) or the share price drops in half. Long-term, a 2% rate of return (which is what a P/E ratio of 50 represents) just isn't going to cut it.
But Facebook is profitable and is huge. So they may be around for a long time. Snapchat is pumping the well dry every day, and the money "raised" by the IPO is a drop in that well. Again, the point of the IPO isn't to raise money but to sell you stock so the owners can sell out. They admit they are not making money and maybe never will. This does not sound like a sound "investment" to me. And if they run out of money to lose, well, the end will come quite quickly, as it seems to be doing for Mr. Elio and his three-wheeler.