Why did dotcom companies crash so drastically?

By Andrew Beattie AAA
A:

The craze of the dotcom bubble and the flood of capital that came with it led to many back-of-the-napkin business models becoming publicly traded companies almost overnight. Companies like Amazon (Nasdaq:AMZN) and eBay (Nasdaq:EBAY) adapted on the fly and survived the bust, but many others went under within months of their IPOs. One of the quickest journeys from IPO to insolvency was Pets.com.

Pets.com was based on an Amazon-style internet purchasing system where users ordered pet supplies from the website and the company arranged delivery. The company brought in $82.5 million during its IPO. Its shares opened at $11 and then went up as high as $14. However, less than three months after the IPO, the company's share price dropped to $5, in large part because the company had failed to post a profit and was, in fact, operating at a loss.

The problem with the company's business plan was that pet supplies of all types - food, toys, clothing and so on - could be found easily at the nearest grocery or department store. Given the choice between ordering online and waiting for delivery or walking into the nearest store to buy the product and take it home immediately, the majority of people preferred the latter. Nine months of straight losses convinced the company to fold and sell its assets before more losses were incurred. To Pets.com's credit, it used the funds raised by the fire sale to pay back investors what they could. Although Pets.com tried to do the right thing in the end, questions remained about how they ended up conducting an IPO with a business plan that made Swiss cheese look solid.

Behind the fall of Pets.com, the darker story of underwriting banks and their analysts loomed during the internet boom. Even as Pets.com posted losses and the stock price dropped, the issuing firm's analyst, Merrill Lynch's Henry Blodget, did not change his buy rating until the summer. It fit Merrill Lynch's plans to keep Pets.com in action for as long as possible because the bank was collecting millions in investment banking fees, regardless of the company's condition. This was yet another example of a supposedly impartial analyst being directed to protect a bank's interests, rather than those of investors who depended on honest ratings.

(For more on this topic, read Crashes: The Dotcom Crash.)

This question was answered by Andrew Beattie.

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