Internet Firms: Party Like It’s 1999?

A successful share offering by PayPal, an Internet firm, does not signal a new dotcom boom. But it does show that investors can now tell good dotco...
Economist StaffFebruary 22, 2002

For a moment, it felt like the good old days of the new economy. When PayPal, an online payment start-up based in Silicon Valley, went public on February 15th, its shares surged by as much as 54%—even though the firm had lost $18.5m on sales of $40.4m in the quarter ending in December. PayPal had postponed its initial public offering (IPO) earlier this month after a company called CertCo filed a lawsuit accusing it of patent infringement. Surging share prices, non-existent profits and legal wrangles—it was as if the dotcom crash had never happened.

Yet anyone now hoping for a revival of the dotcom boom is in for a disappointment. PayPal’s successful IPO is, instead, a sign that investors have finally figured out the ingredients of a winning dotcom, having first bet uncritically on anything even remotely Internet-related, and then having equally indiscriminately dumped the shares of all Internet firms. Winning dotcoms appear to have three characteristics.

First, they exploit the Internet’s ability to exchange information at very low cost in order to offer valuable services that would be prohibitively expensive offline. Prime examples are eBay and, leaders in online auctions and job markets respectively. Travel sites such as Priceline and Expedia also fit this bill.

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In comparison, e-tailers are much less virtual. With its huge distribution centres, is as much a logistics firm as a dotcom. That is not to say that e-tailers cannot be profitable—Amazon recently posted its first ever quarterly profit, of $5.1m—but it is hard, as the bankruptcies of eToys, Webvan and many others attest. Except for niche sites, online retailing seems to have more of a future as an additional sales channel for existing businesses. Some believe that even Amazon will one day be taken over by an offline retailer.

PayPal, for its part, is squarely in the camp of the pure bit-shovers. Its aim is to provide the online equivalent of cash, to allow web surfers to exchange payments easily. Users open a PayPal account linked to a credit card or a bank account. To send money, they simply type in an e-mail address and the amount. To collect the money, the recipient must also register.

That highlights the second ingredient for success, which is to take advantage of a property of communications networks: that their value increases with the number of users. Most start-ups tried to jump-start such “network effects” by being first to market and spending a lot of money on advertising to develop a brand—a strategy which proved a disaster in almost all cases.

In contrast, neither eBay nor PayPal ever spent much on marketing. But after eBay became the preferred place on the web to trade collectibles in the late 1990s, largely through word of mouth, it quickly entered a virtuous circle in which more buyers attracted more sellers, who attracted yet more sellers, and so on. At the end of last year, eBay had 42.4m users worldwide. In the previous three months they listed 126.5m items and spent a total of $2.73 billion between them.

PayPal’s business is similarly self-feeding—not least due to eBay. PayPal quickly became the payment scheme of choice on eBay, which generates about 65% of PayPal’s revenues. To reach critical mass, the start-up paid users $10 to sign up their friends—an incentive it was soon able to drop. The firm now has around 14m users, and signs up over 24,000 more each day.

Online job listings are much less of a winner-takes-all (or almost all) market. Businesses like to post their openings in more than one publication, be it offline or online. That is why Monster has spent millions on advertising, in particular on horrendously expensive Superbowl commercials. But thanks to network effects and acquisitions, the company, which was founded in 1994 as a simple job board, can boast over 20m users and 14m listings.

Now that they have established themselves, PayPal, eBay and Monster have a third advantage: relatively high switching costs that enable them to retain customers and give them pricing power. On eBay, for example, buyers rate sellers, allowing the latter to build a reputation—which they would lose if they were to switch to another auction site. Such potential losses make it much easier to introduce or increase fees. Last month, eBay raised the amount it charges per auction (a percentage of the value of a sold item), in some cases doubling fees for sellers. Unsurprisingly, this caused much protest, but no mass exodus.

PayPal and Monster have less pricing power, but they are able to milk at least part of their clientele. In both cases, individuals can use the service free of charge, for instance to post a resume or to send some money within America. Businesses, on the other hand, must pay. PayPal charges merchants, of which 2.6m have signed up, a commission of between 2.2% and 2.9% to receive money via e-mail. On Monster, employers pay $305 for a job listing which remains on the site for 60 days. Yahoo!, a web portal, in contrast, is having trouble encouraging its 219m users to pay for its services. Most of the information it offers is available elsewhere, and switching costs are low—a share price is a share price, wherever you read it.

To be sure, combining all these characteristics is no guarantee that a dotcom will succeed. Success attracts competition, for one thing. Following in PayPal’s footsteps, Citigroup now offers a person-to-person payment system, called c2it, as does eBay itself, called BillPoint. And a consortium of major American newspapers operates an online recruitment site, CareerBuilder.

Then there are legal risks, as Napster, the online music-swapping service, demonstrates. It was shut down by the courts, though it recently came back as a paid subscription service. eBay, for its part, was accused of monopolistic behaviour when it moved, in early 2000, to keep other sites from accessing its auction database. Similarly, it will be interesting to see whether PayPal will ever allow its users to send money to c2it accounts. And some states may decide to regulate PayPal as a bank—which would prove costly for the firm.

In short, PayPal’s success is by no means assured. Its ability to attract investors may prompt other firms to launch IPOs. But such firms will, like PayPal, have to convince sceptical investors that they are not just clever business models hyped by venture-capital dollars.