Few dotcom multi-millionaires have fallen as far or as fast as Joe de Saram, head of software encryption specialist Rhodium. One year he was 18th on The Sunday Times young rich list – sharing the same ranking as Posh and Becks – the next he was believed to have fled to Sri Lanka, while a creditor filed a winding up petition against his company with the High Court in Leeds over a #205,000 unpaid invoice for computer hardware.
De Saram is far from the only casualty of the burst dotcom bubble. High profile companies, such as boo.com, and lesser known names, like community shopping specialist adabra.com, found rediscovering forgotten laws of commerce a painful experience.
Those dotcoms which remain in business face a difficult future. Take the case of auction site QXL.com. Directors watched its share price plummet from a high of 800p to a low of 17.5p in just a few months. And they faced some tough talking from investors when they raised a new round of financing at the end of last year. The deal involved convertible bonds with three-year warrants exercisable into ordinary QXL shares at variable prices within an agreed range. One analyst says the complexity of the funding implies they couldn’t get the money any other way.
But will any lessons be learnt from the dotcom debacle? There is certainly much for FDs to ponder upon, as new research among 400 dotcom companies carried out by PricewaterhouseCoopers* shows. It found that a quarter of dotcoms fail basic financial hygiene tests because they do not prepare cash-flow forecasts or management accounts at least once a month. Fewer than half of the dotcoms held proper board meetings.
Certainly, lax financial management is part of the story of some dotcom failures. After on-line shopping specialist boo.com crashed, tales emerged of Concorde flights, luxury hotel stays and champagne parties. What is significant in that kind of situation is not so much the waste of money, but the poor management judgement that allowed it.
The PwC survey, however, detected a change of attitude among dotcom companies after the spring 2000 crash. Most now strongly agree that “keeping overheads to an absolute minimum” is important. And others claim to be “slashing costs to protect cash reserves”. Few now suggest that “conventional management practices are not appropriate to a dotcom company like ours”. Recognition of the fact has been slow, but dotcom survivors know that the business rules of the old economy also apply in the new.
Reducing cash burn is now the mantra of dotcoms. When it launched last autumn, information portal Britishinformation.com took positive pride in the fact that it had spent only #100,000 developing its site. Director Sean Barrington-Murphy says: “We do not have the worries of mounting debts, neither are we constrained by outside investors’ decision-making processes.”
But lack of financial control is not the only reason for dotcom failure, as the story of TheStreet.co.uk (see box, page 40) shows. More fundamentally, many dotcoms simply did not have a robust business model. Too many relied on attracting advertising revenue which never materialised. Significantly, the PwC research revealed that 81% of dotcom companies making a profit were direct sellers of goods or services over the internet.
PwC partner Kevin Ellis says: “The direct sale model is the easiest to make money from. You’re getting higher margins and need to access fewer customers, so you can break even more quickly. But it’s also less ambitious because you might be giving up value in the future through having a very simplistic model. The ambitious model, which is more common in the UK than elsewhere in Europe, is the indirect model, where revenue comes from advertising or commission. That model might be the ultimate winner, but it has not proved itself. It needs a much wider audience and huge brand advertising.”
The harsh fact is that even where dotcom ideas seemed innovative, many foundered because the cost of recruiting customers was more than the business plan allowed for. The Harvard Business Review recently reported that the largest US corporations had spent $10bn on consumer websites in 1999 but the sites gained meaningful response data from fewer than 1% of their customers.
Peter Blau, director of consultancy Customer Growth Partnership, believes troubled dotcoms should adopt a three-point strategy to cut what are often crippling marketing costs. “First, replace your wasteful mass media campaigns with highly targeted drive-to-web direct mail – both postal and e-mail.
Secondly, since most web visitors are simply browsers, marry telemarketing with the web to boost conversions to sale. Thirdly, promote previous buyers to buy again, with targeted direct mail techniques such as print and on-line catalogues.”
What is blindingly obvious is that the FD, who may have been ignored during the heady months of the internet bubble, is now up there in the driving seat. This is just as well – there are a host of accounting issues which dotcom FDs need to address if they are to restore the confidence of investors.
Ted Awty, head of assurance at KPMG, says: “Investors are becoming reluctant to support the heavy on-going cash requirements of dotcom companies in the loss-making start-up stages and the accounting challenges, which were already significant, are being thrown into even sharper focus.”
The virtual world has often relied on virtual financial transactions, such as barter arrangements or share options, where real money doesn’t change hands. There is nothing wrong with the principle of such arrangements – indeed, they are plainly sensible for a business which is trying to conserve its cash – but contained within them is the danger of creating a smoke and mirrors world in which the hard facts about the financial performance of the company is obscured both to internal management and external investors.
A new KPMG publication on accounting in the new economy** gives the example of reciprocal advertising arrangements between two dotcom companies where no money changes hands. It asks: should the transactions be recognised within each company’s financial statements and, if so, should the values be attributed? Obviously, reciprocal arrangements during identical accounting periods will show no effect on the net results of the two companies. But that won’t necessarily be the case if the advertising is not concurrent – temporary profits and losses will arise if both the transactions and their value are recorded in the accounts.
The report also looks at special offers. It’s tempting to record the offer – for example, a free CD-Rom – as having been supplied at the list price, with the discount treated as a marketing expense. But that approach inflates the turnover of the company, which may be an attractive objective for a company wanting to impress investors with its growth. The correct and prudent accounting approach, suggests KPMG, is for the discount to be set against gross revenue rather than being accounted for as a separate cost.
Expense classification is also a key accounting issue for dotcoms. As the KPMG guide states: “The market often places more emphasis on the nature of the revenue and expenses of internet companies than in their bottom line. In addition, while companies are in their early stages, investors may also expect substantial marketing costs to be incurred, the extent of which will reduce considerably in future periods.”
There is also a need for more detail in published accounting policies, especially as they relate to revenue recognition. KPMG studied 25 dotcoms and found that 15 did provide information that went beyond a bland statement such as “turnover represents the value of goods and services provided and is stated net of value added tax”. For example, in its 1999 annual report and accounts, Interactive Investor International describes three types of revenue in detail and, critically, describes the timing of payments in relation to the provision of service (see www.iii.co.uk).
Clearly, FDs will need to spend more time developing appropriate and detailed accounting policies to take account of the special circumstances of dotcom companies. The results should give investors more confidence in the long-term and may also uncover business practices that are misleading directors about the performance of companies.
However, investors are going to need more than reliable accounting policies if they are to stump up more cash either for second-round financing for existing dotcoms or for new ventures. With this in mind, Gareth Lloyd, leader of the digital strategy team at Deloitte & Touche, targets three key issues – market opportunity, quality of product and management. He says: “On market opportunity there are many key questions such as: is there a big market, what is the competitive landscape like, who is in there at the moment, who is about to move into the market and is there room for a new entrant?”
On quality of product, it’s clear that investors no longer believe a good idea is enough. They want to see that idea realised in an effective way with issues such as customer care and fulfilment given top priority.
The question of value proposition also becomes important here – what does a customer get out of using this service that he or she won’t from another?
Finally, investors will be looking for more management experience in future, with, perhaps, a few grey hairs on the board. The days of youngsters barely out of short trousers being handed millions to start dotcoms are probably over for the time being.
But dotcom watchers say that market sentiment will return, and dotcoms will be flavour of the month once again. “There will be one or two very major successes in this area, ” says PwC’s Ellis. “Once these successes come, I think that investors will start to look at businesses on their own merits.”
* After the goldrush – the dotcom dilemma, PricewaterhouseCoopers (see www.pwcglobal.co.uk). ** The internet: accounting in the new economy, KPMG (see www.kpmg.co.uk).
GETTING IT RIGHT: wickedcolors.com
The tale of wickedcolors.com brings together most of the critical success factors in a dotcom. The site, which went live in June last year, is aimed at “tweenage” girls, from eight to 14.
Unlike many dotcom hopefuls, Michael LeFort, the driving force behind wickedcolors.com, has an established track record in running “real world” businesses. And he brought in a marketing manager, 24-year-old Lucy Laverack, who has a strong affinity with the target audience.
The business model is robust. It relies on two main revenue streams – advertising and sales from the site. Many commentators have suggested that relying solely on advertising is unlikely to be a viable business model for most dotcoms.
So far, LeFort says that Wickedcolors’ revenue splits around 70% advertising and 30% e-commerce sales. These are mostly of cosmetic and toiletry products aimed at tweenagers.
The site has scored because it’s tackled the payment problem, which is especially difficult in this case because the target audience don’t own credit cards. LeFort has signed a deal with Y-Creds, similar to Beenz, a Net payment scheme that lets tweenage surfers pay for goods from credits paid from their parents’ credit cards. When the credits expire, the parents have the option of topping them up again.
Wickedcolors has also managed to carry its branding through from the site into the off-line world. Many of the cosmetics sold are Wickedcolors’ own brand. LeFort is now exploring the possibility of selling these through retail outlets. “Staying purely on-line is very short-sighted,” he says.
Off-line marketing and sales reinforce the website.
The rules of business are not suspended in the on-line world and in all start-ups cash is king. LeFort is quite clear that Wickedcolors would not have got so far without running a tight ship. He started the business with just #500,000 – a factor several times below what other sites have spent.
He’s situated the firm in Bournemouth, where both office and staff costs are lower than in favoured locations in central London or Docklands. The company has a staff of 10, including three who work on the e-zine which forms the central part of the site.
Another key lesson is that he has kept marketing costs under control.
Most promotion is through advertising or advertorials in teen magazines or at pop music shows. There’s also on-line marketing, where existing members are encouraged to recommend the site to friends.
Running costs are #30,000 a month and LeFort says the business has broken even on a month by month trading basis since December. With 60,000 members already signed up and new signings coming in at a rate of 10,000 a month, Wickedcolors looks set to become one of the first pure dotcoms to turn a real profit.
LeFort now hopes to sell the company this year, probably by a trade sale, and will pocket a substantial return on his investment.
GETTING IT WRONG: TheStreet.co.uk
The sad story of TheStreet.co.uk is an example of how it’s too easy for a dotcom company to get things wrong, even though it thinks it’s doing everything right. Its story shows how, when push comes to shove, investors are not always impressed with promises of jam tomorrow. This explains why so many dotcoms experience difficulty getting second-round funding when they’re not turning in a profit and have no realistic short-term prospect of doing so.
TheStreet’s business model was based on generating advertising revenue.
In its first year it had notched up #2.2m and claimed to be on target for #4m in year two. It had spent just #3m on marketing, reasonable in view of its revenue ambitions. But with first year costs of #10m and continuing cash burn of #350,000 a month, profitability still looked far off.
TheStreet’s financial director Bryan Levine believes that the UK site would have come into profit in 2002. But as any magazine publisher can tell you, a hiccup in the economy can translate into a belch of lost advertising revenue. With growth prospects looking uncertain on both sides of the Atlantic in the next two years, it was anyone’s guess whether the site would have been profitable on schedule.
Yet, for the TheStreet.co.uk, everything started so promisingly. There was a clear business plan in place and during its first year the company exceeded the plan. But management had failed to understand just how important market sentiment would be when it came to raising that all-important second-round funding.
When the US parent company’s value crashed from $600m to $80m, Stateside investors became nervous and the focus of the company switched from buying market share – the dotcom mantra in those mad early days – to boring old-fashioned profitability. That meant that unprofitable and non-core activities had to go. And what better to chop than a subsidiary 3,000 miles away that was making a substantial loss?
Looking back, Levine has lamented the fact that TheStreet.co.uk didn’t have all the investment it needed in place to avoid further calls for funds. He said: “I would have looked for enough funding to take it to cash generation. That gives you a different focus on the business as well. You then know you’ve got to get there in that timeframe.”
But the company found that when you float an unproven company with other people’s money, you need to maintain confidence. In the end, TheStreet.co.uk simply ran out of road.