Explaining the E-Commerce Shakeout: Why Did So Many Internet-Based Businesses Fail?
Author(s): Janet Rovenpor
Source: e-Service Journal, Vol. 3, No. 1 (Fall 2003), pp. 53-76
Published by: Indiana University Press
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53
Explaining the E-Commerce
Shakeout
Why Did So Many Internet-Based Businesses Fail?
Janet Rovenpor
Manhattan College
ABSTRACT
In the years 2000 and 2001, almost 800 Internet-based firms went out of business. Consistent
with the management literature on organizational failure, factors that contributed to the collapse of dot.com firms were either internal (e.g., poor strategic planning, inexperienced management, inactive board of directors) or external (e.g., lack of available resources and
marketplace competition). Short case studies of two recent dot.com closures reveal that they did
not fail for any one reason but for a combination of reasons. Not surprisingly, 31 dot.coms that
had either gone public or were about to go public before they failed were young, small to
medium sized, had never made a profit and were likely to run out of cash in just over a year’s
time. Contrary to popular belief, the chief executive officers of failed dot.coms were middleaged and well educated. Boards of failed dot.coms were small and had less outside representation than customary. A majority of failed firms were founded by more than one individual.
Keywords: dot.com, business failures, Internet firms
INTRODUCTION
The Internet promised to be a technology with unlimited applications that had the
potential to radically transform modern day life—from the way we communicate with
one another, to the way we access information, and to the way we purchase goods and services. The Internet was seen as having a replacement effect. Instead of writing letters, we
would communicate with one another via e-mail and instant messaging. Instead of calling a broker to buy 100 shares of IBM, we could place a buy order electronically, by ourselves. Instead of waiting in line at a local post office to purchase stamps, we could pay for
postage online and have the stamps printed directly onto envelopes using our ink-jet
© 2004. e-Service Journal. All rights reserved. No copies of this work may be distributed
in print or electronically without express written permission from Indiana University Press.
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printers. Industry observers claimed the Internet could enlarge and shrink time, help
businesses reach vast numbers of customers from all corners of the world, reduce information asymmetries between buyers and sellers, and lower the costs of conducting business transactions (see Afuah and Tucci, 2003). Venture capitalists rushed to fund
Internet-based startup firms and senior executives left such well-established companies as
Bank of America, Sun Microsystems, Citicorp, and Andersen Consulting to work in the
“new economy.”
The years 2000 and 2001 proved that the e-commerce revolution was not as sweeping as originally envisioned. Starting in April 2000, Internet-based businesses (known in
colloquial terms as “dot.coms”) began to go bankrupt. According to Webmergers.com,
225 Internet companies failed in 2000 and 537 failed in 2001 (“Dot-com busts,” 2001).
Between 7 to 10% of the total number of Internet firms in existence (estimated at
between 7,000 and 10,000 globally) ended in failure (cited in Whitman, 2002). The
impact of failed dot.coms on employees and on the economy has been significant. The
Chicago outplacement firm, Challenger, Gray and Christmas, reported that 41,515
dot.com employees were laid off in 2000 while 98,522 (more than double) were laid off
in 2001 (“Dot-com busts,” 2001). The Internet failures have had a domino effect on
other related businesses in advertising, consulting, and computer hardware and software,
contributing, according to some experts, to the current economic slowdown.
The purpose of this paper is to identify some of the factors that have contributed
to the failure of Internet-based firms. What happened? Why did so many young, entrepreneurial firms with such good ideas and strong support from venture capitalists collapse? By analyzing what went wrong, we can learn from the past and identify those
strategies or operating principles that should be avoided in the future. As James Schrager
(2002, p. 129) proposes, “Failure is a wonderful teacher.” He believes that since the new
economy revolution seemed so real; there must be something we can learn from the revolution that never was. There must be some lessons that can be applied to new ventures.
A review of the management literature reveals that factors commonly associated
with organizational failure are either internal or external. Internal factors identify problems residing within the organization, such as inefficient use of capital or inadequate strategic planning. External factors result from unanticipated changes in the environment
and can include economic recession or intense competition. Short case studies of two
noteworthy dot.com failures will be presented so that readers get a flavor for a few of the
obstacles facing dot.coms. In addition, thirty-one dot.com firms are profiled. An attempt
is made to describe a few financial, managerial, and organizational characteristics of
failed firms.
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Explaining the E-Commerce Shakeout: Why Did So Many Internet-Based Businesses Fail?
MANAGEMENT LITERATURE ON ORGANIZATIONAL FAILURE
The management literature provides a framework within which researchers can study
organizational failures in general and dot.com failures in particular. It offers a rich tradition with some theories viewing the failure of an organization as an inevitable event that
occurs in the death stage of an organization’s life cycle, and other theories suggesting that
an organization is part of a population of organizations that together fail when they no
longer possess the attributes necessary to adapt to a new environmental niche.
Factors Contributing to Organizational Failure
Three streams of research in the management literature have identified different types of
factors that lead to organizational failure. Among organizational theorists, the most
widely researched variables are firm age, firm size, and population density (see Panco and
Korn, 1999; Hager, Galaskiewicz, Bielefeld and Pins, 1996). Among strategic management scholars, a lack of financial resources, inadequate planning, and composition of the
board contribute to organizational failure (Sheppard, 1994b). Small business experts
focus on the education, age, and experience of a startup firm’s founders as well as on the
adequacy of a firm’s resources in the form of capital and access to professional advisors
(Lussier, 1995). These studies might find that failed firms, in contrast to successful firms,
were founded by owners who did not have a college education, who could not attract and
retain quality employees, and who did not use adequate financial controls in running the
business.
Firm Age, Firm Size, and Population Density. In general, researchers have found
that younger and smaller firms are more likely to fail than older and larger firms. Stinchcombe (1965) believed that young firms suffer from a “liability of newness.” They are
more likely to fail than their older counterparts because they have less experience, fewer
resources, and sporadic support from external constituencies. Financial resources are
especially important for survival since they can be used to weather economic downturns
and to recruit high quality managers.
Freeman, Carroll and Hannan (1983) found that age and size contributed to the
failures rates of firms in three sectors: national labor unions, newspaper publishing, and
semiconductor manufacturing. Delacroix and Swaminathan (1991) found that organizational age and size had a significant negative impact on the probability of disbanding
among California wineries. Yet these relationships are not always linear. Bruderl and
Schussler (1990), for example, proposed an inverted U-shaped relationship between age
and the risk of failure. In an early stage (referred to as adolescence), failure is low because
the firm has access to a stock of initial resources. These resources can consist of capital,
goodwill, trust, or psychological commitment (Fichman and Levinthal, 1991). They
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provide a firm with an opportunity to establish itself. It is only at some time later
(between one year and fifteen years) that the firm’s future potential is judged. At that
point, the “death risk” reaches a peak, after which it begins to decline.
Density refers to the aggregate number of organizations in a given population at a
given time (Aldrich, 2000). It is often calculated by counting the number of company
foundings minus the number of company disbandings (Panco and Korn, 1999). Carroll
and Hannan (1990) determined that organizations founded during periods of higher
density were more likely to disband than organizations founded during periods of lower
density. The main reason for this finding is that when startup firms compete with
numerous well-established firms, resources are scarce. Managers are unable to strengthen
their firms, finding it difficult to cope with adverse conditions. They are forced to the
sidelines, and in the end, fail.
Dobrev, Kim and Hannan (2001) also take a population ecology approach to organizational failure. They examined the effects of crowding in a market center on rates of
change in organizational niche width and organizational mortality. Automobile manufacturers in Europe were more likely to disband, exit to another industry, or merge/get
acquired by another firm when intense competition forced them to change their strategies and offer a broader range of products than before, thereby widening their niche. The
process of change, more than anything, represents a destabilizing force bringing with it a
new internal balance of power, structural inertia, and new competencies which take time
to develop.
Financial, Strategic, and Industry-Specific Factors. The strategic management
literature attributes organizational failure to a lack of financial resources, inadequate
planning and faulty decision-making. Managers are required to use their knowledge,
skills, and business contacts to chart a successful course of action for their companies.
They are expected to create a vision for the firm and put together a high-quality management team. If their companies go bankrupt, it is their fault, not the result of predetermined circumstances beyond their control.
Sheppard (1994b) found that failing firms have fewer direct board interlocks, less
evenly balanced boards (in terms of diversity of member business backgrounds), and
lower net worth to asset ratios than surviving firms. In another study, Sheppard (1994a)
concluded that companies failed because: (a) they did not posses a high degree of equity
relative to assets that could serve as a buffer against bankruptcy; (b) they sought increased
market share which hastened their demise; (c) they did not use networking strategies to
garner support from the environment; and (d) they were unable to change their strategies, suffering from rigidity. D’Aveni (1989) also found that firms facing the prospects of
bankruptcy experienced strategic paralysis (they did not take domain initiative) and managerial imbalances (more managers with legal, financial, and accounting backgrounds;
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Explaining the E-Commerce Shakeout: Why Did So Many Internet-Based Businesses Fail?
fewer managers with marketing, research and development, production, and operations
background). They also demonstrated concerns with efficiency and centralization.
Small-Business Owner Demographics and Firm Resources. Research in the small
business literature examines a firm’s ability to survive based on managerial and organizational characteristics associated with the firm when it was founded. Inaki (2002) compared the levels of intellectual capital among startup firms experiencing growth,
possessing no growth, or showing declining results over time. The researcher found that
growing firms were run by entrepreneurs who had college degrees, prior management
experience, and high levels of motivation (i.e., human capital). These firms also had the
capacity to adapt quickly to a changing market (i.e., organizational capital) and were able
to develop productive business networks (i.e., relational capital).
Lussier (1995) developed a startup business success versus failure prediction model
based on 15 variables that were derived from 24 prior studies. Five variables related to
organizational resources and internal controls. Firms had a greater chance of failure if
they did not possess sufficient capital at startup, did not keep accurate records or use adequate financial controls, did not develop specific business plans, did not use professional
advisors, and did not attract and retain quality employees. Eight variables related to the
personal characteristics of the firm’s owner/founder/manager. Firms had a greater chance
of failure if they were started by only one person. They were more likely to fail if the owners/founders were young, came from a minority group, did not have parents who owned
a business, did not have a college education, and were not skilled at marketing. Businesses
would fail if their managers lacked prior industry and management experience. Finally,
there were two timing issues. Businesses that were started in a recession were more likely
to fail than businesses started in a period of expansion. Businesses offering products/services that were too new or too old were more likely to fail than firms offering products/
services in a growth stage.
Lussier and his colleagues tested the predictive model separately on 216 small businesses in the Northeastern region of the US, on 96 retail businesses in the Northeastern
region of the US, and on 120 businesses in the Republic of Croatia (Lussier, 1995, 1996;
Lussier and Pfeifer, 2001). Using the 15 variables, the model correctly classified firms
into failures or successes between 69% to 72% of the time.
In their book, When Things Go Wrong, Anheier and Moulton (1999) suggest that
the causes of organizational failure can be classified into either internal or external factors. Internal factors include poor business decisions, mismanagement, disputes and infighting, and lack of organizational slack. The studies of Lussier (1995, 1996), Lussier
and Pfeifer (2001), Inaki (2002), and Sheppard (1994a, 1994b) would fall into this category. External factors refer to a decline in available resources, intense competition, unexpected catastrophic events, isolation, and changes in niche dimensions and density. The
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studies of Dobrev, Kim and Hannan (2001) and Carroll and Hannan (1990) would be
relevant examples of this type of research.
A model showing the internal and external factors that contribute to firm success/
failure appears in Figure 1. For internal factors, the model suggests that firm characteristics, firm management, and firm founder/owner variables play an important role in
determining whether or not a firm will succeed or fail. For external factors, the model
indicates that the availability of resources, industry competition, significant environmental events, isolation, and population density can significantly affect a firm’s chances for
success or failure. Variables listed in bold print are studied in relationship to failed Internet-based companies in the following section.
FACTORS CONTRIBUTING TO THE FAILURE OF INTERNET-BASED FIRMS
It is assumed here that Internet-based businesses are no different from traditional
businesses in the startup phase of corporate development. Entrepreneurs interested in
profiting from Internet technology need to develop strong business plans. This requires
an understanding of the competitive landscape, the development of an innovative product or service that satisfies an unmet consumer need, and the flexibility to modify strategies as the environment changes. Businesses should forge partnerships with reliable
suppliers and develop delivery systems so that merchandise reaches customers in a safe,
timely, and cost-effective manner. Factors contributing to the success or failure of firms
are the same for traditional startup businesses and for Internet-based businesses.
Figure 1. Factors Contributing to Firm Success/Failure
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Explaining the E-Commerce Shakeout: Why Did So Many Internet-Based Businesses Fail?
Drawing on the management literature, the failure of Internet-based companies is
attributed to such internal factors as (a) inadequate financial resources, (b) young firm
age, (c) small firm size, (d) poor strategic planning, (e) characteristics of managers (e.g.,
inexperience), and (f) lack of board oversight. The following two external factors are suggested: (a) resource scarcity and (b) intense competition. These factors were chosen
because they seemed particularly relevant to Internet startup firms that ceased operations
in 2000 and 2001. Some factors not on this list are discussed indirectly along with other
factors. Lack of financial controls is covered in the description of poor strategic planning
at dot.com firms. A significant environmental event that affected Internet–based firms
was the withdrawal of funding from venture capitalists. This is discussed simultaneously
with the resource scarcity variable.
Other factors were not examined because it was felt that variations between firms
would not have been found. Consider, for example, Lussier’s finding that businesses
started in a recession were more likely to fail than businesses started in a period of expansion. Time of firm launch is not a valid predictor variable for Internet-based firms that
began to fail in April 2000, since they were all founded during the long period of expansion spanning from 1991 to 2001. Research on population density suggests that the
chance of failure is high for startup companies operating in industries in which there are
many well-established firms. Internet-based businesses operated in an emerging industry
in which there were very few well-established firms. Thus, the Internet-based firms of
interest here were not founded during a recession or during periods of high density; they
all offered new products/services for which acceptance by customers was uncertain.
Internal Factors for Dot.com Failure
Financial Resources. According to Garbi (2002), “A key potential indicator of survival (or the threat of failure) is the burn rate, i.e., speed at which the company is spending money. This rate determines when the capital raised will run out.” Periodic reports by
Barron’s magazine tracked the burn rate of Internet companies and found cause for concern. Willoughby (2001), for example, reported that more than one-third of Internet
firms would run out of cash by the end of 2001. At that time, they would need to raise
additional funds, sell out to a more financially stable company or cease operations.
Kathman (2000) advises investors to take a publicly-held company’s cash and cash
equivalents at the end of a period (usually a month or a quarter) divided by cash flow
from operations for that same period. At the end of the second quarter of 2000, for example, The Street.com had $65 million in cash and was spending $23.5 million a quarter.
If the firm were to keep spending money at that rate, its cash would last only another 2.8
quarters (65 divided by 23.5). Kathman (2000) suggests that companies with less than a
year of cash left are unattractive investments.
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Firm Age and Firm Size. There do not seem to be any studies examining whether
younger and smaller dot.com firms are more likely to fail than older and larger dot.com
firms. Clearly, however, some of today’s most successful Internet companies, such as eBay,
Amazon.com and Yahoo, were first movers in their respective industries and benefited
from getting an early start. They were able to attract resources, build their infrastructures
and even create some slack resources that would enable them to cope when technology
stocks collapsed and the environment became turbulent. Amazon.com and Yahoo were
both founded in 1994, making them 9 years old in 2003. eBay was founded in 1996,
making it 7 years old. By 1999, and before significant industry-wide downsizing began,
Amazon.com had 7,600 employees while eBay and Yahoo had 1,212 employees and
1,992 employees respectively. This makes Amazon.com large in size while eBay and
Yahoo were of moderate size.
Richard Spider, a managing director of an Internet consulting firm, commented
that young startup companies, even if they eventually failed, served an important purpose in the Internet revolution: they forced older, more established companies to develop
Internet strategies. He believes that it is these older companies that will have “staying
power.” When faced with an economic slowdown, they will pursue new opportunities to
generate sales and reduce costs by making better use of Web technology (cited in Willoughby, 2001). Hamel (2002) believes that size still matters; it provides evidence that
companies are using the learning curve and taking advantage of economies of scale and
scope. As he writes, “The companies that survive that dot.com shakeout aren’t going to
be will-o’-the-wisp, thin-as-gossamer virtual companies. They are going to be companies
like Cisco and Amazon.com—companies that have had their share of ups and downs, but
have never lost sight of the fact that scale matters” (Hamel 2002, pp. 316-317).
Poor Strategic Planning. According to Michael Porter (2001), the managers of
many Internet businesses ignored strategy. They erroneously assumed that profits were to
be made later, once loyal customers were acquired and once the company gained a lead
over its competitors. Heavy advertising, discounting of merchandise, and the offering of
free products/services were viewed as the route to building brand awareness and attracting supporters. But, basic business fundamentals, such as the need for revenues to exceed
costs, were forgotten. Companies failed to deliver real value to customers. In Porter terminology, these Internet companies undermined the structure of their industries. As he
writes, “A destructive zero-sum form of competition has been set in motion that confuses
the acquisition of customers with the building of profitability. Worse yet, price has been
defined as the primary if not the sole competitive variable. Instead of emphasizing the
Internet’s ability to support convenience, service, specialization, customization, and
other forms of value that justify attractive prices, companies have turned competition
into a race to the bottom” (Porter, 2001, p. 72).
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Explaining the E-Commerce Shakeout: Why Did So Many Internet-Based Businesses Fail?
Managerial Characteristics. In order to develop a successful business plan, companies need experienced managers. However, as Paul Weaver of PricewaterhouseCoopers
said, “In the haste to get into the public domain, a lot of the companies just didn’t have
the depth of management. As importantly, they didn’t have the right kind of people on
the board or in advisory roles. They didn’t have adult supervision, someone who would
just sit back and say, ‘That’s crazy! That would never work’” (cited in Isaacs, 2001). Some
dot.com ventures (e.g., Mothernature.com, World Online International NV, and Value
America) were run by individuals who had managed companies that had previously
failed. Executives at two Internet-based firms were charged with illegal activities allegedly
committed earlier in their business careers. Marc Collins-Rector of Digital Entertainment Network was accused of molesting a 13-year-old boy employed in a former company; David Stanley of Pixelon was convicted of multiple counts of fraud for stealing $1
million in a mutal fund investment scheme. According to Kroll Associates, a business
intelligence and security firm, Internet executives are four times more likely to have
“unsavory backgrounds” than their counterparts from other industries. Background
checks on 70 executives, directors, and consultants in high-tech firms found that 39%
had been charged with securities violations, insurance fraud, undisclosed bankruptcies,
and links to organized crime (“Criminal element,” 2000).
Some of the demographic variables studied most frequently as a measure of managerial experience are age and education. Older managers with a college education are said
to benefit from greater experience and an understanding of important business values
(e.g., customer satisfaction and control over expenditures) than younger managers without a college education. Among the findings of a KPMG study in the U. K. of 101 British
executives, it was noted that the average age of leaders of new economy firms was 38 compared to 46 at old economy firms (Lymer, 2000). Other studies indicate that founders of
failed dot.coms are even younger. From brief profiles of 31 executives of failed dot.coms
that appeared in Fortune magazine, one can calculate average age to be 34 years (Wheat,
Dash, Tkaczyk, and Lashinsky, 2002).
The KPMG study also found that leaders of new-economy firms were less likely to
have a degree and more likely to have gone to private schools than leaders of old-economy firms. Leaders of new-economy firms had backgrounds in marketing and information technology, not finance (Lymer, 2000). This may account for why many dot.coms
placed too much emphasis on brand building and advertising; managers did not realize
the importance of establishing financial controls over spending. It also suggests that technology-oriented executives were very capable of building user-friendly Web sites but they
perhaps lacked an understanding of what makes a business work.
Lack of Board Oversight. Business miscalculations made by inexperienced managers
may have been exacerbated by boards of directors whose members may have failed to fulfill
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their oversight duties properly. Boards of Internet firms have been criticized for being small
and insular with too few non-technology representatives and too many venture capitalists
with conflicting interests (Swisher, 2001). A survey by the executive research firm, Spencer
Stuart, indicated that the average number of independent directors on dot.com boards fell
from 68% to 62% in one year. Standard and Poor 500 companies, in contrast, have an
average of 78% outsider representation (“Dotcom boards,” 2001).
External Factors for Dot.com Failure
Resource Scarcity. Finding sources for a second or third round of financing
became very difficult for dot.com firms that were in danger of depleting their existing
funds. Resources became less available: in 2000, $90.1 billion were raised for venture
investment; in 2001, $48.2 billion were raised (“Venture Capital,” 2002). Moreover,
venture capitalists became more selective regarding which companies they would fund.
Basically, companies had to show that they would be profitable in the near future.
PricewaterhouseCoopers (“Paths to Value,” 2002) identified 4 time periods in the
market environment of dot.coms: (a) pre-bubble (1st quarter 1998 to 3rd quarter 1999);
(b) bubble (4th quarter 1999 to 2nd quarter 2000); (c) post-bubble (3rd quarter 2000 to 1st
quarter 2001; and (d) downturn/recovery (from 2nd quarter 2001). In their study of 350
companies, the firm’s researchers found that companies that received financing during
the pre-bubble period made slower progress but had more customers by their initial
rounds of financing and increased in value in subsequent rounds compared to companies
that received financing in the bubble period. Companies that received financing in the
bubble period attracted strong management teams at the seed stage but made little customer and business model progress and experienced down rounds in later stages of
financing (Goncharoff, 2002).
Competition. As in any industry, intense competition is a factor that can lead to a
shakeout. In some product categories, especially pet supplies, toys, and apparel, there
were too many retailers chasing too few interested customers. Competition also came
from traditional bricks and mortar companies that added an Internet presence. Their
advantage over “pure-plays” is that customers can return items they are not satisfied with
to a physical store. Such companies already have a well-established name and can, therefore, save on advertising costs. Back office operations, as well as inventory and distribution systems, are already up and running.
Drawing from his book, The Innovator’s Dilemma, Christensen explains that Internet
companies often failed because they chose the wrong basis of competition (Christensen,
Johnston and Barragree, 2000). They may have decided, for example, to compete on the
basis of convenience and price when customers still wanted functionality and reliability.
Companies must understand the prevailing logic of competition that holds true for every
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Explaining the E-Commerce Shakeout: Why Did So Many Internet-Based Businesses Fail?
industry. First, consumers want products that provide functionality—products that enable
them to do things that they could not do before. Once that ne
