By Alam Srinivas

It was an atypical millionaires' millennium bash. At the New Year's party at a plush hotel in Silicon Valley's Fremont city, two things stood out. One, that the rich Indians there were high on scotch, arrogance, and ambition. And, two, they were all banking on the dot.com hype to become the next Jim Clarke, or the next Sabeer Bhatia. ''The valuation of my group is currently $2 billion. But I am growing my dot.com venture to increase that by a few multiples,'' said one of the Indian geeks. A few steps away, a 29-year-old was talking animatedly about selling his fourth Net start-up in as many years.

Rubbing shoulders with such naked ambitions were the traditional millionaires-doctors, surgeons, even lawyers. They too wanted to join the dot.com gush. A few days later, at a frequently-held networking meet among the Indian dot.comers, someone was searching for a consultant who could draw up a business plan for a Net venture. It was none other than a famous Indian lawyer who specialised in H-1B visas. Lurking in another corner of the vast hotel lobby was a brick-and-mortar entrepreneur who owned four packaging firms, but had turned into an investor-mentor for budding Indian e-ntrepreneurs in the Valley.

That was four months ago, when the dot.com delirium-both in the Valley and in India-was being driven by whopping valuations which, unfortunately, were as virtual as the Web businesses themselves. No one questioned the flawed valuation models that were being touted by analysts to explain the intricacies of the New Economy. No one questioned how revenues could be more important than profits, or how the value of a company could multiply manifold in months, even weeks. ''Tech stocks have been overvalued across the board,'' avers Rajiv Memani, 32, Partner, Ernst & Young.

Reality has, finally, struck the virtual world. In fact, in the past few weeks, warnings have been flashing on every investor's screen from New York to New Delhi, from Silicon Valley to the land of the rising sun. Hear what McKinsey & Co. stated in the latest issue of the McKinsey Quarterly (Vol. 1, 2000), about the Net frenzy: ''Record number of people and amounts of money are flocking to the New Economy's Pied Piper, the Internet start-up... And when the time comes for the piper to be paid... the least informed and most starry-eyed of the participants-retail investors-will probably pay the highest price.''

They did, as they shockingly witnessed the bear attack on the NASDAQ. Looking at the earlier valuations, it seemed unbelievable that investors thought that, by 2013, eBay could chalk up a turnover equivalent to 3 per cent of the US GDP, and Yahoo! could grab a quarter of all on-line advertising. Explains R. Ravimohan, 42, Managing Director, CRISIL, which has devised a new model to value Net companies: ''For Yahoo! to justify its market cap of over $87 billion (in January, 2000), its revenues would have had to grow by a compounded rate of 177 per cent per annum for five years.''

Not that the situation in India was any good. Although none of the Indian dot.coms are quoted on the stockmarket, a number of deals in the past 12 months indicate the valuations hype. One company witnessed its valuation jump four-fold to nearly $150 million even before its six proposed portals had been launched. Another one, whose site was still under construction, was valued at Rs 33 crore by ICICI Ventures, ICICI's fund for investing in dot.coms. Not to forget the much talked-about takeover of indiaworld.co.in by Satyam Infoway for Rs 499 crore.

How new models were used to
justify exaggerated valuations

Such valuations could not be explained by traditional models like Price-to-Earnings ratios or Discounted Cash-Flows. For, most of the dot.coms have red ink on their balance-sheets. So, analysts cooked up new ones in which metrics like growth in revenues, and the number of page-views, subscribers, and unique viewers became paramount. But recent studies have indicated that these models were imperfect. For instance, McKinsey concluded they were ''fundamentally flawed'' as these benchmarks could not ''account for the uniqueness of each company.''

Similarly, Anthony Perkins and Michael Perkins, co-authors of the book, The Internet Bubble, found that, based on the market cap of a sample of 133 Net companies in early 1999, their combined revenues would have to grow by 80 per cent per annum for the next five years. While that may not sound unachievable for the Amazons and the Yahoo!s, the fact is that high growth rates taper off over time. In fact, a study by Bernstein Research, a US-based consultancy firm, proved that, over the past 40 years, tech companies could only retain growth rates of 30 per cent after five years, which fell drastically to 11 per cent after 10 years.

Worse, most of these new models are based on translucent information. While the Web is supposed to instill transparency in the way business is conducted or information is disseminated, dot.coms are cagey about doling out figures. Fortune, in its issue dated March 27, 2000, revealed how dot.coms were exaggerating their revenues in a bid to show high growth rates. Dozens of people-including consultants, venture capitalists, and promoters-that BT spoke to were also reticent about giving out financial details or information about specific deals. But most of them agreed that valuation metrics like page-views and the number of subscribers could be rigged.

In that environment, it becomes very difficult to justify why indiainfo. com was valued at Rs 700 crore, or 40 per cent more than indiaworld.co.in a buyout. Or that rediff. com is valued at over four times the worth of indiainfo.com. Or how valuations can change dramatically in short periods. For instance, lexsite.com, a portal on legal affairs, sold a 51 per cent stake in its first round of funding for just over Rs 3 crore and, within a year, sold a 20 per cent stake to ICICI for Rs 6 crore. Explains Rohit Bhasin, 36, Executive Director (Financial Advisory Services), PricewaterhouseCoopers: ''Certain synergies or critical events can actually push up the valuations of dot.coms.''

How vested interests were
responsible for higher valuations

In retrospect, the valuations were supported by vested interests, which needed an exit route at high prices. That is clearly evident from events during the heady, dizzy days when valuations were skyrocketing through the NASDAQ a few months ago. Both in the Silicon Valley and in India, there was a mad rush to close deals in record times. Says a venture capitalist based in San Francisco (US): ''Decisions that would require a few months, were being taken in days.'' Adds Beerud Sheth, the 33-year-old co-founder of elance.com, based in the Valley: ''It was greed and fear that was driving the frenzy.''

The greed came in the form of profits that could be made as venture capitalists eyed minimum returns of 30 times their initial investment by selling the shares at a huge price after the Initial Public Offering (IPO) of the company. McKinsey called it the ''insider's game'' being played to achieve the first-day ''IPO pop.'' That's when promoters, venture capitalists, and merchant bankers keep the supply of shares below the hyped-up demand to achieve a jump in scrip prices on the first day of listing. That attracts new investors, which further pushes up prices in the short-run and allows a profitable exit route.

According to an article in the McKinsey Quarterly, the share prices of 175 tech companies that went public in the first nine months of 1999, closed on their first trading days at levels that were, on an average, 77 per cent higher than their IPO prices. Unfortunately, by end November, 1999, the shares of these companies stood at a mere 8 per cent above their first-day jumps, which means that while the so-called insiders made a killing if they sold off their stake, the common investors saw minimal gains. This trend has not been witnessed in India as no dot.com has yet gone public.

But the greed in India manifested itself in the form of a fear; the fear that deal-makers would be left out if they refused to play the valuations game. Since during the boom too much money was chasing too few companies, it became imperative for the venture capitalists to push for high valuations without asking the right questions. Explains Rashesh Shah, 36, CEO, Edelweiss Capital, which has financed or advised 35 Net start-ups: ''In the old days, if you asked too many questions about business models or revenue-streams, the promoter would ask you to join the end of the (financiers') queue.''

Obviously, everyone wanted to be in the front. That eagerness only fed the frenzy. With each new deal, a new price-benchmark would be set. And with each new benchmark, the next deal would be pursued at higher valuations. In fact, some of the promoters that BT met actually worked backwards to arrive at a price once they had decided how much money they required and how much stake were they willing to part with. As one of the consultants succinctly put it: ''It was like the M&A deals in the 1980s where you fixed the price first, and justified it later.''

Why dot.com valuations will come
down to realistic levels now

Until now, the basis for arriving at realistic valuations of dot.coms was neither art nor science; it was more of a game. A game that was enthusiastically played by all the players with the same vigour and energy. Today, there is a sense of sobriety. Explains Bhasin: ''Equity fund managers have become wary of dot.com ventures.'' Agrees Ravimohan: ''Now, revenue-streams will become important. So, rather than the number of subscribers, one will need to check whether the eyeballs will run away once a company starts charging a fee for its hitherto free services.''

True, since dot.coms will now be forced to show profits faster-in five years, as opposed to the earlier 8-10 years. Therefore, crisil is trying to evolve a model based on the elasticity of demand for the eyeballs attracted by each site. That will instantly lead to a segregation between the good and the bad companies. This has happened to some extent in the Silicon Valley. According to The Economist (February 26-March 3, 2000), nearly three-fourths of the Net-related IPOs that have hit the US markets since mid-1995 are quoting below their issue prices. Another study stated that only 20 per cent of tech stocks accounted for 80 per cent of the net gains in the S&P Index in 1999.

Even the yesterday's stars are losing their lustre today. In January, 2000, when the US-based Lucent Technologies hinted that its financial performance in the coming quarter wouldn't be up to expectations, the scrip crashed. In fact, the company was forced to announce that it was demerging three slow-growing divisions to maintain higher growth rates. And its competitors were forced to issue press releases stating they will not face the same fate. Around the same time, when AOL took over Time Warner, the former's scrip fell sharply since investors perceived slower revenue growths in the near future.

Clearly, there will be both winners and losers in the dot.com revolution. The ''you ain't seen anything yet'' logic to explain the Net hype is a compelling one. For, the World Wide Web will definitely inflict cataclysmic changes in the global business arena. But, according to Memani, the companies that will fall by the wayside could account for 80-90 per cent of the dot.coms that enter the fray. If that's true, investors will need to become choosy and think twice before joining the virtual herd. Else, they could burn their fingers while dabbling with the fiery-hot tech stocks.

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