"Arguing in My Spare Time" No. 3.02
by Arnold Kling January 10, 2000
May not be redistributed commercially without the author's permission.
"when success depends on being able to convince other people to let you take huge risks with their money, it is not the paranoid but the megalomaniac who survive."
--Paul Krugman, "Tiger's Tale," Slate, Nov. 3, 1999
Krugman is referring to hedge fund managers. However, his comment applies equally well to the executives of bubble-financed Internet companies. The enormous market capitalizations of these firms create a sense of obligation and capacity to undertake projects that are way beyond the legitimate scope of the enterprise. This phenomenon is what I call Netscape Syndrome.
Netscape ended up better than it deserved. At the time that it was sold to AOL, I calculated that even a shareholder that bought the stock at its ridiculously high opening-day close of $55 a share made a profit (taking into account Netscape's subsequent split).
AOL has been a very generous buyer of Internet companies. In 1995, it paid $35 million for a browser company called Booklink, which it ended up discarding in favor of Internet Explorer. It paid $300 million for ICQ, an instant messaging company. It paid $1 billion for Mapquest, which is at least 10 times what it would cost to reproduce that company's assets starting from scratch. And this week AOL paid a huge premium for Time-Warner, a company notorious for its expensive failures in the online arena. Of course, as long as its shareholders value size instead of earnings, AOL might as well buy every company it can get its hands on.
Most of Netscape's salvage value was due to a usability defect. Because it is very difficult for inexperienced users to figure out how to change the default home page, Netscape generates considerable traffic to its "Netcenter" web site. These were the eyeballs that AOL paid for.
As a software company, I would argue that Netscape was a failure. In spite of the rewards that its shareholders received in the end, I think it is fair to say that most observers would agree that the company did not succeed in the software business.
The Netscape legend is that it failed in the software business because Microsoft gave away its competing browser, Internet Explorer, for free. Accordingly, Netscape was unable to charge for its browser, which made it impossible for Netscape to earn revenue. This is supposed to be the ultimate example of the predatory behavior of the Redmond monopolist.
The reality is that the most critical market in Web software never was the browser market. It was the market for Web server software. In that market, Netscape failed more dramatically than in the browser market.
In March of 1996, before Microsoft began to compete in the Web server market, the market shares of Web servers, according to netcraft.com, was:
In October of 1999, the market shares were:
In October, 1999, there were 8 million web sites. Each percentage point of market share is worth at least 80,000 web servers (a bit more, since the top sites use multiple servers). Each web site probably upgrades its servers once every two years. Therefore, if you sell server software for $800, you can earn $400 per year.
Accordingly, the market share that Netscape lost in 3-1/2 years was worth $400 times 720,000 servers, or almost $300 million per year. Had Netscape held onto its market share, Netscape would still be an independent company.
One of the many disappointing aspects of Cusumano and Yoffie's book, "Competing on Internet Time" is that it does not mention that where Netscape really lost out was to Apache. As business school professors, Cusumano and Yoffie only can interpret corporate outcomes in terms of the strategies articulated by the highest executives. Since the open source Apache project had no MBA's in charge, Cusumano and Yoffie have no way of getting their arms around it.
The reason Netscape did not hold onto market share is that its web server was not quality software. Contrary to their public pronouncements, Netscape never "ate its own dog food." While Microsoft tested its Internet Information Server on its own web properties, Netscape's web developers never used the dynamic features of Netscape's web server. In fact, Netscape's own web site waited several months until after the production release of Enterprise 3.0 to upgrade from the 2.0 version. Meanwhile, the open source Apache developers kept eating their own dog food and improving the recipe.
I believe that Netscape would have been a stronger, more focused company had it not gone public. They might have focused on getting their Web servers to work. Instead, they became consumed by megalomania, trying both to overthrow Microsoft and to become a media company comparable to Yahoo. The rhetoric was brash and the stock price was high. Meanwhile, the code was junk.
When your stock price reaches a huge multiple of revenues, megolomania becomes almost inevitable. Because you cannot possibly achieve the implied level of earnings in your current business, you extend into different businesses. Hence, Amazon loses focus on its book business and reaches for auctions and small retail.
Another effect of a high stock price is that it makes it appear cheap to acquire other companies. However, mergers and acquisitions are very difficult to execute. Traditionally, it takes years to absorb another company. The Internet does nothing to simplify this process, although it does create a sense of urgency, due to "Internet time."
The effect of the stock market is to create a species that is the opposite of the lean, agile creature that one would think is adapted well to the pace of technology. Instead, we are watching the Internet companies transforming themselves into neo-dinosaurs.