The Man Behind the Curtain and the New Keiretsu:
A Closer Look at the Internet Equity Frenzy

by, Barclay T. Leib

June, 1999

It was almost quaint to see Californians gripped by Lotto fever for a mere $80 million this week. For most of the past three years the stakes have been much larger as Californians have been purchasing tickets to the ultimate national lottery: shares of internet stocks. Silicon Valley computer programmers quite regularly wager a job-hop for newly minted stock options, and then, using their high-speed office IP connections, trade their ever-more volatile portfolios for small Palo Alto lots at $140 per square foot. To build their new dream houses, they contract for a wrecking ball, and then tear down someone else's original idea of the American Dream.

Now the technological advances that the Internet brings are of great significance and importance. There is something very real going on here: a technological jump that will indeed change the way we live in the years to come. The business press and sell-side analysts may call the current national obsession with the Internet a "mania," but it is unlikely that this "mania" will be of the same variety as the South Sea bubble or the Tulip Bulb craze. Instead, it would appear to us that a fundamentally important technological event is being exploited by a select group of insiders, and analysts are spending far too much time discussing the effect of the Internet stock craze, rather than some of its root causes. Much ink and analysis has been wasted on showing how the thinly floated issue, when rapidly traded among the keyboard cognoscenti, has the obvious consequence of prices going up and occasionally (or eventually) way back down. Less has been written about how we get to this point in the first place and how, allegorically, the flea market dealers swap the garage sale chair among themselves until it magically turns into a pricey antique for public consumption.

At best, this current approach by the popular media is laziness masquerading as cleverness. At worst this is actual cleverness obscuring the rules of the insider's game. It's an intellectual sleight-of-hand in the service of commissions and the next fee. In Wizard of Oz parlance, its akin to saying, "please pay no attention to the man behind the curtain."

But there is a man behind the curtain. There always is. State lotteries and the current search for the greater fool are, of course, not random events, but rather highly sophisticated exercises in marketing. Given the public's known propensity for greed, the man behind the curtain has both the knowledge and the tools to induce it. Every once in a while (just as there is a statistical certainty that millions of Californians won't pick the same six numbers that pop out of the lottery commission's random number generator for weeks in a row and create a giant jackpot) the conditions appear that allow a fundamental trend to become a short term excess.

To examine causes, it helps to know the goals of these marketers. State lotteries are, of course, voluntary tax systems that market the word "voluntary" to the exclusion of the word "tax." The lotteries are marketing case studies, rapidly introducing new products, developing vast, low-cost distribution systems, binding their distributors to their customers through sharing the jackpots and incessantly advertising on billboards, TV, radio and point-of-sale.

Venture capital firms, the source of the product from which the recent Internet frenzy takes its force, are in the business of selling stock at higher prices than where they bought it. Buy low, and just sell a little higher. They are not about creating "insanely great" products, building lasting enterprises, fostering innovation or mentoring entrepreneurs. Sometimes venture capitalists do these things; sometimes they just talk about them. Action or lip-service, it's all just part of the marketing. It's the new company as a vehicle for a stock offering that is important. It's all in service to the goal. And the goal is to make money. The way venture capitalists make money is to sell you their stock.

Kleiner Perkins and the New Keiretsu

This leads us to the current venture capitalist media darling--Kleiner, Perkins, Caufield & Byers, a firm that has been around since the early 1970's, and seemingly has a finger in almost every Internet stock offering one hears about. On their website, they boast of an alliance among 175 some companies between which there is "significant collaboration," all led by the Kleiner Perkins team of venture capitalists. Kleiner Perkins has even given this network of companies who share information and knowledge a fancy buzzword. They call it a "keiretsu," in reference to the modern Japanese network of companies linked by mutual obligation. But whereas the Japanese version of keiretsu is now very much on the waning side of popularity, having been partially responsible for Japan's current depressed economic state, the Kleiner Perkin's keiretsu has seemingly been able to do no evil to date. If one part of the keiretsu gets into trouble, it appears another part of the keiretsu is always there to lend a helping hand. One is reminded somewhat of the Michael Milkin days of junk bond offerings where one Milkin sponsored company would quite often buy the debt of the next Milkin sponsored company to come to market. Let's take a closer look at how Kleiner Perkin's keiretsu of interlocking ownership, self-trading and incestuous management has been dressed up for stock selling consumption.

The Netscape Stumble & Excite Deal

One doesn't need a particularly long memory to find a singularly good example of the keiretsu in action. Back in the spring of 1998, Netscape, an original Kleiner Perkins financed browser company, found itself in fierce competition with Microsoft Explorer, Microsoft having itself yet to feel the full force of the government's antitrust efforts. Netscape was looking increasingly like a loser. They were continuously losing market share for their previously popular home page to Microsoft and others. Netscape had previously sold access to Yahoo and Excite search engines on their page for a fee to both companies of some $5 million apiece. But as the popularity of these search-engine companies grew on their own, they actually needed Netscape less and less. The portal offspring were largely biting the hand that originally fed them, complaining that the fees Netscape required were too high and would not be renewed. In a word, Netscape was getting squeezed out on both sides of its business, Microsoft on one side and the search-engine portals on the other, and Netscape itself desperately needed a new strategy. Enter Excite, another member of the Kleiner Perkins keiretsu, to the rescue. Previously one of the loudest complainers about Netscape fees, Excite suddenly turned around and signed a "co-branded services" agreement with Netscape, providing Netscape with Excite technology to re-engineer their home page as a full Internet portal, not just a browser. Better yet, Excite actually agreed to pay Netscape $70 million, plus warrants valued at $16.1 million for Excite stock, as an advance on future advertising revenues that their joint venture would supposedly create.

Excite In Turn Leans on Intuit...

Now this was a pretty sweet deal for Netscape, and Wall Street cheered the entry of Netscape into the sexy web-portal business. Was it surprising that Excite was to pay 600% more for somewhat better placement on a service that it had previously said was not essential to its business strategy? Maybe Excite had previously just been negotiating. Was it surprising that Excite only had a little more than $25 million in cash the month before it made the deal? Not given the "I will gladly pay you tomorrow for a hamburger today" financing mentality of the 'net. Excite simply turned to another member of the Kleiner Perkins keiretsu, Intuit, for a $50 million bridge loan, with Intuit (albeit a large stockholder in Excite at the time) suddenly deciding to get into the investment banking business. It lent the money to Excite for the Netscape deal even though Excite didn't have a prayer of repaying the money from actual operations.

...Before Excite then Sells More Stock To the Public

But then the really fishy stuff began, even within the same month that Excite signed the Netscape deal. Excite suddenly announced that it would write off $56.8 million or about two-thirds of the consideration in the Netscape deal, in effect announcing to the world it had grossly overpaid for its rights. Then in the midst of mania, Excite just sold stock, raising $84 million in a secondary offering. Excite, in its business wisdom, had just turned a dollar into three dimes and some pennies in a little under a month, but investors were still willing to send them more money, obviously not paying close attention to the offering prospectus where these gory details were explained. What these new investors obviously didn't know, or appear to know, was that their new equity cash injection was keeping not just a couple of companies alive, but the ever-increasing stock dreams of the investors who had come before. Mr. Ponzi take note.

Then @Home Rescues Excite

With a bleeding core business and the prospect of a few more keiretsu-inspired wounds, Excite probably was told by its real investment bankers to start looking for a new donor. Eight months later, the Company signed its premium-priced merger agreement with @Home, another Kleiner Perkins keiretsu member. According to the New York Times, this merger occurred despite the very board of @Home questioning the wisdom and rationale for the merger. But really, was there ever any question? Who wouldn't want a merger that valued the combined entity at nearly $20 billion, and Excite itself at $7 billion, when Excite had an accumulated deficit of some $143 million just two months before. @Home was just the latest recipient of the Excite hot potato, another strategic deal to camouflage the mistakes and excesses of the past, and another way to assuage shareholders and to keep the overall Internet game going.

And our other characters? Netscape ended up being dismembered by other keiretsu members AOL and Sun. While Bill Campbell, Intuit's former CEO has been rumored to be starting a new company with Mike Homer, one of the architects of the Netscape/Excite deal. In the trade press accounts it was mentioned their relationship goes back to Apple, conveniently overlooking the fact that these two individuals actually worked together in a Kleiner Perkins funded company known as Go, Inc. that was a disastrous effort to launch an early Palm Pilot type product. Where do you think these fellows will look for funding this time? We'll lay even money Kleiner Perkins pops up behind the scenes once again. Follows a Questionable Path

Perhaps inspired by Excite's example, fellow Kleiner Perkins-funded venture, has turned to the public for debt to play its own hand in the stock appreciation game. Having for a time gotten sell-side analysts to parrot the line that it doesn't matter how much money the company loses in the name of market share, Amazon has figured out even better ways to use cash at prodigious rates. They have obtained a bigger bankroll via an issue of $1.25 billion of convertible notes launched recently for a 10-year term, a 156.05-strike price, and a 4.75% coupon. They will be paying over $59 million in real interest for each of the next ten years. How do they plan on making it back? Well, through buying stock of course, preferably among the keiretsu. There are the "strategic investments" in,, and for a reported total in excess of a year's interest payment. But unlike some recent acquisitions, these investments are in cash, rather than Amazon's own stock. What are they going to get for their investment? The dividends? One must question that if Amazon has gained all this amazing brand equity through marketing and its consequential operating losses -- why must it now invest in other companies that will have to build their own brands through further losses? Why doesn't Amazon just start its own pets, drugs, or grocery section? It seemed to work for their auction plans against eBay. Or can identify friends and foes by their Kleiner Perkins venture capitalist shoguns? Is Amazon being used to keep the latest leg of the Internet feeding frenzy alive? Among Amazon's latest acquisitions (this time for newly filed stock) one finds Accept.Com, another Kleiner Perkins-funded company that as recently as May was still preparing to announce their first product "to simplify business-to-consumer and person-to-person transaction over the Internet." Whatever it was they were working on, it would appear that wasn't successful enough to even make it to the IPO stage by themselves (or Kleiner Perkins would have surely launched them in the current environment), so has conveniently come along to scoop them up.

No Major Casualties Yet, but History Is Against Keiretsus

To date, courtesy in part to the Kleiner Perkins keiretsu, there have been few real Internet horror stories. Even after all of Excite's and Netscape's fun and games, there basically has been a happy ending so far. One thing is clear, however. When every Lotto ticket you buy is a winner, hubris only looks like chutzpah. Historically, venture capitalism has sported a hit-miss ratio of some seven or eight misses for every hit. When the otherwise sophisticated investors and managers decide that they can do better than this using even more leverage, and their own inner circle of keiretsu incestuous inter-dealing, hasn't the man become tangled in his own curtain? Maybe they should ask themselves the same question Internet fund buyers in April have been asking: "when is it enough?" Kleiner Perkins is a brilliant firm that has produced brilliant results. But so too did the Japanese keiretsu up until 1989; so too did Michael Milkin's gang of debt-leveraged companies that blithely followed their junk-bond leader, until that keiretsu like others eventually came tumbling down.

The author wishes to thank sources in Silicon Valley who greatly contributed to the above article, but who otherwise wish to remain anonymous. Copyright 1999 Princeton Economic Institute

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