What Causes Internet Companies To Fail?

Do you want to own a company that analysts value in the millions, with a product used by people all over the globe, which becomes a cultural phenomenon overnight? Start a social media site. The past decade has seen a new class of dotcoms that offer people a new way to connect to each other and spread information, and coupled with the massive proliferation of mobile technology, these startups have become a ubiquitous presence in the daily lives of people worldwide.

While the omnipresence of social media may give the uninformed the impression that they are massive "cash cows," the fact is that many of these companies fail to maintain a sustainable following after a few years.

While this frequently touted web 2.0 period has transformed global culture into one that embraces constant connectivity, the financial longevity of the companies born in the past few years still remain to be seen. Investors who endured the turbulence of the late 90s dotcom bubble are undoubtedly the first (and perhaps the most vocal) critics of this new wave of companies with bold ambitions but thin financials - and justifiably so.

Early dotcom companies operated on venture capital while offering their products for free in hopes of later profiting from brand recognition. Now, many companies have adapted business models wholly dependent on ad revenue (such as Facebook), with some companies offering additional content access - or simply the removal of ads - for a small premium, while offering services to consumers free of charge.

The primary purpose of a business is to provide a good or service in exchange for money, and many web 2.0 companies fail to fulfill half of that equation. The NASDAQ 100, an index comprised of 100 of the largest companies on the exchange, is full of tech companies, many of which operate under this simple financial formula. Even companies such as Blizzard Activision and EA Games, which debatably provide no economic benefit to their consumers, provide a tangible good. Though they may not grace the ranks of the DOw Jones Industrial Average anytime soon, questions regarding their ability to generate revenue are far from the mouths of critics.

Unlike video game companies, where the product is video games, the product for social media sites is you. Without charging members use of services, social media companies depend on targeted ads located in the margins of pages to earn profits. Thus, without your information and eyes on the page, the company loses money. If the site fails to maintain a strong user experience, or becomes unfashionable to use, the decline in traffic equates proportionally to the decline in ad revenue. A company with revenue streams that sensitive to trends is unlikely to last.

The Bottom Line - A business philosophy of providing free service is obviously a red flag for traditional investors when analyzing future earnings. Despite the popularity and ubiquity of social media in today's culture, in the grand scheme of the markets, nebulous services like allowing users to drench their phone photos in sepia or broadcast the contents of their breakfast in less than 140 characters, are likely passing fads. Without a long-term commitment to keeping users coming back to use your services, as well as a sustainable model where revenues aren't entirely dependent on whether something is trendy, investors should approach these companies with skepticism before sinking money into them.

Source:  Investopedia

The information contained in this article does not constitute a recommendation, solicitation, or offer by D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.

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