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by Bob Hiler
For two years during the Internet Bubble, I worked as a Wall Street analyst in Frank Quattrone's CSFB Technology Group covering Internet stocks.
When the bubble burst, research analysts like me got a lot of heat for playing such a central role in the Internet Bubble. I didn't mind the heat--but for a long time, I didn't understand how the bubble had worked... and that really bothered me.
In the aftermath of the bubble, it's easy to point to empty income statements and weak balance sheets. But in the early days of the bubble, these companies blew past every single earnings estimate that anyone put out there. Even skeptics watched in wonder as these companies grew to generate millions and then billions in revenue.
Where did all the money come from? I struggled with this question for a long time, finally writing out the criteria for the ideal answer:
And then it hit me: the Internet Bubble was a pyramid scheme.
PYRAMID SCHEME 101
I got my first lesson on pyramid schemes in high school. Leafing through the local paper one day, an advertisement caught my eye:
Are you a hard worker? Want to make money working from home? Call Susan at 703 XXX XXXX to set up an interview.
After years of boring temp work, this sounded like it was worth taking an afternoon off to find out more.
When I got to the company for my interview, I found out that there were lots of other interviewees. In fact, while we waited for the boss to arrive ("from a big regional sales meeting!"), we all crammed into a conference room to watch a video on the company. It wasn't clear what they did, but the video made clear that everyone made a lot of money doing it.
At this point I was pretty curious, so I stuck around until the boss got back. After hearing him talk for half an hour about how much money he had made working for this company, I finally raised my hand.
"I'm not exactly sure what exactly it is that you sell," I said. "Could you go over that part again?"
He smiled as if he'd been waiting for that question his entire life. "Opportunity, m'boy... we sell Opportunity!" As I looked for the exit, he explained how his company worked.
Apparently, I was supposed to go around selling kitchen knives to all of my mom's friends. Meanwhile, I'd also sell my friends on the "opportunity" to become a distributor, so they could sell knives to their mom's friends. In return for becoming incredibly unpopular with my friends, I would get a commission if my friends bought a Distributor's Kit with knives they could sell on their own. If they sold any knives, I'd get a piece of that too.
I declined the opportunity to build my own little kitchen knives empire. But when I got home, I started reading up on pyramid schemes.
WHY PYRAMID SCHEMES ARE DOOMED
As I quickly learned, pyramid schemes are a lazy man's dream. As long as I could recruit my friends to become Distributors for the low, low price of $100, I wouldn't actually have to sell any knives. And if my Distributors sold their friends on the same sucker's deal, I could retire and cash checks without actually selling any knives myself. The boss was right: he was selling Opportunity, not kitchen knives.
This is the key to every pyramid scheme scam: selling Opportunity to new recruits. As long as each level of the pyramid recruits others to the pyramid, everyone generates astonishing returns. But the pyramid's growth sows the seeds of its own doom. If everyone recruits ten people, the pyramid grows at an exponential rate, with each level of the pyramid ten times larger than the one above it.
For our pyramid of kitchen knive Distributors to hit eight levels, we'd have to convince a billion people to buy Distributorships. If we failed (and no one actually bought the knives), then the pyramid would collapse. If you got in early, you probably had plenty of time to cash out. If not, you had some decent kitchen knives, but lost all your money.
HOW DID THE INTERNET BUBBLE WORK AS A PYRAMID?
So was the Internet Bubble a pyramid scheme?
As I've learned about pyramid schemes, I've noticed a few patterns. No matter what the scam, there are four consistent themes to how they worked.
Let's apply these four themes to both kitchen knives and to the digital media stocks that I covered.
HOW DID THE INTERNET BUBBLE GO UNRECOGNIZED?
So, Internet Bubble = pyramid scheme. How the heck did we miss that?
In comparing kitchen knives and digital media, one big difference keeps coming up. The kitchen knife pyramid scheme was carefully designed and built by a centralized founder. In a lot of ways, the digital media pyramid scheme was the world's first decentralized pyramid scheme.
Take a look at the way that money flowed through the decentralized pyramid scheme:
Look at all the players involved:
Each player was acting in their best interests, and yet somehow a pyramid scheme emerged from all of this.
The truth is, this decentralized pyramid scheme was more effective than any centralized pyramid scheme could have possibly been. And this is where Wall Street and the press really contributed, giving society's imprimatur and blessing to something that ended up being a pyramid scheme. Net skeptics like Jonathan Cohen at Merril Lynch were fired and replaced with bulls like Henry Blodget. Even if skeptics kept their job, it's hard for non-billionaires to be taken seriously when Yahoo's shares hit record highs day after day.
Compare this to the historical treatment of pyramid schemes. The SEC and FTC has cracked down on undisguised pyramid schemes for decades, forcing them to the society's margins. The failure on the part of Analysts like myself to pierce the decentralization of the digital media pyramid scheme gave the Internet Bubble the validation - and access to IPO millions - that it needed to suceed.
CAN WE IDENTIFY AND STOP PYRAMID SCHEMES?
Not only is the answer "Yes", but all the heavy lifting has already been done. After all, centralized pyramids have been subject to government regulation for years. Now that we know that decentralized pyramids can happen, we can apply the government's traditional pyramid tests--the FTC's so-called "Amway Safeguards"--to identify and stop illegitimate pyramids.
If a pyramid passes these Amway Safeguards(as Amway, Avon, and Tupperware have all done), then they are highly unlikely to collapse. Rather than tar these companies with the "pyramid scheme" brush, we call them Multi-Level Marketing (MLM), Network Marketing, or Direct Sales companies.
So what differentiates illegal pyramid schemes from legitimate MLM companies?
All pyramids must collapse if the major source of cash comes from the pyramid's participants, instead of selling a good or service. As long as I'm not selling kitchen knives, I'd better be recruiting new members to keep the pyramid going.
However, a pyramid is not doomed to collapse if there's real money coming in. In other words, if my mom's friends are actually buying kitchen knives, maybe this business won't collapse after all. (To be fair, I'm pretty sure this was the plan of the kitchen lnife company whose recruitment session I attended).
Building on this logic, in 1979, U.S. courts established three "Amway Safeguards" to differentiate between genuine MLM companies and illegal pyramid schemes. By applying these tests to the Internet Bubble, we can see whether or not existing laws would have protected Internet investors:
Existing regulations would have served their purpose for the Internet Bubble. The problem lay not in the regulations, but in actually identifying the Internet Bubble as a decentralized pyramid scheme.
WHAT'S THE POINT?
Identifying the Internet Bubble as a decentralized pyramid scheme after the fact may seem like 20/20 hindsight. But I think it's enormously important to understand that many bubbles are formed by decentralized pyramid schemes.
Actually, I've been using "Internet Bubble" and "Digital Media Bubble" interchangeably, but I should probably be more precise. The Internet Bubble was made up of several related bubbles: the Digital Media Bubble, the IT Services Bubble and the Internet Incubator Bubble come to mind. And not all Internet companies were Pyramid Schemes - Amazon, Google, eBay, and Overture are all healthy companies with positive cash flow.
In future articles, I'll take a closer look at these other bubbles, as well as mapping out this generalized theory of Bubble Investing, and how it tells us:
But you don't need any fancy analysis to avoid pyramid schemes yourself. Don't get distracted by flashy technology or the lack of a centralized ringleader. Just ask yourself: are these guys selling Opportunity or kitchen knives?