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Published: February 28, 2007


Lessons of the Last Bubble

By contrast, Wal-Mart achieved its scale over a very long time. Sam and Bud Walton opened the first Wal-Mart in 1962, but only after Sam had spent a dozen years running five-and-dime stores for the Ben Franklin chain. Eight years later, in 1970, Wal-Mart went public with $44 million in sales from 18 stores. It also opened its first distribution center that year. Sam Walton expanded much more slowly and only after proving the profitability of the small-town discount store strategy. Webvan tried to grow rapidly while struggling with the complexity of a highly automated business model and uncertain demand. Even though the model might have proven advantageous over time — with more experimentation — the “get big fast” thinking created a risk profile that was simply too extreme.

The Herd Instinct
Why did so many companies try to be the first mover and pursue a “get big fast” strategy despite the questionable economic and strategic logic of that approach? Part of the blame clearly falls at the feet of the venture capitalists. Venture capitalists play a critical role in the economy by funding business ideas early in the life cycle when the risk of failure is high. By having a portfolio of such investments, venture-capital funds offer extraordinary returns even when only a small fraction of the businesses succeed. In normal times, venture-capital firms view thousands of ideas from passionate entrepreneurs, but generally fund just a handful of businesses each year. Furthermore, they parcel out the money gradually as the companies prove the viability of their business models.

But during the heady days of the dot-com era, the venture capitalists found themselves with a surfeit of money as more and more investors wanted a piece of the action. Although far more projects were chasing those funds than had been the case in past years, the venture-capital firms did not necessarily have the resources to screen all of those ideas with consistent rigor. Since investors couldn’t maintain their formerly high levels of fundamental due diligence at the faster pace of the bubble years, they began to make investment decisions by looking to the decisions of other venture investors. As with the buffalo on the prairie, a few leading examples charging off with abandon can create a stampede. And when no one knows with confidence where to go, the safest path is to follow the herd.

Sociologists have a fancy name for this herd instinct: mimetic isomorphism. They have documented its prevalence in industries as varied as trucking and banking. That research has also demonstrated the rationality of copying others. Although copying rarely produces a breakthrough outcome, it does keep an organization from being left behind. Only a brave buffalo goes against the stampede. And unless that buffalo is extremely agile, it may well be crushed by the herd.

Unfortunately, once the process of mimetic isomorphism gets started, it is hard to stop. The only way to get funding during the dot-com heyday was to identify a new market and promise exponential growth (à la Metcalfe’s Law). That exponential growth required huge funds that siphoned money away from potential late starters who could learn from the initial failures. The “get big fast” strategy produced more losses as companies focused on market share rather than profits. But the venture capitalists — and then the capital markets — agreed to fund the massive investments and simultaneous losses. The only way to avoid the day of reckoning on profits was to continue promising more growth and seeking more money to fund it. Even before it went public, Webvan scored a $1 billion market capitalization by promising exponential growth from a mere $4 million in revenues — less than one-fourth of the annual sales of a single grocery store.

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