The Dot-Com Crash

1. What is the intended role of each of the institutions and intermediaries discussed in the case for the effective functioning of capital markets?

Venture Capitalists

VCs have several intended roles in order for capital markets to function effectively. First of all, VCs provide needed financing for startup companies and, also, build strong platform for further financing. Since it is difficult for new companies to raise capital in public markets, VCs are necessary intermediaries. Another role of VCs is to determine good business models and ideas worth investing from bad ones. They need to identify startups that have high potential to become great solid companies and provide high returns for their investors. Therefore, most venture capitalists are savvy professionals with the backgrounds in corporate finance, investment, and management.

Investment Bank Underwriters

Main role of investment bank underwriters is to provide their expertise and financial services, such as price IPO or underwrite shares, when a company wants to go public. In addition, since most investment banks are well-known institutions with good reputations they play significant role in introducing new companies to investors.

Sell-Side Analysts

As the name speaks for itself, the central focus of these intermediaries is to conduct and then publish research on public companies. A sell-side analyst closely studies a company of interest and based on his or her findings makes a recommendation to buy, sell, or hold this company’s stock. It is challenging tedious process requiring specific knowledge and considerable amount of time devoted. Many investors have no such expertise and thus rely greatly on analysts’ recommendations. As Paul-Choudhury correctly noted in his article "Option Bubbles" “if analysts with Ph.D.s find it difficult to price real options, investors who know nothing of quantitative finance are in quite a predicament”. Thus, I consider that these intermediaries have a great influence on investors’ decisions and play enormous role in capital markets. In order for capital markets to function effectively, sell-side analysts should do their best in order to provide the most accurate and reliable information to portfolio managers and other investors.

Buy-Side Analysts and Portfolio Managers

Buy-side analysts have the same duties as sell-side analysts – to research and valuate companies – though, quite a different role. After the valuation is done, buy-side analysts do not publish their recommendation but represent them to portfolio managers. Acting on behalf of investors, portfolio managers, in their turn, eventually buy stocks that they consider, based on analysts’ recommendations and their own judgment and experience, fairly-priced or undervalued; or sell stocks that appear to be overvalued.

Accountants and Auditors

The key role of independent accountants is to audit financial statements of public companies to make sure their accurate, compliant with established standards, and free of fraud. Both individual and institutional investors rely extensively on auditors’ opinions. An unqualified opinion gives confidence to investors that financial statements of a company have been presented fairly and that investors can trust the information represented in those statements. On contrary, modified, qualified, or adverse opinion would give investors a reason to think carefully if they should invest in a company.

The Financial Accounting Standards Board, Securities and Exchange Commission, and the American Institute of Certified Public Accountants

The FASB is an autonomous regulatory body independent of all other business and professional organizations. The duty of the FASB “is to establish and improve standards of financial accounting and reporting that foster financial reporting by nongovernmental entities that provides decision-useful information to investors and other users of financial reports” (www.fasb.org). SEC and AICPA, in their turn, officially recognize those standards as authoritative. “Such standards are important to the efficient functioning of the economy because decisions about the allocation of resources rely heavily on credible, concise, and understandable financial information”(www.fasb.org).

The Media

Investors receive their information through many different media sources such as TV, web, and financial press which can be very influential. As Miranda Ferrara and Michele LaMeau describe in their book Corporate Disasters: What Went Wrong and Why “people became swept up in the dot-com frenzy, which was often fueled by success stories reported in the media about someone who started an Internet business in a basement or garage and a few years later sold the business for millions of dollars.” It is obvious that media can have tremendous influence on general public and particularly on individual investors.

2. Are their incentives aligned properly with their intended role? Whose incentives are most misaligned?

The main income source for venture capitalists is a large share of a company profits (usually 20%) as well as relatively small management fee. I consider this to be a properly aligned incentive because the compensation directly depends on how well the company will perform. On contrary, investment bank underwriters make considerable commission (usually 7%) on the funds a company manages to earn on securities offering. What happens after is of no big concern for investment bank underwriters since they have already made huge profit. Therefore, this would be the most misaligned incentive, on my view. Sell-side analysts made their money from trading revenues they generated, as well as, from published rankings. In addition, some analysts received compensation from investment banking fees. From all of these incentives the latter has a potential to jeopardize analysts’ rankings and their “buy” or “sell” recommendations. The compensation incentives of buy-side analysts and portfolio managers are accordingly aligned with the interests of investors meaning that they make money when investors make money. The downside here is, as we could see from the Dot-Com Crash study, they could have recommended and bought stocks simply because they knew it would go up although at the same time they also knew that those stocks had been tremendously overvalued. Accountants and auditors charge fees for the work they perform. These fees do not directly depend on what kind of opinion is issued and on how well the company being audited is doing. Investors rely heavily on auditors’ opinion while making their investment decisions especially on opinions of audit firms that have good reputation for long time. Media, another important intermediary which has enormous influence on investors, has its incentives seriously misaligned with its role. Financial newspapers, “Money” sections in regular print, business channels, and broadcast networks all made huge profits during the Dot-Com hype covering successful “new economy” stories, inducing positive expectations and predictions, and, therefore, encouraging investors to buy overvalued stocks.

3. Who, if anyone, was primary responsible for the Internet stock bubble?

After the Dot-Com Bubble has burst, of course, there were fingers pinpointed right and left at many intermediaries that played their role in fueling the dot-com hype. I do not think that we can choose only one responsible for the crash. Obviously, venture capitalists were the one who supported and invested many questionable startups with bad business ideas while being blinded by huge profit expectations. As well as, investment bank underwriters that made a fortune on IPOs of dubious internet companies. Sell-side analysts also had a great part in the crash making positive predictions about stock prices instead of analyzing traditional economic factors such as sales and revenue, profit margins, and earnings per share. And of course, overly optimistic individual investors hungry for quick profits made the bubble even bigger by making poor decisions to buy highly overvalued stocks.

4. What are the costs of such a stock market bubble? As a future business professional, what lessons do you draw from the bubble?

The cost of the Dot-Com Bubble was tremendous. Investors lost a lot of money when stock prices fell. Many internet businesses went bankrupt and disappeared almost overnight. Employees lost their jobs. Many lawsuits were filed against investment banks, brokerage firms, individual companies and their executives. Investors trust in supporting institutions and intermediaries in capital markets has been notably shattered.

There are several important lessons to draw from the Dot-Com Crash: * It is necessary to study business idea and evaluate if it has a profit-making strategy; * It is vital to analyze traditional economic values of a company; * It is important to evaluate long-term prospects for company growth; * Do not let short-term high profits blind you; * Be realistic.

Works Cited List www.fasb.org. 26 Aug. 2012;
Paul-Choudhury, Sumit. "Option Bubbles." Risk Management Oct. 2001: 8. Gale Biography In Context. Web. 26 Aug. 2012;
Starr, Paul. "Thy Kingdom Dot Com." The American Prospect 11.12 (2000): 6. Academic OneFile. Web. 25 Aug. 2012.