Building the Perfect Dot-Com: Secret Ingredients to Net Success

Wednesday

Adam Lashinsky on the State of the Internet

Dan Colarusso on Internet Growth Projections

Katherine Hobson on E-tailers' Push for Profitability

Catherine Valenti on Ailing Internet Funds

Jamie Heller on Using the Net to Track Net Stocks

Thursday

Tracy Byrnes on the Frenzy Next Time

George Mannes on Self-Hating Dot-Coms

K.C. Swanson on Old Economy Winners

David Gaffen on Measuring the Internet Economy

Friday

Ian McDonald on 'Butterfly' Companies

Justin Lahart on Real Net Valuations

Joe Bousquin on Building the Perfect Net Company

A Dan Gross Opinion Piece: Were the Old Guys Right?

TSC Roundtable on Predicting Six-Month Winners

Roland Jones on The Last Days of Daytrading

Eric Gillin on Working for a Dot-Com

These days, it seems even the best Internet companies lack something. After all, the mighty Yahoo! (YHOO Quote), considered by many to be an Internet company that has done nearly everything right, is having a tough time generating enough advertising revenue to keep Wall Street happy.

So what are the key ingredients of a successful Internet company?

"The companies that have built great enterprises didn't take a lot of financing in the beginning," says Ben Smith, a consultant with A.T. Kearney. "The great ones, like Ariba(ARBA Quote), used customers to finance themselves.

"Traditionally, companies have used customers to finance themselves, instead of the equity markets. In the last few years, we had the opposite. People used the equity market in place of revenue." (A.T. Kearney hasn't done consulting for Ariba, though its parent, EDS(EDS Quote), has an alliance with the company.)

Ariba, which announced that it broke even in its latest quarter, has been cash-flow positive for the past three years. With more cash coming in the door than leaving, the business-to-business software-maker has been able to finance its tremendous growth internally, without having to go back to the equity markets for additional funding.

Ariba also has fat operating-profit margins, a prerequisite to building a good Internet company. Ariba has an advantage because it produces software, which is relatively cheap to develop but can be sold for a high price.

A Good Business?

"It sounds so obvious, but it's really important," said Todd Dagres, a partner at venture capital firm Battery Ventures. "You have to decide, 'Is this a good business?' That's something that, up until a few months ago, had been ignored."

Dagres says a winning Internet company needs to make "contributive margins."

"That means [asking], 'What is the sale of a product contributing to cover fixed costs?'" he said. Many e-tailing dot-coms, in order to win customers, sold products for less than what they paid, which is ultimately a good way to go out of business. And it's part of the reason Dagres thinks eBay(EBAY Quote), which doesn't own the products sold over its Web site, is a better Internet company than Amazon.com(AMZN Quote), which does. (His firm hasn't invested in either company.)

"I would always probably gravitate toward an eBay, because I like the fact that it's very easy for them to get to positive gross margins," Dagres said.

The Network Effect

Good Internet companies also use the Net's "network effect" to get other companies to sell their products. One example is Agile Software(AGIL Quote), said Chuck Phillips, the high-profile Internet and enterprise-software analyst at Morgan Stanley Dean Witter. (His firm has done underwriting for Agile, which he rates outperform.)

"I would say you're looking for a business that has an economic model that grows revenue without costs increasing -- so that if I add an additional customer, that would be an incremental cost," Phillips said. "And getting business partners or your customers to sell your product for you."

Agile, for instance, writes software that enables collaboration over the Internet between manufacturing partners. So if one company that's involved in a manufacturing project buys Agile's software, it's likely to encourage its partners to do so as well in order to get the most out of it.

Some Internet companies have done well with the tried-and-(sometimes)-true "Three Cs" of the Internet: content, community and commerce. Tony Treccapelli, who heads Internet services at Arthur Andersen Business Consulting, heaped praise on Napster, the online music-sharing site, which built a community of nearly 40 million users and then used it to land a big deal with media-giant Bertelsmann this week.

"They built a huge community based on content -- saying it was legal, by the way, because it wasn't for commercial use -- and now they're going to leverage that into commerce," Treccapelli said. "That cloverleaf type of model is something that our clients have had success with." (His firm hasn't done consulting for the company.)

Change

If Internet companies want to survive, they can't be afraid to change, either. That's one lesson that Kevin Hickey, Homebid.com's CEO, has learned in his tenure at the applications service provider for the real estate industry.

"When we first started out with this thing, we had somewhat of an auction model. But when we got together some focus groups to try to prove the concept, we just knew it wasn't going to be successful," Hickey said. "We could have tried to perfume the pig -- I think a lot of people fall into that, because they don't want to go back to the investment community and say, 'Hey, we made a mistake.'"

Hickey changed his company to fit the existing real estate industry, rather than changing the industry to fit Homebid's ideas.

Ariba and archrival Commerce One(CMRC Quote) both started by making software that would buy simple office supplies over the Internet. Now they're aggressively building systems that enable companies to buy more of the complex materials used in the manufacturing process, because that's a larger market.

"They went indirect first, because they wanted to prove themselves," said Jon Ekoniak, B2B analyst with U.S. Bancorp Piper Jaffray. "They went after the low-hanging fruit -- because it wasn't mission critical if you didn't get your pencils, for example, the next day.

"But if they had messed something up with a company's manufacturing supply chain and caused that company to miss its quarter, then they would have never gotten that company to deal with them again," Ekoniak said. (Piper Jaffray has done underwriting for Commerce One but not Ariba.)

"A lot of people know that if they get their plan up and running, they'll take over the world. But they haven't figured out how to get the first dollar in revenue," added A.T. Kearney's Smith. "Once you take over the world, it's easy. Getting that first dollar of revenue is a lot harder."