Are we heading towards another internet crash?

Tudor Aw looks to history – the manias over the steam train revolution and the boom – for lessons on how companies can avoid becoming victims of a digital bubble
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Stockton and Darlington may seem an unusual place to begin exploring the potential pitfalls of the digital revolution, but as the birthplace of the railway revolution, it provides a context for some alarming parallels to be drawn.

September 1825 saw the first passenger steam train chug along the Stockton & Darlington railway line. In the period that followed, entrepreneurs flooded the market with speculative investment in new railways, all hoping to capitalise on this new technology.

By 1845, a full railway mania was underway. More than a dozen new schemes were being launched a week, attracting investors from all walks of life. Many of these investors knew little about the transport industry, but entered the fray expecting extraordinary returns, even on essentially unviable projects. The recklessness prompted a prominent judge of the time, Lord Cockburn, to comment that "the country is an asylum of railway lunatics".

Overcapacity ultimately burst the railway bubble. There were widespread bankruptcies, and an economic collapse that affected much of the country.

Fast forward 160 years to the beginnings of a new digital mania. Keen to take advantage of digitalisation, companies are entering new, uncharted areas of business. News Corp bought MySpace for £300m; Microsoft is in the process of purchasing the internet advertising firm aQuantive for a spectacular £3bn.

There has been unprecedented consolidation not just in the media, telecom and technology industries, but among publishers, music labels and gaming companies. In the last month alone, the US online video syndication specialist Brightcove announced content deals with Emap, IPC Media and Hachette Filipacchi UK for video clips on websites; Channel 4 and Emap announced a joint venture aimed at creating a music TV provider; and Facebook bought Parakey, a site that is yet to launch, which aims to be a web operating system that bridges online and offline content.

Digital is rapidly becoming a strategy cornerstone in the new world economy. Just last week, Dow Jones Venture One data announced that venture capital investment in information services companies, including internet companies, has reached nearly $1bn (£493m) for the first time since the blowout seven years ago. Indeed, the amount of worldwide venture capital invested in internet company deals has doubled every year since 2002.

There is no denying digital revenues will be key for all companies over the coming years. The figures speak for themselves. Mobile music accounts for approximately 40 per cent of record company digital revenues. Online advertising enjoys a return on investment of 26 per cent, compared with 17 per cent for magazines. Global online advertising revenue is forecast to increase from $25bn in 2005 to $55bn by 2010. The list goes on.

The existence of a "digital bubble" has yet to be proven. However, similar warning signs to those present in the rail and bust are already identifiable: investments based on speculation rather than economics; unproven business models; overheated prices; and capital in excess of available assets.

Obviously, many deals are too recent to know if they will succeed. But we need only look as far back as the collapse to find sobering examples of disastrous online investments. US flops such as and were classic cases of spending outweighing income. Fashion website, a high-profile UK failure, suffered due to its complicated, slow website and rife mismanagement (although the domain name has found new life after relaunching as a travel site).

Unlike the bust, the impact of a digital bubble may go beyond the financial loss associated directly with any one digital venture. Frequently, digital initiatives also impact an organisation's existing business.

For example, digital music is effectively a replacement for physical CDs, and digital TV channels may be seen as cannibalising existing analogue channels. The risk should therefore be seen as both financial and operational, and may threaten existing "old world" business models. So should companies back away from digital initiatives given the risk that a digital bubble poses? Again, history provides a clue. Previous technological revolutions suggest that hiding is not the answer. Instead, the key is to ensure that you understand what it takes to be one of the survivors who enjoy the sustained growth that typically follows a crash.

After the rail backlash, the surviving operators went on to enjoy a golden period of sustained growth and profitability. Similarly, while the burst of the bubble caused the failure of hundreds of start-ups, it also gave rise to some of the world's top companies, including Amazon, Yahoo! and Google.

Past technology revolutions suggest that there are two key factors that help companies survive burst bubbles. First, successful companies tend to ensure that they make their technology relevant and easy to use, rather than just promote its inherent qualities. The companies that survived the railway revolution, for example, did so by focusing not just on building new routes, but by providing toilets, new dining cars and better suspensions on the carriages.

Similarly, websites such as Amazon, eBay and iTunes are all notable for their functionality. The iPod, too, provides not just mobile music but a great customer experience.

Second, companies need to focus on operational execution. All too often, management attention is on strategy and the excitement of launching or acquiring new business ventures. The more mundane task of meeting customer requirements can get neglected. One of the failings of the original was that it spent a great deal of time and money marketing itself as a global company, yet wasn't sufficiently prepared to deal with all the different languages, pricing and tax structures of the countries it aimed to serve. And just this month, Amp'd Mobile, a US start-up looking to provide mobile entertainment, announced it was closing for the mind-boggling reason that its back-end infrastructure was unable to keep up with customer demand.

Companies must develop a structured and rigorous approach to identifying, prioritising and managing digital challenges. All considerations pretty much fall into seven categories: strategy, security, licensing and rights management, managing third parties, finance and accounting, sales and marketing, and operations. By approaching this age with a clear strategy – and learning the lessons history has taught – investors and companies alike can limit their chances of becoming victims of a burst digital bubble.

In the meantime, perhaps we should consider the words of Bill Gates. Speaking at the recent World Economic Forum in Davos, Gates summed up current trends in internet valuations thus: "There's this other manic depressive on the side who's valuing [companies]. In 2001 he wasn't taking his medicine at all. Maybe he's a little bit hallucinating now?"

Tudor Aw is a convergence partner at KPMG and author of the new report: 'The Digital Bubble: Balancing Operational Challenges wih Growth'