So is There a New Tech Bubble?

The short answer is yes. The longer answer is: depends how you look at it.

There has been a lot of discussion recently of the insanely high valuations of web startups. It’s an entrepreneurs market again, with Venture Capital firms fiercely competing for deals. They often do so by offering ever-higher valuations for companies with little or no revenues, and at least in some cases, without even a clear path to revenues.

Are many of these young companies highly overvalued? you bet they are. From a startup valuation perspective, the bubble is definitely out there. These startups will have to reach significant revenues to exceed these valuations in their next round of financing or get acquired for a descent amount. As the bar is set so high by current valuations, most startups will probably fail to deliver.

But why isn’t that a real bubble? The answer is pretty simple: most of these crazy valuations and cash infusions are given to private companies by other private companies.

During the happy days of 1999, almost everyone with a brokerage account took part in the party, investing like wackos in companies with horrible business models and broken fundamentals. When these companies ran out of money, the stock market crashed and the whole world took a hit. The hangover was painful and lasted for year.

Nowadays however, IPOs are far, far away for startup companies. Unlike 1999, you need to have a real business, with real revenues, and I would even boldly mention a non-startup-friendly term called profits.

So who is going to pay the price for this bubble?

First and foremost – founders and employees. If these companies will be forced to raise capital at a lower valuation than their previous round of financing – founders and employees will be heavily diluted. Same goes if their startup gets acquired for a valuation lower than the last round of financing. VCs put various protection mechanisms in each financing round, and are the first ones to take money off the table (usually, with a 2x-3x multiple). In many cases, little will be left for the people who devoted years of their lives to the company.

Second in line are the VCs. Even if a company is still private, down rounds are written in VC books as losses. No one wants to show too many loses when he tries to raise money for his next fund. Personally, VC partners will also experience a financial disappointment if their fund can’t show nice returns. The management fees are pretty generous, but the real personal home run for partners is the 20% share of their investors profit.

Then, you have the suckers. Big companies (Yahoo, anyone?) that buy hot startups for crazy valuations that cannot be justified economically (eBay buying Skype for ~$4B, AOL buying Bebo for $800M only to sell it for $10M a year later). For some reason, it seems that most of these crazy acquisitions take place in California, where medicinal weed is legal.

Finally, us. Many of our pension funds are diversifying their portfolios by investing in Venture Capital. Losses for venture capital firms will represent a loss to our personal pensions. However, as the allocation to the venture capital class is relatively small (and keeps decreasing as the venture capital asset loses its positive sentiment), its direct effect on ua will be minimal.

So, from a personal finance perspective, there is no real bubble. It’s really just a redistribution of wealth: The pension funds invest our pension money in VCs, who keep 20% and invest the rest in startups, who in turn offer higher salaries to young, talented engineers, who can now drink higher quality liquor on Friday nights. I bet the average income per shift of a waitress in Silicon Valley went up at least 20% in the previous 12 months.

Nevertheless, the price we will pay as a society may be harsh: We need startups to create innovative products and technologies that will make out lives better. The startup eco-system is critical not only for the stock-options-hungry engineers from Silicon Valley, but for our everyday lives. Startups are a critical part of the evolution process that optimizes and improves the world we live in and we must make sure the people who supply the fuel to these innovation labs (i.e., the VCs), act reasonably enough as a group to allow the eco-system to thrive.

2 thoughts on “So is There a New Tech Bubble?

  1. I think the net effect on "products that make our lives better" is close to zero.
    The real significant products get created in *any* kind of conditions. Many of the bubble-type acquisitions are of companies that actually created very little or no lasting value to real people.
    If anything, the drop in the price of doing business (which is of course unrelated to a bubble) will have a positive effect on the pace of actual valuable products/technology.

    Like

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