Why this “Bubble” is Different (The Valuation Bubble)

Editors Note: This article was originally written in early 2011. We are re-running it given the recent events in the tech sector. We also note that the valuation bubble lasted a lot longer than the author of this post would have predicted…


Are we in a Bubble?

Of course we are.

People who live in Silicon Valley and work in or around startups are in a bubble everyday, no matter what is happening.  It happens to be a great freaking bubble though.

What about a startup bubble? Are we in another one just a bit over a decade since the last one burst?

Of course we are.

But this one is different. No seriously, it is.  Here’s why.

In 1999 and early 2000 people were funding businesses that had no realistic chance of becoming big companies, throwing lots of money at them, and then managing to get them public before they had any meaningful revenue to speak of.  The “Internet Bubble” had many people here in Silicon Valley convinced that the world would change overnight and everything was going online, from pet food sales to grocery delivery. One VC we talked with said he started to worry when the fourth website focused on selling sports gear to women came in in the same month, and three of them got funded by someone. It was crazy, the people who purported to be experts were really just hyping their own companies for personal benefit and the net result was that everyone suffered (entrepreneurs, investors, public company investors, economy, etc.).

The 1999-2000 Internet bubble also introduced a lot of people to the the Gartner “Hype Cycle” (http://www.gartner.com/technology/research/methodologies/hype-cycle.jsp#) where the initial excitement about a new category (in this case the Internet) went well beyond the near term reality of what it could deliver and change in a short time frame.  We all rode that curve to the top, and the precipitous drop hit hard and fast, and spread to many related markets quickly.

What no one seemed to want to talk about in 2001 was that the Internet was still around, more and more people were subscribing to DSL and other broadband connections from home, and the average amount of time spent online kept steadily increasing. In other words, as with every hype cycle, while people were running away from the sector as an investment sector, users were steadily increasing their reliance on the Internet and getting comfortable performing a broader range of tasks online (shopping, banking, trading stocks, sharing photos, sending instant messages, etc.).

So here we are, a bit over a decade later, and valuations on unproven early stage companies are going through the roof, respected venture firms like Sequoia Capital are plunking down $40+ million on iPhone apps like Color, and it seems like every investor with a blog is working to espouse their ‘entrepreneur friendly’ credentials by talking up deal terms that few self-respecting investors would accept and few self-respecting entrepreneurs would demand. We keep hearing about $100 million plus financing rounds at billion dollar plus valuations and see individuals and institutional investors scrambling to buy up shares of “hot” private companies on secondary markets.

So, another bubble?  If it is not obvious that we are in a bubble you either are not paying attention to this market, or you have a personal vested interest in seeing the current bubble continue uninterrupted. Those are the only two explanations that make any sense.

The question is, should anyone care?  We say no, and here’s why.

This “Bubble” is very different from the last Internet bubble. There is no longer a question about whether the Internet will take hold and become a resource that the average human being will use on a daily basis (remember, we’re talking worldwide now where ten years ago most of the startups focused on the US only). In addition, the combination of every increasing broadband speeds and improved technology for delivery and display of content have made the experience more compelling for user. And more recently, some really smart (and other really lucky) people have tapped into a latent desire by what appears to be the vast majority of people online to be better connected with a broader range of people around them, and to leverage these connections to learn, debate, share and feel involved.  We’re talking some about some seriously different stuff here people.

On top of this, and more significantly as we consider the current bubble, most of the companies being talked about in “hyped” tones these days, like the ones raising $100 million rounds, are REAL businesses with REAL revenue and previously unheard of growth trajectories. There are not companies like WebVan or Pets.com that are raising tons of money based on virtually no revenue and spending all of it to build out infrastructure in anticipation of growth that will never materialize.  These are companies raising hundreds of millions of dollars because in the span of a few short years since they were started they have grown to billions of dollars in revenue, continue to grow at astronomical rates, and need capital to keep up with the growth that is already happening. We’re not talking about MVP.com, these companies will be some of the largest corporations in the world for years to come (and in some cases already are).

So, what about the bubble?

The bubble we are in this time is a Valuation Bubble. Investors are paying valuations that are far ahead of the reality of the businesses they are funding. In some cases this will work out as the company continues to grow and eventually “grows into” the price paid, but in other cases the businesses will slow down and never justify the prices paid.

So how does a “Valuation Bubble” play out?

Eventually people will step back and look at the Web 2.0 sector and start asking why a company in that market, growing at the same pace and with the same margins as a business in a different market deserves a valuation that is ten times higher. Smart investors will realize they are better off getting out of these overpriced deals and putting their money in other sectors because over the long run these businesses will be valued based on revenue (and revenue growth), net income and cash flow, just like any other.  People will eventually ask what the true market reach can be for a company like Groupon, Pandora, LinkedIn and yes, even Facebook, and will ask whether the business has clear potential to continue to grow at current rates ad infinitum.  People will also ask how Twitter will eventually make money, and whether a potential acquirer for the business will pay a huge premium (over the last round price) to gain access to its users and the data flowing through the system if it cannot figure out how to monetize them.

We don’t know when this will happen, but aren’t expecting to see it happen anytime soon.  There is too much excitement around this sector and too many companies delivering astounding results.  In addition, because the companies in this trend focus on consumers, and consumer investors knowingly or not the famous investing advice of Peter Lynch to “Invest in what you know”, there is a clamboring from the public markets for these shares.

Undoubtedly the public markets will welcome these companies with open arms and upcoming IPOs such as LinkedIn and Pandora will see valuations that are mind boggling when compared to their current results and growth projections. They will likely always retain some sort of premium thanks to the fact they are consumer facing businesses (see Apple and Google for two established examples).  They will deserve to hold this premium, even if over the course of time the massive multiples are hard to justify. As a result, public investors will soon join in the valuation bubble just like secondary purchasers have already done (helping to fuel the frenzy along the way – if you have a million dollars to toss away right now and want to make a splash, find an early engineer at Facebook and offer to buy a million dollars worth of their options at a Trillion dollar valuation. They will accept, and your .0001% equity purchase will cause everyone to believe the business is now worth a Trillion dollars. You’d always be known as the person who got Facebook a Trillion dollar valuation – seems worth a measly million bucks, doesn’t it?).

But at some point down the road public investors will take a harder look at these companies, start asking tougher questions about value versus performance and, without directly intending to do so, will deflate the valuation bubble (for a while).