By Michael Woloszynowicz

By Michael Woloszynowicz

Sunday, November 21, 2010

Web 2.0 Businesses, a Bubble, a Boom, or Just Crazy?

In the recent conversation between John Doerr and Fred Wilson at the Web 2.0 Summit, the discussion of whether we are on the verge of a new bubble in the internet company investment environment came up. The argument is that time tested standards on valuations no longer apply and even small firms with little more than an idea are getting massive valuations. This conversation has prompted me to think about whether we are in a bubble or boom, what the effects of the rising valuations are, and whether we will see a repeat of the dot com bubble a decade ago?

The Tech Crunch page that featured a video of this discussion had an astute comment from one of the readers who noted the one of the key differences between today and a decade ago is that today we are dealing with private companies whereas in 2000 we were dealing with public firms. Let's begin by carrying on this argument and discussing the differences between these two firm types:
  • Since the firms are private, any damage is contained to a smaller group of investors such as the VC firms and fund participants, angel investors, founders, and employees holding shares or options
  • Private companies do not disclose financials so we can't tell just how inflated the valuations really are
  • Valuations are determined through negotiations with a small group of players whereas public share prices are determined by a large pool of investors in an open market
  • The liquidity of private shares is much lower (although increasing for popular companies) than it is for public shares so we won't see any rapid trading
  • Because of a number of reasons, including high costs, signaling, etc. public firms tend not to issue equity frequently, while private firms often undergo several series of funding so valuation has a profound impact at every financing round
With the above differences it is clear that a bubble would develop in a somewhat different manner than it did a decade ago. The origins of the bubble lie within the VC firms which are seeing the popularity of their funds rising as a result of low interest rates and an improving economy. After the significant reduction in VC investment in 2008 and 2009, they are looking to increase the size of their portfolios and searching for runaway hits in hot sectors like mobile, geolocation, cloud computing, etc. Over the last two years we've seen many announce the death of venture capital as IPO exits were more or less nonexistent. Although IPO activity is still fairly stagnant for a multitude of reasons, VC's are now driven by the prospect of private sale exits. With large players such as Google, Apple and Microsoft looking to expand horizontally beyond their core business, and with an unprecedented amount of cash on hand, VC's are hoping that acquisitions will provide a way out. We're already seeing quite a bit of buyout offers with a potential Google-Gowalla deal looking to be one of the bigger ones this year. Another worry is that we're seeing the liquidity of private shares increasing in the secondary markets which further increases valuations on a wider level. In addition to rising competition between top-tier VC firms, they are also facing competition from a growing number of "super angels" that have become popular thanks to their smaller ownership requirements and lower appetite for go big or go home strategies. Due to their resource dependence, venture capital firms target high potential businesses that can offer 10x and above returns, and as a result they tend to invest large sums of money to ramp up development and increase growth rates. This is not necessarily healthy as firms that service unknown markets should operate in a lean manner and focus on learning the market and what a winning model is rather than questing for rapid growth on an unproven business model. This is precisely the approach that Y Combinator favors as they prefer investing a small amount of capital in startups and providing advice and guidance to help firms hone in on a viable model. The Y Combinator strategy is inline with the tenants of the lean startup, and makes sense now more than ever as startup costs have been driven down drastically thanks to a multitude of open source technologies and cloud computing services. The other problem with the increased flow of VC money is that it reduces the motivation for firms to turn cash-flow positive by monetizing their efforts quickly, and instead encourages them to focus on growing their user bases. 

This leads to one of the parallels to the dot com bubble and that is that we're valuing companies that are in most cases not profitable. The valuations are therefore based on expected payoff from a large and rapidly growing user base. Further increasing risk is the fact that in many cases the markets that these firms operate in are unproven and only developing. Fourquare is a perfect example of this, as it doesn't have a revenue model and operates in a market that is being flooded with competitors, all of whom are trying to find a sustainable business model in that market. Given a lack of cash flows and huge risks to those cash flows, financial models are discarded and replaced with euphoria and optimism. That's not to say that all large investments in businesses with unproven business models are silly. In some cases they are justifiable. In fact, if we didn't have aggressive VC's looking for the next big thing, we wouldn't have many of the free services we love today. What I am suggesting is that we simply ask ourselves whether a company like Twitter really needs to have 300 employees at its current stage, and whether a small early stage startup really needs a cash infusion of several million? Can we accomplish the same result with a little more restraint and a greater focus on fundamentals? 

The problem is that there is no easy way to cool the market down. Even if VC's were to collude in an effort to drive down the prices of new deals, the negative signal this sends would also reduce the value of their existing holdings. Whether we're dealing with a bubble or a boom, the access to capital is great for startups and things will continue to operate well, provided the flow of capital continues. If however we find ourselves in the midst of a double dip recession, those firms that have learned to run lean and generate positive cash flows will emerge unscathed, while the exuberant bunch may find themselves starved for capital. A positive note is that the public markets are far less frothy. Public tech companies are trading at far more reasonable levels than we saw at the peak of the market near the end of 2007. Companies like Google and Yahoo were trading at trailing PE's of 53 and 49 respectively at the end of 2007 and now trade at more reasonable levels of 24 and 22 respectively. Regardless of the outcome, the greater population can take solace in the fact that any fallout will be contained to a small group of players, and thanks to the growing tide of super angels, we'll be left with lots of tech startups that chose control over optimism. 

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