Another Tech Bubble? Separating the Froth from the FactsPublished: April 13, 2011 in Knowledge@Wharton
Back in December, Google made a bid for the social e-commerce company Groupon that valued the company at $6 billion, according to press reports. By the end of the month, TechCrunch and others were putting a nearly $8 billion value on the company based on a new round of venture capital (VC) funding. Two weeks into the New Year, The New York Times reported that Groupon was talking to Wall Street bankers about an IPO that would value it at $15 billion. By March, Bloomberg had upped the IPO price tag to $25 billion.
How does a company that helps people buy $30 worth of Chinese food for $15 see its estimated value more than quadruple -- to $25 billion, no less -- between Thanksgiving and St. Patrick's Day? Must be Internet II: Return of the Dot Com Bubble, right?
Not necessarily, say Wharton faculty and other observers. "I would put myself in the class of bubble skeptics," says Luke Taylor, a Wharton finance professor. "People have knee-jerk reactions when they call something a bubble; it's a non-explanation. It's a name for something that we haven't taken the time to understand."
Taylor suggests that valuations for Groupon and a handful of social media companies that investors can't get enough of these days -- Facebook, Twitter, Zynga, LinkedIn and Foursquare -- are aggressive and perhaps overly optimistic. He points out that companies listed on the S&P 500 trade at "zero to four times revenue." Meanwhile, these social networking darlings are being assigned valuations as high as 100 times revenue, or more. "Does Twitter deserve a multiple 25 times larger than any company in the S&P 500?" Taylor asks.
That question is itself debatable and will be answered when Twitter eventually goes public and has to show all its cards. In the meantime, if you think the company's valuation is arguably on target -- and the case can be made that it is -- then the bubble debate ends there. Even if you doubt it is, the question becomes: Do a handful of companies signal a bubble? That depends on whether or not they are having an undue influence across the tech landscape.
So far, the effect is muted at best.
One angel who works closely with an East Coast technology accelerator says he is seeing companies coming out of the accelerator pull in $3 million to $4 million in funding, compared with $2 million to $3 million for comparable companies a year ago. That is an uptick for sure, but it is small in the context of VC funding. The jump can be justified to some extent by the economy recovering, and by the markets for social media and mobile applications coming into their own as a viable sector, observers note.
Beyond that, however, tech companies and the venture firms that back them are dealing with many of the same trends and issues that they have been working through for quite some time.
The VC Picture
Brand-name VC firms have big funds and are struggling to find companies that can absorb eight-figure investments and generate outsized returns on them. This has led to a semi-permanent overhang for VCs, which has kept valuations artificially high. But it has not driven big exits -- quite the opposite, in fact. The IPO window has been narrow for several years now, with fewer companies overall and still fewer web-based businesses squeezing through.
Meanwhile, countless start-ups have sprung up, thanks to low-cost business models that capitalize on the potential of cloud computing, social media and mobile web applications. These fledgling firms do not need much VC money, if they need it at all, and mostly count on lasting long enough to prove their concept and be acquired. Competition for the attention of a few active buyers has kept prices for these deals fairly low.
The result is that VCs are buying relatively high and often selling relatively low, often after holding on to companies for longer than they would like. And they have the so-so returns to show for it. The Cambridge Associates U.S. Venture Capital Index had a five-year return of 4.25% as of September 30, 2010 -- ahead of the major stock indices but hardly the outsized returns that garner big VC fees. One-year returns of 8.2% actually trail all the major stock indices and the Barclays Capital Government/Credit Bond Index. That is quite a come-down from the triple digit returns the index shows for 1999 and 2000, or even the sizable double-digit one-year returns the sector enjoyed for most of the 1990s.
Some point to the large number of companies finding angel and venture money as a sign that the tech sector is getting frothy. Doug Collom, vice dean of Wharton San Francisco and a partner in the Silicon Valley law firm Wilson Sonsini, acknowledges that a lot of companies are finding money relatively easily, but he also points out that these companies are extremely capital efficient. "They can bootstrap to get started [and] then, when they acquire a customer or two, get $500,000 from angels and small VCs," he says. "After six months, these investors will look at you steely eyed and ask, 'Is it working?' And if it isn't, they will cut the cord and move on to the next 40 seed investments.... The press doesn't pick up on the dozens of companies that raise $500,000 and crash and burn."
Take a look at more figures: The number of VC firms that closed new funds in the first quarter of this year is down from the same period in both 2009 and 2010, according to Dow Jones LP Source. Those funds collected a total of $7 billion, up quite a bit from $3.9 billion in the first quarter of 2010. This combination of data suggests consolidation among the strongest players, rather than the broad, foot-on-the-gas acceleration the sector experienced at the end of the 1990s.
Similarly, exit returns have been up and down from one quarter to the next, with the biggest deals often coming from the cleantech or life-sciences spaces, where companies need large chunks of VC money, rather than from Web 2.0 plays. In 2010, only one of the 10 biggest VC deals was a social media effort, according to the PricewaterhouseCoopers/National Venture Capital Association MoneyTree Report. Twitter raised $200,000 in its ninth round of funding. The rest of the top 10 were later-stage cleantech, financial services and equipment companies.
One could argue that, against this backdrop, Facebook and company are seeing their valuations soar because they are rare exceptions to persistent trends rather than forerunners of a new trend, Taylor says. Tech investors are starving for companies that have the capacity to hit homeruns. Groupon, Facebook, Twitter, Zynga, LinkedIn and Foursquare are likely to have IPOs -- much-hyped, high-flying ones at that -- making them the closest thing investors have seen to a Babe Ruth or a Hank Aaron in quite some time. Everyone wants a seat in the ballpark for these at-bats, experts note.
A 'Wait and See' Approach
Rather than pursuing the bubble-or-not questions, Wharton faculty and other experts have been exploring the extent to which these valuations are supported by hype, demand and likely financial prospects.
"You have a bubble when valuations aren't justified by the underlying fundamentals," according to Wharton management professor David Hsu. "We still have no filing documents for most of these companies to see the experimentation with monetization that's going on, or the proof that [their business models] work." In the meantime, he says, "You have to look at issues like barriers to entry, the value of first-mover advantage [and] the importance of reputation, and consider whether these factors justify these superstar valuations."
Hsu and others say that to some extent, everyone still has to wait and see how these companies, and the space in which they do business, evolve. But observers seem more likely to give Facebook, with its billions of users and versatile platform, more benefit of the doubt than they do, for example, Groupon, which has had to contend with fickle consumers, an expensive sales force and a slew of copycats chasing after its business.
Lubos Pastor, a finance professor at the University of Chicago's Booth School of Business, has done research that indicates that when there is a lot of uncertainty surrounding a fast-growing company, its market value tends to go up. "Suppose you have two companies that are identical, but one will grow at 20% and one will grow at either 10% or 30%," he notes. "The second is more valuable because it would great if it hit 30%, but 10 % isn't terrible. With VC investments, loss is limited to what you put in, but the upside is tremendous."
And, Collom points out, these social media and social commerce companies are so capital efficient that "there is a belief right now that you can make huge amounts of money on a small investment if you play it right."
In 1999, the uncertainty was centered on whether and how Internet companies would make money; it turned out a lot of them couldn't, or at least not enough. This time around, talk of another tech bubble is focused on firms that have revenue streams and even profits. There are few doubts that seven-year-old Facebook is viable: The uncertainty is focused on what additional revenue streams it might leverage from the community it is amassing and how big those revenues can grow.
"As long as there is uncertainty, people will pay for the upside potential," Pastor says. "We don't know how fast this market will grow. We don't know if everyone on the planet will be doing business through Facebook. If that happens, Facebook will look like a bargain today."
Helping the hype and uncertainty to grow are secondary markets such as SharesPost and SecondMarket, which didn't exist for Internet 1.0 the way they do today. "These types of companies were initially only available to a limited pool of money, via venture funds," according to Bo Brustkern, a former venture capitalist who now runs a firm that consults on private equity valuations. "Now, with the secondary markets, there are vastly deeper pools of capital. Increased demand for a limited supply of stock will inevitably push the price up."
Major stakeholders who have solid insight into what a company is worth, including founders and VCs, are probably not selling their preferred shares on SharesPost (that doesn't mean they aren't selling, but these private deals tend to happen behind closed doors, not online). But angels who bought in early only to see their stakes diluted and their board seats taken over by bigger investors might decide to get some liquidity this way. Employees and former employees whose shares have vested might decide to cash in, too. This scenario, however, has people with very limited insight into a company's fundamentals selling to people with deep pockets and absolutely no insight into a firm's worth.
"If there is froth, it's froth created by a lack of information. Most of the transactions being conducted are without a lot of information, so I don't give them technical credibility," says Brustkern. Taylor concurs: "If an employee sells $1,000 worth of shares, would you use that tiny transaction to judge the value of the entire company? I wouldn't."
These secondary offerings, online and off, have allowed shareholders to cash in a little bit, Brustkern notes, which in turn has allowed Facebook CEO Mark Zuckerberg and the founders of some of these other companies to schedule exit events on their own watches rather than those of their investors.
But Collom points out that these executive teams don't benefit from the speculative valuations the secondary markets are putting on their firms. Having their companies' perceived market values taken out of the leadership team's control can cause headaches. If shares of a firm become spread among too many secondary buyers, it could hit a 500-shareholder cap the SEC puts on private companies, forcing them to go public prematurely. In addition, too much of a discrepancy between the value executives place on a company -- when they are issuing options, for example -- and the value the market puts on it can cause legal and accounting headaches.
Moreover, eventually these companies do want to go public, and they want those offerings to be successful. "Suppose people have been buying your shares on the secondary market at $50, which gives you a $5 billion valuation," says Collom. "Then you register for your IPO and the investment banker says your financials don't support that; they support a $2 billion valuation. You have discontent among all these investors who bought in at $50 a share." In that scenario, the positive hype for a company can turn the other way very quickly at exactly the wrong time.
But even if one or a few of these companies cannot sustain their valuations when they finally open their books and go public, no one is expecting them to crash and burn. They might simply have to "recalibrate" their value, as Hsu put it, adjust and move on.