There has been a lot of discussion recently on whether a tech bubble has developed and just what the severity will be if this bubble decides to burst. Pundits and industry insiders have weighed in with their vastly differing opinions, but what is the real story?
Don’t be silly, of course there is. One just has to look at the crazy valuations to confirm its existence. What is truly up for debate is what will be the impact if this bubble implodes. I think there will be a major knock-on effect for the tech space, but not as intense as the 2000 dot.com fiasco.
Back then the Internet had shifted the playing field into unknown territory and any CEO and his dog could claim to have the corner on a ‘lucrative’ but yet to be developed market. This allowed many companies to jump to public trading when there was no revenue never mind a product. Investors got it between the eyes when the Internet began to show its true shape in relation to these hopeful enterprises and soon realized that the majority of this tech ventures were stark naked like the proverbial emperor – without a hope in hell of achieving their lofty objectives.
The crash hammered the market and the Nasdaq composite sank 78% as it plummeted from 5046.86 to 1141.11. With tech companies folding left and right, and once-moneyed CEOs moving back into basement suites, the markets became far more conservative. There were a total of 76 IPOs in 2001, a faint shadow of the 456 that made their market debut in 1999. While investors were frenzied in 1999, doubling the SP of 117 IPOs on the first day of trading, none of the 2001 IPOs hit that magical multiple in the same amount of time.
Unlike the market catastrophe 15 years ago, this bubble is going to explode on the private equity sector. The term ‘unicorn’ has only recently entered the business lexicon and has been used to describe the once rare occurrence of a privately held company reaching a valuation of $1.0 billion or better. Now there are 110 unicorns worldwide with 18 U.S. companies hitting billion dollar valuations since the beginning of 2015. The numbers are still pretty low comparatively speaking, but they are growing at an alarming rate. What’s more disturbing, is analysts are bandying about the term ‘decacorns’ for private firms valued over $10.0 billion like Airbnb, Pintrest and Snapchat.
Another decacorn, Uber, holds a reported $40.0 billion valuation, which eclipses the global taxi market it is attempting to replace. So even though this company is gaining traction, it is nowhere near its proposed market potential and yet valued as if it has reached it and then some. Right now, this still-forming entity is valued more than Hyundai and Mitsubishi. The private equity world is clearly out of touch.
Who’s to blame for this? CEOs are taught to grab whatever valuation they can so that they are able to raise increasing rounds of capital. But what happens when it comes time to exit? Will the market support it? I am hoping that there is enough common sense that investors will realize the obvious and turn up their nose. Facebook and Twitter already made it by our better judgement. How can you justify Facebook’s 80 times P/E ratio?
The biggest concern at the moment is how this situation will impact the tech community if everything goes sour. Private equity is the driving force behind tech start-ups and the controlling force behind that resides in Silicon Valley. There is no other like it, as every tech hub around the world is dubbed, ‘the Silicon Valley of’. Over and above the fact that the overwhelming majority of private equity for tech comes streaming out that fabled point of geography, Silicon Valley has become the validator of any start-ups wishing to make a real go of it around the world.
It starts with the rabid entrepreneurial mindset in Silicon Valley, where dollars are invested in tech start-ups somewhat like a casino gambler playing Roulette. It is relatively easy to get financing if you play the game and have the right contacts. However, VC firms and angel investors outside of the golden zone view their investments much differently. They aren’t necessary interested in funding a dream. They want to see real results before they start to put down serious dollars. This leaves many tech start-ups in places like Vancouver and Dubai starving for funds in a catch 22. However, if these start-ups are able to attract interest from Silicon Valley, it is like getting a grand stamp of approval and investors come out of the woodwork to get involved.
If the bubble does indeed burst, the private equity gang in Silicon Valley are going to take a hit and will be less likely to get involved internationally which could have disastrous effects on the emerging global tech hubs in India and elsewhere. The Silicon Valley of the North (Vancouver) could suffer another debilitating blow and go into hibernation yet again. It seems that the tech world is being driven insanely on hype and I wonder if it will ever be sold otherwise. After all, when you start with vapourware how else are you going to get investors involved without a little hope and hyperbole?
Another reason for these crazy valuations is that we have an optimal environment for hopeful PE investment. The central banks sporting interest rates at near zero make even the most marginal business returns attractive. The moment those rates raise, many pipedream ventures will fall flat on their faces. As well, with many first-mover tech start-ups, there is the luxury of commanding whatever price they wish, but as competition builds, so will margin compression and those businesses may find their models untenable, causing a major slide in their valuation.
Regardless of the reasons behind it and its potential impact, Silicon Valley will survive this bubble, just like it weathered the last one, but the worldwide fallout will take longer to dissipate. We may see an innovation stall from global hubs which could also have a knock-on effect for the industry as a whole.
Will investors, PE and VC firms learn from their mistakes? Probably not, considering the tech sector was able to put itself into this precarious position just 15 years after it collapsed on itself the last time. It all comes down to the fear of missing out on the next Apple, Google or Facebook and when it comes to the investment community, that fear abounds.