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If it looks like a bubble and it feels like a bubble…

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The debate over whether we are in a technology bubble — and if so, what kind of bubble it might be — flared up again over the weekend, sparked by a piece in the New York Times that said venture-capital investors are encouraging startups to forego revenue so they can fetch higher valuations. Others immediately took issue with this idea, however, saying there is no bubble and repeated attempts to find one are just an attempt to stir up controversy. So which is it? That depends a lot on what you mean by the term “bubble.” Does it mean the kind of investment mania that resulted in a public-market bloodbath a decade ago, or just any sign of overvaluation?

Bits writer Nick Bilton says in his NYT piece that venture investors are all busy denying there is a bubble, despite the mounting evidence to the contrary, because they have an obvious vested interest in perpetuating a hype-filled investment atmosphere:

Acknowledging any possibility that tech companies aren’t worth what you say they are worth would be followed by the sound of a giant pop, and the money and investments would dry up. The machine could grind to a halt.

In fact, says Bilton, venture capitalists are busy inflating the bubble as quickly as they can by telling the companies they invest in to avoid making money as long as possible. Why would they do this? So that valuing the enterprise is as difficult as possible and investors can then propose all kinds of inflated numbers, something financial analyst and venture investor Paul Kedrosky calls “mark-to-mystery” financing. “As long as there are no numbers, I can have whatever mark I want for an external valuation,” he says.

Is this just 1999 all over again?

Bilton also quotes Jeffrey Pfeffer, a professor at Stanford’s Graduate School of Business, as saying what we are seeing in Silicon Valley right now is “1999 all over again — but this time, it’s gotten worse.” The professor adds that companies are “throwing around funny money” and that the “economic values don’t add up.” Technology veteran Dave Winer also says he believes the market is fundamentally bubble-oriented at the moment.

It’s not clear what Pfeffer is referring to exactly, but it’s not a stretch to think he’s probably talking about deals like Facebook’s $1 billion purchase of Instagram, which sent shock waves through the startup scene. But is that the sign of an impending bubble? It might be if you assume that Facebook itself is overvalued and therefore was able to pay a ridiculous sum of money for a small startup. The most obvious sign of whether Facebook is overvalued or not, of course, will come when the company starts publicly trading and investors of all kinds get to weigh in on what they think of its future prospects.

Venture investors like Dave McClure of 500 Startups argue that Pfeffer is mistaken and there are no signs of a 1999-style bubble in technology.


If public stocks aren’t overvalued, is there a bubble?

And McClure is right in a sense: The kind of mania the tech sector witnessed in the late 1990s, with unprofitable and even revenue-less startups going public at massively inflated valuations, has yet to manifest itself in today’s markets. You could argue that Zynga, (s znga) Groupon (s grpn) and other companies are overvalued, but they have suffered share-price declines that show a substantial amount of skepticism — the kind of skepticism that was in short supply in the late 1990s. Apart from Facebook, there are few signs of any kind of mania for public technology stocks.

StockTwits co-founder and venture investor Howard Lindzon (see disclosure below) says the only bubble that exists is in the oversupply of what he calls “wantrepreneurs” — people who are chasing the pot of gold at the end of the startup rainbow. That kind of impulse has likely been accelerated by stories like Instagram’s but also by the ease with which startups can be built and grown in today’s digital world, thanks in part to “crowdfunding” platforms like Kickstarter and the availability of cheap computing services in the cloud, which have dramatically lowered the barriers to entry.

Even if there is a lack of public-stock mania, however, that’s not to say there aren’t still risks. If the flow of investment money at the angel and seed-stage level gets too large, it can inflate bubbles that can in turn help produce bubbles further down the spectrum. And if that pressure overflows into the public markets, it could start to look a lot more like the 1990s fairly quickly. But for the moment, whatever financing pressure there is seems to be concentrated at the smaller end of the market.

Bubbles, yes — but not a capital “B” bubble

This is the conclusion that angel investor and entrepreneur Chris Dixon comes to in a smart post on the topic, in which he looks at the different elements of the bubble case. Public stock prices don’t really look overvalued at all, Dixon says, and one-off deals like the Facebook purchase of Instagram aren’t compelling evidence either. And while there are signs of inflated valuations in certain parts of the ecosystem such as the seed stage, he says — driven by people trying to find the next Facebook — there are signs of undervaluation in other parts, including at the Series A level.

One of the parts in the New York Times story that got the most reaction from venture investors — apart from just the general suggestion that they are inflating a bubble — was the accusation that “[M]ost venture capitalists . . . are not interested in building viable long-term businesses. Rather, they’re interested in pumping up enough hype and valuation to find a quick exit through an acquisition at an eye-popping premium.” Some critics said this is true by definition, since venture investors are interested primarily in short-term returns. But Dixon argues that even if it is true, smart investors don’t take that approach:

No good venture investors invest in companies with the primary strategy being to flip them. This isn’t because they are altruistic — it is because it is a bad strategy. You are much better off investing in companies that have a good chance to build a big business. This creates many more options including the option to sell the company. Acquisitions depend heavily on the whims of acquirers and no good venture investors bet on that.

So while some venture funds may be doing their best to inflate expectations and cash in on high valuations, that appears to be causing problems only at the small end of the startup pool — for now. Without any obvious signs of a public-stock mania that puts individual shareholders at risk, it’s hard to argue that we are in a 1990s-style bubble yet (although some critics fear that the new crowdfunding bill could accelerate the problem). Whether Facebook’s IPO triggers a broader inflationary atmosphere remains to be seen.

Disclosure: StockTwits is backed by True Ventures, a venture capital firm that is an investor in the parent company of this blog, Giga Omni Media. Om Malik, the founder of Giga Omni Media, is also a venture partner at True.

Post and thumbnail images courtesy of Flickr users Photo Clinique and Bill S

8 Responses to “If it looks like a bubble and it feels like a bubble…”

  1. Steve K

    In the immortal words of Clara Peller: “Where’s the beef?” In 1999 there was beef, only everyone thought they were going to sell the same cow to the same market. I was working in a tier 1 CM and had at least 3 big league router companies and more than that smaller companies telling me that they were on the cusp of getting this or that big account and would be needing to ramp to volume. They insisted that we stock the material inventory for this projected ramp. The only thing was they were telling us about the same customers. Non-disclosure meant we had to bite out tongues and wait to see who got the big score. This was also at the time of the big promise of optical (fiber everywhere), which obviously never happened for practical economic reasons. The upshot of the whole thing is that nobody scored the big contracts, nobody ramped to insane volumes, and the whole thing came crashing down like the housing market.
    At least there was some actual hardware and a reasonably potential market for it, that eventually dribbled in over the next 10 years.
    This time around, there’s no beef at all. If all these social marketing companies had popped up at the boom of funny money when everyone was taking 2nd mortgages on their houses to put granite countertops in and buy fancy cars, then you could make a case for crazy marketing budgets. But today, most folks are looking over their shoulders waiting for an axe to fall and hit what little unemployment insurance is left. The days of free money and a Mercedes and big screen for every kid is over. With no market out there, big marketing budgets are unsustainable. And companies whose only purpose in life is to provide marketing will have their gravy train dry up just as they have sucked in the last of the wannabe Warren Buffets (who won’t touch this stuff with a ten foot pole) and skimmed off their life’s savings.
    That, together with the student loan bubble looming out there is going to make 1999 look like a party.

  2. I have been using the term “Social Bubble”. Of course they are “tech” but they all revolve around social. Zynga – social gaming. Groupon – social group discounts. Instagram – social image sharing. Facebook – social king.

  3. Steve Ardire

    Nick Bilton did a nice job cutting through the VC smoke and mirrors game in Start-Ups Keep Revenue at Zero to Cash In on Acquisition

    IMO his best points were….

    > Getting acquired while producing no revenue is like performing a card trick without the deck of cards: the magician simply explains how magical the trick is, never actually showing it. (And we are supposed to step back in sheer awe.)

    Brillant snark !

    > The term often used behind closed doors with this no-revenue formula is mark-to-mystery. This is a play on the common term for a more logical investment practice called mark-to-market, which is used to create a realistic appraisal of a company’s financial assets. Paul Kedrosky weighed in here with “V.C.’s can create this mark-to-mystery valuation because as long as there are no numbers, I can have whatever mark I want for an external valuation of a start-up”

    Yup !

    Spot on !

  4. Jeff Kibuule

    Most investors want to pump and dump and get their money’s worth. No example is clearer than the last round of funding Instagram valuing it at $500 million before it was bought at $1 billion, doubling it’s return in 3 days. If that doesn’t scream bubble (or at least insider knowledge), I don’t know what does.

    • Oscar Gonzalez aka @notagrouch

      fortunately for us, this is not “most investors.” *Most investors* want a high guaranteed return. When the guarantee or security doesn’t exist that’s when people pump & dump.

    • Dave McClure

      Facebook bought Instagram for $1B. Twitter rumored to have offered $750M. if multiple *acquirers* (note: not investors, acquirers) are ready to buy the company, what makes you think you’re smarter than they are? if anything, it’s validation that the venture market & investors are NOT overpricing companies if they get BOUGHT for those sums. “bubble” means unsustainable pricing, whereas in this case the transaction HAPPENED. period.