Bubble Notes

There has been an intense discussion lately around valuations and the so-called bubble. Some leaning to reflexive, others to catastrophic. As I came across more and more articles about the topic, I thought it could be useful to organize my thoughts and understand a little bit better what’s going on here.

But before we begin, just to clarify, despite being an active member of the startup community (I had no choice, I founded one…) I have no relation with any of the companies I’ll mention in the post. Our company is far from becoming a unicorn and being based in Barcelona maintains us a little isolated from all the rush happening in the Valley. So, that being said, let’s dive deep into the topic.

What is a bubble?

Yes, I hear you, everybody already knows. So here comes my question, if we all understand the term, why we have such a hard time telling if we are actually in a bubble? Maybe is a question worth asking before we begin to lay out some of the facts…

As I understand it, a bubble is a run-up in the price of an asset that is not justified by the fundamental supply and demand factors. To narrow the perspective, Peter Thiel put it in a “less academic” way that might suit better this context.

A true bubble is when something is overvalued and intensely believed

There are two parts of the equation, the first one, the price increase and, the second, if there is really a legitimate situation that validates the “new value” of the asset. 

A narrower view

The first step in order to understand the bigger picture is to focus the question and narrow the perspective. We are listening “tech bubble” but this is actually vague description. Is the whole market that suffers from this bubble? Or is just a subset of a particular industry, like say, biotech? To narrow the question I recommend this article written by Bill Maris (president and managing partner at GV) that brings some light to the topic.

He makes two cases, one against and, an other in favor of the bubble.

  • Against. VC fundraising and investing are not increasing in absolute numbers, but companies take more time before they go public. The number of VC investments is fairly flat.
  • In favor. Dollars poured into late-stage rounds are, in fact, increasing at worrisome rates, as well as valuations for those companies. The gap between IPO and late-stage valuations is narrowing.

There’s a clear case to be made here. Just by looking at this data, we’ve narrowed the question to a more comprehensible subset: late-stage companies that used to IPO, now are rising money from VCs instead. So there’s an increase in the valuations and the money flowing to those deals. Despite we will look deeply around the question, Maris draws his own conclusions from the increasing late-stage funding.

The data clearly shows an increase in late-stage financing, but there are a couple ways to interpret this. One hypothesis is that plentiful late-stage financing from VCs and private-equity funds is causing companies to stay private instead of going public or being acquired. Another take is that technology has enabled companies to grow more quickly, and late-stage funding has risen to meet the needs of these young (but large) startups.

And it makes sense, because if we take a broader look at the public market valuations for tech companies, it seems like average in comparison with other sectors. At least to me, a P/E ratio of 24 it’s not a hint for a bursting bubble.

So, this section served as a better approach to frame the question, but two important questions remain unanswered. The first is why companies are not going the IPO route anymore and are instead staying private for longer periods of time (this might explain the greater valuations), and the second, if we can extrapolate any conclusion from the tech bubble that happened in 2000. These questions inevitably lead us to the next section and the incentives for a company to IPO.

1999 Parallelisms

To tackle this question I’ll turn to the fantastic Ben Thompson’ blog and his related article “It’s not 1999”. He starts with the 1999 vs. 2015 tech bubble question and borrows a clever analogy from the Mac vs. Windows. He argues that we face a completely different situation and any parallelism could be out of place.

By the time the Mac arrived in 1984, the battle was already over: businesses, the primary buyers, were already invested in MS-DOS (and, over time, Windows), and not many consumers were buying PCs. Today, of course, the situation is the exact opposite: consumers vastly outnumber business buyers. Thus, the chief reason iPhone/Android is not Windows/Mac is because the market is fundamentally different.

The differences between 1984 and today are clear, but let’s focus on why today is different than 1999. Ben makes the following assumptions (I’m paraphrasing here).

  • Tech is outgrowing tech. This is actually a Benedict Evans’ point, but it fits gently in here. In 1999 tech companies where competing with tech products and solely focused on the technology market. Today it looks nothing like that, and technology companies are disrupting entire industries that had nothing to do with tech: “many of the most valuable unicorns are consumer-focused companies like Uber or Airbnb. Moreover, these companies are competing not with other tech companies but rather with entirely new (to tech) industries like transportation or hospitality”.
  • Reach. In 1999 the market was fairly limited to techies and IT managers. Today technology has taken over the (much bigger) consumer market, so the potential business for those companies is not even comparable: “even for more traditional pure software plays like Snapchat or Stripe the implications of mobile-everywhere means a whole lot more time — and contexts — to reach consumers. In short, the size of the addressable market for tech companies has exploded — why shouldn’t valuations as well?”.
  • Business models. The structure of business models has changed dramatically from 1999. Today the SAAS prevails in the tech industry and this has two critical implications. 1/ The companies that flourish in this environment are far more sustainable thanks to the recurring nature of their revenue. 2/ To take off the ground such companies, usually, more capital is required since the CAC is always higher than the first payment perceived from the user. This fundamentally changes the implications of growth, because the more you want to grow, the more capital you’ll need to sustain the new customer acquisitions.

So it’s clear that there is a run up in prices for late-stage companies that used to go with an IPO, but it’s also clear that their motivations are far different than the ones these companies had in 1999. Let’s explore that.

Why IPO?

Following Ben Thompson’ article, it explains the motivations behind why companies go with an IPO. He states three reasons.

  • The company gets additional capital to fuel growth, non-dilutive shares to use for acquisitions, and a bit of added prestige that can help with sales, particularly to enterprises.
  • Founders and employees can finally be fully compensated (by selling shares) for their years spent building the company.
  • Venture capitalists get a return on their investment that they can distribute to their limited partners.

While all these things make a lot of sense, the question of why companies don’t follow this path anymore is a little bit more complex. The answer is called growth capital and it has recently become some sort of buzz word.

Growth capital is less speculative than traditional venture capital; it seeks to make relatively larger investments for relatively smaller stakes in companies with provably viable businesses that are seeking to grow for all of the reasons listed above. Now an IPO is no longer necessary for growth.

This new kind of capital is fueled by low interest rates and the enormous liquidity that flood the markets. In other words, there’s a lot of money around (not in the real economy, though) and these funds are seeking returns that bonds or interest rates are not providing. Instead, they are betting on winners.

So what’s happening? The emerge of this kind of resources is providing a way for late-stage companies to raise the capital they need to grow, without the hassle and paperwork required to prepare an IPO. This trend is actually taking off and as Tomasz Tunguz points out the numbers speak by themselves.

In contrast to the frenetic private market, there were 15 US IT venture-backed IPOs with offerings greater than $40M last year, slightly more one IPO per month in 2014. Private market rounds were 14x as common as IPOs in 2014, compared to the 2004–2007 era, when IPOs were about as equally common as large private financings. […] In the past, companies went public to raise large amounts of capital, because the IPO markets were the only place to do it. Going public meant a lot of internal work preparing for regulatory scrutiny, but a substantial cash injection and shareholder liquidity. Today, that’s no longer the case.

Right now we’ve already answered a lot of the questions. We know what kind of companies are sensitive to this trend. We know this is different than the 1999 bubble, and finally, we understood why these companies are doing it. But yet, we need to ask the last and most important question: what does it mean?

The implications of growth capital

  1. Late-stage, founder driven companies can better focus on long term goals. Without the public market pressure these companies can pursue a log term vision without being evaluated by Wall Street every 3 months. That’s a perfect fit for tech companies that are making bold bets into the future, like Uber or SpaceX, because it removes arbitrary time constraints on growth and profits.
  2. Opacity to the public. This is, of course, a direct consequence of the previous one. Investors are betting on these companies with less information. This also means that the general public is not able to join the party. It can be seen from two different perspectives, though: 1/ the average Joe will not be able to participate in the “best companies” because only sophisticated investors will have access to them. 2/ If there really is a bubble here, the ones that will suffer will the ones who can afford it the most[1].
  3. Context of illiquidity. The vehicles used to invest in these companies are fairly illiquid. One can rightly ask: if stock in a company is worth what somebody will pay for it, what is the stock of a company worth when there is no place to sell it? That leads us to valuations, in a public market, companies are valued daily, but a private company can maintain a valuation for years. That is worrisome because higher valuations in private markets might led to down-rounds when it comes to IPO.

Conclusions

Once reached this point, I clearly understand the situation better, but I don’t know if I have cleared things or I have complicated it even more :) The best conclusion I draw from the article is that yes, valuations are unusually high for the market as we knew it. But one has to step back and ask if maybe this growth stage is a whole new dimension of the market. A new step on the way to a remote IPO. So maybe we don’t face a bubble problem, maybe a new phase in the arc of investment has been created and these are the rules that apply to it.

I like the idea. So I’ll leave you with this article that explores it deeply.


[1] In the 1999 context particular investors took part of the hit. Because the investment vehicles were not sophisticated and in reach of anybody. That sounds really democratic, but it also meant that if things went south, they would be the firsts to suffer. And that is exactly what happened. Today the “bubble” is driven by professional investors and deep pocketed groups, then an hypothetical crash might not affect (directly) the real economy. Although there are cases to be made against the investors ultimately taking the hit.