The rage lately has been to debate whether or not there is a tech bubble. Everyone from the most prolific of venture investors to my college drinking buddies all have offered to share their opinion on the situation. Like everyone else, I also have an opinion…but I know I’m not an expert, so I could easily be as right as I am wrong about what is going to happen. But to be a good entrepreneur or investor, it is not necessarily important to be an expert, it is important to understand, adapt and prepare. Therefore, given my hopefully relevant perspective of both sides of the table, I’ve decided that instead of writing an academic paper on the economics of the current situation, I’d rather try and translate what I see to what I think it means for the ecosystem moving forward.
So to start and get it out of the way, do I think there is a bubble? Yes I do. But, is this bubble as bad it was in 2000? Nowhere near it.
Now why? Well first I think it is important to understand the current environment from two perspectives: the early-stage and the late-stage. On the early-side, two trends are the most prevalent: 1) the reduction in cost to launch and the rise of the angel investor have led to increased volume of startups and funded startups, while 2) the increase in supply of early dollars and price-insensitive investors have created an increase in price of early stage deals. These are both bubbles. But, according to Eric Paley, this is not necessarily a bad thing. The more early stage companies that are funded, the higher the likelihood an entrepreneur creates the next Google, Facebook, or on a smaller level, Mint, Milo, etc.; and for VCs, based on simple Darwinism principles, more competition will drive to a better pool of companies from which to fund. Sounds familiar? Sure. But what makes this less worrisome than last time is that ultimately the amount of dollars flowing into this sector is only ~$500M, the size of a mid-cap VC fund. Downside here: entrepreneurs fail, prices are too high, some investors lose money – this time though it isn’t dangerous, it is just the reality of our ecosystem and the game we play.
On the later-stage, the recent flurry of so-called “inflated valuations” (see Facebook at $50B, Groupon at $6B and Twitter at $4B) has started to create a scare. Furthermore, due to the stockpile of cash at behemoths like Google, Apple, Facebook, eBay and Amazon there has been a flood of M&A activity, and resulting, price speculation. The fear here is that this is not sustainable – what happens when cash runs out, or these companies IPO? Last time it was not good. This time, I think it will be very different. First, other than Twitter, I truly believe the aforementioned valuations are very reasonable. All these businesses have not only built a solid user base with a lot of eyeballs, but also a profitable business generating significant cash. If these companies IPO, unlike last time, they can become sustainable businesses (see Google) – and therefore, these valuations may not be absurd. Second, the flood of new startups almost certainly mandates that every once in a while, there will be a new company to join the ranks of Facebook, Zynga and Groupon. If this is true, continued disruption will only drive more cash flow and therefore, M&A. Plus, does anyone realistically believes Google or Apple will run out of cash anytime soon? High cash flow business continue to grow their cash stockpiles, even if some dry powder is being used…
Regardless of whether or not I’m right or wrong, what does this mean to us as entrepreneurs and investors? For starters, we all must realize that the early stage bubble will drastically increase the number of companies in the ecosystem. There will be many new ideas and opportunities, but there will also be an even larger number of failures. In order to prepare for this, entrepreneurs must focus on iterating quickly in order to stay as competitive as possible. Furthermore, failures must be embraced; otherwise, the ability for young entrepreneurs to take big, disruptive risks will be stymied. Both entrepreneurs and investors must be accordingly cognizant that there are many stages to a startup – getting funded early on doesn’t mean you will be successful. Therefore, being mindful of not only how to build a business from a product, but also how to fail gracefully, exit appropriately or find the next opportunity is crucial.
Next given the flurry of high valuations and M&A activity, it is important for both startups and investors to realize each company’s place in the ecosystem – i.e. not every company can be a standalone $B business. Every entrepreneur should focus on being disruptive; but as her business grows, she must also begin to focus on the strategic vs. standalone value. There are exits to be had, but can you create a standalone business ala Facebook, or have you created a disruptive technology that will drive value for an acquirer ala Milo? Understanding the reality of each model will not only drive the most value, but also prevent an unnecessary burst. If startups can continue to innovate around new and disruptive business models, or help large companies execute around current business models, a doomsday scenario is far less likely.
As an investor, these facts must be applied to not only their investment thesis but also their approach with their portfolio companies. Small bets and small wins shouldn’t be frowned upon, especially if you believe there is an impending bubble (as opposed to Fred Wilson’s comment re: Hot Potato and drop.io), because these small victories still provide marginal value to the ecosystem. Furthermore, even though early seed deals and large late stage deals are hot, investors should try and focus on the new crop of early growth deals that are springing up. After seed companies get funded, all the companies that have enough stamina to raise another round (Darwin will no doubt reduce this pool) will be better tested for future success. Again, as I alluded to earlier, if funds are proactive, they will realize (although some of these deals might be overpriced), these companies will be better positioned for success.
So, again, do I think there is a bubble? Sure. But things are different this time, and lessons have and can be learned from last time. As a forward thinking ecosystem, we must be constantly focused on avoiding past mistakes…but only time will tell. My guess is we learn, people will succeed, but there will also be some pain. Isn’t that what we all signed up for though?
As always, I appreciate comments and discussions on each of these posts. I don’t profess to always be right, but I hope my thoughts can be used as a springboard for further discourse. If you disagree, please let me know, I look forward to your opinions!