The "Bubble" and What's Really Going on with Startups

Today's New York Times declares that there an investment "bubble" in Silicon Valley being concealed by venture capitalists, and that it's so out of control that startups are being told not to generate revenue for fear of disrupting their fantasy valuations (link).

I think the article is about 1/3 correct and 2/3 nuts.  Yes, some startup valuations do seem amazingly high.  No, there isn't some grand conspiracy, and there isn't necessarily a bubble. 

This is an important issue for the mobile tech world because mobile startups are a huge part of the so-called bubble.  If you're working in a mobile startup, or thinking about doing one, you need to understand what's happening.  Here's my take:

I've spent more than a year pitching the startup I'm working in, Zekira, to VCs and angels in Silicon Valley.  I've met with scores of them, taken them to breakfast and coffee, and had long philosophical conversations with them about our company in particular and startups in general.  I have friends and former co-workers who now work in the VC and angel world.  I've also spent a huge amount of time networking with other entrepreneurs, successful and otherwise, and the conversation always turns to the fund-raising process.  So while I don't claim to be the world's greatest expert on startup funding, I do have a pretty good ringside seat.  Here's my list of venture funding myths and realities as they relate to the Times article:

Myth 1.  Venture capitalists and angels are in the business of creating new technology products.  Not true, and in this respect the article is right.  Many people who work as VCs and angels are passionate about technology and love to be personally involved with new tech products.  They give great, enthusiastic advice.  But their business is to create companies they can sell.  Period.  They don't get paid until a company either gets acquired or goes public, so their focus is on creating companies that they can sell to someone for a markup.

There's nothing new about this.  Venture capital has always worked this way.

Myth 2.  We are in another tech bubble "worse" than 1999 (in the words of the article).  In the late 1990s, valuations of all tech companies, startups and otherwise, were wildly over-optimistic.  This situation made it easy for VCs to take new tech companies public at a much earlier stage, and at a higher value, than was possible previously.  As one VC explained to me at the time, "there's market demand for companies that are much less mature than those we launched in the past, so we're going to fulfill that demand."

Because the entire stock market was involved, and because immature companies were offered in IPOs, the retirement fund of every American was put at risk.  That's not the situation today.  The market valuations of existing tech companies are not wildly out of whack (a point made well here).  The startups being sold without revenue are almost all being peddled to other tech companies, not to the public.  Facebook and Google and some other big firms have decided that they need to buy consumer internet and mobile companies with rapidly growing audiences.  Competition between them has driven up the valuation of those companies.

Are the valuations inappropriate?  I don't know, but Facebook and Google and the rest are big and successful and presumably know what they're doing.  They can also afford to lose the money they're spending.  So even if there is a bubble, at this point I don't think is is even remotely the sort of economic threat it was in the late 1990s.

As for the VCs' role in this, they're just doing what they always do, fulfilling the demand for a particular type of company.

Myth 3.  Startups are being told not to make revenue because that will disrupt their valuations. 

Oh, please.

The reality is that there are at least two tracks of startup activity, which I will label trendy and traditional.  The trendy startups are web and mobile services hoping to be acquired by the big web players.  For those companies, the source of their valuation is the number of users they attract and the rate at which they grow.  Revenue is irrelevant because Facebook and friends aren't buying revenue, they are buying market position.

In a trendy startup, making revenue is a problem because it distracts you from the goal of growing the audience.  The VCs are right to tell companies to disregard it.

But the traditional startups are treated very differently.  In those companies, the VCs are looking for a strong team, good product, and proven revenue.  In fact, the problem is not that companies are being told not to make revenue, it's that even angels are often demanding that companies have a customer base and substantial revenue streams before they'll make an investment.  In other words, the investors don't act like the stereotype of early-stage people who fund a cool idea, they act more like banks.

From my perspective, it looks like most of the big VCs are investing in a mix of trendy and traditional startups.  Among the angels there seem to be different circles, some specializing in trendy startups and some specializing in traditional ones.  But the trendy startup scene gets almost all the public attention.  It's what drives the startup weblogs, it drives the big drinking parties, it brings people out to the conferences, and it generates most of the press coverage for spectacular acquisitions.

You often see news articles focus on the trendy startups as if they're the only thing happening in venture capital.  That's exactly what the Times article did.

The trendy startup scene is entertainment, spending a weekend in Vegas without the long drive across the desert.  Like gambling, the attraction of trendy startups is that you might get wildly rich for a small investment of money and time.  Also like gambling, you'll probably lose your shirt. 

Is that a bad thing?  Only if you bet money and time that you can't afford to lose.

The danger to the public (and to the economy as a whole) will be if and when trendy startups start to be offered up in IPOs.  If that happens, it will be very important for all of us, the New York Times included, to raise an alarm very loudly.  But that's not the situation we're in today.  Calling today's situation a bubble is crying wolf, because it may cause people not to pay attention when there really is a problem in the future.


Anonymous said...

It's nice that the VCs evade moral responsibility for outcomes by claiming the market demanded it.

Retail investors want to sink their 401ks into hype-driven mismanaged money-pits? Go for it!

Big companies are willing to buy faddish consumer apps at inflated prices? Happy to oblige; longterm value to the app's users or the purchaser's shareholders is irrelevant.

The market always demands a false promise of something for nothing; that doesn't mean it's ok to make those false promises.

Lie to me!

Tatil said...

I normally like and admire your posts, but I gotta say I disagree with this post vehemently. Inflated prices for start-ups with barely any income can form a dangerous bubble whether they are snapped up through IPOs or acquired by bigger companies. The retirement accounts of Americans are still in danger. If Google (or Facebook in a few months) wastes any of its cash reserves or employee and management time on a series of bad acquisitions, its future growth and stock price will suffer. Unless you are constructing an unrealistic hypothetical of a retiree who tied up all his savings in a fresh IPO vs. Google, the danger to investors in general are fairly similar. It does not matter whether you are exposed to these start-ups when you "own" them through one of your mutual funds or through holding Google stock.

Marketshare is meaningless if it does not lead to profits in the end (and soon). Too much investment in an unproductive (in other words, non-profitable) area is a waste of resources and will limit future GDP, regardless of whether the acquiring company can afford to lose its investment or not. Inefficient allocation of resources always have costs for the economy as a whole. If a bubble is in the works, the public at large should be worried, just like they should about other macroeconomic indicators such as credit growth, inflation rate or manufacturing orders.

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Anonymous said...

Bubble? VC time line is rather short. inflation of the price sure would be one way to match quick return on short time scheme. Still hard to wrap my head around the software based "innovation". Look like the too many sky trajectory "hot" stuff out there. Not like the hardware steady invention: transistors, steady move forward from three legs to millions on chip, still going. Clearly got some potential - at the invention time, unlimited. Super conductor is another, still try to explore its way after ground breaking conference leak. Bubble? yap, I would say so. Corp R&D is better way to invest = need support structure, long term vision, critical mass and enough smart people in one place, like ATT bell lab and Watson IBM lab. too bad the corp bean counter went to the VC style. That is what cause of the down fall in Western world. (the new grad got quick $ in the eyes too, including some of chaps works in start ups).

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