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Is Silicon Valley Being Irrational About Tech Startups?

Reproduced from our original post on LinkedIn (June 1, 2016)
Donald Trump says a lot of things, mostly crass, divisive and slighting. He has spoken once again – this time about a possible tech startup bubble, which is due to pop.
I’m talking about companies that have never made any money, that have a bad concept and that are valued at billions of dollars,so here we go again.

Surprisingly, this remark appears to have some reason and unsurprisingly, the Silicon Valley is miffed. Here’s the thing. No one wants to pay attention to some offhanded comment from an unwanted GOP front-runner. But then, here’s another thing. The likes of Bill Gates and SEC chief have also expressed concerns about the market, not to forget market analysts too. As a matter of fact, Trump only mentioned what some experts have been thinking.
Is there a tech bubble?  Yes, there is. In the last couple of years, the persistent low interest regime in the U.S. and soft markets made investors look elsewhere. While it may be hard to locate the tipping point, but it was Fidelity that seemed to have sparked the trend with Facebook funding. Increasing accessibility to cost-effective technology, including cloud, provided fuel to activity on the other side. During any boom phase, a sort of network effect comes into play, i.e. larger the number players the higher is the inflow of new players. The rush is more of a sentimental response to a perceived opportunity than anything based upon prudent business decisions. The enthusiasm of the stakeholders often borders on blind optimism – the key factor responsible for skewed valuations. This is what happened when the news about some successful private exists began pouring in around 2011-13 (such as Facebook, Twitter and LinkedIn). Potential investors went into the startup frenzy because no one wanted to miss out on an idea that might pour in big returns in a matter of a couple of years. The drift continues, although with some moderation now. Talking of investors, Gates remarked
It never should be a case of closing your eyes  and saying ‘Oh, it’s a tech company, just throw money at it’. That strategy worked for about two years;  now you actually have to open your eyes and look at the company.
So, what is a bubble?  It signifies a phase when asset valuations do not justify the fundamentals (mainly, the profit generating potential) and are largely driven by speculation. If you look around, the unicorns (billion dollar startups) have been losing valuations globally. That implies unrealistic expectations at the the time the investments were made. Interestingly, unicorns are mythical creatures. Now, we do not mean to suggest that these businesses are completely worthless or imaginary; rather the question mark is on the insane valuations. Globally, most of these highly valued enterprises are either running into losses or have returns that do not justify the rate at which they are burning cash. Uber is a case in point, which sits at $62.5 billion in valuation within 6 years of its existence. At one time, it was valued at 125X trailing annual revenues! For those interested in digging deeper, here’s a reference. During the first nine months of 2015, it spent $1.7 billion to earn $1.2 billion revenue worldwide. The company claims that it has become profitable in the U.S. and Canadian markets with $0.19 earnings per ride, the number more closely relates to EBIT and does not take into account equity compensation for employees. The company is aggressively trying to gain market share in China, spending $1 bn in 2015 and another $1 bn planned for this year. (Source:Bloomberg)
Recently, the shareholders reduced the value of their investment in Snapchat by 25%. Other big names to lose value are Uber, Airbnb, DropBox, Evernote and Cloudera. The news in India, world’s third largest and fastest growing startup space, is also not encouraging as well. Unicorns Flipkart and Zomato have been marked down by investors and some well-known names have closed their shops. Uber Board member and Benchmark General Partner, Bill Gurley did not hold back in expressing his views.
As long as private companies are allowed to recklessly burn massive amounts of capital, we’ll simply have no idea how sustainable their businesses are.
Trump is trying to find similarities between the startup bubble and the last recession, fearing things might go the same way. But, if anything, some parallel can be drawn here with the dotcom bubble. The internet revolution around that time was the key trigger for mushrooming of dotcom companies, a lot of which turned out to be shaky business models. It was as if anyone with an idea and a domain was an entrepreneur. The race to capture market share and huge advertising expenditure was very similar to what is happening now. Many businesses started off by providing free services which they hoped to monetize in future – again, not very different from the current scenario. The major change this time, however, is in the source of funding, which is mostly private. During the dot com boom a lot of “websites”, even some pre-revenue ones, made way to the stock markets. It needed the NASDAQ crash to make investors accept that it indeed was a bubble.

Is there going to be a replay of the tech crash? Not really, the scale is not going to be anywhere near that. As it stands presently, the stock markets have already snubbed many tech IPOs during the past three years and companies are choosing to stay private longer. Most want to achieve double digit valuations ($10 bn or more) while staying private. This implies that the risk of the bubble popping primarily rests with these venture funds and not the wider public. We would not be too concerned because these investors have deep pockets and they fully appreciate the risk-reward dynamics. There will be unemployment for sure, but that would be limited to the startup ecosystem and companies that will be impacted, directly or indirectly.

Some people would argue that startup initiatives will be impacted negatively. We believe it will raise the bar for excellence, which will have its positives.The story doesn’t end here though. U.S. Mutual Funds and Pension Funds have been contributing to the venture capital ecosystem for a long time and this boom phase is no exception. BlackRock, T. Rowe Price, Fidelity Investments, Janus Capital, and Wellington Management are among the top players in this category. These funds are late stage investors and target companies that have already gained traction in terms of market share and revenues. While the funds are containing their exposure in individual stocks, their overall tech funding is increasing. The top five funds invested $8.3 bn during first three quarters of 2015 against $1 bn for the full year 2011. Now, this is a cause of concern, considering the fact that retail interests are involved in these funds. Following is global venture capital data that reflects how small change in the number of deals has magnified impact on total funding, suggesting that mega deals have been largely driving the market change.

The fund managers justify the rising exposure because they have long-term horizon of 10 years or more. They expect mitigated risk and better returns over that horizon. The regulators are not bemused though. The SEC is keenly scrutinizing the proportion of hard-to-sell securities (private stocks) in these portfolios. On the other hand, research firm Morningstar has highlighted the inconsistencies in valuations of the unicorns, whereby the same company is valued differently by different investors at the same point in time. An even bigger concern is that the companies are giving out varying information to different investors. A small part of variation in valuations is also attributed to the internal calculation methodologies adopted by these funds. SEC Chairperson, Mary Jo White is worried about the secondary market developing around tech companies that are planning an IPO. It is largely a derivatives market and includes some financially engineered options. Speaking at Stanford on March 31, 2016, she said,

Depending on the structure of these derivative deals, errors or misconceptions in valuation could be amplified- whether through leverage or simply contracts built on faulty valuations.

All said, venture funding has slowed considerably in the last year and the downward slope continues. Private Funding dropped by 29% in Q4 2015 globally. As mentioned before, investors are marking down the value of their investments in some of the prominent startups and Mutual Funds are leading the pack. What may appear like a meltdown is actually a market correction that will help check the unfounded speculation of past couple of years. These markdowns are also sending out pointers to other players to tread carefully. The investors are now slowly diverting their focus away from unicorns. Findings of Venture Pulse, by KPMG, clearly endorse this trend. Global funding in Q1 ’16 is down by 8% and the number of deals by 4%. The big-ticket late stage investments have also taken a beating with median plunging from $35 mn in Q3 ’15 to $22 mn in Q1 ’16.Exist unicorns, enter cockroaches! No, not because they are one of the oldest inhabitants of the world. Actually, the latter is a term used for resilient business models that have sustainability and can weather industry storms. These are the ones that stakeholders would hope to become the Amazons and Googles of the dot com boom. Their goal is not essentially a speedy growth, rather slow and steady development of a solid enterprise. In the hare and tortoise story, they are the tortoise that wins the race. But there are misconceptions about what goes behind a really successful business. Most entrepreneurs at the starting gates visualize a business in three steps – idea, market share and consequent funding. They are so fixated on growth and funding that idea validation (one of the most important initial steps) is often compromised. The problem compounds when there is no one to to correct that mistake. It is not unusual to find very enthusiastic investors, sometimes irrationally so. Over optimism (read, greed) about a concept and a push for hogging market share at any cost is damaging businesses more than anything. And yes, it is true that investors’ interests are driving how these tech companies should operate. Profitability seems to have taken a backseat and is being treated more as a natural consequence of acquiring a larger market share. Except that, there are absolutely no guarantees as everyone wants to believe. The glossy startup presentations and fancy pitches do talk about how the cash will be burned, but they hardly contain a clear long-term vision for profitability. Is it because the investors do not care about long-term profitability and are only concerned about their “exists”? Once again, this is no generalization and we are only talking about the majority!

The bottom line is that as Donald Trump woos the bald eagle, one of his concerns may be that there aren’t enough cockroaches around.

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