On Bubbles … And Why We’ll Be Just Fine

Posted on Jun 22, 2011 | 32 comments


This post originally ran on TechCrunch.

I recently spoke at the Founder Showcase at the request of Adeo Ressi.  I asked what the audience most needed to hear.

He said, “They need an unbiased view of the fund raising environment because there is too much misinformation and everything seems to be changing fast.”

This was an audience of mostly first-time entrepreneurs. They have seen one side of a market where many of us have seen the ebb and flow multiple times. Still, market amnesia by ordinarily rational actors always surprises me.

I spoke about a lot of things during the keynote. If you are interested the Vimeo is here. I spoke about whom to raise capital from (funding options), how much I thought they should consider raising (18-24 months), how fast they should spend it (lean until product/market fit, then fat when they’re ready to scale), how fast they should raise it (now, now, now) and at what valuation (at a fair price that I call “the top end of normal“).

I spoke about how Amazon Web Services deserves far more credit for the last 5 years of innovation than it gets credit for and how I believe they spawned the micro-VC category. I said that I felt that Micro-VCs were the most important change in our industry. I believe that. It is great for entrepreneurs and great for VCs.  I will write more about this in the next 2 weeks.

I also spoke about why I believe we’re in a “localized” bubble. I suppose I should have imagined that this line would get more press than all other comments combined. Fair enough.

But a certain amount gets lost in the headlines – especially when not everybody actually heard the video and knows the nuance of the message.

So here is what I have been telling entrepreneurs privately for the past 6 months.

1. Why I believe we’re in a bubble
People get too worked up over the word. I’m no great scholar on bubbles – I have more interesting things to spend my time worrying about than the exact definition, but having been around a few I have at least given them intellectual consideration. I know that most people who are close to them tend to deny their existence, as we saw in the great housing bubble of 2002-2007 and the dot com bubble of 1997-2000.

I believe a bubble occurs when a market is willing to pay greater than intrinsic value for an asset class. That asset class need not represent the broader market. As any historian of bubbles will tell you – there were periods of bubbles in assets as arcane as tulips, South American trading companies, dot-com bubbles & housing bubbles. They are often bound by geographies and asset classes. But they also often have a rippling effect on broader markets as all of our economies seem to be intertwined these days. I said that at the Founder Showcase, too.

The fact that today’s Internet bubble does not represent all companies does not disprove its existence.

Ah, but today’s Internet companies have real revenue! and profits! Sure, that makes them better companies than those of 12 years ago. But that doesn’t mean that people are paying rational prices as investors based on intrinsic value. Rational people can disagree and some may argue that today’s prices are rational and under-pinned by economic drivers. That’s fine. It’s just not my judgment based on the data I see.

In the past I have publicly commented on some specific companies that seemed over valued. Responses ranged from, “hey, they’re in a HUGE market” to “it is an amazing company and their technology rocks.” Sure. But everything has intrinsic value. And you may choose to overpay hoping that the future value will be worth your while. That doesn’t mean it’s not a bubble. It’s like people arguing that there’s a beautiful beach house in 2006 that represents great long-term value due to scarcity of similar property. All of that might be true, but the 2006 price might still be over-valued

What I believe is happening is that private-market investors are getting ahead of themselves for fear of FOMO: fear of missing out. If you are an early investor in Facebook, Twitter, Zynga, Tumblr, GroupOn, LivingSocial, etc. – you’re very well positioned as a fund. I guess that makes USV, Spark Capital, Foundry Group, Accel, Benchmark, Revolution (along with several others) pretty happy right now. And well they should be.

But this mania to not miss out on the next big thing is driving some investors to pay growth-equity prices for traditional market risk (as in, they’re paying up before it is clear there is product / market fit). And so on down then line.

In addition to FOMO it is partly driven by massive increase in valuations for earlier-stage companies who raised money at bit seed prices but who still have product risk. If a company that would traditionally raise $500k at a $3.5 million pre-money valuation is now raising $1 million at a $12 million valuation the next investor has nowhere to go but up (or sit out the investment). Just because the valuation in absolute terms isn’t a big difference does not mean that people aren’t paying higher than intrinsic value for these investments.

And this is happening in mezzanine (pre-IPO) deals as well. And post IPO deals, although these tend to correct more quickly.

Why does all this matter?

2. There are fewer big deals than people imagine
If everybody is over-paying for early-to-mid stage deals you’d imagine that these all need to feed into a frenzied M&A and IPO market that will garner big returns for these risks investors are taking. Perhaps this will trend up massively but historical data doesn’t bode well.

source: Capital IQ

In any given year there are about 50 venture-backed companies or so that are bought for $100 million or more. And for many of these they were (over) funded 7-10 years ago and don’t necessarily all represent great returns for investors or founders. I would guess (I don’t have the data) that less than 5 companies / year are purchased above $100 million that have been funded within 5 years of the being started and have raised less than $10-15 million in capital.

And as you probably guessed the data aren’t any better on IPOs with less than 20 / year average for the past 10 years. Yes, everybody expects a continued uptick given the euphoria of  LinkedIn & Pandora and long anticipated Facebook, Zynga, GroupOn and one day, Twitter. But it’s not enough to justify over-paying for deals.

source: Capital IQ

3. What a bubble means for each entrepreneur
To anybody who asks my advice I repeat the same line, “I don’t know whether this party will last 6 weeks, 6 months or 18 months. But it will end. And when it does the market will shut off immediately. Investors will focus only on protecting existing deals. They will enter the “triage phase” of the market where they figure out which of their existing deals will survive. Many good companies will not get funded. New investors hate down rounds. Vultures will start circling looking for deals. Get funded now, if you can.”

Note: I did not say, “funding is easy” as some people have quoted me. I said, “It’s much easier now than it was in 2008/09.” That’s a fact. And for some it is actually easy. For others it feels like a two-speed economy, where rules apply to hot tech startups that don’t apply elsewhere. Huge structural under-employment in much of the country and full employment in some niche tech markets where it’s impossible to hire developers, designers or sales professionals. You know what I’m talking about. You feel it, too. It’s surreal.

So I’m not advocating panic or a need to rush your funding round. I just think that some entrepreneurs try to “optimize” too much for short-term prices. They hope to delay fund raising (or only raise small amounts now) so that they can raise at a much bigger price later. That may happen.

That’s the problem – you never know when the party’s over. And time is the enemy of all deals so start sooner rather than later, as anybody who was planning to raise in October 2008 will tell you.

And for some that means that despite waiting they may see worse valuations in the future than now. Or worse yet they may never get financed. That happened a lot in 2002 and again in 2008.

I tell people to raise money when you can, but don’t ramp up your spending in a crazy way afterward. Have a cushion. Raise at “the top end of normal” but not so high that future financings in a corrected market become impossible.

4. Bubbles are inevitable
I guess it’s an inevitable process that we seem to go through where markets heat up, get euphoric & irrational and then external market drivers remind us all at once that we were being irrational as a market. We go through our “Bear Stearns moment.” I learned long ago at the University of Chicago where I got my MBA that investors tend to want to invest when markets become over-valued and sell when they become undervalued. Exactly the opposite of what a rational investment strategy would advise.

Why?

In a booming market your investment is worth more than you paid almost instantly. You come in at a $10 million price and somebody else invests at $50 million 6 months later. Feels good.

In contrast, when the market is falling, by definition your investment is worth less THE DAY AFTER you have invested. In a public market this is measured immediately. You are “catching a falling knife.” You have to have patience, which is hard when you see red. So people sell or at least don’t invest.

Some people argue that we’re not in a bubble because the prices are not as crazy or as inflated as they were in the late 90′s. That may be. It may also be that this lasts another 18 months. But when it’s all over and they define the era of this mini run up in stock prices I suspect they’ll include 2011 in the “over valued” category.

5. Good things may come out of bubbles
Bubbles are not all bad. There are great societal benefits that sometimes come out of bubbles. One example is that the telecom bubble of the late 90′s left both the US and the international markets with a greatly expanded footprint of fiber-optic cables laid at the expense of many an over-zealous investor and entrepreneur. I can’t argue that this is better than slow, rational growth. I only point out that there are side benefits of the bursts of energy, enthusiasm and investment dollars.

And the bursting of bubbles isn’t bad for everybody. Those with strong business models suddenly stand out when the tide goes out. An obvious example is Google who may have gotten less market attention if there would have been 8 well-financed competitors during the 2001-2005 timeframe. Or Salesforce.com who rose to prominence in this same period where they were ramping up PR and shouting from mountain tops when everybody else in the market was mute.

6. Why the bad side of bubbles affects entrepreneurs & investors alike
Another misconception of bubbles is that they only hurt investors. That’s not true. When you’re building a startup and can’t hire the engineers you need, can’t retain staff, can’t get press coverage and can’t hire sales people – it certainly affects you. When your competition does irrational things to grow fueled by low-cost capital it makes it harder for you to compete by playing by the conventional rules.

I remember in the late 90′s trying to charge fair prices for software when my well-financed competitors were giving things away for free.

7. Why the bursting of bubbles also affects more than investors
I also point out that bursting of bubbles also affects us all. Sometimes callous observers say, “Who cares if some VCs lose money in a bubble?”

Um …

  • many people also lose their jobs when bubbles burst
  • some founders lose their life savings
  • people who poured their hearts into projects see their efforts vanish over night
  • customers who paid for services often get burned
  • many ancillary businesses (legal, real estate, services) are affected
  • and those VCs are actually investing money from places like state pension funds & university endowments

Trust me, we’re all hurt when bubbles burst. Just think about how you felt the impact of the real estate bust even if you didn’t own property or if you bought well before 2006/07. This market will be the same.

8. The road ahead

I’m not an alarmist person, I’m rational. The sky isn’t falling. There are many things to be encouraged about.

I see opportunities for disruption all around me and am meeting amazingly talented entrepreneurs. I’m looking for ones that understand that in order to build huge, meaningful companies they’ll need to likely build through these boom years and some lean ones. When I find people like that it’s great chemistry.

When I look at the headwinds we face as a country and as a society they are also big. This concerns me about the growth rates we can anticipate for the next 5 years.

I’ve wrote about this 9 months ago. If you want a more detailed analysis see that post. Nothing has changed in my mind since then but it does go to show how difficult it can be to predict the timing of economic impacts. In economics we call these “exogenous events” and if they happen (Greek debt crisis, problems raising the US debt ceiling, trouble in Saudi Arabia) – you will not be shielded.

That said, for every set of global challenges there are entrepreneurs dreaming of solutions, solving big problems and ready to lead us into the next 20 years. It’s what I love about entrepreneurship and about venture capital. We get the opportunity to serve these amazing talents that hold our futures in their hands & minds.

9. Why I will still be investing
I know prices are higher than the norm right now. I am confident they will be lower at some point on a relative basis. But as an investor you cannot simply sit out period of great innovation. As Fred Wilson once pointed out to me, he invested in both Twitter & Tumblr during a high-valuation period.

So at GRP Partners we’re very active now. We’re just conscious to invest in realistic entrepreneurs who know that it will take years of hard work, who are committed to building large businesses over time, who have exceptional skills & passionate about the disruption they’re causing and who are cost-conscious enough to be around for the long haul. Building billion-dollar businesses requires 7-10 years which means operating through at least one full economic cycle, if not two.

We may invest at the “top end of normal” but not at such a high price that we create future problems. We’re not cheap, but we’re disciplined. We are definitely still open for business.

Bubble image courtesy of Fotolia.

  • http://profiles.google.com/mvg210 Mike Gnanakone

    Mark, as you pointed out valuations are increasing to bubble like levels, but since there are 10x more people online doesn’t it make sense that valuations should be around 5-10x they were in the last bubble in the “new economy” when there were on 100 million people online?

    Also, do you think the education sector will see an increase in VC money? I feel like all the companies getting funded are for iPhone photo/check-in apps… I think education is a way bigger market.

  • Datt

    This is very serious concern right now. B’coz of that high valuation people who are having stake in Facebook wants to sell but they issued not to sell.   Still we are not fully recovered from the housing bubble once again if we get a bubble now things will be entirely different like grate depression.                                                                                                                                                                                   
        
    Bubble is not all bad b’coz it can give the new innovation,opportunities in the new field so that their is lot of possibilities exploring the new things. 

  • http://www.charliecrystle.com Charlie Crystle

    education is a big market, as long as you find a way to skip the decision-making process of school boards. But it’s ripe for disruption;  our district paid $660k over 3 years for what’s effectively a pretty front end to student data. couldn’t believe it…

  • Robert Thuston

    I see your point as how bubbles can affect entrepreneurs with hiring, media coverage, etc., but I still see all this information as more of a distraction than anything.  As an entrepreneur you are responsible for making a value-driven product (where there is demand), and for picking a value-driven investor (not market driven).  As an investor, the same as above, but vice versa.

  • foobar

    Well, we’re certainly in a booming market. A booming market means prices going up quicker than values. In part to catch up with the previous baisse, and another part that will melt away in the next correction. Up and down is an integral part of the economy. The term bubble doesn’t apply.

    A bubble is a ridiculous inflation. People start investing for different reasons. Many of them even know they’re in a bubble and just think they’re smart enough to take advantage of it and get out in time. It’s a pyramid scheme.

    Pandora collapsed on day two. It might have been a brutal correction. But it’s the lack of these corrections that makes a bubble. And all the big companies aren’t along for the ride. Google, Microsoft and Apple are actually down YTD.

  • http://twitter.com/dgeorge Devon Angelpreneur

    Ben Horowitz & Steve Blank are into a good, moderated/official, debate on The Economist website.  I highly recommend – http://www.economist.com/debate/days/view/711

    Mark, love your coverage of this topic and you should jump into the economist debate.  Those people could use some of your sound insights.

    Keep up the good posting, and videos.
    Happy Summer.
    Devon

  • http://about.me/humphrey HumphreyPL

    Hi Mark,
    Thanks for the break down once again. I am co-founding a startup in Australia and valuations here are 1/5th of what we could get in the US but working visas, moving overseas and family are issues to overcome.
    I am wondering what your thoughts are on the recent investment by Accel into Australian startups and if you see more firms heading to South East Asia (I include Australia in this Group) in search of deals. Even Steven Blank talked at StartupLessonsLearned.com about the new service LeanLaunchLab.com which allows investors from afar keep track on startups progress without the need to travel for board meetings. He mentioned Australia in this example specifically.
    Great work as always!
    Cheers,
    Humphrey

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  • Dave W Baldwin

    Appreciate your posts, a lot of work goes in.

    Hopefully some of the corrections taking place this year dampen expansion of potential bubble that bursts.

  • http://www.virtuallybing.com Bing Chou

    Agreed.  Bubbles cover up (and encourage) deviation from those principles for a short while, which is a shame.

    “Those with strong business models suddenly stand out when the tide goes out.”

  • http://www.twitter.com/stevenkane Steven Kane

    Very well done. Thank you.

  • http://www.ipatient.com Dan Munro

    This one cuts through the headline hype – great post.  The only real miss I see is under “worries” – Healthcare.    

    AHIP (America’s Health Insurance Plans) just concluded their annual event in SFO last week.  Nothing all that newsworthy for this audience – except one tidbit.  Laura Tyson (16th Chair of the Council of Economic Advisors) captured it eloquently in her keynote:  ”We don’t have a debt problem in the US economy, we have a healthcare problem.”  

    Healthcare spending now accounts for about 18% of US GDP.  On it’s current CAGR – by 2025 the annual cost of healthcare insurance will equal the average annual household income (see chart).  Clearly we won’t let that happen – but the healthcare “overhang” is a big drag on EVERY aspect of our economy – including startups – most notably in the competition for talent.  Dave Chase wrote a piece on TechCrunch recently that highlights some interesting solutions that have started to emerge to combat the advantage big companies (GOOG, MSFT etc…) have in the talent wars (namely healthcare benefits).  As a footnote, the healthcare business unit Dave founded at MSFT is now their most significant vertical.  http://tcrn.ch/jTZLiq

    Solid progress this year for healthcare ventures (Massive Health, Green Goose, RockHealth – and more in the pipeline), but it’s still a very small (too small) percentage of the overall funding pie – 3%.  The top 4 categories (Social, Advertising, Gaming and Storage) account for a whopping 55%.  There’s definitely a bubble over here in healthcare – but it’s spending – not investing.

  • http://www.commun.it SharelOmer

    Hi Mark,

    10x for sharing this important information… 

    This data force us to prepare for the upcoming changes, and set realistic goals…
    its time to take the lessons we learned from Mr. Warren Buffet regarding building a Moat ( Sustainable Competitive advantage, scalable biz model) and prepare for the next bubble borst.

    it makes you think, if you want to build a business that valued at over $200m (and we see there are not so many of them…) what type of Moat we need to build now :) we talked of stamina in the past… I believe its still holds water :)

    10x,Sharel

  • Robert Thuston

    I see from your profile you hiked the AT.  I hiked it in ’04 ME > GA “Porch”.  Cheers

  • http://www.virtuallybing.com Bing Chou

    Small world. I just saw an old friend “Griz”, also from ’98 – we decided to
    organize a 15 year reunion hike for ’13 – it’ll be interesting to see if any
    of us can handle a week of backpacking any more.

  • Robert Thuston

    I know, I’d be struggling out there now too. But what a nostalgic feeling to get into a rhythm hiking on the trail again. I get it every time I hike now.

  • http://twitter.com/ameensaafir Ameen Saafir

    Mark, great stuff as always.  The biggest difference I see between the current climate and 12 years ago is that people are taking the time to at least *think* about how they are going to make money.  The 1999 bubble seemed to be a lot more product driven, whereas now there is more focus on actual revenue models and monetization.  I don’t think anyone can argue against companies being overvalued right now, but 12 years ago a lot of those business were infinitely so.

  • Todd_Andelin

    Bubbles.
    I like carbonated soda anyways.
    Some companies and ideas etc…are just transient.  Just fizz.
    But what would Coke be without  fizz? 
    We have a carbonated market here.

  • http://www.alearningaday.com Rohan Rajiv

    Thanks Mark. I loved this post – clear and flows well with all the data backing it up. 

  • http://www.smallbusinessbible.org Small Business

    You did it again Mark! Great Article

  • http://bothsidesofthetable.com msuster

    Thanks. I agree with you about the healthcare problem and one of GRP’s portfolio companies is attacking just that. 

    With that said, I don’t think it’s one of the immediate problems that will cause a short-term economic shock. It’s like all the biggest issues that won’t get tackled, important but not yet urgent enough for anybody to take action. Kind of like the gas problem from the 1970′s to present. Eventually both will become urgent & important.

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  • Smaxwell

    Mark, I agree that a bubble seems to be forming and I really appreciate all your data and thoughts on the topic.  My sense is that we are still in the early stages and it has a long way to go before it really gets excessive.  When all the tech investors are all-in, that will be the peak of the bubble, as there will not be anyone left to buy into the growing valuations.

    Of course, the bubble may deflate slowly before that happens if there is a serious event of some kind or if the economy falters again.

    Btw, we are still actively investing as well and the pace this year is higher than last year.  Perhaps we are all contributing to the bubble…

    Scott Maxwell
    OpenView Venture Parnters

  • http://www.springmetrics.com Tim Huntley

    Great post Mark!

    And a very interesting chart above (yearly exits > $100M) – I had the exact same discussion with a VC firm in 1995 (I was the CEO of Ganymede Software). 

    Luckily it looks like we were one of the VERY rare firms (even in those crazy times) that raised $10M in VC money and were able to exit in a total of 5 years (4 years or less for various VC’s).  We sold the company in 2000 to NetIQ for $170M.

    I just subscribed and will look forward to reading your posts.

    …Tim Huntley

  • Anonymous

    Fair point – it’s just a really big anchor/tax on the whole system (including startups).  Not a lot of easy/short-term fixes at all.  I do applaud every investor/entrepreneur focused on healthcare innovation – including GRP!       

  • Thiebaut

    Hi Mark !

    Where exactly did you get the data on the 100M exits ? I’d love to study this in detail.
    Could you provide a link ?

    Thanks

  • http://blog.openviewpartners.com/author/brandonhickie/ Brandon Hickie

    This is a very informative post about the upcoming tech bubble and how it has affected start-up company valuations and the price of venture funding.  Mark provides some great advice to startups who are considering raising funds in the next couple of years.  I have commented on his tech bubble startup financing advice in my most recent blog post at http://blog.openviewpartners.com/tech-bubble-capital-a-perspective-on-mark-suster%e2%80%99s-venture-fundraising-advice-to-hedge-against-tech-bubble-risk/.

  • http://blog.openviewpartners.com/author/brandonhickie/ Brandon Hickie

    This is a very informative post about the upcoming tech bubble and how it has affected start-up company valuations and the price of venture funding.  Mark provides some great advice to startups who are considering raising funds in the next couple of years.  I have commented on his tech bubble startup financing advice in my most recent blog post at http://blog.openviewpartners.com/tech-bubble-capital-a-perspective-on-mark-suster%e2%80%99s-venture-fundraising-advice-to-hedge-against-tech-bubble-risk/.

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  • http://www.kidmercuryblog.com kidmercury

    lol mark did you seed wadhwa embarrass kedrosky on bloomberg about the bubble…..HAHAHAHA you gotta admit wadhwa brought his A game! i gotta give props!