In the ongoing debate over the existence of a tech bubble, the bubble-deniers have settled on a common theme: The valuations of tech companies may be rising, but the people bidding them up are savvy insiders. They’re unlikely to be completely blinkered. “It’s a handful of very sophisticated investors who have insight into the companies and into the market,” private equity investor Edwin Poston recently told Bloomberg Television.
That makes the experience of the last few years much different from the tech craziness of the late ‘90s, when anyone with a few thousand dollars and an eTrade account was piling into Internet stocks. “Bubbles are a very specific phenomenon where you've got mass psychology and you’ve got … every shoe-shine boy buying stock,” venture capitalist Marc Andreessen told The Wall Street Journal in January. “There's nothing like that [now].”
Poston and Andreessen have a point. The great bubbles in history, right up through the dotcom fiasco and last decade’s real estate unpleasantness, have typically been mass phenomena. Indeed, as Charles Kindleberger explains in his classic text, Manias, Panics, and Crashes, the actual bubble phase of these episodes tends to occur when insiders start selling to credulous outsiders.
But just because bubbles typically don’t inflate until the small-timers get involved doesn’t mean you can’t have a bubble without them. According to Kindleberger, economists consider a bubble to be “any deviation in the price of an asset or a security or a commodity that cannot be explained in terms of ‘fundamentals.’” His preferred definition refers to “an upward price movement over an extended period of fifteen to forty months that then implodes.” Obviously, we don’t know about the implosion part of the story yet. But everything else about today’s tech valuations fits the profile.
Start with the price movements. There are any number of signs that tech companies have become wildly overvalued, but my favorite comes from David Golden, managing partner of Revolution Ventures. According to Golden, there were roughly a dozen tech startups that raised more than $10 million in their first round of fundraising in 2009.1 Last year, there were over 100 such companies—this at a time when it’s getting cheaper and cheaper to launch a start-up.
As for fundamentals, often there are glaringly few on which to hang these valuations. Earlier this year, Facebook paid $19 billion for WhatsApp, a messaging app with 450 million users but little revenue to speak of. Facebook’s next big splurge--$2 billion on the virtual reality headset-maker Oculus VR—didn’t even have a product the average consumer could buy yet, to say nothing of real revenue or profits. The only way to defend these gob-stopping prices is to invent new ways of valuing the companies, something that happens pretty much any time there’s a bubble. Unfortunately, as the hedge fund manager David Einhorn recently wrote to his investors, the old methods almost always come back with a vengeance once the mania dies down.
In fairness, there is evidence that WhatsApp and today’s other Silicon Valley darlings have some value that their late ‘90s predecessors lacked, even without much revenue. Facebook, after all, has the ability to parlay non-paying users into dollars by way of its advertising infrastructure. “One would have thought that a company with no revenue would be valueless,” says Steve Blank, an entrepreneur and Stanford professor who warned about a tech bubble back in 2011. “But for the first time users are equivalent to sales,” at least for certain companies. Still, says Blank, who has slightly moderated his bearish views, it’s hard to believe the value remotely approaches the sums being paid.2 Evenjudging by the price-per-user it spent acquiring Instagram two years ago, which was itself considered inflated, Facebook overpaid for WhatsApp by several billion dollars.
It turns out that insider-ness provides little protection against delusional thinking. “A fundamental observation about human society is that people who communicate with one another regularly think similarly,” the Nobel-Prize winning economist Robert Shiller writes in Irrational Exuberance, his book on the late ‘90s. This is as true of venture capitalists and tech executives as it is of lowly clock-punchers. Indeed, Shiller cites several experiments showing that people will often accept an observation that is self-evidently bonkers merely because seven or eight peers—about the size of a typical Silicon-Valley board meeting—insist it’s right. “People simply thought all the other people could not be wrong,” Shiller explains.
A market dominated by insiders may even exacerbate the self-delusion. When most tech stocks trade on public exchanges like the NASDAQ or the New York Stock Exchange, skeptical investors at least have the opportunity to bet against them by selling short, which can have a disciplining effect. But when firms stay private, only insiders like venture capitalists and other tech executives have a chance to invest, and there is no way to bet against them.3 “I had lengthy discussions with [the French bank] Societe Generale for six months about how to short,” says Bob Rice, a New York-based money manager, who ultimately threw up his hands. “It’s a terrible problem that you can’t short [tech startups].”
Ultimately, it’s the tech companies’ preference for putting off IPOs and staying private, and not the soundness of their valuations, that may be the biggest difference between the current tech boom and the last one. According to University of Florida finance professor Jay Ritter, the average company goes public after 10 years today, versus just six years in 2000. David Golden points out that tech companies were going public so quickly in the ‘90s that the mom-and-pop investors who bought their stock were essentially fronting them venture capital—a highly risky form of investing not normally associated with grandmothers in Nebraska.
Today, on the other hand, something close to the opposite is happening: Tech companies are putting off their IPOs for so long that venture capitalists and other private investors are playing the role of the moms and pops and buying in at hugely inflated prices. The New York Times recently reported that the average size of a “late-stage” round of funding for private tech companies was over $44 million this year, up 77 percent from 2013. Many of these private companies, like Airbnb, Dropbox, and Lyft, are raising hundreds of millions of dollars from investors—the kind of capital companies previously raised by selling shares to the public. These insiders have, in effect, become the dupes that other insiders exploit.
The good news, as the Times’ Annie Lowrey later pointed out, is that most of the money lost when the bubble bursts will come from private investors, who can afford it, not people invested in the stock market, where relatively few tech startups dwell these days. The only average folks likely to suffer are those who make their living in the Bay Area.
The bad news is that, 15 years after the last tech bubble, we still haven’t proven we can look at a tech startup and judge it by the value it actually has (or is likely to have), rather than the value we want it to have. Surely the money could be better spent elsewhere.
Noam Scheiber is a senior editor at The New Republic. Follow @noamscheiber
I’m referring to the first round of money they raise from institutional investors.
Suppose for the sake of argument that WhatsApp really was worth $19 billion to Facebook. (Hard to believe, but okay.) It clearly overpaid nonetheless. In a rational market, the fair price isn’t the value to the buyer; it’s a little bit more than the next guy was offering. And, so far as we know, there wasn’t really a next guy. Certainly not one offering double-digit billions.
I await the Michael Lewis book explaining how this can be done.