startupIn spite of recent legal troubles, six-year-old on-demand transportation network Uber is valued at a staggering $50 billion. Vice Media’s $2.5 billion valuation technically makes it worth more than The New York Times. And it’s only been two years since Evan Spiegel wisely turned down Facebook’s whopping $3 billion acquisition offer for Snapchat– the messaging service is now valued around $16 billion.

The tech community is abuzz with the possibility of an impending bubble in which the valuations of companies will overstate their earnings and profitability. Understandably, the term is emotionally charged: it harkens back to not only the 2007 housing bubble but also the dotcom bubble at the start of the new millennium. Although the media’s selective attention toward successful start-ups has fueled perceptions of a tech bubble, most of the evidence indicates otherwise, even in the face of an expansion in angel investing.

Fantastic Beasts …

If there were really a bubble in tech, then funds would theoretically be readily available. Yet venture capital firms fund only two out of every one thousand start-ups they meet with annually, and only one out of 10,000 funded start-ups becomes a “unicorn”–a start-up worth over $1 billion. Currently, the chance of a random start-up reaching a value of over a billion dollars is a flimsy one in five million. Journalist Kevin Maney called this phenomenon the “start-up wealth gap,” noting in a 2014 Newsweek article that since 2000, only 80 companies had reached the $1 billion mark. Half of these companies were called “Category Kings”: enterprises that create and command a fresh business category, conquering roughly 70 percent of the market.

A Play Bigger study that Maney co-wrote found that if a start-up is not yet a Category King after six years of existence, it has almost no chance of becoming one in the future. In this sense, although Uber is valued at $50 billion, investors gave Lyft only a $2.5 billion valuation because they foresaw a zero-sum game between the ride-sharing companies. As Highland Capital Partners principal Chris Protasewich told the HPR, “Solutions targeted at specific markets are hard to displace … This is the path to becoming a clear market leader.” These kinds of zero-sum games push back on the idea that there is a bubble in tech.

In the early 2000s, the dotcom bubble was characterized by companies with little real revenue selling stocks to ordinary people in order to raise money. Although such initial public offerings (IPOs) were an effective way of gaining funds, they placed a great deal of risk on ordinary individuals instead of more customary institutional investors. Protasewich explained that when these companies failed to generate real profit and declared bankruptcy, ordinary people were the ones who bore the brunt of these losses. Thus, these bankruptcies negatively affected several sectors of the economy. In contrast, he pointed out that today’s companies are more likely to raise money from growth- and later-stage venture capital firms that specialize in these kinds of investments. Such companies would hopefully be better informed about their investments than the ordinary stockholders of the dotcom bubble.

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…And Where To Find Them

But when he examined the behavior of these mature and growth stage venture capital firms in bigger, later fundraising rounds, John Backus—a board member of the National Venture Capital Association—found evidence of bubble-like behavior, especially when he differentiated between “unicorns” and “dragons” in a venture capital firm’s portfolio. “Unicorns” and “dragons” are both worth at least $1 billion; the distinction is that a venture capital firm invests in a “dragon” very early on. This allows the “dragon” to yield a much larger return. In contrast, a firm invests in a “unicorn” later on in the start-up’s lifetime, typically after the “unicorn” has gained significant traction. In these cases, interested venture capital firms often embark on a bidding war that can quickly escalate the valuation of the company; a firm entering the fray in a later round may end up forking over millions of dollars for ownership of a miniscule fraction of the unicorn.

Given the scarcity of dragons, some argue that venture capitalists could be contributing to a bubble in tech by over-focusing on unicorns. By paying so much for a unicorn, a venture capital firm may more successfully attract top entrepreneurial talent to increase its chances of nabbing future dragons. However, unicorns are such a recent phenomenon that the efficacy of this strategy remains to be seen.

In Backus’s analysis of all exits of at least $1 billion from 2004 to mid-2014 (such as IPOs or acquisitions by another company), 74 venture capital firms made 339 investments in companies that already were or would eventually become unicorns, but only 21 of these investments (seven percent) became dragons. Almost all of the firms that held dragons in their portfolios only had one. Because they want to attract dragons through high-price-tag unicorn investments, such venture capital firms might conceivably end up boosting valuation for tech companies—which could play a role in any potential bubbles.

However, given that only one in five million start-ups becomes a unicorn, this unicorn-hunting only inflates the value of a few companies, not necessarily all start-ups as a whole. And as Geoff Ralston, a current partner at Y Combinator and an executive at Yahoo during the dotcom bubble, told the HPR, “A small number of big investors losing money on those investments is highly unlikely to cause any sort of [economic] contraction.” He is skeptical that there is a bubble today based on the valuations given to companies such as Uber and Airbnb.

Brian Truong, the current CEO of startup HelloToken and a former investment professional at Rothenberg Ventures, agrees that valuations are far from an exact science. Truong does not necessarily think there is a bubble. Nevertheless, he told the HPR that if there were to be a bubble, it might happen on a smaller scale for start-ups that make consumer apps, which are used by individuals rather than businesses. Although valuations of a company are typically based on revenue, consumer apps—many of which are free—do not always have an apparent source of revenue. Instead, venture capital firms often base valuations on growth and the number of users, with the understanding that monetization will occur later on. “There is something to be said [for] growth, but it’s not necessarily the perfect metric for whether or not a start-up is going to be sustainable, much less profitable,” Truong said.

One reason that he thinks that growth-based assessments lead to higher valuations today is that cost barriers are now low enough for most people to access the Internet—and therefore consumer apps—on their mobile devices in addition to their personal computers. Truong continues, “Internet usage … has grown exponentially, especially in developing countries,” he said. “We’ve hit a critical mass of users and connectivity between each other and what we use. For many companies, there’s more of a market for their product today than ever was before. So, if there is a bubble, it hopefully isn’t bad.”

Here Be Dragons

Venture capital firms are not the only source of cash for start-ups in today’s market: while venture capitalists invest the money of limited partners (typically university endowments, mutual funds, and the like), angel investors invest their own money. In a recent blog post, Shark Tank investor Mark Cuban stated that he believes there to be a bubble in tech due to increased activity on the part of inexperienced angel investors.

Yet as the Angel Capital Association indicates, angel investors invest far smaller amounts than venture capital firms—most of the former give up to $100,000 to start-ups, whereas the latter contribute $2 million or more. Additionally, Truong reasoned, angel investors do not always invest for profit: “They often want to give back to their community and support the next generation of entrepreneurs.” This kind of behavior is unlikely to create a new tech bubble.

Furthermore, whereas angel investors only use their own money, venture capital firms employ other people’s funds. Because ordinary individuals do not yet seem to be pouring a significant portion of their wealth into angel investing and venture capital appears to be steering away from many risky tech investments, it is unlikely that there is presently a tech bubble like in the early 2000s. When the media highlights the massive funding rounds for unicorns like Uber, Airbnb, and Snapchat, their valuations may indeed seem gargantuan, but these Category Kings are the one-in-five-million exceptions to the rule.

But all players involved in a fundraising round still have their own motives to drive up valuations: founders often seek higher valuations to allow them to raise capital without giving up as much ownership to venture capitalists as well as to help their start-ups recruit top talent; venture capitalists will often accept the higher valuation a hot start-up seeks in the hopes of getting in on the action. A better question to ask might be this: what should these valuations mean to us?

 

Image Source: Flickr/Heisenberg Media

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