Is the startup bubble going to burst?

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A business contact asked me the question after the flurry of acquisitions and investments in startups. He opined that it brought about a number of similarities with the dotcom bubble that happened in the late 90s. I thought that it might be good to delve deeper in the situation before coming to a verdict.

Let’s pull up from Wiki a little bit of history of how the initial dotcom bubble came about.
The dot-com bubble (also known as the dot-com boom, the tech bubble, the Internet bubble, the dot-com collapse, and the information technology bubble) was a historic economic bubble and period of excessive speculation that occurred from 1995 to 2001. During the bubble, the valuations of companies in the quaternary sector of the economy increased extremely rapidly. The value of the Nasdaq Composite, which includes many technology companies, rose from 1,000 in 1995 to 5,000 in the year 2000.
While the latter part of the dot-com bubble was a boom and bust business cycle, the Internet boom is sometimes meant to refer to the steady commercial growth of the Internet with the advent of the World Wide Web, starting with the release of the Mosaic web browser in 1993, and continuing through the 1990s.
The period was marked by the founding and, in many cases, spectacular failure of several Internet-based companies commonly referred to as dot-coms. Venture capitalists were eager to invest in any company that had one of the Internet-related prefixes or a “.com” suffix in its name. By the end of the 1990s, the NASDAQ Composite reached a price–earnings ratio of 200, a truly astonishing plateau that dwarfed the peak price–earnings ratio of 80 for the Japanese Nikkei 225 a decade earlier.
The collapse of the bubble took place during 1999–2001. Some companies, such as Pets.com and Webvan, failed completely. Others, such as Cisco, whose stock declined by 86%, lost a large portion of their market capitalization but remained stable and profitable. Some, such as eBay and Amazon.com, later recovered and even surpassed their dot-com-bubble stock price peaks.

What factors contributed to the perfect storm?

1) Increases in computer and internet usage

The expansion of the internet occurred in industrialized nations due to the reduction of the “digital divide” in the late 1990s and early 2000s. Between 1990 and 1997, the percentage of households owning computers increased from 15% to 35%. Previously, the absence of connectivity infrastructure and a lack of understanding of the internet were two major obstacles that previously obstructed mass connectivity to the internet. Increased means of connectivity to the Internet and the increased functionality of the internet caused the use of information and communications technology to progress from a luxury to a necessity. The shift to an economy based on computerization is known as the Information Age.

2) Record-setting growth by technology companies

Due to the advent of the Information Age, technology companies realized record-setting growth and experienced meteoric rises in their stock prices. Venture capitalists, eager to profit on this growth, moved to raise and invest capital faster and with less caution than usual. The low interest rates of 1998–99 helped increase the availability of funding.

3) “Get big fast”

A canonical “dot-com” company’s business model relied on harnessing network effects by operating at a sustained net loss and building market share (or mind share). These companies offered their services or products for free or at a discount with the expectation that they could build enough brand awareness to charge profitable rates for their services in the future. The phrase “Get large or get lost” was the wisdom of the day. The motto “get big fast” reflected this strategy. Internet companies believed that their survival depended on expanding their customer bases as rapidly as possible, even if it produced large annual losses. For example, Amazon.com spent large sums on advertising to alert people to its existence and expand its customer base, and Google distributed its operating system for free and spent rapidly to create more powerful machine capacity to serve its expanding web search engine. At the height of the boom, it was possible for a promising dot-com to become a public company via an initial public offering and raise a substantial amount of money even though it had never made a profit—or, in some cases, realized any material revenue whatsoever. In such a situation, a company’s lifespan was measured by its burn rate: that is, the rate at which a non-profitable company lacking a viable business model ran through its capital.
The “growth over profits” mentality and the aura of “new economy” invincibility led some companies to engage in lavish internal spending, such as elaborate business facilities and luxury vacations for employees. Executives and employees who were paid with employee stock options instead of cash became instant millionaires when the company made its initial public offering; many invested their new wealth into yet more dot-coms.

Cities all over the United States sought to become the “next Silicon Valley” by building network-enabled office space to attract Internet entrepreneurs. Communication providers, convinced that the future economy would require ubiquitous broadband access, went deeply into debt to improve their networks with high-speed equipment and fiber optic cables. Companies that produced network equipment including Nortel Networks were irrevocably damaged by such over-extension; Nortel declared bankruptcy in early 2009. Companies such as Cisco, which did not have any production facilities, but bought from other manufacturers, were able to leave quickly and actually do well from the situation as the bubble burst and products were sold cheaply.
In the struggle to become a technology hub, many cities and states used tax money to fund technology conference centers, advanced infrastructure, and created favorable business and tax law to encourage development of the dotcom industry in their locale. Virginia’s Dulles Technology Corridor is a prime example of this activity. Large quantities of high-speed fiber links were laid, and the State and local governments gave tax exemptions to technology firms. Many of these buildings along I-495 became vacant office buildings after the bubble burst.
Similarly, in Europe the vast amounts of cash the mobile phone operators spent on 3G licences in Germany, Italy, and the United Kingdom, for example, led them into deep debt and led to the telecoms crash. The investments in infrastructure were far out of proportion to both their current and projected cash flow, but this was not publicly acknowledged until as late as 2001 and 2002. Due to the highly networked nature of the information technology industry, this quickly led to problems for small companies dependent on contracts from operators. One example is of mobile network company Sonera, which paid huge sums in German broadband auction then dubbed as 3G licenses. Third-generation networks however took years to catch on and Sonera ended up being bought by Telia.

4) Stock market bubble

In financial markets, a stock market bubble is a self-perpetuating rise or boom in the share prices of stocks of a particular industry; the term may be used with certainty only in retrospect after share prices have crashed. A bubble occurs when speculators note the fast increase in value and decide to buy in anticipation of further rises, rather than because the shares are undervalued. Typically, during a bubble, many companies thus become grossly overvalued. When the bubble “bursts”, the share prices fall dramatically. The prices of many non-technology stocks increased in tandem and were also pushed up to valuations uncorrelated to fundamentals.

So if you look at the above, the first three reasons seem to apply. Mobile adoption rates rose by double digits over the past couple of years propelling ecommerce. Records continued to be broken as tech companies earnings soared. Unicorns seem to be a word popping up frequently as funding continues to poar in. And Get Big Fast is still applicable in a majority of the startups with everyone driving growth in incomes, users and revenue. The final one is tricky. Are we in a stock market boom at the moment? Since President Trump came into office, the rise in the overall stock market indices has been good. That rise even started prior to Trump coming into office.

There are a couple of detractors though. Jeffrey To thinks differently and provides the following reasons:

1.”Prove it to me”

In spite of tales of VCs writing checks without term sheets or proper due diligence, particularly in the early stages, many veteran VCs remain cautious about jumping into the fray. They expect entrepreneurs to demonstrate that their startups are viable with proven revenue flow, rapidly increasing traffic or customers, unique assets and intellectual property, and/or some combination of the aforementioned.

2. Find really big problems to solve

Investors today are looking for entrepreneurs who are building solid companies based on solving real problems, and building value and defensible competitive barriers over the long-term.

 

3. Longer planning horizons

Businesses focused on solving bigger problems take longer to build. But the other reason for longer planning horizons is the fact that investors and founders can no longer count on IPOs as a short-term exit.

 

4. Microclimates

Perhaps what we should really be asking is “Where are the bubbles?” not “Are we in a bubble?” The latter question implies that we’re in some broad-based bubble which, if popped, would have far-reaching impact. However, in spite of all the excitement about heated valuations hovering above 25 times revenues, it’s still fairly contained within pockets or “microclimates” of a handful of well-known emerging startups.

 

5. SOX Sucks

One of the byproducts a couple years after the bust was Sarbanes-Oxley, an attempt to hold executives accountable for what and how they report. The costs, in terms of financial and executive energy, are so high that it has implicitly raised the threshold for companies seeking to go public.

So maybe this time is different or does history repeat itself? I leave you to come to a conclusion but you have to admit that the resemblance albeit with certain differences is uncanny.

Source: https://en.m.wikipedia.org/wiki/Dot-com_bubbleOther interesting reads

Picture source: http://www.afr.com/technology/uber-and-other-hot-internet-companies-not-immune-to-dotcomlike-bust-20160811-gqqqhg

http://www.businessinsider.sg/a-4-step-startup-plan-from-south-parks-eric-cartman-2014-11/#sTkytbFWPsHx6qq6.97

http://www.cnbc.com/2017/04/25/cramer-compares-the-2000-dotcom-bubble-bust-to-todays-market-moves.html
http://www.businessinsider.com/heres-why-the-dot-com-bubble-began-and-why-it-popped-2010-12?IR=T&r=US&IR=T
https://www.fastcompany.com/1715201/tech-bubble-5-reasons-why-time-its-different
https://www.forbes.com/sites/petercohan/2016/02/12/7-ways-2016s-tech-bubble-differs-from-the-dot-com-disaster/#41644d506fff

https://www.caseyresearch.com/articles/why-it-feels-like-the-dot-com-bubble-all-over-again
https://www.pcworld.idg.com.au/slideshow/528854/pictures-10-signs-dot-com-tech-bubble-has-returned/
http://www.zerohedge.com/news/2017-03-18/signs-silicon-valley-tech-bubble-about-burst

https://venturebeat.com/2017/04/30/surge-in-startups-and-capital-could-be-bad-news/

https://techcrunch.com/2017/05/01/2017-tech-ipos-are-on-a-tear-compared-to-last-year/

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