Dot-Com Bubble 2.0? Valuing Today’s Internet Stars
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By Knowledge Wharton,
Knowledge@Wharton
April 15, 2011

In December, Google made a bid for social e-commerce company Groupon that valued the company at $6 billion, according to press reports. By the end of the month, TechCrunch and others were putting a nearly $8 billion value on the company based on a new round of venture capital (VC) funding. Two weeks into the new year, The New York Times reported that Groupon was talking to Wall Street bankers about an IPO that would value it at $15 billion. By March, Bloomberg had upped the IPO price tag to $25 billion.

How does a company that helps people buy $30 worth of Chinese food for $15 see its estimated value more than quadruple — to $25 billion, no less — between Thanksgiving and St. Patrick's Day? Must be Internet II: Return of the Dot Com Bubble, right?

Not necessarily. "I would put myself in the class of bubble skeptics," says Luke Taylor, a Wharton finance professor. "People have knee-jerk reactions when they call something a bubble ... It's a name for something that we haven't taken the time to understand."

Taylor suggests that valuations for Groupon and a handful of social media companies that investors can't get enough of these days -- Facebook, Twitter, Zynga, LinkedIn and Foursquare -- are aggressive and perhaps overly optimistic. He points out that companies in the S&P 500 typically have a market value "zero to four times revenue." These social networking darlings are being assigned valuations as high as 100 times revenue, or more. "Does Twitter deserve a multiple 25 times larger than any company in the S&P 500?" Taylor asks.

That question will be answered when Twitter eventually goes public. In the meantime, for those who think the company's valuation is arguably on target -- and the case can be made that it is -- the bubble debate ends there. Even for doubters, the question becomes: Do a handful of companies signal a bubble? That depends on whether they are having an undue influence across the tech landscape.

Tech companies and the venture firms that back them are dealing with many of the same trends and issues they have been working through for quite some time. Big VC firms are struggling to find companies that can absorb eight-figure investments and generate outsized returns. The availability of unused capital has kept valuations artificially high. But it is also hard for VCs to cash out. The IPO window has been narrow for several years now, with fewer companies overall and still fewer web-based businesses squeezing through.

Meanwhile, countless start-ups have sprung up, with low-cost business models that capitalize on the potential of cloud computing, social media and mobile web applications. These fledgling firms don’t need much VC money, if they need it at all, and mostly count on lasting long enough to prove their concept and be acquired. Competition for the attention of a few active buyers has kept prices for these deals fairly low.

The result is that VCs are buying relatively high and often selling relatively low, often after holding on to companies for longer than they would like. They have the so-so returns to show for it. The Cambridge Associates U.S. Venture Capital Index had a five-year return of 4.25 percent as of September 30, 2010 — ahead of major stock indexes but hardly the outsized returns that garner big VC fees. One-year returns of 8.2 percent trail all the major stock indexes and the Barclays Capital Government/Credit Bond Index. That is quite a come-down from triple digit returns for 1999 and 2000, or even the sizable double-digit one-year returns VCs enjoyed for most of the 1990s.

Doug Collom, vice dean of Wharton San Francisco and a partner in the Silicon Valley law firm Wilson Sonsini, acknowledges that a lot of companies are finding money relatively easily, but he also points out that these companies are extremely capital efficient. "They can bootstrap to get started [and] then, when they acquire a customer or two, get $500,000 from angels and small VCs," he says. "After six months, these investors will look at you steely eyed and ask, 'Is it working?' ... The press doesn't pick up on the dozens of companies that raise $500,000 and crash and burn."