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."
Exit returns, when VC-backed companies go public or are sold, have varied from one quarter to the next The biggest deals often come from clean technology or life-sciences, where companies need large chunks of VC money, rather than from Web 2.0 plays. In 2010, only one of the 10 biggest VC deals was in social media, according to the PricewaterhouseCoopers/National Venture Capital Association MoneyTree Report. Twitter raised $200,000 in its ninth round of funding. The rest of the top 10 were later-stage cleantech, financial services and equipment companies.
One could argue that, against this backdrop, Facebook and company are seeing their valuations soar because they are rare exceptions to persistent trends rather than forerunners of a new trend, Taylor says. Tech investors are starving for companies that have the capacity to hit homeruns. Groupon, Facebook, Twitter, Zynga, LinkedIn and Foursquare are likely to have IPOs — much-hyped, high-flying ones at that — the closest thing investors have seen to a Babe Ruth or a Hank Aaron in quite some time. Everyone wants a seat in the ballpark for these at-bats, experts note.
A 'Wait and See' Approach
Rather than pursuing the bubble-or-not questions, experts have been exploring the extent to which these valuations are supported by hype, demand and likely financial prospects. "You have a bubble when valuations aren't justified by the underlying fundamentals," said Wharton management professor David Hsu. "You have to look at issues like barriers to entry, the value of first-mover advantage [and] the importance of reputation, and consider whether these factors justify these superstar valuations."
Observers seem likely to give Facebook, with its billions of users and versatile platform, more benefit of the doubt than, for example, Groupon, which has had to contend with fickle consumers, an expensive sales force and a slew of copycats chasing after its business.
Lubos Pastor, a finance professor at the University of Chicago's Booth School of Business, has done research indicating that when there is a lot of uncertainty surrounding a fast-growing company, its market value tends to go up. "Suppose you have two companies that are identical, but one will grow at 20 percent and one will grow at either 10 percent or 30 percent," he notes. "The second is more valuable because it would great if it hit 30 percent, but 10 percent isn't terrible. With VC investments, loss is limited to what you put in, but the upside is tremendous."
In 1999, the uncertainty was centered on whether and how Internet companies would make money; it turned out a lot of them couldn't, or at least not enough. This time around, talk of another tech bubble is focused on firms that have revenue streams and even profits. There are few doubts that seven-year-old Facebook is viable: The uncertainty is focused on what additional revenue streams it might leverage and how big those revenues can grow.
"As long as there is uncertainty, people will pay for the upside potential," Pastor says. "We don't know how fast this market will grow. We don't know if everyone on the planet will be doing business through Facebook. If that happens, Facebook will look like a bargain today."
Secondary markets that trade private company shares are adding to the hype. But Collom points out the speculative valuations on these firms can cause headaches. If shares become spread among too many secondary buyers, the firm could hit a 500-shareholder cap the SEC puts on private companies, forcing them to go public prematurely. In addition, too much of a discrepancy between the value executives place on a company -- when they are issuing options, for example -- and the value the market puts on it can cause other difficulties.
Eventually these companies want to go public, and want their offerings to be successful. "Suppose people have been buying your shares on the secondary market at $50, which gives you a $5 billion valuation," says Collom. "Then you register for your IPO and the investment banker says your financials don't support that; they support a $2 billion valuation. You have discontent among all these investors who bought in at $50 a share." Positive hype for a company can turn the other way very quickly at exactly the wrong time.
Even if one or a few of these companies cannot sustain their valuations when they finally open their books and go public, no one is expecting them to crash and burn. They might simply have to "recalibrate" their value, as Hsu puts it, adjust and move on.
Adapted with permission from Knowledge@Wharton, the online research and business analysis journal of the Wharton School of the University of Pennsylvania.
This Tech Bubble is Different (Bloomberg Businessweek)
Twitter Investor Says Twitter’s Valuation is “Ridiculous” (Business Insider)
Tech Bubble: 5 Reasons Why This Time It’s Different (FastCompany)