Fifteen years after the dotcom collapse we see another tech crash approaching. ‘Bubble’ and ‘unicorn’ are entering the mainstream vernacular. We are becoming comfortably numb with tech company overvaluations.
The vocabulary has changed (for ‘dotcom’ read ‘unicorn’), the dynamics are different (largely private rather than public), but the impact on the tech sector, and the choices companies should be making now, are no less profound as the coming crash slowly unfolds.
The signs are already here that a serious correction is in the air:
VC investment pace is blistering – Venture capitalists invested $18B in the second quarter of 2015, the largest quarterly amount since 2000. That’s $200m per DAY of venture investment. And yet VC confidence has dropped to its lowest level since 2013. VC’s may be investing a lot, but their outlook has turned negative. Magister Advisors polled senior European VC’s and found over 70% viewed early stage valuations today as ‘very high’ or ‘extremely high.’
Unicorn valuations for lower quality assets – $1B ‘unicorn’ valuations are being paid for companies that are essentially glorified ‘features’ not products or platforms. Features have always been modestly valued, then bought when they reach any degree of scale, and quickly integrated into a larger company. But only once before in history have features been valued at $1B+, during the dotcom boom. Remember ‘companies’ like Blue Mountain Arts?
VC valuations have uncomfortable echoes of ‘Ponzi’ schemes – Many VC’s are raising new funds based on writing up the value of existing portfolio companies that have yet to exit. This is uncomfortably close to the mechanics of a Ponzi scheme and works as follows: a VC’s private portfolio company is valued too highly. That inflated paper value is a benchmark that in turn inflates the value of a VC portfolio (which remains illiquid). That ‘big gain’ encourages new fund investors to raise a larger next fund. Of course the VC has not actually MADE that money. It’s only on paper, and can disappear tomorrow.
Macro factors are negative – Interest rates can only go up, growth can only drop. European Central Bank rates reached NEGATIVE 0.2% recently, indicative of how low rates have dropped everywhere. All signs point to rates moving up in many market in coming years. Meanwhile growth worries are everywhere. China’s recent devaluation was surely indicative of growth worries, after recent industrial, real estate and stock market booms. If Newton were an economist, a law would be: when rates rise and growth slows, valuations go down.
It seems now we need to talk about when a tech crash comes, not if.
Crashes or corrections very rarely happen smoothly and ratably; they always hit hard, causing over-reaction, and ‘sudden’ significant loss of value for many investors. The dotcom crash of 2000-2002 wiped $5 trillion off stock values worldwide.
In general we see the coming crash as a value crash not a company crash; meaning we expect many funded businesses to stay in business, just to be worth a fraction of what they are being valued at now. This is fundamentally different to the 2000 stock market bubble, where many companies simply went bust, literally overnight.
We hazard a few guesses as to the look and feel a coming crash could have:
It will be quiet – money has overflowed to private companies and those companies have stayed private far longer than in previous crashes, notably the 2000 bubble burst. In 1999, there were 457 IPOs; in 2014 only 118 companies went public. When billions in value are lost, it is most likely that it happens fairly quietly, silently crushing thousands of founders (whose equity will become worthless), and putting tag-along VC investors quietly out of business. Since it takes years for a VC to actually go bust, we will not see the crash’s destruction immediately after it happens, but feel its effect over 5-10 years.
Early stage companies will suffer most – money during a crash will simply become unavailable, and many early stage companies looking to raise $5-15m to scale will not find any funding, literally anywhere. Those companies planning to raise money 2-3 years from now must already be planning on accessing other sources, such as corporate investors, family offices and the like.
Perversely we think real innovation will benefit – This is a bit of a leap, but we see $ billions of VC money being invested in businesses with little fundamental innovation (for every Palantir or Cloudera there are a dozen Snapchats). While a rising tide lifts all boats, to some extent this is diverting investment from serious, long-term innovation. A valuation crash will hit me-too scale businesses the hardest, killing future investment in ‘disposable’ consumer tech firms. Since VC money won’t disappear overnight, we can see how for several years in future science driven, innovation-led growth companies will attract more interest proportionately than today.
Tech M&A will stall then rise sharply – during a valuation free-fall, companies that should be sold will find their investors are ‘deer in the headlights,’ requiring months or years to adjust their thinking and expectations, especially since many of these private companies wont actually be going bust, they will just drop permanently in value. This will cause tech M&A to stall as buyers start to expect realistic prices, and sellers cling onto unrealistic price. However after the inevitable adjustment period, many privately funded companies will become very attractive M&A targets, and we will see a very brisk rise M&A activity as buyers ‘clean up’ the VC mess the current bubble is creating.
IPOs will simply stop – If a $1B+ ‘unicorn’ drops in value to say $500m, no group of investors will vote to IPO it even if they could get $600m from public investors. Those companies will stay private and VC’s will aim to defer recognizing the losses for as long as possible. This will simply kill the IPO market.
The crash will hurt emerging tech clusters far more than Silicon Valley – while many unicorns are based in the Bay Area, the fact is the Valley has weathered several crashes before, and the depth, experience and resilience of tech talent there is unmatched anywhere. Emerging clusters like Austin London or Berlin however will see a very painful few years after a crash, with investors pulling back sharply, and talent deciding to work in the financial industry (London) or media (Berlin) instead of starting a business. Emerging clusters are inexperienced clusters, and inexperience usually over-reacts in the face of adversity.
What should private companies and their backers do in the face of the above? Uber, Slack and other category ‘winners’ provide an answer. Raise as much money as possible now, even if you don’t need it. Manage burn to run for longer so you don’t have to raise in 2-3 years time unless the climate is positive enough. Take a lesson from companies like Glasses Direct and use raised cash to acquire companies, fill out your offering, and develop towards ‘winner status; in a negative funding climate, money will likely flow to winners and away from challengers.
Fundamentally we see the coming crash as being entirely different from 2000. It will be quiet and unravel slowly, but its effect will last for many years. At this point we no longer see any way to avoid this unless VC investment and valuations reduce significantly, and very quickly. But that would be like asking a serious heroin addict to voluntarily cut their daily doses and taper till they were out of danger.
Posted by Victor Basta @MaExits