Bubble or Not: What Tech Startups Need to Know

Are you confused on the debate between whether there is a tech bubble or not? Are you wondering if a bust might happen and what you can do about it? In this post, Ben Larson analyzes the trends to see if a tech bubble is happening, and gives advice for what tech startups can do to prepare ahead.

Ben Larson is the Director of Founder Institute San Francisco Bay Area and Regional Success Manager at Founder Institute Headquarters. He is also a Senior Advisor and Mentor to Youth Business USA.

The article "Weathering the Bubble: How to Position Your Tech Startup to be Enduring and Meaningful" originally appeared on Ben's LinkedIn. It has been republished below with permission.

There is a lot of anxiety in the tech world about a potential bubble. It’s become an extremely polarizing discussion where the thought-leaders in the industry feel the necessity to pick a side and defend it fervently. Very smart and seasoned people completely contradicting each other on a daily basis for the past year. It’s kind of like politics. So, the question still remains: are we in a tech bubble or not?

Well, to even attempt to answer that, we need to know what defines a “bubble.”

If you go to Google and search for the term “tech bubble,” it will return a clear and succinct definition provided by Investopia:

A pronounced and unsustainable market rise attributed to increased speculation in technology stocks. A bubble is highlighted by rapid share price growth and high valuations based on standard metrics likeprice/earnings ratio or price/sales.

So, let’s break it down…

Pronounced and Unsustainable Market Rise

Pronounced? Certainly. The market as a whole is definitely witnessing an influx of investment (a significant amount coming from unsophisticated investors), escalating valuations, large companies continuing to grow without proving viability, and there appears to be an arms race on scaling, and therefore burn. The big question is, however, is it sustainable? This is where speculation seems to be at its peak. On one side, you have arguments suggesting that companies are being poorly run in the interest of growth. The classic land-grab for whatever vertical you’re trying to become the dominant player. On the other side, it seems like we have merely exposed the tip of the iceberg when it comes to the market potential of the tech market. E-commerce growth potential, the power of distributed labor forces and the sharing economy, and the impact of truly immersive 3D support the idea that maybe this growth is rational and sustainable.

Increased Speculation

Again, some people say yes, and some people say no. There are many more “investors” getting into the private investing game via syndicates, crowd-funding, or just trying their hand at angel investing. The US government is working towards making this more accessible to non-certified investors. Should they? Sure, why not, let people gamble their money how they wish, but the clear vehicle for doing this in the past was the stock market and the IPO flood in the late 90s. Traders were seeing 600% gains in very short periods of time and then would pull their money out. Now, people are getting into private investing, but while it is becoming easier to put money in, you completely lose the liquidity of your assets. So what happens if confidence in this system wanes? Investment slows. What happens when investment slows? Companies die.

Rapid Share Price Growth

Not in the traditional sense perhaps, and I’ll talk about this a little more in a bit, but how are we supposed to feel about escalating company valuations.

High Valuations Based on Price/Earnings Ratio or Price/Sales

Some of the top “unicorns” out there are still seeing astronomically high Price/Earnings ratios. Understandably, this is the definition of a startup. You’re still supposed to be figuring things out. However, the desire to dominate the market before establishing a sustainable business model seems to diverge further every day. We have companies remaining private longer and longer.

So the question remains. Bubble? No bubble?

We’re certainly at no shortage of opinions. Shri Bhashyam from Equity Zen compiled a fine list of commentary, including names like Bill Gurley (bubble), Dave Crowder (no bubble), Mark Cuban (definitely a bubble), and many others doing what I’m doing … collecting a lot of information, but still relatively uncertain.

What many people naturally think to do is look to compare it to the last tech bubble. The clear indicator of what happened in 1999/2000 is often clearly represented by comparing the NASDAQ, which is made up of tech companies, and the S&P 500, a 500 company cross-section of our economy. Have a look at this chart. Seems totally normal right? No, of course not. There’s a very obvious pronounced and unsustainable market rise due to increased speculation, which caused rapid share price growth and high valuations compare to the P/E ratios.

But hind-sight is 20/20.

If we extend this graph to today, things look pretty normal; but remember, hindsight is 20/20 and not always the best indicator of explaining the future. It’s a completely different landscape today than it was 15 years ago. Money is flooding into different areas of the market.

Sam Altman of Y-Combinator observes that “valuations for tech companies don’t look any higher than other stock valuations…price-to-earnings ratio…is in fact lower than for the index as a whole. Come on, Sam. Can we really pass judgment on the situation based on an index full of dinosaurs? That’s not where the speculation and escalating value is occurring.

The fine gentlemen at Andreessen Horowitz put together a collective brain child that culminated in a 53 page slide deck. It’s a great bedtime read. If long-winded analyses are your thing, then perhaps you would be interested in Lou Kerner’s (Social Internet Fund) attempt to best them … 64 slides!

Both conclude the same thing: no bubble. The a16z fellas say that “steady growth in funding reflects the scale of opportunity” and Lou backs them up by saying that “more mature companies at IPO is a sign of a healthy market.”

Sounds pretty reasonable actually.

But who are we, as in those in the tech industry, to determine the value of that opportunity? Fred Wilson, famed investor from Union Square Ventures, back in July of this year said that “the tech sector is making a huge mistake in thinking that they know their companies and how to value them better than Wall Street. That kind of thinking is arrogance and pride comes before the fall.” Profound. Sure, you might argue that Wall Street is not structured well for tech, or that it doesn’t even understand tech, but I’ve often told people that your company is worth as much as people are willing to pay you. Isn’t that what the public market is all about?

In a recent Tech Crunch article where the author accuses the entire industry of being in denial and that the bubble is about to burst, Tallat Mahmood backs-up Mr. Wilson by claiming “the jury is still out on actual profitability.” Furthering the doomsday prophecy is Mark Cuban, who says that “If we thought it was stupid to invest in public internet websites that had no chance of succeeding back then, it’s worse today.”

Just look at all these companies hiding under the private veil. Do you think SnapChat is worth $16B? Is Uber really a $51B company when it's burning $750 million a year, $60MM of which are in legal fees? I mean, could be.

With all these exceptions, unknowns, and speculation, perhaps it would be better to take a step back and look at this from a larger scale. In his 1986 book, Stabilizing an Unstable Economy, American economist Hyman Minsky’s postulated the five stages that culminate in a bubble:
displacement, boom, euphoria, profit taking, and panic.

Displacement, or disruption, is the first step. In the nineties, it was the internet. The excitement of scalability through tech and the potential for unprecedented profitability. In the late 2000s, sub-prime mortgage loans and variable interest rates? Now that everyone is trying to “disrupt” their respective industries, we are witnessing similar opportunities. The sharing economy? Crowdsourcing and funding? What else? There most certainly has been a boom and a euphoric response from investors.

Bill Gurley, a partner at the venture capital firm Benchmark, warned in an interview with The Wall Street Journal that “no one’s fearful, everyone’s greedy, and it will eventually end.”

Uber, AirBnb, and Instacart are just a few of the disruptive companies today. No fear. Profitable? Who cares? Just give them another 10M dollars.

So what about the last two stages? Profit Taking and Panic. Well, this is the bust we have yet to see. But how does profit taking work when investments have no liquidity? Unloading on secondary markets? Scarcity in follow-on and new investment? There are a lot of questions, but one thing becomes clear to me: that profit taking and panic wont look the same as years past and the results may take longer to realize. Instead of a pop, perhaps it would be a longer transition to increased unemployment and profit losses. A slow recession instead of a crash. Time will tell, but I predict that we will be doing a retroactive analysis three to five years from now instead of suffering an eminent pain in 2016.

Marc Andreessen of Andreessen Horowitz, the same Andreessen Horowitz that put out the 53 page rebuttal to the bubble, went on 18 tweet tirade in September of last year saying that “new founders in the last 10 years have ONLY been in the environment where money is always easy to raise at higher valuations. THAT WILL NOT LAST. When the market turns, and it will turn, we will find out who has been swimming without trunks on (a reference to the famous quote by famed investor Warren Buffet): many high burn rate co's will VAPORIZE. When the market turns, M&A mostly stops. Nobody will want to buy your cash-incinerating startup. There will be no Plan B. VAPORIZE.

18/Worry.

First, what is it with Twitter tirades? Isn’t the 140 character limit there for a reason? Isn’t that why we have blogs? Anyhow, I digress. (138 characters)

So, to this, I pose a question.

Does any of this really matter to you? It’s entirely possible that this is a completely justified market rise. I mean, as Bill Gurley has pointed out, we are in a risk bubble. The industry is taking on a level of risk that we’ve never taken on before in the history of Silicon Valley startups. But we are still unsure of the outcome. High risk can lead to high reward. It may or may not pop on its own volition, but what about other factors? 2008 had nothing to do with the tech sector. It certainly impacted us. It is still impacting much of the world and coined phrases like the new normal.

Just look at the history books. Predicting a market turn is like predicting earthquakes in San Francisco. You generally know it’s going to happen again. It’s cyclical.

In the last downturn in 2008, Sequoia put out the famed R.I.P. Good Times presentation and sent it to all the founders in their portfolio. (What is it with these people and their 50+ slide decks?) Again, not a tech bubble that popped, but look at the advice. Sounds very similar to the advice you might give if it were a tech bubble that popped.

Manage what you can control: spending, growth assumptions, and earnings assumptions. Focus on quality, lower risk, and reduce debt.

Towards the end of the deck, they give a short checklist for the founders to follow.

◻ Must-have product
◻ Established revenue model
◻ Understanding of market uptake
◻ Customers ability to pay
◻ Assessment vs. Competitors
◻ Cash is king
◻ Need for profitability

Again, sound advice when financial support and market demands are questionable.

So, are we comfortable saying that the time will come when the market takes a turn? Or in the words of Warren Buffet, when the tide goes out? Yes. Don’t be that guy or gal swimming naked in that proverbial ocean.

Fred Wilson says it perfectly. “At some point you have to build a real business, generate real profits, sustain the company without the largess of investor’s capital, and start producing value the old fashioned way.”

So let’s build some real f*$&ing businesses!

Real profits. Actual revenue models.

Growth built upon actual revenue and market projections, not driven by a “keep up with the Jones’s” mentality.

And produce real value. What is value? Value is having a product or service that people are willing to pay for because it actually improves their life. They are willing to dig into their pockets, pull out some hard-earned cash, and hand it to you in exchange for something amazing that you’ve created.

This is why we focus on building enduring and meaningful companies at the Founder Institute. Will your company stand the test of time? Is it built on a scalable revenue model that can adjust to market demand? Is it meaningful? Does it have value? Does it change people’s lives? If you can’t answer ‘yes’ to these questions, try harder.

I’ve had the pleasure of working very closely with Adeo Ressi, CEO and Founder of the Founder Institute, for the past two years. The other day, I asked him, “What are the secrets to sustaining success in a down market?” He simply stated, “Be smart. Be frugal. Have revenue.” Seems simple enough.

We dug a little deeper and found an interesting pattern. Let’s take those three elements of advice, and add one more: scaling. If you were to order them by priority in a strong market, it might look something like this:

Scale Quickly
Be Smart
Be Frugal
Have Revenue

Scaling quickly during a boom time is admittedly essential. If you don’t, your competitor will. When scaling quickly, you have to be smart. See the future kind of smart. Everything changes drastically when scaling: staffing, communications, culture, etc. Frugality and driving down costs are what make good companies great, Apple being the prime example. They are the masters of driving down their bottom line and capitalizing on the margins. Finally, having revenue. In a good market, this can come last because investment is largely available, especially if you can prove that you can scale quickly, be smart, and be frugal with said investment.

Now what happens when the market turns?

Well, so should your priorities. In this case, they flip. Since investment is going to become much more competitive, figure out that revenue model and provide value. Be frugal and make your money go further. Being smart. I feel conflicted putting this third, but realistically, in a down market, money talks. Once you have money, and act smart, you can scale quickly without using investment as a crutch.

If you can succeed in a bad market, the market will turn back, and you can again reverse your priorities and capitalize. This sort of agility is what will help you build a meaningful and enduring company that has the ability to weather a bubble.

So, whether a bubble burst is eminent, few years away, or it simply dissipates on its own due to environmental powers, don’t you want to make sure you’re not the one swimming naked?