Lately, there is plenty of speculation and discussion about the existence of a ‘tech bubble.’ That is, an ecosystem-wide over-valuation of tech companies. Typically, this refers specifically to the early stage “start-up” companies proliferating in Silicon Valley, with new hubs popping up in Seattle, Boston, Austin, and Raleigh-Durham, as well as internationally in cities like Tel Aviv, Singapore, London, and Toronto. But let’s be a bit more comprehensive in that definition.
What exactly is a tech bubble?
Firstly, a ‘bubble’ refers to an over-inflation (like the inflation of a bubble) in the value of companies a particular industry or function. Note also that the word ‘bubble’ implies that this overvaluation can’t last forever. What goes up must come down, and every bubble pops eventually.
In the case of a ‘tech bubble,’ we’re referring to unwarranted share price growth and high valuations due to increased speculations in technology stocks. Unwarranted means that the company in question has yet to prove that it deserves such a lofty valuation. In theory, companies’ valuations should be based on their ability to generate profits in the future.
Famously, Amazon posted losses for many consecutive quarters early in its takeover of the mass eCommerce market. Still, investors were bullish, and the value of its stock continued to grow. Investors were speculating that Amazon would begin to bring in profits in the future. Whether or not such speculation constitutes a bubble is up for debate, because Amazon certainly hasn’t remained in the red.
How does a tech bubble come about?
Today, we hear the word ‘tech bubble’ often in reference to smaller companies, typically companies are still privately held. Privately held companies are not publicly traded on exchanges like the New York Stock Exchange. They are owned by their founders and early stage investors like ‘Angel’ investors and venture capital funds.
Tech bubbles inflate (that is, prices of tech companies inflate beyond appropriate valuations) through somewhat of a ‘vicious cycle’ effect in which:
- greater company valuations result in
- greater returns on investments, resulting in
- more dollars flowing into the investment, resulting in
- greater company valuations
Venture capital funds are the largest source of funding for early-state tech start ups, and 2015 saw the second-highest level of venture capital funding in the past 20 years. While there has been a downtick in that funding level in the first quarter of 2016 (likely because venture funds are now oversubscribed with capital), the macro trend still shows significant growth in funding for tech companies.
As shown in the four-step cycle above, the trend of increasing investments in venture capital funds has led to increased valuations of tech companies, and of start up tech companies in particular.
Technology Investments in the Past
In terms of changing our daily lives, the impact of technology innovations is unmatched in how much it has altered the history of mankind. For instance, internet changed how we live our lives about 15 years ago. The smartphone again changed everything, bringing about the rise of the mobile universe, a mere 10 years ago. The rise of eCommerce led to the formation of hundreds of online companies popularly known as ‘dot coms’ with the hopes of making millions.
Tech companies like Amazon, eBay, Yahoo have flourished, growing significantly and making billions even as hundreds of other internet companies failed to survive.
A new tech bubble is not far away with companies like Facebook, Twitter, and LinkedIn growing globally at a significant rate. Investors generally make huge investments with the hope of generating huge profits which in turn leads to increased share price rates. Silicon Valley is considered the best place for the venture capitalists to invest over the last few decades.
The number of industries has been increasing continuously in the Silicon Valley over the last few years and attracting more investors. Stats show that between 1985 to 2014, the number of venture capital funds increased from 432 to 1206, understating the importance of Silicon Valley for entrepreneurs and investors. While a number of tech companies have made it big down the years, the dot com bubble is what ave got many talking, and made investors more wary about their decisions.
What Was the Dot Com Bubble?
Back in the 1990’s, when people first started to begin using the internet, we had a number of new investment opportunities opening up. New internet companies were founded, and investors ensured that their equity values rose rapidly. These companies, known as ‘dot-coms’ had rapidly increasing values, with investors estimating that there would be great profits to be derived in the future.
Unfortunately, it resulted in the tech bubble, better known as the infamous ‘Dot Bubble’ that occurred during the late 1990’s and crashed abruptly in early 2000. Stock markets including NASDAQ crashed, and companies blew up. The investment money was gone, and companies shut down before anybody could understand what happened.
The bubble gobbled up many companies including pets.com and Webvan, which failed completely. A primary reason for the bubble’s failure was that investors ignored the basic fundamental laws of stock market like reviewing business plans, market study and analysing P/E ratios that led to the sudden demise of the bubble.
Modern Day Tech Unicorns
Companies that have a well-organized business plan today with adequate resources are making billions. And those that reach a billion dollar value in less than ten years are generally termed as ‘Tech Unicorns’.
Stats show that usually four companies emerge as ‘Unicorn’ out of 10,000+ companies that are founded every year. Companies like Uber, Palantir Technologies, Xiaomi, Spotify, Fanatics, Snapchat and AirBnB, have emerged as unicorns over the last few years. These startups, like Uber, are valued at more than $1 billion – and they still have to justify their valuation.
Uber Technologies Inc. is an American transportation company serving globally that was founded in 2009 and has emerged as one most promising tech startup over the last decade with an estimated worth of $62.5 billion in the late 2015. Uber has successfully managed to receive huge funding again and again over time which is one of the reasons for the success of the company. And this is due to successful returns made by the company towards its investors due to the proper planning and execution of the business plan.
Snapchat is one of those apps that you probably already have on your smartphones. It is one of the best ways to send across messages to your loved ones, and even pics that are displayed only for a limited amount of time – we are talking about seconds here. The idea was novel, sharing your life with others in a unique way. The company got funded, and even recently in March 2016 raised another $175 million in funding.
Going the IPO Route
We see more startups going the IPO route, and there seems to be a distinct advantage in the company expansion plans when they have more investment money. Initial Public Offering (IPO) is a process of going public in which a company sells it stocks to the public for the very first time. It is generally done by small companies to expand and increase their capital. IPOs can be a risky investment as it can lead to both successful results and failures.
The Success Stories
One of the most successful IPO was made by Facebook. The company sold as many as 421.2 million shares on the first day and generated a capital of $16 billion, making it the largest tech IPO and third largest overall in the U.S. history.
Recently, ‘The Alibaba group’ a made successful IPO of the whopping amount of $25 billion in 2014.
Twitter and LinkedIn also made it to the headlines and still ranks among the best IPOs so far. Few other IPOs that have been successful are Google, and Yelp. Apple too has a stock share price worth a few hundred dollars per share.
While there have been companies that have been encountered success, companies like Globe.com, Vonage, Pets.com and Kozmo.com weren’t as lucky. Initially, they did see an increase in the stock price but later fell drastically during the market crash in 2001.
The tech startups are increasing greatly with more than 10,000 companies starting every single year and so is the investment made by private markets to help these startups.
Conclusion: is there a tech bubble or not?
With all the new startups coming in today, a new tech bubble does seem probable. Most analysts would agree that the patterns before the tech bubble meltdown of 2001 is eerily similar to what is being witnessed today. For one, just like then, there is speculative valuation of companies, with investors keen on making huge investments with greater expectations. The problem though is that most of the valuations are overvalued as investors fail to successfully understand the market demands and business plans.
The overvalued valuation finally leads to the failure in the real market as they fail to survive. In a number of cases, the valuations have been cut to half once the business model has been seen to not be as effective as thought out to be. While aggressive valuations do tell that the company has potential, overvaluing could mean another tech bubble that can hit the investors hard.
Investors need to be careful to evaluate the business plan of the startups when coming out with a valuation. While startups often needs funds to reach the next level, it is a good idea to invest only in those companies that have ensured a sustainable and positive cash flow in the past to avoid the risk of running into a loss.