Caught In The Webb

Everything You Ever Wanted to Know About Why We’re Definitely in a Bubble

A thoughtful dialectic with our esteemed columnist on why we’re in a social/media bubble.

The Arguments against it being a bubble:

There are a bunch. Let’s go through them one by one:

“This time it’s different”
There is a strange paradox going on with some observers contending that no one’s saying that this time things are different, while actually, this time, people are saying it’s different. Henry Blodget just gave us the best example of this. “Is everyone justifying today’s prices by saying ‘this time it’s different?’” he asks? “No.” And yet, right after saying that no one was saying ‘it’s different this time,” 15 slides later, Blodget is outlining why it’s different this time. It’s kind of awesome.

Paradox aside, Blodget’s arguments for why it’s different are the same as many others in the anti bubble camp: that way more people use the internet than during the dotcom boom, so the valuations are more realistic. That we are undergoing a social revolution, and that we are undergoing a mobile revolution. All of these are true. All of these are irrelevant to the existence of a bubble. They are arguments on one side of the “considerable variance” debate. Personally, I hope they are true. But we are sticking to the actual definition of a bubble here, and the fact that it’s different is moot. Indeed, both Schumpeter’s creative destruction and Peres’s technical revolutions, imply that many bubbles do result in something different, in a leap forward. And yet, the bubbles still happen, as do their commensurate crashes.

“Bubbles can be good.”

This is true. Bubbles can be good. They are still bubbles. The benefit of bubbles are moot to whether or not a bubble is happening. “Are we asking if consumer web/app technology’s impact and influence on mainstream culture and ordinary people will decrease? I can’t imagine so,” Anil Dash commented on Branch. It is an important point. Bubbles do destroy value, but good things can come out of them. This is probably more about the internal morality debates that many of us in tech have – are we helping the economy or hurting it? We may well be helping it, but it will still be a bubble, and someone else will bear the cost.

Nowhere in the definition of a bubble does social good enter into the equation. Carlota Peres predicates her whole seminal book on the fact that bubbles drive all major innovations. They do, however, come with costs, which she outlines in gory, devastating detail.

“Prices are in line with value”
The Public Markets are Fine, For now. Investor Chris Sacca colorfully sums it up: “As you guys know, I am also a very active late stage investor. Business on that end is entirely different than in the 90s when I first got to the Valley. Facebook, Twitter, LinkedIn, etc are all real businesses with CAGRs that would make a hockey stick blush and reach for the Viagra.”

Blodget points out that the IPO market is open, but it is far from robust. This is true. The bubble is not in public markets.

Yet many bubble deniers continue to use public market data to defend the private markets. Investor Chris Dixon does so in the Branch debate by saying, “In particular, in every bubble in the past, P/E ratios of securities bought and sold by non-professional investors were way higher than the historical average. During the dot-com bubble and housing bubble, P/E’s were over 40…. Current P/Es in tech are a reasonable 17 (historical average for S&P is 15).” Blodget uses Apple as an example, showing that it’s P/E ratio is a reasonable 15.

Mark Andreessen echoed these sentiments last week when he said “If we’re in a bubble, it’s the weirdest bubble I’ve ever seen where everyone hates everything. If you check tech stocks that went public recently, it’s nose down to the ground. We’re now 15 years of flat stock market returns. That’s a weird bubble.”

And yet public markets are irrelevant unless we’re arguing a narrow bubble of public market tech stocks only, which no one is arguing. It’s a red herring.

Public markets are tight right now partially due to tech stocks doubt, but the main reason for the lack of IPO access is due to larger issues with the recession we are currently in, and slowly working our way out of. This will change.

Previously, I had commented on how as pressure for tech companies to IPO increases , the public market tightness will come under attack. This absolutely came to fruition with the JOBS act, and Blodget as much as gives up the game in his recent presentation in a footnote that says ”The JOBS act could begin to change this. Fingers crossed…”

So let’s move on, then, to where most bubble-believers argue that the bubble is forming, in the private markets. As we’ve said, the hardest part of bubble identification is figuring out whether the prices have decoupled rationally or not. Whether “intrinsic values” are still being considered. Many bubble deniers concede this, such as Chris Dixon, who said of early stage private companies “those have never been valued by VCs on purely financial metrics.” This is, of course, true, but could be interpreted to tacitly admit that pricing is not at “intrinsic value.” Of course, things still need to be “considerably at variance” and “high volume” to be a bubble, but this does effectively concede that things are not at intrinsic value.

There exists a large body of work explaining the apparently irrational yet defensibly logical pricing of tech startups – quality of the founder, mobile trends, social trends, competitive funding environment. If you look at something like this Quora thread, you’ll see a lot of talk about normal valuations, with some admissions that they are mainly guesswork. Indeed, it’s comical how many different Quora threads ask the same question in different ways. Poke around. Also often mentioned are whether the founder is still at their job, the quality of the founder, and whether they have a prototype. It’s worth noting that none of these three factors are related to the economic definition of “intrinsic value.” I’m not saying they don’t matter – they’re factors I base my own investment decisions upon – and god knows what ELSE we’re supposed to use. But nonetheless, they are irrelevant to economic theories of bubbles.

Chris Dixon recently conceded that “certain stages of venture valuations do seem over-valued, in particular seed-stage valuations and (less obviously) later stage ‘momentum valuations.’” He explains this by talking about the proliferation of seed stage investors who are investing in what they believe in (I would be one of those) and in the momentum stage by non-inherent-value decisions such as “VC’s who want to be associated with marquee startup names, the desire to catch the next Facebook before it gets too big, and the desire of mega-sized VC funds to “put more money to work.” He counters this by saying that Series A seems under-valued. Dixon rightfully points out that it’s hard to have a public debate about this due to confidentiality. He’s right. So basically Chris is saying there’s froth in early stage due to lots of angels (like me) and froth at the late stage because of “momentum” valuations (ie tumblr and foursquare, groupon etc). In the middle, around Series A, he thinks that there’s not frothy valuations. He may be right. So can it be a bubble if there’s a sober moment in the process from early stage, to series A, to “momentum” valuations? It’s an interesting point of view. I do wonder, though, If there’s froth before and after sober Series A, however, does it really matter? And for what it’s worth, personally, I have seen plenty of froth in Series A as well.

One thing I will cave on. Dixon makes the excellent, eye-opening point that “This doesn’t mean the investors think they will invest and then get some greater fool to invest in the company again. For instance, at the seed stage, intelligent investors are quite aware that they are buying the dream but will need to have numbers to raise a Series A.” I admit I hadn’t thought of that in exactly that way before. Yet if our bubble is in Social Mobile, a world still primarily of light revenue, I wonder what metrics those valuations are based on? Revenue is, after all, the only metric relevant to “intrinsic values.” But most Series A rounds I’ve seen are still very light on revenue. The metrics used to establish value are based on users, who will, hopefully, one day be turned into revenue. Most of those valuations are, in my experience, fairly optimistic about per-user future revenue.

Andreessen’s method of market potential multiplied by likelihood does a good job at addressing these concerns. Though as we’ve seen, interpretations of the numbers can vary widely.  And none of those, however, work in situations like YC’s new “Apply without an idea” program, or the funding of some founders without any idea (i.e. Jakob Lodwick)

I’ll admit that we can’t get anything off the ground if we fund everything at zero or near zero valuations. We have to put a stake in the ground somewhere. But in terms of a strict definition of a bubble, it’s hard to deny that intrinsic value, from an economist’s point of view, hasn’t been thrown out the window.

In a recent controversial (in tech circles) NY Times piece by Nick Bilton, Paul Kedrosky,  an investor and editor for Bloomberg, explained “It serves the interest of the investors who can come up with whatever valuation they want when there are no revenues. Once there is no revenue, there is no science, and it all just becomes finger in the wind valuations.”

Chris Dixon partially affirmed this last week by saying “The argument that sometimes startups get better valuations without revenue is somewhat true.’

In the end, it’s anyone’s guess. Investor Chris Sacca sums up the conundrum on the Branch debate by saying “It’s easy to moan about valuation creep on the seed stage deals, and I cringe at some of the entitled attitude I see around these days. However, for all the whining, I will concede that two of my best performing deals ever, Twitter and Instagram, were done at roughly $25mm and $30mm pre respectively. So, what the fuck do I know?”

It’s a mess. It’s a constant debate. But if we can’t know prices are too high, we certainly can’t know that they’re reasonable, and, thus, the defense crumbles.

The “greater fool” inversion.
Bilton, who was on the Branch thread, parries for the bubble believers: “One of the signs of a coming bubble could be seen with the high valuation of start-ups. Viddy at $370 million; Foursquare at $700 million; Pinterest at $1+ Billion. All of these companies, and many others, have very little, if any, revenue. When start-ups reach such high valuations, they are left with only a handful of suitors that can acquire them. If there is no buyer, these companies have to go public, which is where the price-earnings ratios become a problem and confidence can wane.”

To which Michael Arrington shot back “A lack of buyers is an excellent indicator of a not-bubble. The greater fool theory assumes there’s always someone dumb enough to pay more.” Apparently because the number of buyers is limited, the greater fool theory is not in play.

I love this. The flaw here is that the whole point of the greater fool theory is that this is true until it’s not. One day the music stops.

Barring that, Bilton is correct: pressure is coming to push these companies public, before their ready (see below), thus, the “greater fool” argument is still in effect.

As an aside, Economists do not currently find the “greater fool” theory to be true, despite such believes being “prevelant among practitioners

“No one is getting hurt.”
The argument here is that this is just a bunch of rich people gambling, it’s only in the private markets, and no one else is getting hurt. Your mom and dad aren’t going to get hurt.

This is so not true. Public pension funds have always been a massive source of venture funding. Says the Times recently, for example, “By September 2011, retirement systems with more than $1 billion in assets had increased their stakes in real estate, private equity and hedge funds to 19 percent, from 10.7 percent in 2007, according to the Wilshire Trust Universe Comparison Service.” Even in staid Europe, Pensions makes over 10% of the VC funding, The Economist points out.

Your mom and dad can still get hurt. This is not just rich people’s money. Not even close. It may ease our conscience to think that, but it is a lie.

Low costs in early stage startups
Paul Kedrosky made a point in the Branch debate I had not thought of before in terms of bubbles, and it’s an interesting one. “There does seem to be more activity at the early-stage than is justified by outcomes, & it is frequently happening at higher valuations than would seem prudent. Having said that, the costs are low, so, in the same way the Cambrian explosion led to most modern forms of life, cheap speciation (with high die-offs) is an unsurprising ecosystem response to incident energy..”

Basically, yes, values are high relative to intrinsic values, but startups are so cheap now that it doesn’t really matter if a bunch of them die off. Good will be done.

To me, this seems to be a combination of the “bubbles can be good” argument and the “no one is getting hurt” argument. I’ve tackled each individually, and should point out that  both are specifically not relevant to the definition of the bubble, and in aggregate, damage may still be done if capital is being diverted from other, more useful sources. Recall the recent Tweet heard round the world by ex-Facebooker Jeff Hammerbacher, as highlighted in a recent Business Week article that expounds upon this point: “”The best minds of my generation are thinking about how to make people click ads. That sucks.”

There you go.


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