Bubbles

Will the Tech-Startup Bubble Burst in 2015?

Some entrepreneurs help create bubbles. These can benefit all startups -- or kill them. The two things that make all the difference? Timing and strategy.

By bubble, I mean an economic process by which stories of initial financial wins draw in "tourists," capital providers without deep expertise in a particular industry who are attracted by others who are making more money than they are. Tourists flood that industry with money that flows into businesses that can’t provide a return.  

A few big busted deals cause the tourists to flee. And the collapse begins. If the "tourists" include banks, Wall Street hedge funds and other institutional lenders, the collapse can extend more broadly throughout the economy. That's because failed banks that loan out government-guaranteed deposits are bailed out by taxpayers.

If the tourists' funding is in the form of equity, these capital providers lose but the collateral damage is not as severe.

Related: Venture Capital Is In a Recovery, Not a Bubble

And given the National Venture Capital Association report, released Jan. 16, on the state of venture capital, I have no doubt there is a bubble. And this raises two questions that should be of interest to entrepreneurs: When will it will burst? And what should entrepreneurs do before it does? 

Before delving into these questions, I want to put the current bubble into context by reviewing five recent bubbles that varied according to the form of capital that expanded the bubble, one equity led, the others debt led. 

In 2000, I watched three companies in which I had sunk venture capital collapse when they could no longer obtain financing after the dotcom bubble burst, beginning with the March plunge of the Nasdaq. 

I had predicted this collapse in my 1998 book Net Profit, which divided the world of Internet business into nine segments with varying degrees of profit potential. I imagined that those with weak profit prospects would perish. And they did.  

Of the four debt-led bubbles, the biggest by far was September 2008’s near collapse of the entire global financial system due to too much money being borrowed by people who could not repay their mortgages.

(I also observed the bust of the junk-bond-fueled leveraged buyout bubble of the late 1980s and the 1990 collapse of the commercial real estate bubble in New England that nearly tanked my then employer, Bank of Boston. And in 1982, I consulted with the Federal Deposit Insurance Corporation to help it manage the disposition of assets it acquired when banks went bust after lending too much money to oil and gas explorers and real estate developers in Oklahoma and Texas.)

What does the current bubble share with these five? A surge of cash from tourists: Mutual funds like T. Rowe Price and Fidelity are writing big checks to get a stake of private companies right before they go public.

Venture investing involves putting money into private companies at distinct stages of their development -- from the very beginning, the seed stage (when a company has just one or two employees but has not yet developed its product) to the late stage of investment, a few months before the firm goes public.

And that's where a huge chunk of money is going now -- into late-stage investments. 

The National Venture Capital Association's report shows that a quarter of the $48.3 billion invested in startups last year went to late-stage investment rounds. According to Bloomberg, “Uber raised so much cash that it’s worth $41 billion. With a $500 million investment, Airbnb is worth $10 billion." 

Related: Uber Raises $1.2 Billion in New Funding Based on a $40 Billion Valuation

That's not to mention that "Snapchat turned down $3 billion from Facebook and is now valued at $10 billion," according to Bloomberg, and that "With $500 million in investment, Vice Media is worth more than the New York Times.”   

These are all classic examples of huge amounts of tourist capital flowing into late-stage companies poised for boffo IPOs.

What's driving all that late-stage money into these companies is the low-risk nature of the big paydays that inevitably occur when IPOs are on the rise. 

The National Venture Capital Association also reported that the market for initial public offerings last year was the best since 2000, the year of the dotcom collapse. With 27 venture-backed IPOs raising $4.4 billion last quarter, the period was the seventh consecutive quarter with 20 or more venture-backed IPOs -- a tally not seen since the fourth quarter of 2000, according to the venture capital association. 

The IPO boom is attracting late-stage capital that's driving up some company valuations to very high levels. When a lot of investors are trying to gain a stake of a company widely believed to be poised for an initial public offering, its owners can negotiate for a high valuation. Thus the new investors of that company receive a fairly modest stake in exchange for their big checks. 

This trend is driving more enterprises into the club of private companies valued at more than $1 billion. CB Insights reported the number of late-stage tech companies worth more than $1 billion increased 160 percent from 2013 to 2014, according to Bloomberg.   

And the list of such highly valued companies is likely to increase this year as long as there are enough successful IPOs or acquisitions delivering high returns to late-stage investors. CB Insights counted 588 companies in the IPO pipeline, of which 42 raised money for a valuation of about $1 billion each.

If some of these higher-profile IPOs go bust, that late-stage money will flee and the bubble will burst.  

Here’s an open secret: People make the most money during bubbles. The hard part is for investors to get in and out before the bubble bursts. I think this year could be a good time to invest before the collapse. 

The entrepreneurs who get my capital will run businesses with a shot at surviving a bursting capital bubble. Their companies will target large markets with excellent products for which customers are willing to pay a high enough price to enable the company to profit while growing fast.

Entrepreneurs should be building their companies to satisfy investors such as this -- so if the bubble does burst, they will increase the chances of having a viable business on which to build through other sources of capital.

Related: Snapchat Valuation Skyrockets to $10 Billion Following New Funding