Are We In a Second "Tech Bubble"?
In a recent class at Tuck, we were treated with a guest lecture from a Tuck alum who is well established in the VC industry. In preparation for this class, my classmates and I were asked to formulate an opinion on whether or not we believed the tech industry was experiencing a second bubble. Below is my brief response, which I hope some will find interesting:
Over the last several years, talk of a new “Tech Bubble” has accelerated. Arguments for a second “Tech Bubble” typically focus on what seem to be unjustifiably high valuations for what are colloquially known as Unicorns, venture backed companies valued above $1b dollars. In reality, a conflux of macroeconomic trends largely outside the realm of “tech” has led to a valuation spike unique to late stage venture investments.
It is difficult to deny an overvaluation of late stage venture companies. From the market’s trough in 2009 to 2014, Series C and Series D or later median pre-money valuations increased by 144% and 187% respectively. By comparison, pre-money valuations for Series A and Series B rounds increased by 108% and 103% percent respectively over the same period[1]. These increases are much more in line with the equity market where prices in the SP 500 index have increased by 111%. Overall, post-money valuations for expansion or later investment rounds are above their 2000 valuation peaks, while seed and early stage valuations are still below[2]. But does an overvaluation make for a bubble?
A bubble is typically characterized by market wide speculation and investors who buy assets for potential upside in a flip rather than intrinsic value. If speculation has caused overvaluation in the late stage venture market, it hasn't continued past it. The ratio of IPO valuations to median round valuations for expansion and later deals (i.e. the "potential upside" to a late stage investor) are at all-time lows[3]. Several recent high profile IPOs like Box and Zoosk were delayed due to valuation concerns, and others like New Relic and Zendesk went public at a discount to their late round valuations[4]. These are signs of a functioning capital market, not a bubble. More than anything, high late stage valuations are the result of non-tech economic trends.
Through past experience and better understanding of disciplined approaches to company building, Venture Capitalist have largely recognized the overvaluation in late stage deals and avoided them. Ironically, it is the typically sophisticated Hedge Funds and Mutual Fund investors who play the inexperienced fool in this game, coming in on highly valued late stage deals that fizzle at IPO[5]. These investors seek higher returns in the Venture Capital markets because near-zero interest rates have caused yields to evaporate in their usual asset classes. Hedge and Mutual Fund investors unwisely see investing in late stage companies as the “safe” way to invest in venture, when in reality, they are assuming venture risk for below venture returns.
The Venture Capital market is not in a “Tech Bubble” precisely because poor IPO performances haven’t effected overall valuations. In a bubble environment, lower prospective IPO payouts would flow down and crash speculation fueled venture valuations. In reality, rising venture valuations are being driven by truly ground breaking business ideas. Entire industries are being transformed by next generation marketplaces, enterprises are being reshaped by cloud services and analytics, and operations are being revolutionized by automation through the Internet of Everything. Rather than being in the middle of a second “Tech Bubble”, I believe it is much more likely we are simply experiencing a third wave of technological innovation equal to the micro-processor and internet advances that preceded it.
[1] PitchBook 2Q 2015 US Venture Industry Report
[2] Google Ventures via Tech Crunch (http://techcrunch.com/2015/03/24/tech-bubble-maybe-maybe-not/)
[3] Google Ventures via Tech Crunch (http://techcrunch.com/2015/03/24/tech-bubble-maybe-maybe-not/)
[4] Bloomberg (http://www.bloomberg.com/news/articles/2014-12-09/silicon-valley-startups-begin-taking-haircuts-in-ipo-market)
[5] Institutional Investor (http://www.institutionalinvestor.com/inside-edge/3412986/venture-capital-enters-the-bubbleof-irrelevance.html#.VT7w0CHBzRY)