Big names in the VC industry, including Andreessen Horowitz cofounder Marc Andreessen and Sequoia Capital chairman Sir Michael Moritz have openly expressed their concerns about the bubble they believe is forming. Another familiar name, Mavericks’ owner Mark Cuban, claims that this bubble is actually worse than the one that took place in 2000, mainly as a result of the transition of general public investments from public to private ventures, which he believes has eliminated the liquidity of those investments.
But perhaps things are not as bad as Mr. Cuban would like us to believe. Given the resemblance with the dotcom bubble, one has to wonder whether we actually learned the lesson or if we are about to fall into the same hole for the second time. While there is not a definite answer to this question, one thing is clear: things have changed. It has been 15 years since the dotcom bubble burst, and it has taken a long time for the venture capital industry to recover. The data show that both the industry and entrepreneurs have modified their approach by focusing on proven profitability and waiting longer before going public.
The public market is highly volatile and often irrational. For companies with a shaky business model and uncertain future revenue this might be beneficial in the short run, as unsubstantiated “hype” and excitement about potential growth might allow them to attract large amounts of equity. However, the 2000 crash that resulted in a total loss of $5 trillion made it clear that this is also the perfect recipe for disaster, because as soon as doubts arise things can get very ugly very fast (the Nasdaq dropped 78% from March 2000 to October 2002). The disappointing aftermath of Facebook’s IPO (the stock fell 50% over the first six months) convinced entrepreneurs that it is not a good idea to take a company public before its business model and profitability have been proven to be sound, even for firms with high chances of profitability in the future.
As a consequence, startups are opting to stay private for significantly longer, with average years to IPO increasing from 3.1 to 7.4 and average revenue at the time of IPO going from $35 million to $102 million over the last 15 years (Suster). Patience has indeed proven to be beneficial for up-and-coming tech companies. Today, firms are more seasoned by the time they go public, and a remarkable result of this approach has been a significant increase in the share of profitable technology companies in the market (from barely over 50% in 2000 to 90% in 2014) (Richardson). Entrepreneurs have learned the hard way that Wall Street analyzes firms very differently from private valuation experts, with the former being sharply focused on short-term profits and revenue, while the latter places more emphasis on long-term growth and market potential. Growing startups would much rather avoid Wall Street’s impatience and the scrutiny associated with having publicly traded stock.
This begs the question: what has changed in order to allow the race to success to change from a sprint to a marathon? The answer is the venture capital industry, which has provided the money companies need to remain private. The consequence has been average late-stage funding skyrocketing to levels only seen during the dotcom era. While some see this as clear sign of a bubble forming for its resemblance with the late 1990s trends, most experts would agree that late-stage funding is simply replacing IPOs for fundraising in companies over the extra time they stay private. This opportunity to capture extra value in the private markets has led some hedge funds and other major non-private-market investors to become late-stage VCs. Even J.P. Morgan has jumped on board by developing debt products for high-flying startups that do not think they are ready for IPOs. The reason is that many investors lack the skills, the time or the experience to make great, patient, long-term, private-market investments and established late-stage companies (that in the past would have certainly gone public) are simply much safer bets. As a result, 66 percent of venture capital funds are now concentrated in late-stage investment.
A perhaps more legitimate concern arises from the fact that private valuations have been soaring out of control, with the combined valuations of the Top 30 US startups ballooning from $78.8 billion in March 2014 to $181.2 billion a year later. Although in theory they are meant to be based on revenue and EBITDA multiples, valuation of startups are often not based on fundamentals. According to Randy Komisar, a partner at venture firm Kleiner Perkins Caufield & Byers: “these big numbers almost don’t matter… [they] are sort of made-up. For the most mature startups, investors agree to grant higher valuations, which help the companies with recruitment and building credibility, in exchange for guarantees that they’ll get their money back first if the company goes public or sells.” Public valuations on the other hand has shown very positive improvement since the dotcom days, with average price to earnings ratio in the market going from roughly 200 down to about 23.