Many observers see this rise in valuations as a bubble. They argue that a combination of low interest rates, aggressive strategies by venture capitalists, and our obsession with finding the next Facebook, have produced an environment where companies can receive extraordinarily high valuations with little justification.
The theory that there is a bubble in startup valuations, misses a few key points. While it certainly is true that low interest rates have led to higher valuation, and that certain startups have artificially high valuations because venture capitalists wanted to be included in their round, these aren’t the only reasons for the high valuations. These companies are not like the notorious online grocery stores of the dot com era, rather there are other factors at play that justify the increased valuations. Maybe not to the extent being seen now, but still high enough where it is hard to call the current climate a bubble.
The causes of the rise in investments in private companies are partially explained by more companies staying private for longer periods of time. An article in the New York Times, states that the median amount of time it took for a tech company to go public from 1980 to the present was seven years. Yet, tech companies that went public in 2014 waited, a median of eleven years before going public.
This push towards more privatization has been caused by a number of factors. Changes in certain financial regulation, specifically Sarbanes Oxley Section 404, which increased the degree of financial transparency a company must have, prompts startups to stay private for longer, as they wouldn’t have to file cumbersome earnings reports, and can instead focus on increasing productivity. With increased focus on financial transparency, it’s now in a company’s best interest to avoid the scrutiny of going public. Also by not going public, firms don’t have to worry about investors who are likely to sell of their stock if they don’t meet earnings. Finally, startup founders now have the ability to sell some of the shares of their startups on alternative markets, yet another reason to remain private. Companies like Equidate and SecondMarket, allow people to sell their shares in a startup, effectively enabling them to cash out of a private company. These secondary markets have made it increasingly more tolerable for founders to keep their companies private, as both they and their employees can make significant amounts of money without doing an IPO.
Companies have also been going public later because of empirical evidence that shows investors prefer larger tech companies. According to Barron’s, the median returns for tech companies on their first day of going public are significantly larger for bigger companies. Companies valued between zero and $500 million returned only seven percent, whereas companies valued over $1 billion which returned 32.2 percent. This difference is even more pronounced after the first year of being public. After the first year of being public companies valued between zero and $500 million dollars returned a median of -25.9 percent, as opposed to those initially valued at over $1 billion returned 30.1 percent. There is a clear incentive for companies to wait before going public and first mature in the private sector.
The increase in privatization has led to the increase in valuations. More mature companies that generate substantial revenues are holding funding rounds. This trend allowed companies to raise more money as investors are more trusting of companies that lead multiple rounds of funding. For example, Uber, which was valued at $50 billion, expects, two billion dollars in revenue next year. In the cases of late round funding, many of their high valuations are justified by established revenue streams. Three partners at Andreessen Horowitz, Scott Kupor, Morgan Bender and Benedict Evans, made this argument in a presentation, where they showed that P/E multiples for tech companies were actually quite low, (about 15 times earnings) similar to where they were in the early 1990’s. In contrast, multiples hit 50 at the height of the dotcom bubble. These companies would probably receive similar valuations on the public market, yet for reasons mentioned earlier have decided to stay private.
Another reason that the high valuations are justified is because these markets are significantly larger than they were during the dotcom bubble. For example, according to Time, in 2000 only 738 million people were online as opposed to 3.2 billion people in 2015. Scott Kupor, in a Forbes article, argues that part of the reason for the dotcom bubble was that there weren’t enough users to justify such high stock prices. Now, however, with the advent of mobile devices, and the overall increase global access to the internet, tech companies have enough users to account for these valuations.
Finally, even though the market for tech products is already huge, there is still legitimate room for growth in the technology sector. According to an Andreessen Horowitz presentation, over the next five years an additional billion people will be on the internet and 2 billion people will get smartphones. Ecommerce also has a lot of room to grow. While, according to the presentation, ecommerce is just six percent US spending on retail, this number should grow dramatically over the next few years as more companies, shift to online stores, and more people gain access to the internet and smartphones internationally. One of the reasons valuations are so high is because, according to even conservative estimates, there should be an explosion in online activity over the next few years.
The tech industry is not experiencing a bubble. While the dotcom era has produced a lot of hypersensitive investors, this time the pricing of private tech companies is actually justified. If interest rates rise, funding for tech companies will certainly come down a little, but they are not the main force driving this growth.