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With web companies valued in the billions, some see a bubble

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When it comes to the valuations of internet companies, has Silicon Valley simply gone off the rails?

Cases in point: Zynga, Living Social, and Groupon are set to go public at valuations of between $15 and $30 billion. Meanwhile, social media blockbusters like Twitter and Facebook—which some have valued as high as $100 billion—are waiting in the wings.

It seems that the gold rush is on, and many internet companies are taking a cue from LinkedIn’s wildly successful IPO in May this year. A company like LinkedIn does well and then “other companies try to quickly follow and take advantage of the positive sentiments,” Tony Jeffries, an attorney with the Silicon Valley law firm Wilson Sonsini Goodrich and Rosati, told Firstpost.

“It puts pressure on [companies] to go public. They may feel like they’re missing out on something, especially if your competitors are doing it. That’s how the snowball picks up and grows and rolls down the hill. It accelerates to keep up with the Joneses.”

But this flurry of IPOs—the most since the dotcom bust in 2000—coupled with these eye-popping valuations beg the question: Is Silicon Valley facing another dreaded bubble?

The value of uncertainty

The debates on this topic have been vociferous, and the massive valuations of internet companies tend to be at the heart of these discussions.

“When people are screaming ‘bubble,’ they are not screaming ‘bubble’ in the same way that they did in the late ‘90s when companies were not making money,” Leigh Drogen, the founder and chief investment officer of investment management firm Surfview Capital, told Firstpost. “This is a very different time. People are screaming ‘bubble’ because we are seeing companies going public with market caps of between $10 and $100 billion and how can it be that they are so valuable?”

The logic behind these valuations have been central to a particularly engaging online debate published by the Economist between serial entrepreneur and UC Berkeley business school lecturer Steve Blank and venture capitalist Ben Horowitz of Andreesson-Horowitz.

Blank argued that “Prices for both private and public tech valuations exceed any rational valuation to their current worth. In five to ten years most of them will be worth a fraction of their IPO price.” Conversely, Horowitz argued that these tech company valuations “have not become completely divorced from any rational thought.”(It should be noted that Andreesson-Horowitz has some skin in the game, having invested in social media companies like Twitter, Facebook, Zynga, and Groupon.)

Tech insiders say that that’s natural confusion over this crop of tech company valuations since few people understand their business models, and people are ultimately banking on their disruptive and revolutionary potential.

“When you have a more opaque and highly changing business model, you get higher valuations because you want to protect to the upside,” said Drogen, who also serves as a Focus.com finance expert. “What you are generally seeing is that people don’t understand the business models of these companies. As opposed to Coca-Cola—people understand why it has value. You sell a product that you can hold in your hand and you pay a certain amount for it. The [tech company] business model is based on the idea that people are valuable and users are valuable if you can monetize them.”

It seems that the gold rush is on, and many internet companies are taking a cue from LinkedIn’s wildly successful IPO in May this year. AFP

Still, these enormous valuations have Wall Street worried. A survey of capital market executives released this week by professional services consultancy BDO USA found that 75 percent of the respondents think tech companies are over-valued.

“When you combine the inflationary effect of the pre-IPO, private marketplace with the common practice of Internet businesses only releasing a small number of shares in initial offerings to drive up demand, it isn’t surprising that the investment banking community believe concerns about a possible Internet bubble are warranted,” Jay Duke, a Partner in the Capital Markets Practice at BDO USA, said in a statement.

“At the same time, any comparisons between today’s market and the dotcom crash of the late 1990s are simply not accurate. In the Nineties, you had businesses that were little more than a concept going public. For the most part, today’s Internet offerings have sound business models with real customers, real revenue and real profits. Moreover, they all benefit from the enormous growth of the social and mobile Internet market over the past decade.”

In other words, these companies have value, but no one agrees what dollar figure to pin on them.

Psychology v/s economics

Though the debates on valuations will continue, the common wisdom seems to be that without fear, there is no bubble. As David A. Kaplan of Fortune recently put it:

Reasonable folks can disagree about the prospects for boom or bust. But their reckoning is about psychology more than economics.The consensus is that there remains sufficient fear in the marketplace — be it on Sand Hill Road or Wall Street — to prevent exuberance from becoming totally irrational. For there to be a bubble, the wisdom goes, greed must overcome fear.

Indeed, New York Times business columnist Jim Stewart recently used LinkedIn as a case study for whether or not we’re in the midst of a bubble. He looked at three factors: Whether the company is overvalued (yes), whether investors are ignoring the fact that the company is overvalued (yes), and whether everyone has drank the Kool-Aid and believes that LinkedIn is properly valued (no).

In the end, he concludes that we’re still safe from the bubble, at least for the time being because “bubbles usually don’t burst when lots of pundits are still calling something a bubble, as they are now.”

Embracing the bubble

But here’s the thing. Ultimately, both sides concede that the current circumstances will result in a bubble—it’s just unclear where we are in the cycle and when it will burst.

Focus.com’s Drogen thinks we’re years off from catastrophe, but when the bubble does pop, he’s predicting that it will be worse than last time.

“It’ll be more traumatic,” he told Firstpost. “What we saw in the last tech bubble was lots of investors who were able to get into some of these companies at lower valuations before they blew through the roof. There was a hysteria of, ‘I can get my piece, too.’ What may happen this time in five to seven years, the bigger institutional investors start to hand off their inventory of stock to mom-and-pop investors, and the valuations are going to be at a place where they have nowhere to go but down. The majority will be toward the top end of their value for that life cycle. It’s dangerous; it’ll be a disaster when it happens.”

Though the debates on valuations will continue, the common wisdom seems to be that without fear, there is no bubble. AFP

Meanwhile, even those who worry that the bubble is upon us don’t think that they’re necessarily a bad thing. According to UC Berkeley’s Blank, a “bubble is simply the redistribution of wealth …. I hypothesise that, unlike bubbles in other sectors—tulips, Florida land prices, housing, financial—tech bubbles create lasting value. They finance companies that invest in new technologies, new ideas and new products. And it appears that, at least in Silicon Valley, a larger percentage of money made in the last tech bubble has been recirculated back into investments in the next generation of tech startups.”

Vernon Smith, a Nobel Prize winner and a professor of law and economics professor at Chapman University School of Law in Southern California has spent decades studying asset markets. In one study featured in the documentary “Mind Over Money,” he recruits students to trade an asset on a simulated trading floor for a real cash reward. Even when research subjects are told outright that the value of their asset will decline over time and it will be worth nothing at the end of 15 trades—in other words, that the bubble would burst—the study subjects continue to trade beyond the intrinsic value of the asset until many are left with nothing at the end. Studies involving over-the-counter traders from the Chicago Stock Exchange produced similar results.

So in the end, Smith concludes that there’s just no getting around them. “Bubbles are inevitable and they’ve been going on for so long, you have to say that it’s part of the human condition,” Smith told Firstpost.

Let’s just hope you’re not the one hanging onto a failing tech stock when the bubble finally bursts.




Written by Mjay

July 25, 2011 at 13:16

Posted in Tech Stuff

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