The good times are back for Silicon Valley.
The number of startups is increasing at a seemingly exponential pace. The Valley’s reach and influence has expanded beyond its circumscribed borders to mainstream society both domestically and abroad. And, to top it all off, a record amount of funding is flowing into Valley startups.
The value of the average private company deal in Silicon Valley, as measured by share price, rose 115% this quarter, according to a quarterly survey by Fenwick & West, a Valley-based law firm. The same figure rose by 113% during the same period last year. In addition, venture capitalists set a 13-year record last year by investing $13 billion in startups, according to a report by Money Tree.
No wonder, then, there are so many lists touting the number of startups valued at $1 billion or more. But does this mean that the most innovative place in the world has cause to celebrate?
While most institutions and individuals are rushing to invest in startups, noted venture capitalist Bill Gurley from Benchmark Capital sounded a note of caution at the recent Goldman Sachs technology conference. According to him, Silicon Valley venture capitalists are suffering from a case of FOMO, or Fear of Missing Out, and startups are being treated as if they are publicly traded companies, receiving huge amounts of investment cash. But, this is being done without the necessary checks and balances of a public market or without scrutiny of their finances or profitability.
The dot-com bust around the turn of the century was the last time such behavior was seen. In its prospectus filed with the SEC, Webvan, an online grocery delivery company, famously listed operational exigencies as one of its major risks. As we know now, that probably wasn’t a good idea.
To be sure, there are a number of quality startups in the billion-dollar club and the Internet has a much more mature ecosystem of services now as compared to the dot com bust years. Still, there are a number of reasons to be scared about frothy valuations.
Here are three of them.
Silicon Valley startups do not make much money
The revenue argument generally takes the form of a disconnect in valuations between Wall Street and private markets. A Wall Street Journal post quotes David York, managing director of Top Tier Capital partners on this topic, “The valuation of risk is a public market thought process versus a private market thought process.”
Box’s recent IPO exemplifies this disconnect. When it first filed to go public, the Los Altos, Calif.- based startup sought a valuation of $2.4 billion from the public markets. But, that was before investors expressed concern about its revenues. In its second (and more successful) attempt, the startup discounted its valuation by almost a billion to $1.5 billion. Similarly, Facebook was valued at $50 billion without much revenue in 2011. Wall Street, however, brought a reality check. After a historic IPO that valued the company at $104 billion on the back of private market chatter, the company lost as much as $50 billion off its initial valuation due to slow revenue growth.
This dichotomy is a result of different perspectives about the importance of revenue in maintaining cash flows. In an offline setting, a positive cash flow is important to sustain business growth. Startups and small businesses aim to hit the ground running in their quest for profitability. Revenues earned through product sales are ploughed back in to scale businesses.
In Silicon Valley, however, revenues are anathema for startups. Instead, software products are distributed free to scale the number of users. This is because the Internet business model works best at a global scale. Venture funding is used to sustain cash flows in the absence of product revenues. Facebook and Google are prime examples of startups that succeeded by prioritizing user traction over paid services.
But both companies operated in incipient industries that did not have prior breakout successes. Plus, the worldwide web was a relatively new medium without a mature ecosystem. Hence, first-mover advantage equaled user traction which, in turn, equaled advertiser attention because the network effect of their products increased the associated switching cost for their products.
Since then, the web ecosystem has matured and the action has shifted to the mobile ecosystem. Advertisers and users are spoilt for choice, as far as products and services are concerned. In such a scenario, only a breakthrough product, such as Snapchat or Uber, which offers a new experience or service will be able to distinguish itself from the hordes of apps crowding a user’s phone.
As an example, consider the case for Tango, an iOS app which is valued at a billion dollars by the private market. The app ecosystem for such services is diverse and includes veterans, such as Whatsapp (which was acquired by Facebook last year), to established companies, such as Google and Skype, which bundle such free services along with a number of other value-add services to increase user traction. Although it had over 200 million users last year, the app did not have a quantified revenue model according to a report by Forrester Research. Hence, the source (and logic) of its valuation is lost to public markets.
There is too much money chasing too few startups
This is an indicator that the market has not really expanded to accommodate a large number of players. Instead, the number of players in that market has shrunk. Consequently, expectations and valuations for that player are outsized and based on the assumption that a select number of players will dominate that market. The barriers to entry for other players also become greater as the switching costs become bigger for users.
As an example, note the frenzy around funding well-known startups, such as Uber and Snapchat. Uber, in fact, has a bunch of diverse investors from monarchy governments to institutional investors to individual venture capitalists. In terms of pure economics, demand for a share in these startups is greater than supply and, as a result, the startups are able to command lofty valuations that are not really commensurate of their size or with their revenues.
Wall Street’s calling
A sure sign of a boom is when Wall Street moves into your space. After all, they have the money and are always looking out for quick and good investments. Although exact numbers are hard to come by, a number of private equity players and investment banks are swarming to the Bay Area. Tiger Global, well-known hedge fund and private equity player, was the third-highest investor in startups last year. According to a report by Reuters, a number of other hedge funds and private equity players have already moved into this space.
The problem with the entry of financial institutions is one of motivations. Wall Street is looking for quick returns and is not interested in long-term company strategy. Their short-term investment outlook inflates valuations at the cost of future investors (day traders and institutions), who put their money into startups when they go public based on hype and media attention.