Here’s Evidence Startup Euphoria Lacks Logic … Again

Startup activity is now displaying many of the rare characteristics not seen since the dotcom bubble. And, if you speak with newbie startup investors or entrepreneurs, they are back with the mantra: “This time is different.” Guess what? Not much is different unless human nature and the laws of economics have suddenly changed.

Let’s start with the differences between the dotcom bubble and what I’ll call the current Web 2.0 bubble:

1) Today, some companies actually have real revenues. Ironically, these revenue-generating companies are not receiving the nosebleed valuations making headlines.

2) Today, early stage investments tend to be smaller, therefore mitigating downside risk.

3) The cost of launching an app or website based business is much less than during the dotcom bubble.

What hasn’t changed?

1) Entrepreneurs say they can scale apps and Web 2.0 widgets faster than any businesses in history. That was the big pitch for websites in 98-99. Nothing new here.

2) Entrepreneurs say they can scale revenues faster than ever. Unless consumer and enterprise wealth is infinite, this is complete ignorance. Real people and businesses have budgets which are largely allocated. If they have debt, they are already over-extended. The idea that every brain fart app with marginal utility will get another $1 from the scaled masses is an economic fallacy.

For example, Amazon gets the majority of my e-commerce spend. Yes, a handful of sites can capture some one-off purchases here and there, and in some cases create a cult following, but when entrepreneurs pitch how their businesses “scale” they are saying they will become the Amazon/Angry Birds/Evernote of their space. Clearly, they will not all win. Not even close.

3) When all the losing businesses fail, investors will lose real money and become more risk averse.

4) The cost of truly talented people is still high because they are scarce. Your engineer costs $10/hr on Odesk? The engineer with $1000/hr skills at your competitor will kill you in the long run.

5) There is a creative and destructive phase of capitalism. Right now we are creating. At some point, we will destroy the redundant and inferior businesses. And I continue to see plenty at this phase in the cycle.

6) If you talk with Silicon Valley investors, there is too much money chasing too few good ideas/teams. Of course, ideas are a dime a dozen, so it’s largely not the case you can mathematically say too much money will be chasing too few ideas per se. But when you define those ideas as “high quality ideas” or “high quality talent/teams”, then you will quickly see all the top investors are jumping over each other to get into a very small number of elite assets. Think I’m bullshitting you? Here’s Y-Combinator alum Jason Freedman screaming bubble:

“The pendulum has swung. It’s easy to lose perspective. It’s weird to see entrepreneurs compare convertible note caps of 7, 8, 10 million dollars from this lens of low, medium and high. I see those numbers and I just can’t believe that any seed company is receiving a 7 million dollar cap. None of us could get over 3 in 2009.”

7) “Markets can remain irrational a lot longer than you and I can remain solvent,” said John Maynard Keynes. How much longer can startup-land inflate? Who knows. In our recent Wall St. Cheat Sheet Premium Newsletter I outlined a few drivers that will keep the bubble going longer: the Facebook IPO, Zero Interest Rate Policy, demand from Institutional Investors (e.g., pension funds) looking for early-stage exposure, and the future wave of capital to bathe startups via the JOBS Act crowdfunding law. After that? Good luck watching the down rounds roll in.

Let’s Review Some Key Logic

If you know people feeling the startup euphoria, here is some logic for them to meditate on:

1) There is a finite pie of consumer dollars (and the economy is sluggish).

2) There is a finite pie of enterprise dollars (and the economy is sluggish).

3) There is a very real bell curve representing the intelligence and skills of entrepreneurs.

1 + 2 + 3) Only a select group of companies will succeed in scaling revenues from a target market.

Bubble, Baby, Bubble

Nick Belton has an insightful post explaining how mark-to-mystery valuations are back for startups. He quotes Jeffrey Pfeffer, a professor at Stanford’s Graduate School of Business, explaining what the current environment means:

Professor Pfeffer said that through “the hideous recession” that America has suffered in the last several years, the Valley has applied increasingly incoherent valuations to companies. “This is 1999 all over again, but this time, it’s gotten worse,” he said, referring to the last technology bubble to burst. “We’re back to companies throwing around funny money. The economic values don’t add up.” He added: “These companies are simply being founded to be bought. With the exception of a select few, Silicon Valley has spawned no real companies over the past decade. Even now, as the value of eyeballs has gone down, people are buying concepts, not companies.”

Funny enough, from 2008-2010 investor discipline required proof of concept via revenue generation. Surely, two huge market crashes in a decade demanded prudence. However, once the Thrill stage (see below) sets in, discipline goes out the door. This is evidenced when the need to get into hot deals becomes more important than the underlying cash flow of the business. Bidding wars start and entrepreneurs garner leverage to get money on looser and looser terms. Just like the no-doc loans which evidenced the end of the housing bubble, when you see significant waves of startup deals getting done around demos and decks without traction, early-stage investing will have reached its no-doc equivalent … and what follows is pre-determined.

P.S. – The Psychology of Market Cycles

Market cycles — that means startup markets and mature markets — follow human patterns of greed and fear. For those of us interested in contemplating the current startup cycle, here’s something that will help you from getting burned: