History Repeats Itself: the Internet Boom and Bust 2.0

The venture market in the United States is in a bubble.  In the US, including (especially) in SV and NY, valuations for companies at every stage are way too high.    Because most of these companies have no revenue, it is not possible to quantify how high but, if you do the math, there will simply not be enough exits at a high enough multiples to provide sufficient returns in exchange for the risk being taken.

Yes, the problem is worse in basic consumer businesses (B2C) than in enterprise businesses (B2B) but the problem is in pretty much all Internet verticals.

I feel more and more like I am re-living Web 1.0 – the Dotcom boom and bust.  I was part of building and investing in a VC fund beginning in early 1997 – we caught the wave and the fund did 90%+ IRR net of fees – this is top tier for VC returns.  It was useful because I witnessed how a VC fund can be successful.  I left for AOL later but my former colleagues – pretty much the same team of extremely smart and talented people – did the same thing with Fund II and it returned $0 because the bubble popped.  So I witnessed how a VC firm could fail.

So you can be smart and good but, with a traditional VC fund, timing matters.  (Timing matters in all investing but moreso in a fund that must be deployed over a fixed five-year time span.)

Some other indicators of a current bubble: the proliferation of “accelerators”.   You had the exact same thing happening during the Web 1.0 bubble – just substitute the name “incubator” for accelerator.   Some of these incubators even went public, then became penny stocks, then got delisted, then went bankrupt.  They all had promising startups inside which, in retrospect, were interesting ideas or products but not actual businesses, at least not sustainable businesses.

Instead of building businesses, the game was a chase to be acquired or, in Web 1.0, go public.  The same is true now.

Economic markets run on fear or greed and we are currently in a “greed” phase.  The Facebook IPO will only increase the frenzy.  Many people who were at FB at the right place at the right time will believe they are smart and either start new companies or become angel investors, which will make the bubble worse.  Again, substitute “AOL” for Facebook and you can see Web 1.0 all over again.

The only difference between the dot-com (Web 1.0) and this bubble (web 2.0) is that web 1.0 included inflated valuations in the public markets. The high prices in public stocks and the ease of going public led to huge valuations in private (VC) markets.  When the public market bubble popped, it immediately popped the private market bubble, since the latter’s valuations were based on assumptions of public market multiples.

The Facebook IPO will be the moment when the Web 2.0 bubble officially comes to the public market and it will be the beginning of the end of this cycle.  It’s not that FB isn’t an incredibly valuable company – it is – the issue is the psychological impact of the IPO on valuations and exit assumptions in general and, again, on the companies and investors lower down the chain.

Right now, the web 2.0 bubble is “trapped” in the private markets and, because it has been trapped in non-liquid markets, it has been hard to quantify just how big the bubble is.  Now, however, the bubble will float up into the public markets.  In the full light of the public markets – liquid markets that require disclosure and quarterly updates, etc. — it is a matter of time before valuations correct.

As an aside, many people have argued that we are not in a bubble because the public markets for tech stocks are not inflated.  This is ridiculous – just because private tech companies have not had access to the public markets, because they are receiving private financing, does not mean that their valuations are sane.  In fact, it is the opposite – a lack of liquidity, transparency and comparables in the private markets leads to the inflation of valuations.

Anyway, since access to the public markets for internet companies has been shut off for many years, we have a huge pent up demand for liquidity in the private venture market.  Dozens of tech companies are lined up like trucks in refugee convoy trying to get to the IPO border.   Investment bankers are once again at the wheel as the SEC directs traffic and public market investors prepare to dump bags of money off the back of trucks and helicopters.

You can’t outrun reality, however, and every business is a function of its current and future cash flows – at some point, the private and public markets will realize that, for most internet companies, the cash flows don’t currently exist and won’t ever exist.

One might ask why the bubbles hasn’t been worse or faster-inflating.  First, a lot of people over 35 remember the dot-com bust – these memories have provided a useful governor on the engine of hype.  Second, we are in the worst economy since the Great Depression – which has dragged on growth even in tech investing.

In sum, for all the negativity in this post, I still believe in venture capital, in early-stage investing and in the future of the US (and Brazilian) ecosystems.  Markets run in cycles, it is natural. We are near a peak right now — so what?

For entrepreneurs, there will always be a place for creating companies with products/services for which many customers pay.  There is as much opportunity to create great businesses as there ever has been in the history of the world.

As for investing: the best advice I ever got in football, maybe in life, was to “Focus only on things you control”.  Simple to say, hard to do. The amount we control is far less than we believe moment to moment.  The point is: ignore the outside noise, cultivate your core investment thesis and execute against it.