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The Tech Bust of 2015

562 points by runesoerensen 11y ago

StriverGuy 11y ago
Very few people would agree regarding Yelp. Almost no financial analyst worth a lick would use trailing revenue (instead of net earnings) as a way towards finding value in a company. Maybe I am missing why Sam points Yelp out at all here...
- harryh 11y ago
  How do you think companies with lots of revenue and zero earnings are valued? Like, say, Amazon.
  - eclipxe 11y ago
    Amazon's earnings are not zero: http://www.nasdaq.com/earnings/report/amzn http://www.nasdaq.com/earnings/report/amzn
    - harryh 11y ago
      They have been for much of the existence of the company though. And their current earnings might as well be.
- nostrademons 11y ago
  Trailing revenue makes more sense than net earnings when a company has proven profitable unit economics but hasn't yet saturated its market. At this point, it always makes sense for the company to reinvest any profits into additional sales & marketing rather than bank it, because it earns a predictable return on capital > the market as a whole. A company in this stage will show zero or negative earnings during the entire growth phase (see eg. Amazon.com), but future DCF will increase in proportion to CLV of the whole customer base. Assuming stable CLV, trailing revenues is a pretty good proxy for this metric. Yelp seems like a fairly good candidate for a business at this stage; its unit economics are probably known to Sam, but it's doubtful that it's saturated all local businesses out there.
  - rhino369 11y ago
    I think Wall Street is now learning away from treating Yelp as a high growth company. The question they are asking themselves is whether Yelp is reinvesting profits or if Yelp just can't be profitable. Yelps business is a competitive one. Their main revenue generation is selling ad space to local businesses. They are a yellow pages of the internet. User growth is slowing. I'd fear that Yelp just can't grow past any profitability issues. There is only so much money you can make from advertising.
  - notahacker 11y ago
    Saturating Yelp's target market is labour-intensive work though, with high churn inevitable due to the nature of their customer base. Selling and renewing classifieds to a mass of small business is costly. Sure, you can eke out more profit even if your costs scale proportionately to revenues, but there's good reason to believe the CLV will actually decline and acquisition costs rise as they aim for higher saturation. With their brand and reach well-established for some time, it's the restauranteurs who aren't digital marketing-savvy (or think Google offers better ROI...) they're now looking to sign up.
  - StriverGuy 11y ago
    You would still never use trailing Revenue. You would want to use y/y revenue growth rate if you are going to use it as indicator for value.
mikeyouse 11y ago
> I saw terms recently that had a 2x liquidation preference (i.e. the investors got the first 2x their money out of the company when it exited) and a 3x liquidation cap (i.e. after they made 3x their money, they didn’t get any more of the proceeds). But doesn't the 3x liquidation cap only come into play if the total exit is less than 3x? In my understanding, if the exit is greater than 3x the invested value, they then convert their preferred shares to common shares and receive their >3x proportional share in common stock thus retaining the upside of the investment.
- sama 11y ago
  No, that's when the 2x comes into play. In this scenario, the investor gets the first 2x, and then after 3x doesn't make any more money.
  - mikeyouse 11y ago
    Oh wow, that is unique and very debt-like. My experience was closer to a 3x participating preferred.. Thanks for the clarification.
  - mbesto 11y ago
    Do you think most entrepreneurs who take these debt structures realize the risk to their paper wealth? Or is it simply a matter of "we need the unicorn status to grow and hire" at any cost?
  - rabbitonrails 11y ago
    Isn't that wrong because the preferred shares always have the right to convert into common?
vasilipupkin 11y ago
if people aren't buying the late stage common stock at high valuations, then how can it be a bubble in late stage valuations ? it sounds more like a bubble in tech press reporting of valuations ?
arjunnarayan 11y ago
This is an excellent post, and I'm in agreement. I particularly like the counterintuitive point that if NO unicorns go bust in the next 2 years, that's more indicative of the existence of a tech bubble than if one or two do go bust [1]. That's contrary to the inevitable media portrayal: I expect that the first unicorn to blow up will be heralded as the harbinger of end times. What I would like is for Sam to expand on what he thinks are some of the pitfalls of this new debt-like financing world. For instance, in the old equity-only world, it was well known that you could "never do a down round". This is because down rounds distort incentives to the point where the company might as well be dead. I suspect[2] that one downside of this "debt-like" world is that there are "implicit nonzero interest rates"[3] on all these debt deals. In the old equity-only world, having a flat valuation was bad but not a disaster. Only the down round was a disaster. I wonder if in this new debt-like world, the expectations have risen. In this world, even rising valuations could misalign incentives. I also wonder what those implied interest rates are at. [1]: Since NO unicorns going bust means that capital is far too accessible, when statistically you'd expect at least a couple unicorns to fail. [2]: I would prefer more expert input because I have low confidence in my suspicions. [3]: I put that in quotes because it's somewhat an abuse of terminology.
- birken 11y ago
  I'd love to see an entire blog post about Sam's footnote #1. Though I find it funny that every point about why this is bad for late-stage companies I believe applies exactly the same to post demo-day YC seed stage companies with extremely high valuations. Though I think in both cases if the company can be disciplined then cheap capital should be good, but staying disciplined is hard...
  - cma 11y ago
    pg: "Yes, investors with preferred stock usually get their money back first. Sometimes they get a multiple, but that's considered overreaching nowadays and the more promising startups never have to agree to that. I suppose that is implicitly a target valuation in a sense. But no one views it as a target, because it only matters if things go badly." https://news.ycombinator.com/item?id=6896833 https://news.ycombinator.com/item?id=6896833 :/
denniskane 11y ago
"No one seems to fervently believe tech valuations are cheap, so it’d be somewhat surprising if we were in a bubble." Is this a typo? s/cheap/expensive/ would make more sense, no?
- CyrusL 11y ago
  The implication is that bubbles require optimistic groupthink. I.e., if everyone thinks it's a good time to buy, then it's a bubble. Sama's point is that because so many people are saying tech stocks are expensive then there isn't the mass delusion required for a bubble.
  - nilkn 11y ago
    Thanks for clarifying that sentence -- I was confused by it as well, but this viewpoint makes sense.
  - denniskane 11y ago
    Wow, okay... the first sentence reads so straightforwardly and the following one is like some kind of reverse judo takedown maneuver. The essential point is to correctly interpret who exactly the "no one" in question is referring to.
    - nailer 11y ago
      Literally nobody. Sam is saying most people think tech valuations are expensive, i.e., they are overpriced.
  - AnimalMuppet 11y ago
    Not quite. There's a difference between an overpriced market and a bubble. A market can be overpriced when the consensus view is that stocks are more valuable than is actually realistic. When more sober judgment sets in, stocks go down to more appropriate levels. In contrast, a bubble is when stocks are going up, and so everybody wants to buy stocks because they're going up, and so stocks continue to go up because everybody's buying them, and so people continue to want to buy them because they're going up. It's not a bubble until you get that positive feedback going.
trjordan 11y ago
This is a pretty solid argument for why tech isn't out of bounds, at most any stage. On the other hand, we've had 7 years of 16% growth in the S&P. At some point, that will correct, and it will have a real effect on tech. We'll all declare the bubble "popped" at that point, and totally reasonable investments will fail, or at least become painfully illiquid for a while. 7 years feels like a long time to have a run like this. Just like every other time, nobody knows when we'll get that correction.
- arielweisberg 11y ago
  My math going back five years says it hasn't been 16% by a decent margin? Wouldn't P/E be a better heuristic? Either CAPE or just basic P/E?
  - trjordan 11y ago
    I've got some serious end point bias going on, but the bottom was ~700 in March '09, and it's currently at 2,100. Triple in that time is actually 18% annualized (6.5th root of 3). There's definitely better ways of measuring "are we near a top", but "length of bull market" isn't meaningless. There have been a few longer ones, and only one ('49 - '61) that was nearly this productive at the 7 year mark. http://greenbackd.com/2013/04/17/bull-markets-since-1871-duration-and-magnitude/ http://greenbackd.com/2013/04/17/bull-markets-since-1871-dur...
- vasilipupkin 11y ago
  One thing that often gets lost in the analysis is the distinction between changes and levels. Yes, S&P has been rising for 7 years straight ( changes ), but it is not at particularly egregiously high levels relative to GDP or relative to whatever metric you prefer, since 2001
- AYBABTME 11y ago
  7 years ago was the middle of an economic crisis, I don't think it's abnormal to be going up for a while after that.
rl3 11y ago
I wonder what the thinking is behind deals like that (2x liquidation preference/3x liquidation cap). On one hand, it strikes me as incredibly beneficial for the founders if the company is a runaway success. On the other hand, the VCs are essentially throwing away their unlimited upside potential, and in doing so signalling they don't particularly believe in the company. There's also the fact that the terms are very unfavorable for founders if they exit at anything below a stellar valuation, though one could argue the entire point of the game is to achieve an incredible exit. Still, when incentives aren't aligned it's disconcerting.
- tyre 11y ago
  These are specifically in late-stage deals, like Uber's recent rounds. The investors aren't traditional VCs, but companies like Fidelity. They don't want a 5% chance at a 100x return; they would much rather a near-guarantee of 2-3x with downside protection. That's why Sam compares them with fixed income.
  - vasilipupkin 11y ago
    it's not clear why Fidelity would want a cap on the upside, since it needs to beat an index. Most likely, it doesn't think it's giving up any upside.
    - jonknee 11y ago
      I would imagine ceding the cap makes it easier to get the 2x liquidation preference.
    - caseyf7 11y ago
      They give up the upside because they have protection from the downside (they get their money back first).
      - vasilipupkin 11y ago
        I understand, I'm saying I don't think they believe they are giving up much upside at all
webmasterraj 11y ago
The major difference between what's going on now and what happened in 2000 is transparency. Not with what's happening at companies, but what investors are thinking. That's important, because investor sentiment is the proximate cause of any bubble bursting. In 2000, it was easy to gauge investor sentiment – you just had to look at stock prices, which are real-time, precise indications of how investors as a whole feel. That meant it was easy to tell when the bubble started to burst (arguably on March 10, 2000, when the Nasdaq peaked). What's hard today, and maybe why there's a lot of these "is it a bubble or not?" stories, is that investors don't know what other investors are thinking. Sam and YC have consistently been open, but they're more the exception that proves the rule. The vast mass of investors are holding their cards close to their chest. The net effect is to prolong an increasingly unsustainable situation. I think it's highly likely that most investors already secretly think we're in a bubble. And that they also believe that other investors haven't realized it (everyone assumes they're the smart one). So we're stuck in this phase of "make my last buck before all the other idiots realize what's going on."
- InclinedPlane 11y ago
  That's one major difference, the other is the maturity of the industry. In 2000 the online tech industry was fledgling, and most of it was vapor. The bubble was bigger than the entire industry. Today tech has grown across the board and the web has become a key pillar of that growth. Trillions of dollars in real value has been built and added to the economy of the world. As big as any bubble might be, the industry is so much larger and on such firmer footing today that a collapse wouldn't have nearly the same impact.
  - ethbro 11y ago
    I hadn't ever really thought about it this way, but it's a good point. Fundamentally, one would expect some relationship between total "digitized" (?) economy value (where digitized means able to be controlled, measured, and/or analyzed by software) and the value of startups. And I don't think many people would argue computer-industry merging hasn't been happening across different industries fairly quickly.
venomsnake 11y ago
Can't we both be in bubble and bust? They are not mutually exclusive. We have just too much money and excess capital chasing limited investment opportunities - so this creates bubbles. On the other hand the increased inequality and concentration of capital in fewer hands means that a lot of financing strategies are performing worse and capital is less efficiently allocated. For example - if the optimal allocation of $1B USD is 1000 investments of $1M - we could have that outcome if the capital is split between 300 people each having 3.33 million. But a single billionaire will prefer to make 10 100M investments, because the cognitive overhead of taking so much decisions will wear him down.
- nostrademons 11y ago
  An individual doesn't have to be rational for the system as a whole to be. In your example, that billionaire's 10 $100M investments will underperform. Meanwhile, some of the 300 people who each invested $1M will overperform. As a result, in the next round of capital allocation, the billionaire is no longer a billionaire while some of those single-digit millionaires are now billionaires. This is actually not all that far off from how things are actually working right now - a number of people from humble middle-class backgrounds are getting phenomenally rich because they understand tech and make smart capital allocation decisions, while a number of rich billionaires who can't be bothered to update their mental models are riding their companies all the way down. All of this is capitalism working as intended. It's only a "bubble" if everybody is a winner; it's only a "bust" if everybody is a loser. Normal operation in capitalism is for there to be both winners and losers.
memossy 11y ago
This is a very good piece, particularly: "In a world of 0 percent interest rates, people become pretty focused on finding new sources for fixed income" The amount of money coming to pay up for growth/quasi fixed-income is almost certain to increase as there are a lot of investors who need to hit 7-8% nominal returns in a 0% rate world: http://www.ecstrat.com/research/why-large-funds-are-piling-into-pe-vc/ http://www.ecstrat.com/research/why-large-funds-are-piling-i...
ThomPete 11y ago
Tech companies in general are underated. One of the things that is going on IMO is that the media in constant need for something to write about started honing in on startups because their growth is much more steep and create a lot of notable events they can write about. And so when we hear about companies being overvalued it's a specific group of companies who give us that impression.
nostromo 11y ago
> No one seems to fervently believe tech valuations are cheap, so it’d be somewhat surprising if we were in a bubble. I'm nitpicking a great post here, but I'm not sure this statement is right. During the real-estate bubble and the dot-com bubble, seemingly few people actually thought houses or internet companies were cheap. I think people felt that they were expensive, but they bought them anyway on the assumption that they would sell to the greater fool.
- danans 11y ago
  I agree that it's a cryptic statement, but I think he meant that bubbles are characterized by investors believing irrationally that an asset class is cheap and buying it. Therefore, investors believing that an asset is not cheap indicates that there is no bubble. Another way of saying it is that if people are generally skeptical about the valuation of an asset class, it can't be in a bubble. That does leave one wondering why said investors would continue to buy the asset, though. With many bubbles, the thing that breaks them isn't investor worry about valuation, but the sudden cascade of failure of mechanisms built on top of the valuations. In the case of the real estate bubble, this occurred because huge numbers of bad loans suddenly stopped being paid when interest rates went up. That broke all the financial instruments built on top of them.
  - adevine 11y ago
    The problem with this circular logic is that it is an EXACT symptom of what happened in the housing bubble "Bubbles can only happen when people believe the price will only ever go up. Look, there are a bunch of people saying housing prices are too high. Thus, we can't be in a bubble, so I'm safe buying this shack for the market value of a million dollars."
    - TheM00se 11y ago
      I see what you did there.
- bkjelden 11y ago
  Aren't the greater fool theory and 'cheap' the same idea, just from different reference points? Both assume I can buy an asset for less than I can sell it for.
siquick 11y ago
> Many of the small cap public tech companies have taken a beating this year. Companies like Yelp are trading at less than 4 times trailing revenue. Could someone explain what this means please? Is Sam saying that the stock price of Yelp is lower than what is actually should be (based upon revenues)?
trader 11y ago
Good article, and I agree with the main points. However, you have to be very careful comparing PE ratios between companies with different capital structures, it is wrong. For example, lets take two companies that are exactly the same, A and B and lets say they should have an enterprise value of $100 and have the same earnings before interest. Company A is all equity and has a PE of 10 ($100/$10). Lets say company B is half equity value and half debt ($50 and $50). Lets also say the company is paying 4% on its debt. Its earnings are lowered to $8, however the PE ratio is actually 6.25 ($50/$8). This company isn't "cheaper" it just has a different capital structure. No measure is perfect, but at least use EBITDA or Unlevered FCF for comparisons. This is especially important now with the large number os stock buybacks.
- malchow 11y ago
  Totally agree on using unlevered FCF as the comparator.
- vasilipupkin 11y ago
  static analysis is always problematic. If a company B is using debt, it should be able to increase its earnings with the debt and increase equity value. if it's failing to do so, it should be cheaper because it is riskier
roymurdock 11y ago
On the whole, it seems harder than any time in the past four years to raise mid-stage rounds. This is also not suggestive of a bubble. It's suggestive of the end of a bubble, when the music stops and the last investors who have not yet exited are left without a chair. If any part of the path to exit breaks down, the whole system will start to fail. There are real problems with these distorted "valuations". Employees these companies hire often think of them as real valuations. It also often makes the company think of itself as much bigger than it is, and do the wrong things for its actual stage. Finally, too much cheap money lets companies operate with bad unit economics and cover up all sorts of internal problems. So I think many companies are hurting themselves with access to easy capital. Sounds like Sam has (unwittingly) become an Austrian. Friedrich Von Hayek on inflation (1970): "The initial general stimulus which an increase of the quantity of money provides is chiefly due to the fact that prices and therefore profits turn out to be higher than expected. Every venture succeeds, including even some which ought to fail. But this can last only so long as the continuous rise of prices is not generally expected. Once people learn to count on it, even a continued rise of prices at the same rate will no longer exert the stimulus that it gave at first." [1] Sounds a little bit like QE stimulus which has been channeled into the private financial markets. I wonder why it hasn't translated into higher salaries. But no matter what happens in the short- and medium-term, I continue to believe technology is the future, and I still can’t think of an asset I’d rather own and not think about for a decade or two than a basket of public or private tech stocks. I'd rather own real estate than a basket of private tech stocks, especially if that basket includes Facebook, Twitter, Snapchat, or really any company where user growth rates and advertising revenues are heavily informing valuations. Users can and will migrate between tech platforms pretty easily - homes, offices, businesses - not so much. Plus, the government has been very pro-landlord lately, soaking up trillions in mortgage debt at the federal level and allowing insane housing bubbles like SF and NY to continue to grow unabated at the state level. Looking for fixed, usury income in a ZIRP and QE-infinity world? Look no further. The only consolation one can take in this situation is the fact that less and less people are even able to play the investing game anymore. Only 26% of individuals under 30 are investing in the stock market, as compared with 58% between the ages of 50 and 64 [2]. So now the SEC wants to make crowdfunded equity the new way to channel middle and lower class money into risky ventures [3]. What's a poor young guy to do? [1] http://www.marketwatch.com/story/why-most-millennials-dont-invest-in-the-stock-market-2015-04-09 http://www.marketwatch.com/story/why-most-millennials-dont-i... [2] https://mises.org/library/denationalisation-money-argument-r.. https://mises.org/library/denationalisation-money-argument-r.... [3] http://www.nytimes.com/2015/10/31/business/dealbook/sec-gives-small-investors-access-to-equity-crowdfunding.html http://www.nytimes.com/2015/10/31/business/dealbook/sec-give...
lmm 11y ago
I might want my wealth in tech stocks. But I sure as hell wouldn't want my wealth in advertising-funded stocks. How many tech companies have any other revenue stream? What does the landscape look like if 2016 is the year that Twitter finally runs out of other people's money? If you'd invested on demo day you'd be happy with current valuations, sure. But that just means the valuations are as high now as they are then. How many unicorns have repaid their investors in terms of dividends? Altman is right that there's been a cooling off in 2015, and right that it's a positive sign - we may yet avoid a dramatic crash. But that doesn't mean there isn't a further contraction to come. We could just be seeing stagflation finally catching up to the tech industry.
- kansface 11y ago
  > I sure as hell wouldn't want my wealth in advertising-funded stocks Where do you expect advertising to go? It looks like about half of all clicks are fraudulent one way or another, but in spite of that, if advertising didn't yield a positive return, I wouldn't expect it be so popular.
  - lmm 11y ago
    I think adblocking is finally going mainstream,and I think that's going to feed into a cultural shift in how much we tolerate advertising in general (see e.g. recent articles about the possibility of banning billboards).
- tptacek 11y ago
  This is a weird thing to say. Look at the Fortune "Unicorn list" (the first Google hit I get for [unicorn list]): 1. Uber (not ad-funded) 2. Xiaomi (not ad-funded) 3. Airbnb (not ad-funded) 4. Palantir (not ad-funded) 5. Snapchat (ad-funded) 6. Didi Kuaidi (not ad-funded) 7. Flipkart (not ad-funded) 8. SpaceX (not ad-funded) 9. Pinterest (ad-funded) 10. Dropbox (not ad-funded) 11. WeWork (not ad-funded) 12. Lufax (not ad-funded) 13. Theranos (not ad-funded) 14. Spotify (not ad-funded) 15. DJI (not ad-funded) 16. Zhong An (not ad-funded) 17. Meituan (ad-funded) 18. Square (not ad-funded) 19. Snapdeal (ad-funded) 20. Stripe (not ad-funded) It just keeps going like this. These aren't even ad-ecosystem companies. I'm not sure how far down the list you'd have to go to find an adtech firm.
snomad 11y ago
> 2015 has seen the lowest level of tech IPOs as a percentage of all IPOs in seven years. Healthcare and finance are leading the IPO percentage. That seems to reflect new opportunities created by legal changes (ACA + Dodd-Frank). I'm not sure you can draw much of a conclusion about tech bubble status because regulatory changes have fostered growth in other industries. > The S&P Tech P/E is lower than the overall S&P P/E. Neither of these facts seems suggestive of a tech bubble. Overall tech P/E may be low, but the recent names are filled with companies that are not making profit, and don't appear on a path to do so over the next few years. Examples: Pandora (-0.65 eps), LinkedIn (-1.15 eps) and Twitter (-0.86 eps), Zynga (-0.20 eps), Trulia (-1.82 eps) and Zillow Group (-2.47 eps), Box (-1.66 eps), Etsy (-1.02 eps) and Shopify (-0.23 eps). (To be fair, there are "winners" Facebook, Kayak, GoPro, Fitbit). I'm not sure you can draw a conclusion about a tech bubble by looking at entire sector. Recent names seem to justify the "unicorn" meme.
quickpost 11y ago
I feel like the lofty valuations of very early-stage companies these days really creates an unfair dynamic for early employees. I've seen people claiming $5MM valuations for fancy powerpoint slides and no product, which seems really high to me. The founders then recruit people and give out equity based on these sky-high valuations despite no product or real offerings. Early employees end up sacrificing significant pay in exchange for equity that is priced far higher than it actually should be.
scottjad 11y ago
> Companies like Yelp are trading at less than 4 times trailing revenue. Yelp has a P/E ratio of either 213 or 80, depending on whether Google Finance or Yahoo Finance have the correct number. So it's pretty rich of him to use Yelp as his first example of a tech company that's dramatically undervalued, purposefully ignore the P/E ratio, and then use P/E ratios for other companies in his next two paragraph to try to claim that tech is undervalued.
- steveplace 11y ago
  Using p/e to value growth companies doesn't work too well. The "E" in the ratio changes too fast.
  - scottjad 11y ago
    If the P/E ratio had been very low, I think he would have used it. The problem with using P/E for an eleven year old company like Yelp is that E is still very small or non-existant and hasn't been changing fast, so the P looks ridiculous.
  - Ologn 11y ago
    > Using p/e to value growth companies doesn't work too well. The "E" in the ratio changes too fast. In 1934, Benjamin Graham and David Dodd published "Security Analysis" which laid out the basis of modern thinking on proper fundamental stock price, both by academics and by mutual fund managers. What you're saying completely contradicts that. Something else is forgotten - the real price is not determined by the p/e ratio but in something even more concrete - the price/dividend ratio. Enron might be fudging their books, but nothing fudges the quarterly dividends. Price/earnings is already an abstraction of what determines the real price - the price/dividend ratio. You're talking about abstracting things yet further - it reminds me of the late 1990s when people talked about price as related to "eyeballs". It's true that a p/e ratio is meaningless when a company is very small - before product/market fit and so forth. But P/E has forever been used to value technological growth companies. Technological growth companies are not a new thing - there were companies like Cisco in the 1990s and like Polaroid in the 1970s. High growth companies have high p/e ratios. It's already abstracted from price/dividend to price/earnings. Then there are companies like Amazon, which are a whole other tangent off this.
marincounty 11y ago
Whenever I see a Top Dog defending their industry--I worry. I don't know if it's a bubble. I'm so bad at predicting the financial future, I looked onto something called a Contrarian Investor. If I had money to invest, I think I would do the ablosute opposite of what the experts advise. While I terrible about predicting bubbles; I, along with most people predicted the last tech bubble. I know certain tech companies are very different today. I don't want to argue with anyone. I'm a nobody. These are just my uneducated/novice inner thoughts. I do know the people around me are underemployed, and too many just stopped looking for work. They haven't benefitted from this recovery. They didn't benefit from low interest rates. The low interest rates just hurt guy's like me. The bank charges me for everything. Rent is always going up. Fines, and fees go up, while my salary stays stagnant. I make nothing on my savings account. I am greatful we don't have much inflation though. I am greatful for health care, but it's not what I thought it would be. I'm not knocking Obamacare, just the enetites that are exploiting it. I couldn't imagine being in a state where the governor declined funds from Obamacare. Yes, tech is booming, and I hope it stays booming. Being in the Bay Area, I see the amount of money tech is bring in. I see rents skyrocketing. I see houses being bought up for outrageous amounts. (I'm not claiming tech is the only reason housing is going up in cost. I see REIT's and foreigners buying residential properties with a phone call.) I just don't know. It's Monday, and I don't feel great. If it is a bubble, I pray it leaks, and doesn't burst. Sorry, about this post. I'm all alone today, and this is my port hole to others. I know--I'm pathetic.
ChuckMcM 11y ago
Excellent post, and the "investment as debt" theme is spot on, who cares what the valuation is if you get 2 - 3x your money back right? However you do need some sort of liquidity event for that and I worry that some Unicorns will become Ponzi-corns as early investors contribute their shares to be re-sold to the later investors as a way to cash out their 2X and move on. Then its "last one in, loses everything". Of course a couple of take out re-capitializations will probably put a damper on some of that zeal. Mostly the people being screwed here are employees with 100% common stock. That argues that high value employees should be negotiating for preferred stock grants rather than common stock ISOs. That will come with a bigger tax bill but has a better chance of providing a return on their sweat investment.
- steven2012 11y ago
  The only "last ones in" will be the retail investor when they eventually go IPO. That's always been the case, just like with GroupOn, Zynga, etc. The VCs and IBs will hype up the company, and then they get their mutual fund buddies with huge piles of cash to pay up for the IPO in exchange for early access to the next awesome company, and these crappy companies get unloaded to the retail suckers. That's how the industry works, but no one seems to care, because there are no consequences, and the incentives are such that no one cares if the retail investors lose a bit of money, and VCs and IBs get massively wealthy.
  - ChuckMcM 11y ago
    Except that the future of Unicorns is not an IPO, its being sold to BigCo for a fraction of their Valuation which pays off some of the investors but fails to trickle down to the common stock. Or like with companies like SilverSpring there is a massive reverse split to get the the number of Common Stock shares down to a number that represents what the current market might pay leaving employees with pre-IPO stock options where the strike price is above the IPO price. How is that not a ponzi scheme?
    - steven2012 11y ago
      Reverse split happened to Hortonworks as well. Lots of employees got completely screwed by this because the sheer number of their options were cut in half.
arca_vorago 11y ago
I don't think you can lump all technology into the same group anymore. There is a big difference between materials science technology, robotics technology, big data and analysis, and your run of the mill internet startup. To me, I would say the industries closer to STEM are far undervalued, and the internet companies are generally overvalued, mostly because of one other industry: advertising. These days it feels like the standard model is to get as many users as possible, secret sell their data to third parties, eventually start advertising to them, and finally selling out to some corporate management husk which will take the company under the same name and run it into the ground capitalizing on the advertising potential, until it collapses or, if it's lucky, it gets turned into some sort of monopoly (eg, reddit on posting, facebook on social, linkedin for business social, google for search and email and big data, amazon for cloud services, twitter for immediate/short blurb social, etc) Maybe it's just me, but it seems like most of the net startups just want to suckle on the teet of big advertising because they have are still so willing to give that teet out, and I'm hoping eventually this model collapses because it corrupts some of the important functions of society (eg, journalism).
- hodwik 11y ago
  Case in point, Tobii -- market leader in pupil tracking tech valued at only $775m. People have no imagination.
d--b 11y ago
Sam is right in saying that equity deals are more like debt. But the reason for this to happen is because the interest rate have been held at 0 for a very long time, and in an economy that has recovered well. Because of the low interest rate in a healthy economy, every investor would be ill-advised to invest their money in safe low-yielding instruments such as treasury bonds. That is why we have seen a dramatic shift of capital from the traditionally safe rates market to higher yielding sectors, such as tech and real estate. That is especially true since there are enough tech companies to pool investment together in somewhat diversified portfolios, which give a false impression of safety (remember the CDOs?). The BIG question is what is going to happen when the Fed hikes the rates in the course of next year. And what will happen when the US passes a law to increase taxes on marginal gains. It is likely that there will be a significant drain of money from the tech sector, and when the money starts to withdraw, it tends to do so in a pretty unorganised manner. We may not be in a bubble that will burst. But we may very well be at the high point of a market cycle. The problem is not the high valuations, it is the high appetite for risky investment.
cdnsteve 11y ago
Maybe the problem isn't the companies or industry but the markets themselves. Going public isn't needed anymore. So why bother? Using publicly traded companies as a market radar is flawed.
WalterBright 11y ago
I've ridden two tech bubbles up, down, then up again. I wish I was able to time the market, but alas, I am not and so settle for patient long term investing.
dionidium 11y ago
And I think that the entire public market is likely to go down—perhaps substantially—when interest rates materially move up, though that may be a long time away. Can someone EL5 this? Arguments that seem plausible (to me): 1) higher interest rates make borrowing more expensive 2) higher interest rates make less risky investments more attractive 3) something hand-wavy about inflation and the role higher-interest rates play in combating it (or, more precisely, the signal that sends to the market)
- cmpxchg 11y ago
  The conventional wisdom is your #2. The idea is that for the past 6 years, interest rates have been close to zero, and as a result, people who would traditionally want to park their money in bonds have been forced into equities just to get any (non-zero) return. This is particularly true for investors like pension funds that need to show a certain return each year or else the manager gets fired or does not receive a bonus. The other issue is that Fed monetary policy tends to work with a lag of ~18 months. In other words, once the Fed starts a cycle of raising rates, recession or slow growth are the expected outcome -- not immediately but within 1-2 years following the rate increases. (Why? The reason is because borrowing costs increase for businesses -> they hire fewer workers -> more unemployment -> recession, etc.) These are general rules of thumb, not hard rules, obviously. Also, the conventional wisdom that reigned supreme between the 1960s - 2009 may or may not hold in the future. Monetary policy has changed dramatically in recent years, and I think it's safe to say that no one is quite sure what will happen when the Fed raises rates. Some question whether they even can influence market interest rates anymore [1]. [1] http://www.nytimes.com/2015/09/13/business/economy/the-feds-policy-mechanics-retool-for-a-rise-in-interest-rates.html http://www.nytimes.com/2015/09/13/business/economy/the-feds-...
dthal 11y ago
The point about the late-stage investments being not-really-equity is a great point. So my question is: why do financial journalists just about always miss it when they write about tech unicorns?
hackguru 11y ago
True. I am cautious to say this, but if one of these over valued unicorns like Uber dies then I think the psychological effect would be similar to a bubble burst. It would tight up the capital flow to a great extent even for solid companies
- prostoalex 11y ago
  Any time you see Fidelity, Morgan Stanley, Coatue or T. Rowe Price names in the funding rounds, 1x liqudation preference is usually a bare minimum for those guys to get involved. Their investors will get their money back, and even if after all is said and done it's 1x, hey, we're in a low-rate environment. Funds tout access, investors have downside protection with a potential of upside surprise, few people that do get nasty surprises are employees of those companies finding themselves staring at the ever-increasing number of newly minted shares to satisfy ratchet conditions and subsequent dilution of everyone else (case study on this is NYSE:BOX).
the_watcher 11y ago
The equity structured so that it's effectively a debt point is a really good one to make. "Valuations" and "venture rounds" are often not really comparable between companies.
gizi 11y ago
Tech companies, no matter how large, are so incredibly founder-dependent. You are not buying into Facebook but into Mark Zuckerberg. You are not buying into Google but into Sergey Brin or Larry Page. With Steve Jobs gone, you are buying into a total lack of vision, called Apple. There are no tech bubbles or tech busts. The type of persons mentioned are entirely oblivious to them. Bursts or bubbles do not affect their vision or their ability to execute in the least. Avoid investing in a weak personality at the top, and then you can ignore the entire market.
- yuhong 11y ago
  To be honest, Apple was able to make a profit before the iMac: http://investor.apple.com/secfiling.cfm?filingid=320193-98-1&cik=320193 http://investor.apple.com/secfiling.cfm?filingid=320193-98-1... (and yes I think most of the listed stuff was doable under Amelio)
pbreit 11y ago
Does anyone know what the common stock valuations (or 409a valuations) even are for the big, later stage companies?
gesman 11y ago
Excellent post. Confirms my original vision.
awwstn 11y ago
> "No one seems to fervently believe tech valuations are cheap, so it’d be somewhat surprising if we were in a bubble." Is this true? I know that high valuations are getting tons of press and shock in the public, but it seems like VCs, Wall Street, and the general population are racing to get their money into startups despite the high valuations everyone is talking about. So to me, that would indicate that many people do fervently believe tech valuations are cheap. I think where we put our money is probably a better indicator of what we believe about a market than what we say, and I get the sense that many of the people who are saying valuations are high are the same ones pumping millions of dollars into every startup they can.
anigbrowl 11y ago
2015 has seen the lowest level of tech IPOs as a percentage of all IPOs in seven years I'm thinking back to the Economist article of a few weeks ago about the future of corporations, discussing how much easier it is to raise capital and stay private these days, so there's not that much incentive to IPO and have to deal with all those quarterly earnings calls and so on.
idibidiart 11y ago
The market has some sort of bipolar disorder.
birbal 11y ago
This is a bit of shameless plug but i think quite aligned with Sam's post but makes a slightly different argument. https://www.linkedin.com/pulse/we-have-been-bigger-tech-bubble-than-now-another-obligatory-ganti?trk=prof-post https://www.linkedin.com/pulse/we-have-been-bigger-tech-bubb... Would love to get critiqued by this uber smart and opinionated crowd here.
- nl 11y ago
  I’d argue on-premise software, as a category, was a bigger bubble than what we have today in tech. It delivered little value to the end-user but the companies that sold them were commanding huge valuations for years because of the huge margins that they were able to charge. Wow. Well that's a pretty strong claim. I'd really like to see some kind of proof. Unless I misunderstand you, you are claiming that companies like Microsoft, Oracle and SAP were (are?) overvalued. You are also claiming that their software delivered little value. Those are some pretty bold claims, and I don't think you've made the case well enough for them to stand up. I think that you point about usage being a good indicator of future revenue is somewhat correct, but the really valuable analysis would be to show the types of services where usage is a good indicator of future value and ones where it isn't. Eg: Free file sharing? Not a good indicator Social platform? Good indicator
  - birbal 11y ago
    I think my points are made at a macro level and not at a specific company level. There is no fool-proof proof to any business/economic hypothesis. Oracle, MSFT and SAP aren't the only companies that make up on-prem software. But even with these companies shelf-ware is rampant. It took large internet companies to come up with competitive stacks to break these virtual monopolies. Having said that your point on making a stronger case is well taken. My bigger point is that the the current trend is less of a bubble than the era of on-prem software - this is a macro level observation. There were company level bubbles then and there are now. I am not commenting on specific companies here at least.
    - nl 11y ago
hack_mmmm 11y ago
I think we are going to witness harder times for unicorns, in general, in the up-coming years. I agree with Sam with most of his points, but I do think there are few startup valuations that seem crazy at this moment. Those valuations will be self corrected in the course of few years or so.
Patient0 11y ago
"I saw terms recently that had a 2x liquidation preference (i.e. the investors got the first 2x their money out of the company when it exited) and a 3x liquidation cap (i.e. after they made 3x their money, they didn’t get any more of the proceeds)." Can someone explain mechanically what this means? i.e. What is the payoff under each scenario? Edit: this link seems to explain it well http://www.businessinsider.com/how-liquidation-preferences-work-2014-3?IR=T http://www.businessinsider.com/how-liquidation-preferences-w...
DigitalSea 11y ago
Call me a cynic, but is it not in the best interests of Sam to tell us everything is alright? Obviously any kind of tech bubble would affect Y Combinator and some of the startups they have invested in. When was the last time a bank was honest with customers and told them that things were bad? Bad news causes panic and panic makes things worse.
herdrick 11y ago
"There is a massive disconnect in late-stage preferred stock, because if you’re using it to synthesize debt it doesn’t matter what the price is." Actually, price is crucial with this weird 'debt' since you're betting on the cumulative probabilities of hitting your liquidity preference and liquidity cap numbers. (Really it's an integral over that range, but whatever.) Whereas in equity venture investing the power law distribution of returns dominates linear optimizations of price. Thanks for reporting on this. I don't think many people knew about this insane liquidation straddle instrument. I sure didn't.
sjg007 11y ago
1. JP Morgan will allow retail investors to buy at the IPO price on deals they lead. 2. Big mutual funds etc.. are buying in at later stage private financing rounds. 3. Many tech stocks are off their IPO price. 4. There is preferred stock, ratchets and lots of other ways to get a specific return at a specific IPO price or to even support an IPO. 5. In regards to #1 one has to think about who the greater fool is.
chris123 11y ago
The post comes across as biased (and wrong).

562 points by runesoerensen 11y ago

Very few people would agree regarding Yelp. Almost no financial analyst worth a lick would use trailing revenue (instead of net earnings) as a way towards finding value in a company. Maybe I am missing why Sam points Yelp out at all here...

harryh 11y ago
How do you think companies with lots of revenue and zero earnings are valued? Like, say, Amazon.
- eclipxe 11y ago
  Amazon's earnings are not zero: http://www.nasdaq.com/earnings/report/amzn http://www.nasdaq.com/earnings/report/amzn
  - harryh 11y ago
    They have been for much of the existence of the company though. And their current earnings might as well be.
nostrademons 11y ago
Trailing revenue makes more sense than net earnings when a company has proven profitable unit economics but hasn't yet saturated its market. At this point, it always makes sense for the company to reinvest any profits into additional sales & marketing rather than bank it, because it earns a predictable return on capital > the market as a whole. A company in this stage will show zero or negative earnings during the entire growth phase (see eg. Amazon.com), but future DCF will increase in proportion to CLV of the whole customer base. Assuming stable CLV, trailing revenues is a pretty good proxy for this metric. Yelp seems like a fairly good candidate for a business at this stage; its unit economics are probably known to Sam, but it's doubtful that it's saturated all local businesses out there.
- rhino369 11y ago
  I think Wall Street is now learning away from treating Yelp as a high growth company. The question they are asking themselves is whether Yelp is reinvesting profits or if Yelp just can't be profitable. Yelps business is a competitive one. Their main revenue generation is selling ad space to local businesses. They are a yellow pages of the internet. User growth is slowing. I'd fear that Yelp just can't grow past any profitability issues. There is only so much money you can make from advertising.
- notahacker 11y ago
  Saturating Yelp's target market is labour-intensive work though, with high churn inevitable due to the nature of their customer base. Selling and renewing classifieds to a mass of small business is costly. Sure, you can eke out more profit even if your costs scale proportionately to revenues, but there's good reason to believe the CLV will actually decline and acquisition costs rise as they aim for higher saturation. With their brand and reach well-established for some time, it's the restauranteurs who aren't digital marketing-savvy (or think Google offers better ROI...) they're now looking to sign up.
- StriverGuy 11y ago
  You would still never use trailing Revenue. You would want to use y/y revenue growth rate if you are going to use it as indicator for value.

mikeyouse 11y ago

> I saw terms recently that had a 2x liquidation preference (i.e. the investors got the first 2x their money out of the company when it exited) and a 3x liquidation cap (i.e. after they made 3x their money, they didn’t get any more of the proceeds). But doesn't the 3x liquidation cap only come into play if the total exit is less than 3x? In my understanding, if the exit is greater than 3x the invested value, they then convert their preferred shares to common shares and receive their >3x proportional share in common stock thus retaining the upside of the investment.

sama 11y ago
No, that's when the 2x comes into play. In this scenario, the investor gets the first 2x, and then after 3x doesn't make any more money.
- mikeyouse 11y ago
  Oh wow, that is unique and very debt-like. My experience was closer to a 3x participating preferred.. Thanks for the clarification.
- mbesto 11y ago
  Do you think most entrepreneurs who take these debt structures realize the risk to their paper wealth? Or is it simply a matter of "we need the unicorn status to grow and hire" at any cost?
- rabbitonrails 11y ago
  Isn't that wrong because the preferred shares always have the right to convert into common?

vasilipupkin 11y ago

if people aren't buying the late stage common stock at high valuations, then how can it be a bubble in late stage valuations ? it sounds more like a bubble in tech press reporting of valuations ?

arjunnarayan 11y ago

This is an excellent post, and I'm in agreement. I particularly like the counterintuitive point that if NO unicorns go bust in the next 2 years, that's more indicative of the existence of a tech bubble than if one or two do go bust [1]. That's contrary to the inevitable media portrayal: I expect that the first unicorn to blow up will be heralded as the harbinger of end times. What I would like is for Sam to expand on what he thinks are some of the pitfalls of this new debt-like financing world. For instance, in the old equity-only world, it was well known that you could "never do a down round". This is because down rounds distort incentives to the point where the company might as well be dead. I suspect[2] that one downside of this "debt-like" world is that there are "implicit nonzero interest rates"[3] on all these debt deals. In the old equity-only world, having a flat valuation was bad but not a disaster. Only the down round was a disaster. I wonder if in this new debt-like world, the expectations have risen. In this world, even rising valuations could misalign incentives. I also wonder what those implied interest rates are at. [1]: Since NO unicorns going bust means that capital is far too accessible, when statistically you'd expect at least a couple unicorns to fail. [2]: I would prefer more expert input because I have low confidence in my suspicions. [3]: I put that in quotes because it's somewhat an abuse of terminology.

birken 11y ago
I'd love to see an entire blog post about Sam's footnote #1. Though I find it funny that every point about why this is bad for late-stage companies I believe applies exactly the same to post demo-day YC seed stage companies with extremely high valuations. Though I think in both cases if the company can be disciplined then cheap capital should be good, but staying disciplined is hard...
- cma 11y ago
  pg: "Yes, investors with preferred stock usually get their money back first. Sometimes they get a multiple, but that's considered overreaching nowadays and the more promising startups never have to agree to that. I suppose that is implicitly a target valuation in a sense. But no one views it as a target, because it only matters if things go badly." https://news.ycombinator.com/item?id=6896833 https://news.ycombinator.com/item?id=6896833 :/

denniskane 11y ago

"No one seems to fervently believe tech valuations are cheap, so it’d be somewhat surprising if we were in a bubble." Is this a typo? s/cheap/expensive/ would make more sense, no?

CyrusL 11y ago
The implication is that bubbles require optimistic groupthink. I.e., if everyone thinks it's a good time to buy, then it's a bubble. Sama's point is that because so many people are saying tech stocks are expensive then there isn't the mass delusion required for a bubble.
- nilkn 11y ago
  Thanks for clarifying that sentence -- I was confused by it as well, but this viewpoint makes sense.
- denniskane 11y ago
  Wow, okay... the first sentence reads so straightforwardly and the following one is like some kind of reverse judo takedown maneuver. The essential point is to correctly interpret who exactly the "no one" in question is referring to.
  - nailer 11y ago
    Literally nobody. Sam is saying most people think tech valuations are expensive, i.e., they are overpriced.
- AnimalMuppet 11y ago
  Not quite. There's a difference between an overpriced market and a bubble. A market can be overpriced when the consensus view is that stocks are more valuable than is actually realistic. When more sober judgment sets in, stocks go down to more appropriate levels. In contrast, a bubble is when stocks are going up, and so everybody wants to buy stocks because they're going up, and so stocks continue to go up because everybody's buying them, and so people continue to want to buy them because they're going up. It's not a bubble until you get that positive feedback going.

trjordan 11y ago

This is a pretty solid argument for why tech isn't out of bounds, at most any stage. On the other hand, we've had 7 years of 16% growth in the S&P. At some point, that will correct, and it will have a real effect on tech. We'll all declare the bubble "popped" at that point, and totally reasonable investments will fail, or at least become painfully illiquid for a while. 7 years feels like a long time to have a run like this. Just like every other time, nobody knows when we'll get that correction.

arielweisberg 11y ago
My math going back five years says it hasn't been 16% by a decent margin? Wouldn't P/E be a better heuristic? Either CAPE or just basic P/E?
- trjordan 11y ago
  I've got some serious end point bias going on, but the bottom was ~700 in March '09, and it's currently at 2,100. Triple in that time is actually 18% annualized (6.5th root of 3). There's definitely better ways of measuring "are we near a top", but "length of bull market" isn't meaningless. There have been a few longer ones, and only one ('49 - '61) that was nearly this productive at the 7 year mark. http://greenbackd.com/2013/04/17/bull-markets-since-1871-duration-and-magnitude/ http://greenbackd.com/2013/04/17/bull-markets-since-1871-dur...
vasilipupkin 11y ago
One thing that often gets lost in the analysis is the distinction between changes and levels. Yes, S&P has been rising for 7 years straight ( changes ), but it is not at particularly egregiously high levels relative to GDP or relative to whatever metric you prefer, since 2001
AYBABTME 11y ago
7 years ago was the middle of an economic crisis, I don't think it's abnormal to be going up for a while after that.

rl3 11y ago

I wonder what the thinking is behind deals like that (2x liquidation preference/3x liquidation cap). On one hand, it strikes me as incredibly beneficial for the founders if the company is a runaway success. On the other hand, the VCs are essentially throwing away their unlimited upside potential, and in doing so signalling they don't particularly believe in the company. There's also the fact that the terms are very unfavorable for founders if they exit at anything below a stellar valuation, though one could argue the entire point of the game is to achieve an incredible exit. Still, when incentives aren't aligned it's disconcerting.

tyre 11y ago
These are specifically in late-stage deals, like Uber's recent rounds. The investors aren't traditional VCs, but companies like Fidelity. They don't want a 5% chance at a 100x return; they would much rather a near-guarantee of 2-3x with downside protection. That's why Sam compares them with fixed income.
- vasilipupkin 11y ago
  it's not clear why Fidelity would want a cap on the upside, since it needs to beat an index. Most likely, it doesn't think it's giving up any upside.
  - jonknee 11y ago
    I would imagine ceding the cap makes it easier to get the 2x liquidation preference.
  - caseyf7 11y ago
    They give up the upside because they have protection from the downside (they get their money back first).
    - vasilipupkin 11y ago
      I understand, I'm saying I don't think they believe they are giving up much upside at all

webmasterraj 11y ago

The major difference between what's going on now and what happened in 2000 is transparency. Not with what's happening at companies, but what investors are thinking. That's important, because investor sentiment is the proximate cause of any bubble bursting. In 2000, it was easy to gauge investor sentiment – you just had to look at stock prices, which are real-time, precise indications of how investors as a whole feel. That meant it was easy to tell when the bubble started to burst (arguably on March 10, 2000, when the Nasdaq peaked). What's hard today, and maybe why there's a lot of these "is it a bubble or not?" stories, is that investors don't know what other investors are thinking. Sam and YC have consistently been open, but they're more the exception that proves the rule. The vast mass of investors are holding their cards close to their chest. The net effect is to prolong an increasingly unsustainable situation. I think it's highly likely that most investors already secretly think we're in a bubble. And that they also believe that other investors haven't realized it (everyone assumes they're the smart one). So we're stuck in this phase of "make my last buck before all the other idiots realize what's going on."

InclinedPlane 11y ago
That's one major difference, the other is the maturity of the industry. In 2000 the online tech industry was fledgling, and most of it was vapor. The bubble was bigger than the entire industry. Today tech has grown across the board and the web has become a key pillar of that growth. Trillions of dollars in real value has been built and added to the economy of the world. As big as any bubble might be, the industry is so much larger and on such firmer footing today that a collapse wouldn't have nearly the same impact.
- ethbro 11y ago
  I hadn't ever really thought about it this way, but it's a good point. Fundamentally, one would expect some relationship between total "digitized" (?) economy value (where digitized means able to be controlled, measured, and/or analyzed by software) and the value of startups. And I don't think many people would argue computer-industry merging hasn't been happening across different industries fairly quickly.

venomsnake 11y ago

Can't we both be in bubble and bust? They are not mutually exclusive. We have just too much money and excess capital chasing limited investment opportunities - so this creates bubbles. On the other hand the increased inequality and concentration of capital in fewer hands means that a lot of financing strategies are performing worse and capital is less efficiently allocated. For example - if the optimal allocation of $1B USD is 1000 investments of $1M - we could have that outcome if the capital is split between 300 people each having 3.33 million. But a single billionaire will prefer to make 10 100M investments, because the cognitive overhead of taking so much decisions will wear him down.

nostrademons 11y ago
An individual doesn't have to be rational for the system as a whole to be. In your example, that billionaire's 10 $100M investments will underperform. Meanwhile, some of the 300 people who each invested $1M will overperform. As a result, in the next round of capital allocation, the billionaire is no longer a billionaire while some of those single-digit millionaires are now billionaires. This is actually not all that far off from how things are actually working right now - a number of people from humble middle-class backgrounds are getting phenomenally rich because they understand tech and make smart capital allocation decisions, while a number of rich billionaires who can't be bothered to update their mental models are riding their companies all the way down. All of this is capitalism working as intended. It's only a "bubble" if everybody is a winner; it's only a "bust" if everybody is a loser. Normal operation in capitalism is for there to be both winners and losers.

memossy 11y ago

This is a very good piece, particularly: "In a world of 0 percent interest rates, people become pretty focused on finding new sources for fixed income" The amount of money coming to pay up for growth/quasi fixed-income is almost certain to increase as there are a lot of investors who need to hit 7-8% nominal returns in a 0% rate world: http://www.ecstrat.com/research/why-large-funds-are-piling-into-pe-vc/ http://www.ecstrat.com/research/why-large-funds-are-piling-i...

ThomPete 11y ago

Tech companies in general are underated. One of the things that is going on IMO is that the media in constant need for something to write about started honing in on startups because their growth is much more steep and create a lot of notable events they can write about. And so when we hear about companies being overvalued it's a specific group of companies who give us that impression.

nostromo 11y ago

> No one seems to fervently believe tech valuations are cheap, so it’d be somewhat surprising if we were in a bubble. I'm nitpicking a great post here, but I'm not sure this statement is right. During the real-estate bubble and the dot-com bubble, seemingly few people actually thought houses or internet companies were cheap. I think people felt that they were expensive, but they bought them anyway on the assumption that they would sell to the greater fool.

danans 11y ago
I agree that it's a cryptic statement, but I think he meant that bubbles are characterized by investors believing irrationally that an asset class is cheap and buying it. Therefore, investors believing that an asset is not cheap indicates that there is no bubble. Another way of saying it is that if people are generally skeptical about the valuation of an asset class, it can't be in a bubble. That does leave one wondering why said investors would continue to buy the asset, though. With many bubbles, the thing that breaks them isn't investor worry about valuation, but the sudden cascade of failure of mechanisms built on top of the valuations. In the case of the real estate bubble, this occurred because huge numbers of bad loans suddenly stopped being paid when interest rates went up. That broke all the financial instruments built on top of them.
- adevine 11y ago
  The problem with this circular logic is that it is an EXACT symptom of what happened in the housing bubble "Bubbles can only happen when people believe the price will only ever go up. Look, there are a bunch of people saying housing prices are too high. Thus, we can't be in a bubble, so I'm safe buying this shack for the market value of a million dollars."
  - TheM00se 11y ago
    I see what you did there.
bkjelden 11y ago
Aren't the greater fool theory and 'cheap' the same idea, just from different reference points? Both assume I can buy an asset for less than I can sell it for.

siquick 11y ago

> Many of the small cap public tech companies have taken a beating this year. Companies like Yelp are trading at less than 4 times trailing revenue. Could someone explain what this means please? Is Sam saying that the stock price of Yelp is lower than what is actually should be (based upon revenues)?

trader 11y ago

Good article, and I agree with the main points. However, you have to be very careful comparing PE ratios between companies with different capital structures, it is wrong. For example, lets take two companies that are exactly the same, A and B and lets say they should have an enterprise value of $100 and have the same earnings before interest. Company A is all equity and has a PE of 10 ($100/$10). Lets say company B is half equity value and half debt ($50 and $50). Lets also say the company is paying 4% on its debt. Its earnings are lowered to $8, however the PE ratio is actually 6.25 ($50/$8). This company isn't "cheaper" it just has a different capital structure. No measure is perfect, but at least use EBITDA or Unlevered FCF for comparisons. This is especially important now with the large number os stock buybacks.

malchow 11y ago
Totally agree on using unlevered FCF as the comparator.
vasilipupkin 11y ago
static analysis is always problematic. If a company B is using debt, it should be able to increase its earnings with the debt and increase equity value. if it's failing to do so, it should be cheaper because it is riskier

roymurdock 11y ago

On the whole, it seems harder than any time in the past four years to raise mid-stage rounds. This is also not suggestive of a bubble. It's suggestive of the end of a bubble, when the music stops and the last investors who have not yet exited are left without a chair. If any part of the path to exit breaks down, the whole system will start to fail. There are real problems with these distorted "valuations". Employees these companies hire often think of them as real valuations. It also often makes the company think of itself as much bigger than it is, and do the wrong things for its actual stage. Finally, too much cheap money lets companies operate with bad unit economics and cover up all sorts of internal problems. So I think many companies are hurting themselves with access to easy capital. Sounds like Sam has (unwittingly) become an Austrian. Friedrich Von Hayek on inflation (1970): "The initial general stimulus which an increase of the quantity of money provides is chiefly due to the fact that prices and therefore profits turn out to be higher than expected. Every venture succeeds, including even some which ought to fail. But this can last only so long as the continuous rise of prices is not generally expected. Once people learn to count on it, even a continued rise of prices at the same rate will no longer exert the stimulus that it gave at first." [1] Sounds a little bit like QE stimulus which has been channeled into the private financial markets. I wonder why it hasn't translated into higher salaries. But no matter what happens in the short- and medium-term, I continue to believe technology is the future, and I still can’t think of an asset I’d rather own and not think about for a decade or two than a basket of public or private tech stocks. I'd rather own real estate than a basket of private tech stocks, especially if that basket includes Facebook, Twitter, Snapchat, or really any company where user growth rates and advertising revenues are heavily informing valuations. Users can and will migrate between tech platforms pretty easily - homes, offices, businesses - not so much. Plus, the government has been very pro-landlord lately, soaking up trillions in mortgage debt at the federal level and allowing insane housing bubbles like SF and NY to continue to grow unabated at the state level. Looking for fixed, usury income in a ZIRP and QE-infinity world? Look no further. The only consolation one can take in this situation is the fact that less and less people are even able to play the investing game anymore. Only 26% of individuals under 30 are investing in the stock market, as compared with 58% between the ages of 50 and 64 [2]. So now the SEC wants to make crowdfunded equity the new way to channel middle and lower class money into risky ventures [3]. What's a poor young guy to do? [1] http://www.marketwatch.com/story/why-most-millennials-dont-invest-in-the-stock-market-2015-04-09 http://www.marketwatch.com/story/why-most-millennials-dont-i... [2] https://mises.org/library/denationalisation-money-argument-r.. https://mises.org/library/denationalisation-money-argument-r.... [3] http://www.nytimes.com/2015/10/31/business/dealbook/sec-gives-small-investors-access-to-equity-crowdfunding.html http://www.nytimes.com/2015/10/31/business/dealbook/sec-give...

lmm 11y ago

I might want my wealth in tech stocks. But I sure as hell wouldn't want my wealth in advertising-funded stocks. How many tech companies have any other revenue stream? What does the landscape look like if 2016 is the year that Twitter finally runs out of other people's money? If you'd invested on demo day you'd be happy with current valuations, sure. But that just means the valuations are as high now as they are then. How many unicorns have repaid their investors in terms of dividends? Altman is right that there's been a cooling off in 2015, and right that it's a positive sign - we may yet avoid a dramatic crash. But that doesn't mean there isn't a further contraction to come. We could just be seeing stagflation finally catching up to the tech industry.

kansface 11y ago
> I sure as hell wouldn't want my wealth in advertising-funded stocks Where do you expect advertising to go? It looks like about half of all clicks are fraudulent one way or another, but in spite of that, if advertising didn't yield a positive return, I wouldn't expect it be so popular.
- lmm 11y ago
  I think adblocking is finally going mainstream,and I think that's going to feed into a cultural shift in how much we tolerate advertising in general (see e.g. recent articles about the possibility of banning billboards).
tptacek 11y ago
This is a weird thing to say. Look at the Fortune "Unicorn list" (the first Google hit I get for [unicorn list]): 1. Uber (not ad-funded) 2. Xiaomi (not ad-funded) 3. Airbnb (not ad-funded) 4. Palantir (not ad-funded) 5. Snapchat (ad-funded) 6. Didi Kuaidi (not ad-funded) 7. Flipkart (not ad-funded) 8. SpaceX (not ad-funded) 9. Pinterest (ad-funded) 10. Dropbox (not ad-funded) 11. WeWork (not ad-funded) 12. Lufax (not ad-funded) 13. Theranos (not ad-funded) 14. Spotify (not ad-funded) 15. DJI (not ad-funded) 16. Zhong An (not ad-funded) 17. Meituan (ad-funded) 18. Square (not ad-funded) 19. Snapdeal (ad-funded) 20. Stripe (not ad-funded) It just keeps going like this. These aren't even ad-ecosystem companies. I'm not sure how far down the list you'd have to go to find an adtech firm.

snomad 11y ago

> 2015 has seen the lowest level of tech IPOs as a percentage of all IPOs in seven years. Healthcare and finance are leading the IPO percentage. That seems to reflect new opportunities created by legal changes (ACA + Dodd-Frank). I'm not sure you can draw much of a conclusion about tech bubble status because regulatory changes have fostered growth in other industries. > The S&P Tech P/E is lower than the overall S&P P/E. Neither of these facts seems suggestive of a tech bubble. Overall tech P/E may be low, but the recent names are filled with companies that are not making profit, and don't appear on a path to do so over the next few years. Examples: Pandora (-0.65 eps), LinkedIn (-1.15 eps) and Twitter (-0.86 eps), Zynga (-0.20 eps), Trulia (-1.82 eps) and Zillow Group (-2.47 eps), Box (-1.66 eps), Etsy (-1.02 eps) and Shopify (-0.23 eps). (To be fair, there are "winners" Facebook, Kayak, GoPro, Fitbit). I'm not sure you can draw a conclusion about a tech bubble by looking at entire sector. Recent names seem to justify the "unicorn" meme.

quickpost 11y ago

I feel like the lofty valuations of very early-stage companies these days really creates an unfair dynamic for early employees. I've seen people claiming $5MM valuations for fancy powerpoint slides and no product, which seems really high to me. The founders then recruit people and give out equity based on these sky-high valuations despite no product or real offerings. Early employees end up sacrificing significant pay in exchange for equity that is priced far higher than it actually should be.

scottjad 11y ago

> Companies like Yelp are trading at less than 4 times trailing revenue. Yelp has a P/E ratio of either 213 or 80, depending on whether Google Finance or Yahoo Finance have the correct number. So it's pretty rich of him to use Yelp as his first example of a tech company that's dramatically undervalued, purposefully ignore the P/E ratio, and then use P/E ratios for other companies in his next two paragraph to try to claim that tech is undervalued.

steveplace 11y ago
Using p/e to value growth companies doesn't work too well. The "E" in the ratio changes too fast.
- scottjad 11y ago
  If the P/E ratio had been very low, I think he would have used it. The problem with using P/E for an eleven year old company like Yelp is that E is still very small or non-existant and hasn't been changing fast, so the P looks ridiculous.
- Ologn 11y ago
  > Using p/e to value growth companies doesn't work too well. The "E" in the ratio changes too fast. In 1934, Benjamin Graham and David Dodd published "Security Analysis" which laid out the basis of modern thinking on proper fundamental stock price, both by academics and by mutual fund managers. What you're saying completely contradicts that. Something else is forgotten - the real price is not determined by the p/e ratio but in something even more concrete - the price/dividend ratio. Enron might be fudging their books, but nothing fudges the quarterly dividends. Price/earnings is already an abstraction of what determines the real price - the price/dividend ratio. You're talking about abstracting things yet further - it reminds me of the late 1990s when people talked about price as related to "eyeballs". It's true that a p/e ratio is meaningless when a company is very small - before product/market fit and so forth. But P/E has forever been used to value technological growth companies. Technological growth companies are not a new thing - there were companies like Cisco in the 1990s and like Polaroid in the 1970s. High growth companies have high p/e ratios. It's already abstracted from price/dividend to price/earnings. Then there are companies like Amazon, which are a whole other tangent off this.

marincounty 11y ago

Whenever I see a Top Dog defending their industry--I worry. I don't know if it's a bubble. I'm so bad at predicting the financial future, I looked onto something called a Contrarian Investor. If I had money to invest, I think I would do the ablosute opposite of what the experts advise. While I terrible about predicting bubbles; I, along with most people predicted the last tech bubble. I know certain tech companies are very different today. I don't want to argue with anyone. I'm a nobody. These are just my uneducated/novice inner thoughts. I do know the people around me are underemployed, and too many just stopped looking for work. They haven't benefitted from this recovery. They didn't benefit from low interest rates. The low interest rates just hurt guy's like me. The bank charges me for everything. Rent is always going up. Fines, and fees go up, while my salary stays stagnant. I make nothing on my savings account. I am greatful we don't have much inflation though. I am greatful for health care, but it's not what I thought it would be. I'm not knocking Obamacare, just the enetites that are exploiting it. I couldn't imagine being in a state where the governor declined funds from Obamacare. Yes, tech is booming, and I hope it stays booming. Being in the Bay Area, I see the amount of money tech is bring in. I see rents skyrocketing. I see houses being bought up for outrageous amounts. (I'm not claiming tech is the only reason housing is going up in cost. I see REIT's and foreigners buying residential properties with a phone call.) I just don't know. It's Monday, and I don't feel great. If it is a bubble, I pray it leaks, and doesn't burst. Sorry, about this post. I'm all alone today, and this is my port hole to others. I know--I'm pathetic.

ChuckMcM 11y ago

Excellent post, and the "investment as debt" theme is spot on, who cares what the valuation is if you get 2 - 3x your money back right? However you do need some sort of liquidity event for that and I worry that some Unicorns will become Ponzi-corns as early investors contribute their shares to be re-sold to the later investors as a way to cash out their 2X and move on. Then its "last one in, loses everything". Of course a couple of take out re-capitializations will probably put a damper on some of that zeal. Mostly the people being screwed here are employees with 100% common stock. That argues that high value employees should be negotiating for preferred stock grants rather than common stock ISOs. That will come with a bigger tax bill but has a better chance of providing a return on their sweat investment.

steven2012 11y ago
The only "last ones in" will be the retail investor when they eventually go IPO. That's always been the case, just like with GroupOn, Zynga, etc. The VCs and IBs will hype up the company, and then they get their mutual fund buddies with huge piles of cash to pay up for the IPO in exchange for early access to the next awesome company, and these crappy companies get unloaded to the retail suckers. That's how the industry works, but no one seems to care, because there are no consequences, and the incentives are such that no one cares if the retail investors lose a bit of money, and VCs and IBs get massively wealthy.
- ChuckMcM 11y ago
  Except that the future of Unicorns is not an IPO, its being sold to BigCo for a fraction of their Valuation which pays off some of the investors but fails to trickle down to the common stock. Or like with companies like SilverSpring there is a massive reverse split to get the the number of Common Stock shares down to a number that represents what the current market might pay leaving employees with pre-IPO stock options where the strike price is above the IPO price. How is that not a ponzi scheme?
  - steven2012 11y ago
    Reverse split happened to Hortonworks as well. Lots of employees got completely screwed by this because the sheer number of their options were cut in half.

arca_vorago 11y ago

I don't think you can lump all technology into the same group anymore. There is a big difference between materials science technology, robotics technology, big data and analysis, and your run of the mill internet startup. To me, I would say the industries closer to STEM are far undervalued, and the internet companies are generally overvalued, mostly because of one other industry: advertising. These days it feels like the standard model is to get as many users as possible, secret sell their data to third parties, eventually start advertising to them, and finally selling out to some corporate management husk which will take the company under the same name and run it into the ground capitalizing on the advertising potential, until it collapses or, if it's lucky, it gets turned into some sort of monopoly (eg, reddit on posting, facebook on social, linkedin for business social, google for search and email and big data, amazon for cloud services, twitter for immediate/short blurb social, etc) Maybe it's just me, but it seems like most of the net startups just want to suckle on the teet of big advertising because they have are still so willing to give that teet out, and I'm hoping eventually this model collapses because it corrupts some of the important functions of society (eg, journalism).

hodwik 11y ago
Case in point, Tobii -- market leader in pupil tracking tech valued at only $775m. People have no imagination.

d--b 11y ago

Sam is right in saying that equity deals are more like debt. But the reason for this to happen is because the interest rate have been held at 0 for a very long time, and in an economy that has recovered well. Because of the low interest rate in a healthy economy, every investor would be ill-advised to invest their money in safe low-yielding instruments such as treasury bonds. That is why we have seen a dramatic shift of capital from the traditionally safe rates market to higher yielding sectors, such as tech and real estate. That is especially true since there are enough tech companies to pool investment together in somewhat diversified portfolios, which give a false impression of safety (remember the CDOs?). The BIG question is what is going to happen when the Fed hikes the rates in the course of next year. And what will happen when the US passes a law to increase taxes on marginal gains. It is likely that there will be a significant drain of money from the tech sector, and when the money starts to withdraw, it tends to do so in a pretty unorganised manner. We may not be in a bubble that will burst. But we may very well be at the high point of a market cycle. The problem is not the high valuations, it is the high appetite for risky investment.

cdnsteve 11y ago

Maybe the problem isn't the companies or industry but the markets themselves. Going public isn't needed anymore. So why bother? Using publicly traded companies as a market radar is flawed.

WalterBright 11y ago

I've ridden two tech bubbles up, down, then up again. I wish I was able to time the market, but alas, I am not and so settle for patient long term investing.

dionidium 11y ago

And I think that the entire public market is likely to go down—perhaps substantially—when interest rates materially move up, though that may be a long time away. Can someone EL5 this? Arguments that seem plausible (to me): 1) higher interest rates make borrowing more expensive 2) higher interest rates make less risky investments more attractive 3) something hand-wavy about inflation and the role higher-interest rates play in combating it (or, more precisely, the signal that sends to the market)

cmpxchg 11y ago
The conventional wisdom is your #2. The idea is that for the past 6 years, interest rates have been close to zero, and as a result, people who would traditionally want to park their money in bonds have been forced into equities just to get any (non-zero) return. This is particularly true for investors like pension funds that need to show a certain return each year or else the manager gets fired or does not receive a bonus. The other issue is that Fed monetary policy tends to work with a lag of ~18 months. In other words, once the Fed starts a cycle of raising rates, recession or slow growth are the expected outcome -- not immediately but within 1-2 years following the rate increases. (Why? The reason is because borrowing costs increase for businesses -> they hire fewer workers -> more unemployment -> recession, etc.) These are general rules of thumb, not hard rules, obviously. Also, the conventional wisdom that reigned supreme between the 1960s - 2009 may or may not hold in the future. Monetary policy has changed dramatically in recent years, and I think it's safe to say that no one is quite sure what will happen when the Fed raises rates. Some question whether they even can influence market interest rates anymore [1]. [1] http://www.nytimes.com/2015/09/13/business/economy/the-feds-policy-mechanics-retool-for-a-rise-in-interest-rates.html http://www.nytimes.com/2015/09/13/business/economy/the-feds-...

dthal 11y ago

The point about the late-stage investments being not-really-equity is a great point. So my question is: why do financial journalists just about always miss it when they write about tech unicorns?

hackguru 11y ago

True. I am cautious to say this, but if one of these over valued unicorns like Uber dies then I think the psychological effect would be similar to a bubble burst. It would tight up the capital flow to a great extent even for solid companies

prostoalex 11y ago
Any time you see Fidelity, Morgan Stanley, Coatue or T. Rowe Price names in the funding rounds, 1x liqudation preference is usually a bare minimum for those guys to get involved. Their investors will get their money back, and even if after all is said and done it's 1x, hey, we're in a low-rate environment. Funds tout access, investors have downside protection with a potential of upside surprise, few people that do get nasty surprises are employees of those companies finding themselves staring at the ever-increasing number of newly minted shares to satisfy ratchet conditions and subsequent dilution of everyone else (case study on this is NYSE:BOX).

the_watcher 11y ago

The equity structured so that it's effectively a debt point is a really good one to make. "Valuations" and "venture rounds" are often not really comparable between companies.

gizi 11y ago

Tech companies, no matter how large, are so incredibly founder-dependent. You are not buying into Facebook but into Mark Zuckerberg. You are not buying into Google but into Sergey Brin or Larry Page. With Steve Jobs gone, you are buying into a total lack of vision, called Apple. There are no tech bubbles or tech busts. The type of persons mentioned are entirely oblivious to them. Bursts or bubbles do not affect their vision or their ability to execute in the least. Avoid investing in a weak personality at the top, and then you can ignore the entire market.

yuhong 11y ago
To be honest, Apple was able to make a profit before the iMac: http://investor.apple.com/secfiling.cfm?filingid=320193-98-1&cik=320193 http://investor.apple.com/secfiling.cfm?filingid=320193-98-1... (and yes I think most of the listed stuff was doable under Amelio)

pbreit 11y ago

Does anyone know what the common stock valuations (or 409a valuations) even are for the big, later stage companies?

gesman 11y ago

Excellent post. Confirms my original vision.

awwstn 11y ago

> "No one seems to fervently believe tech valuations are cheap, so it’d be somewhat surprising if we were in a bubble." Is this true? I know that high valuations are getting tons of press and shock in the public, but it seems like VCs, Wall Street, and the general population are racing to get their money into startups despite the high valuations everyone is talking about. So to me, that would indicate that many people do fervently believe tech valuations are cheap. I think where we put our money is probably a better indicator of what we believe about a market than what we say, and I get the sense that many of the people who are saying valuations are high are the same ones pumping millions of dollars into every startup they can.

anigbrowl 11y ago

2015 has seen the lowest level of tech IPOs as a percentage of all IPOs in seven years I'm thinking back to the Economist article of a few weeks ago about the future of corporations, discussing how much easier it is to raise capital and stay private these days, so there's not that much incentive to IPO and have to deal with all those quarterly earnings calls and so on.

idibidiart 11y ago

The market has some sort of bipolar disorder.

birbal 11y ago

This is a bit of shameless plug but i think quite aligned with Sam's post but makes a slightly different argument. https://www.linkedin.com/pulse/we-have-been-bigger-tech-bubble-than-now-another-obligatory-ganti?trk=prof-post https://www.linkedin.com/pulse/we-have-been-bigger-tech-bubb... Would love to get critiqued by this uber smart and opinionated crowd here.

nl 11y ago
I’d argue on-premise software, as a category, was a bigger bubble than what we have today in tech. It delivered little value to the end-user but the companies that sold them were commanding huge valuations for years because of the huge margins that they were able to charge. Wow. Well that's a pretty strong claim. I'd really like to see some kind of proof. Unless I misunderstand you, you are claiming that companies like Microsoft, Oracle and SAP were (are?) overvalued. You are also claiming that their software delivered little value. Those are some pretty bold claims, and I don't think you've made the case well enough for them to stand up. I think that you point about usage being a good indicator of future revenue is somewhat correct, but the really valuable analysis would be to show the types of services where usage is a good indicator of future value and ones where it isn't. Eg: Free file sharing? Not a good indicator Social platform? Good indicator
- birbal 11y ago
  I think my points are made at a macro level and not at a specific company level. There is no fool-proof proof to any business/economic hypothesis. Oracle, MSFT and SAP aren't the only companies that make up on-prem software. But even with these companies shelf-ware is rampant. It took large internet companies to come up with competitive stacks to break these virtual monopolies. Having said that your point on making a stronger case is well taken. My bigger point is that the the current trend is less of a bubble than the era of on-prem software - this is a macro level observation. There were company level bubbles then and there are now. I am not commenting on specific companies here at least.
  - nl 11y ago

hack_mmmm 11y ago

I think we are going to witness harder times for unicorns, in general, in the up-coming years. I agree with Sam with most of his points, but I do think there are few startup valuations that seem crazy at this moment. Those valuations will be self corrected in the course of few years or so.

Patient0 11y ago

"I saw terms recently that had a 2x liquidation preference (i.e. the investors got the first 2x their money out of the company when it exited) and a 3x liquidation cap (i.e. after they made 3x their money, they didn’t get any more of the proceeds)." Can someone explain mechanically what this means? i.e. What is the payoff under each scenario? Edit: this link seems to explain it well http://www.businessinsider.com/how-liquidation-preferences-work-2014-3?IR=T http://www.businessinsider.com/how-liquidation-preferences-w...

DigitalSea 11y ago

Call me a cynic, but is it not in the best interests of Sam to tell us everything is alright? Obviously any kind of tech bubble would affect Y Combinator and some of the startups they have invested in. When was the last time a bank was honest with customers and told them that things were bad? Bad news causes panic and panic makes things worse.

herdrick 11y ago

"There is a massive disconnect in late-stage preferred stock, because if you’re using it to synthesize debt it doesn’t matter what the price is." Actually, price is crucial with this weird 'debt' since you're betting on the cumulative probabilities of hitting your liquidity preference and liquidity cap numbers. (Really it's an integral over that range, but whatever.) Whereas in equity venture investing the power law distribution of returns dominates linear optimizations of price. Thanks for reporting on this. I don't think many people knew about this insane liquidation straddle instrument. I sure didn't.

sjg007 11y ago

1. JP Morgan will allow retail investors to buy at the IPO price on deals they lead. 2. Big mutual funds etc.. are buying in at later stage private financing rounds. 3. Many tech stocks are off their IPO price. 4. There is preferred stock, ratchets and lots of other ways to get a specific return at a specific IPO price or to even support an IPO. 5. In regards to #1 one has to think about who the greater fool is.

chris123 11y ago

The post comes across as biased (and wrong).