Jason Meyers – Tech Bubble Theory

Jason Meyers – Tech Bubble Theory – March 7, 2015

The escalation of noise about valuations of technology startups as compared to the 1999-2000 tech bubble is highly subjective and misguided. One must first examine the differences between what is now the subject of debate and the conditions that caused the precipitous decline in the value of technology startups 16 years ago.It is assumed that the reader of this blog is familiar with the basic principles of valuation, burn rates, capital structure and capital supply as well as the dynamics of market psychology and market perception before such assessment can be made.

First of all, bubbles burst at a time when they are least expected. They also involve a large number of participants. Pronouncements of “the end” are usually followed by a continued period of inflation lasting between six months and three years.

When was the last time a warning was given, and in an orderly fashion, immediately thereafter, the pronounced elements came together in such a manner that caused a highly expected rapid decline in the value of assets? Never.  Not even Alan Greenspan’s irrational exuberance warning gave way to an expected orderly decline in asset valuations. As history showed, valuations, specifically for technology companies inflated to unprecedented levels. And if anyone can actually cause such a panic, it would be the Chairman of the Federal Reserve.

First, I am anxious to point out some of the capital supply dynamics associated with the capital market for early stage companies and its complexion during the period from 1995-2000. I won’t bore you with detailed statistics because they are not relevant.

During the period between 1995 and 2000, there were a significantly less number of VCs than there are today with significantly less capital under management. The largest VCs controlled the bulk of institutional capital available for early stage funding. For each VC there were many dozens of investment banks who were actively engaged in underwriting activities for early stage companies during the same period. The investment banks controlled the bulk of capital from individual investors available for early stage funding.

In contrast, VCs, as principle investors, (present company included) earn money based on percentage of profits made through exits, while investment banks earn fees based on a percentage of capital raised and commissions on trades for customers. That being said, the motivation behind valuations for a VC and an investment bank are diametrically opposed. For an investment bank, the larger the valuation on an IPO or secondary, the larger the fee.  Naturally, for a VC, the smaller the valuation at the time of the investment, the larger the fee upon exit. At the IPO, the VC, issuer and the underwriter have a motivation to price as high as the market will bear.

When you pair off the opposition, you have a dangerous dynamic for the investor purchasing the IPO and even more danger for those who purchased shares in the open market after the IPO.

What IS ACTUALLY DIFFERENT this time is the stage that a company goes public. Back in the day, a typical startup raised $10 to $50 million privately and, as soon as possible, an army of investment banks underwrote between $50 and $100 million of its equity in an IPO at valuations many times higher than the valuation at the last private round. Profitability was never considered as we were at the dawn of an industrial revolution and not a soul knew what the outcome would be.

When considering the dynamics during the late 1990s, a far larger number of companies went public at a very early stage whose market capitalizations were supported by a far larger number of investment banks than there are today with analysts ratings to document such support. The support was shouldered mostly by large numbers of individual investors at the behest of their advisors at such firms who earned 5% and more on principal trades of ever increasing share prices at a time when you could drive a truck through the bid-ask spreads. Every department of an investment bank participated in the marketing efforts of the IPO and thereafter in what was considered to be the greatest era to be a retail stockbroker and a banker. You want a recipe for a bubble? That’s it.

As a result of the repeal of the Glass Steagall Act, the number of investment banks declined significantly and the independent investment banking boutique became extinct. The army of equity underwriters who dominated the space consisting of the likes of Robertson Stevens, Alex Brown, Hambrecht & Quist, Dain Bosworth, Robinson Humphrey, First Boston, Montgomery Securities and many dozens of other boutiques were acquired by large commercial banks who dissolved the entrepreneurial culture and the eliminated the equity syndicate partnership among boutiques on Wall Street that grew and supported emerging growth for the last 200 years.

Today, its is no longer lucrative to be on the sell side. There are only a handful of investment banks actively engaged in equity underwriting activity which is a very small percentage of their business activity which focuses largely on institutional distribution leaving very little allocation to the retail investor. AliBaba, for instance, was distributed mostly to institutions. Furthermore, managed money has dominated the books of retail brokerage at the large banks to such an extent that retail transactional business is discouraged if not prohibited. Lastly, those advisors lucky enough to have survived the last tech bubble who still engage in retail transactional brokerage advise clients to purchase safer, more mature companies whose share price is highly liquid, not to mention that you can’t even thread a needle through spreads anymore.

There are a far larger number of VCs today and the big firms control significantly larger pools of capital which is available largely for later stage rounds of funding. In addition, large institutions like Fidelity and Wellington Management have made replaced the underwriter and participate in later stage funding for what can be considered as later stage funding. This change in the funding landscape leaves no reason for any well funded disruptor to go public until they are mature companies or are profitable or very close to it. This dynamic has reversed the effect of the wide spread between valuations at private rounds and the IPO in that the level of  private capital invested is far larger now than the size of public offerings of yesteryear.

Comparatively, individuals are now playing little role in supporting the valuations of these later stage IPO companies, some of which may deserve the market caps they now sport but that’s another blog. To compare today’s Airbnb, Uber, Pinterest and Snapchat to The Globe, CommerceOne or Broadcast.com would be outright ignorant.

The major difference today is that should a deflation in the valuation of private companies occur, it would have no economic effect as the institutional investors who funded these companies will only suffer a mark to market impairment on a very small percentage of AUM as opposed to the millions of retail investors who lost significant sums of actual money in the last tech bubble supporting valuations of underfunded startups hoping the next purchaser would pay higher.

Granted, we should all learn from Mark Cuban, for whom I have nothing but love and respect, but the only person he is serving by his “bubble tweet heard round the world” is Mark Cuban. His reason for grandstanding has more to do with an effort to temper the attitudes of entrepreneurs and investors so that he can invest at what he believes are acceptable valuation levels. Let’s face it, Mark is buying, not selling.

As for crowdfunding startups via SEC Rule 506(c); issuers warn the investor AND the investor now understands up front that the investment is not liquid and “should only be considered by those who have no need for liquidity and can withstand the loss of their entire investment”, as stated in every offering document. So if valuations drop and alternative capital markets dry up, it will have minimal economic impact.

We are a long way from a bubble when considering the elements discussed here. As for the scare tactics, ignore them. Don’t stop dreaming but BE CAREFUL! The voices that cry lower are always the loudest at the bottom. The bubble will be fully formed when my shoemaker decides to form a venture capital firm.

Jason Meyers is a venture capitalist based in NYC.