Vainglorious Venture Capitalists! Tech Bubble 2.0 Series, Part 4

For several months, the investment community has been abuzz over the possibility of a tech bubble, with nearly everyone from the financial world weighing in. The very fact that there’s so much chatter about a bubble probably indicates that one doesn’t exist. Nonetheless, I decided to look deeper into the matter.

On August 28, I began examining the evidence in a series of articles titled “Tech Bubble 2.0”? In Part 1, we looked at the Nasdaq’s normalized price/earnings ratio over the last 20 years. Our conclusion: the Nasdaq is due for a correction, but is nowhere near the highs of the dot-com bubble.

In Part 2, we looked at mergers and in Part 3, IPOs—both areas where irrational exuberance would indicate that a bubble is forming. In both areas, we concluded that there are definite signs of excess, but we are not approaching bubble levels… yet.

In today’s fourth and final installment, we’ll take a look at what the venture capitalists are up to and decide whether they’re signaling that a bubble is upon us.

The Unique Barometer of Venture Capitalists

Venture capital (VC) and private equity (PE) are terms that are often used interchangeably. And though in practice they often overlap and are hard to distinguish, in theory they connote two very different kinds of business funding. Private equity investors typically buy existing companies with established products, distribution, and revenues that are under- or mismanaged, then seek to optimize profitability through operational improvements and/or restructuring. Venture capitalists, on the other hand, are the intrepid souls who fund startup or early-stage companies that may have little to no revenue but have extremely high growth potential. Since more growth potential exists in technology than any other field, that’s the sector where most VC activity takes place.

VCs make their money by funding startup and early-stage companies until a “liquidity event” can be arranged, such as an IPO or sale to an established company that sees a strategic advantage to making the purchase. Awash with cash from a few big wins and high demand from investors seeking to jump on the bandwagon, funding and liquidity events tend to reach a fever pitch when a bubble is imminent. Unlike private equity funds that often have strict criteria for what multiples of revenue, EBITDA, and enterprise value they will purchase companies at (which limit their likelihood of overpaying), VCs get to be more creative by definition. Since most VC funding happens based on a vision of what a company might be able to accomplish, they can be much more creative about how they value a company and take on a lot more risk.

When the cash is flowing into funds, the temptation to keep it there often has them throwing more and more money at fewer and lesser-quality deals, all to avoid giving it back to partners and losing out on fees or looking like they don’t know what they’re doing amidst a market where everyone else is doubling down. Of all investment markets, without the healthy forces of short selling, volume declines, and negative analyst coverage to push back against their ideas of grandeur, VCs are most susceptible to the groupthink that drives any bubble and thus tend to blaze the trail going in. That’s what happened in 2000; is it happening again?

Overstating the Case

We hear a lot of anecdotal evidence that a VC bubble is indeed imminent, most of which revolves around seemingly irrational valuations.

“A $10 billion valuation on AirBnB… ridiculous. Or Uber’s $18 billion… preposterous.”

Okay, I won’t even try to justify those, even though AirBnB holds more inventory than most of the world’s hotel chains, and Uber is quickly becoming the eBay of transportation, generating $20 million per week in revenue by the end of last year and doubling every six months… and all this before the company even raised the cash to truly start marketing. None of that matters because:

No one valued AirBnB at $10 billion, or Uber at $18 billion. The companies are twisting the truth for air play, and the media are parroting it back in exactly the way they’d hoped. Bingo!: free marketing.

With VC deals, you see, the terms are far more complex than just a chunk of money for a percent of the company; and as a result, the implied valuation is almost always meaningless. These deals invariably contain options, warrants, and most germane to valuation, liquidity preferences. Those spell out terms that put the VC’s preferred stock ahead of other investors when the stock is sold to an acquirer or the public markets.

For example, if a VC invests $500 million for 5% of a company, the implied valuation is $10 billion. If there’s a liquidation preference on that investment and the company sells out for $3 billion to a competitor, the VC gets paid first. Despite the paper loss against implied valuation, the VC walks away fully paid off and most likely with a profit to boot, because he was first in line before lower-order shareholders… and the common stock is worth wildly less than $10 billion.

The point is this: valuations in the world of venture capital are routinely inflated and misreported because they’re calculated without taking into account the true nature of liquidity preferences. But inflated valuations make for good headlines that drive clicks, so we get stories about bubbles from reporters more interested in sensational claims than anything resembling the truth.

Let’s take those claims with a grain of salt (since we now know they often rest on a faulty premise or three) and turn our attention instead to more quantifiable data as we wrestle with the Tech Bubble 2.0 question.

A Look at the Numbers

Here’s a chart that shows the annual number and dollar amount of venture capital deals from 1998 through 2013.

I think we can all agree that 2000 was a bubble year in the truest sense. The number and dollar amount of VC deals in that year were up 39% and 89% respectively from the year before, and 149% and 421% more than two years earlier. In the 13 subsequent years, the VC market has yet to come close to equaling the number of deals or the dollar amount of financing completed in 2000.

These numbers aren’t even inflation adjusted, so the nominal value is even a bit overstated. And yes, deal flow has been increasing more rapidly than dollars, but that just means VCs are picking up smaller deals on average, which is usually indicative of a focus on earlier-stage companies (counter to all the talk about the comparative handful of “mega rounds” and late-stage financing).

If 2000 is the benchmark for a bubble, these data would suggest that the VC market is nowhere near the hysteria that characterized the dot-com years. But the data cover VC activity for all industries; what about data specific to tech? Let’s take a look.

As you can see, information technology drove the 2000 bubble, accounting for 65% of venture capital financing as it jumped to record heights—not unlike subprime loans in 2005-‘07, the asset class exploded higher in activity. In 2013, tech accounted for a much healthier 26% of total venture capital financing—close to its typical share.

Furthermore, total tech financing (including life sciences) of $17.2 billion in 2013 was only 26% of the $66 billion financed in 2000, while “other” industry financing in 2013 was 59% of the 2000 amount. From the data, an argument could be made that there’s less evidence of a bubble in tech than in the rest of the market.

So the numbers seem to be telling us we’re not yet in a tech bubble. However, our chart also shows us that we’ve had significant VC financings for three consecutive years. And Dow VentureSource reports that in 2014 the pace is accelerating. First-half 2014 venture investment, according to the research firm, was $25 billion and is projected to reach $50 billion for the year. That’s a 52% increase over 2013.

A Bubble of a Different Sort

How do we reconcile the fact that technology isn’t running away from the pack as it did in the dot-com era with the fact that venture activity has surpassed 2007 levels and is climbing? The former seems to contradict the theory that tech is in a bubble, yet the latter shows we have definitely entered an exuberant phase. Has the economy improved so much it’s simply a warranted increase?

Some believe that we’ve simply entered a new golden age of technology, and that differences in the makeup and maturity of the tech market between the dot-com days and the present justify the increased activity. Marty Biancuzzo, writing for Wall Street Daily, effectively describes those differences:

Consider that before the dot-com frenzy took hold, the euphoria came largely from one industry trend: the Internet. Today, we still have tech sector exuberance, of course… but it’s dispersed across several industries instead.

For example, trends like mobile technology, cloud computing, social media, on-demand services, the Internet of Things, and wearable technology. In other words, today’s tech sector is much more diverse than it was 15 years ago, when the Internet was just getting started. We have far more growth drivers now.

In our “always on, always connected” society, says Biancuzzo, we have “unstoppable mega trends that’ll drive underlying growth for years.”

It’s hard to argue with the increased user base of technology over the last 15 years—growth has been enormous all around the world. Fund raising for tech, especially information tech, is primarily driven by fundamentals and growth catalysts today as opposed to the euphoria that came to drive venture capitalist in 2000. But that only answers half the question.

That technology VC activity has grown so much would be a fine explanation had it not stayed at the same ratio to all other venture investing. That means all other venture investing is way up too, and those markets don’t have the same qualitative justification. The same goes for every aspect we’ve explored:

• Revenue and profit multiples in publicly traded tech have increased at only a fraction of the rate of those in financials;

• Private equity financing multiples are up across the board in every sector, including larger jumps in health care and real estate than in technology;

• IPO sizes have increased dramatically, as have the market pops afterward, exactly at a time when the profit quality of those firms is decreasing; and

• The increase in VC activity is much larger outside technology than in it.

All these factors together look like the opposite of 1999. Back then, technology’s bubble caused excess capital to flow into all sorts of industries, pushing up wages, tax receipts, stock values, private equity and venture flows, etc. well beyond the dot-coms. But technology clearly led the way. Today, tech is rising in line with everything else. It appears to be the side beneficiary of a bubble elsewhere, not the cause.

When you cannot pinpoint where you have a bubble, it usually means that bubble is in money and banking itself. While the Mexican peso crashed in the 1980s, many a “millionaire” was minted as the stock market there rose rapidly in nominal terms. Japan has seen a similar trend in recent years, with the yen falling and Japanese stocks rising. And now, America is awash in cheap liquidity. That’s driving up public debt and derivatives activity to unforeseen levels.

Those who hedged their holdings against previous liquidity bubbles did spectacularly well—think George Soros and others who bet against the British pound. Those who didn’t hedge just ended up peso millionaires.

My advice to those who are worried about a tech bubble… think bigger. We’re in the midst of a classic game of excess liquidity driving up asset prices across the board. When that happens, you must stay invested, lest you miss asset prices rising rapidly while wages and interest stagnate (sound familiar for the past five years?). And you would be very well served by hedging against the possibility that our currency goes the way of the peso. After all, that’s the actual goal of current policy, as cheap dollars equal strong exports and blue-collar jobs.

• Article one in this series: Tech Bubble 2.0? Not According to the Stock Market
• Article two in this series: Merger Mania! Tech Bubble 2.0, Part 2
• Article three in this series: IPO Insanity! Tech Bubble 2.0, Part 3