Wednesday, November 17, 2010

Bulls, Bears and Bubbles

Much has been written recently about whether we are approaching, or are already in an investment 'bubble'; it's enough to conjure the ghosts of '00. Rather frightful musings, but I think it's valuable to refrain from blanket 'bubble' statements, and instead look beneath the waves at some market fundamentals to determine if the valuation spikes we are seeing is the cause, or the effect of market shifts.

The technology industry is an ocean of trial and error, failure and success. Participants learn lessons, test theories and derive principals. Such principals often are not transportable across shifts in markets and technologies. For example, the harnessing of 'eyeballs' was the watchword of '99, the cussword of '02, and the mantra of '10. There is no economic inevitability of a company's success or failure. Market conditions, execution challenges, and competitive hurdles contribute to a sea of uncertainty which must be navigated to achieve success. Much of the industry's uncertainties can be tied to a decade of overall failure, where, despite some shining moments, we have produced negative returns for investors.

In large measure, we are still paying for the disappointment the technology industry gave shareholders at the beginning, and the end of the past decade. The public markets continue to punish companies with a skeptical attitude towards financing the next generation of leaders. The probability of securing Company investment/shareholder liquidity via an IPO is, and has been, a difficult path. According to VentureDeal, a scant 6 software/digital media/internet companies went public during the 1H '10, resulting in $612 million raised. (A contrarian view, recently posted by Bill Gurley is here)

Moreover, the venture market is shrinking. Here's a quote from Mark Heesen President of the National Venture Capital Association:

“With funds sizes getting smaller and fewer firms raising money, we are experiencing a
period of time in which venture capital investment is consistently outpacing fundraising,
creating an industry that will be considerably smaller in the next decade”

With this background, you would expect a universal slowdown in funding by venture firms. But that's not happening, and in some areas, the bidding for investment is reaching a pitch that sober people, such as Fred Wilson are lamenting:

"I think the competition for "hot" deals is making people crazy and I am seeing many more unnatural acts from investors happening. If it were just valuations rising quickly, I'd be a bit less concerned. But we are also seeing large deals ($5mm to $15mm) getting done in a few days with little or no due diligence. Investors are showing up at the first meeting with term sheets. I have never seen phases like this end nicely."

Moving to a lower level in the funding food chain, I recently did an analysis of the NY Angel and Micro funding environment. I tracked 24 funds/groups which have completed 406 seed/first round transactions in the past 30 months. Assuming that 20% of these companies graduate to an institutional expansion round, and 20% of these again raise a growth round, then NY will have a requirement for more than $800mm of expansion capital in the next 18 months. All the while the institutional investment pie is shrinking. Perhaps, people are looking at these investments the same way as they invest in the lottery?

This begs the question of who is being irrational? Are funds/people over investing in mirages, or are the institutional backers of venture funds not seeing the full picture? While it will take hindsight, viewed from at least two years out to judge these actions, a few things are clear today.

1. Self-publishing/expression by the masses can and is no longer a questionable value proposition. It's being monetized today and has huge potential for tomorrow. Facebook, at least for now, has done the industry a service by establishing the de facto social 'dial tone' platform for others to plug into. In doing so, they have created massive wealth for shareholders and a huge opportunity for fast followers. Unlike Amazon, eBay, AOL and Yahoo, their ecosystem seems to leave opportunity for others akin to MSFT's OS in the '80's.

2. Tapping into the social dial tone enables companies to hyper-scale. Union Square Ventures has done an admirable job finding, nurturing and realizing great returns for shareholders by executing on the social trend. For example, courtesy of here's the traffic graph for Zynga

And here's one for Tumblr

Finally, Twitter's growth has been widely documented (here's the Wikipedia post with citations)

'Twitter had 400,000 tweets posted per quarter in 2007. This grew to 100 million tweets posted per quarter in 2008. By the end of 2009, two billion tweets per quarter were being posted.[citation needed] In February 2010 Twitter users were sending 50 million tweets per day.[25] By March 2010, Twitter recorded over 70,000 registered applications, according to the company.[26] In the first quarter of 2010, 4 billion tweets were posted.[citation needed] As of June 2010, about 65 million tweets are posted each day, equaling about 750 tweets sent each second, according to Twitter.[27] Twitter has experienced rapid growth as noted on, Twitter has moved up to the 3rd highest ranking social networking site in January of 2009 from its previous rank of 22nd.[28]'

To date, Twitter has raised $57mm in three rounds of fundraising. The last round, completed in September, and reported by Bloomberg to raise $100mm valued the company at $1B

In May '08 the company raised $15mm at a reported $80mm pre-money

In February of '09, Twitter raised $35mm. The pre-money was not reported, but company benchmarks were 29 employees, minimal revenue and 900% growth year over year.

The first round of capital was raised in July '07. I can assume the valuation was not more than $10mm.

3. We have seen a first wave of social commerce embodied by the 'flash' commerce sites such as Gilt group and Groupon. I believe the stunning success of these firms will be dwarfed by successors who harness relationships, in a positive way, to recommend and sell goods and services. Think of Amazon or Ebay's star system, but from people you actually know, respect, and can easily verify. This arena can support many firms with a large market capitalization, and a host of successful 'satellite' firms too.

4. Predictably, most of the leading Web 1.0 Companies have become stagnant. Just compare the innovation behind the concept for Facebook's new messaging product, vs AOL's way overdue facelift of 'you've got mail' as a prime example of incremental vs fresh thinking. The incremental product advancements of AOL, Yahoo, eBay et al (with the notable exception of Amazon), has opened the gates for this new generation of entrepreneur and funding sources (e.g. Spark, Union Square, Andreessen Horowitz) to ride and expand upon the social dial tone within established, large markets.

5. The mobile web, better screens and upcoming tablet form factors will fuel a dramatic increase in engagement and time on site. Key metrics which will accelerate the move of advertising from desktop to phones/tablets.

In the past few years, we have seen great innovation in the three bedrock internet arenas; Communications (Twitter), Commerce (Gilt and Groupon), Community (Facebook and YouTube). The only laggard bedrock segment is search. Wolfram tried something new, and a host of others are challenging GOOG, in much the same way GOOG challenged Yahoo, which vanquished Alta Vista and Lycos.

Putting the pieces together....

1. I really do not see a bubble in the growth/expansion arenas. Instead, there's a stampede of homogeneous players looking to invest in a few hypergrowth companies. Valuation here involves more art than science and the law of supply and demand trumps all. Definitionally, with so few transformational opportunities, the few which achieve hyperscale will be valued quite dearly. The NPV and efficient market theories of Finance 1 go out the window when you are presented with companies with less than 30 employees, growing 900%/year, are in multi-billion dollar markets and only requiring minimal capital to fund its operations. Phenomena like Twitter are special, and deserve to be treated so.

2. The market today seems balanced in the more 'normalized' 50-100% growth per year expansion stage firms. I do, however, suspect valuations will decline in this arena as less capital supply will meet enhanced capital demand. Of course, if Bill Gurley is right, and a vibrant IPO market is around the corner, this segment will ignite and be the biggest beneficiary of the public largess (heaven knows, the industry can use a refresh of middle market M&A buyers).

3. The Angel/Microfund arena seems to be too active. While many fresh and innovative opportunities have arisen, they are in danger of being overwhelmed by too many 'me too's'. Consistent with history, but magnified by scale, I expect the vast majority of firms funded by Angel groups and Microcap firms to fail. The combination of too little capital and too little innovation are a killer cocktail.

4. Great returns were garnered by investments made in the ashes of '00, Venture firms will find great opportunities recapping worthy opportunities from #3 above. They could, and should 'steal' start-up capital as this category will be less risk, lower hold time, and equal reward to their start-up brethren.

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