While the mainstream economy has been riling from one of the biggest financial markets’ meltdowns, the nascent start-up economy in Silicon Valley and other VC havens has shown spectacular growth. Most of that boom has been driven by the advent of all kinds of mobile apps and the merging of those apps with anything related to social media. Riding the tidal wave of Facebook, Twitter, Zynga, the terms “sharing,” “community,” “followers,” “photo streams” have become synonymous with success and lots of hot dollars.
I believe all that frenzy has inflated much out of proportion. It is only a matter of when, not if that this new bubble will burst. In this post, I provide my arguments for why this bubble is nearing its end…
The Pendulum Has Swung… Or So It Seems.
I have been meaning to write this post for a few months. However, every time I sat down to jot down my main ideas, something new would pop up. A new iPhone app would become the darling of all tech blog gurus… A new twist on a social media site would emerge from nowhere to claim a few weeks of stardom fame as it signs up hipsters to become members by the millions… A new round of VC funding would back up the next big thing in mobile technology… And, then, the occasional VC big shot would make a sensational announcement that he would be handing out seed money to those teenagers who drop out of school to start up their dream company. As crazy as all those events looked to me, I kept thinking that reason would prevail. After all, we are living in an age where free cash is scarce and highly valued… Not!
What really prompted me to sit down and finally write about the new bubble was a recent post by Jason Freedman on his start-up’s blog. Jason describes himself as “Entrepreneur, Co-Founder at 42Floors, Co-Founder at FlightCaster, YC-alum, and a Tuck MBA.” While he is ultimately approaching the topic from a different angle, Jason inadvertently nails the key issue right on the head. Describing the recent edition of Y Combinator’s Demo Day, Jason tells the following eye-opening story:
And we saw 500 eager investors, frenzied almost, excited to invest in entrepreneurs. One investor emailed me four times, texted me three times, called me and sent me a message on LinkedIn — desperate to get a check in before the round closes.
No business plans, not even pitch decks this time. One 2-1/2 minute pitch and a quick follow up meeting. Seven figure seed rounds that can be closed within days and oversubscribed 2x to 3x. Founders with no experience fundraising and no pre-existing networks, making connections with top tier guys. It was really a sight to see.
There is currently more capital offered than capital needed. And that shift in supply and demand has had inevitable results in terms of valuations.
As Jason cleverly points out in the title of his post, “the pendulum has swung” — the balance of power has shifted from the investor to the start-up founder.
Three Important Factors
There are numerous developments that have influenced this type of reckless funding in the VC world over the past few years. Suffice it to look at only the three listed below to get the big picture:
- The enormous success of the “true heroes” of the last ten years’ VC period is certainly a big factor. Zynga, Groupon and Pandora have done successful and spectacular exits, making their early investors very rich. Facebook, Dropbox, Airbnb and lots of other hot companies are all expected to do IPOs soon. When each of these companies eventually goes public, its listings will be oversubscribed. Investors of all calibre are flocking to get in on the “Get Rich or Die Trying” game. (If 50 Cent knew about VC when he made his eponymous movie back in 2005, he would have certainly dropped a line or two about some “start-up sh*t” in the script.)
- Lots of “easy” money has been made in and around the Silicon Valley in the past 5-10 years. Early employees from Google and Apple have already cashed in on their “sweat” equity. Facebook staff will do so very soon too. The numerous co-founders of a whole myriad of successful start-ups are flush with cash and itching to give back to the community where their roots were. By calling it “easy” money, I do not want by any means to diminish the significance of the individual achievements of any of those people. I dub it “easy” because it originated from the same bubble that has now grown close to bursting. People have become millionaires overnight. Now, they want to play in the same big league as the VC old-timers. Encouraged by their own success, many of these people are willing to hand out piles of cash to any idea that slightly resembles the same things that made them rich — mobile, internet, social media, connected, network effect.
- As the overall economy has not been that great — even in those parts of the world that we call “emerging markets” — many mainstream investors have also been turning their attention toward the start-ups’ playground. They read about all the successes, then they see the Silicon Valley wonder kids invest in their own brethren’s enterprises. They can’t resist the urge to follow the lead. The herd mentality is way too strong.
Facebook Drops the $1 Billion Dollar Bomb
As I was slowly preparing my new post, Facebook stirred one of the biggest commotions in the tech blogosphere for this year. On Monday, April 9, Mark Zuckerberg announced that Facebook would be acquiring Instagram for $1 billion. As I first heard the news, I started double checking the number. “Did I read right? Is there a typo?” I wondered. I knew Instagram was hot, but I could not believe anyone would be willing to pay $1 billion for it. After all, Instragram is simply an iPhone app that applies sepia and a few other arguably cool and artsy digital filters to your photos. Oh and yes, it allows you to upload these photos to social media sites and share them with friends.
Despite all the articles that have been written in both mainstream media and tech blogs, I really don’t see too many strategic reasons for Facebook to buy Instragram, let alone for a colossal figure like $1 billion. If anything, most of the synergies outlined by tech gurus bear the potential to benefit Instagram much more than Facebook. Let’s face it — is filtering photos in Facebook really worth $1 billion?
I get the argument about the network effect, with Instagram having been downloaded by 30 million users so far. But, as one of the professors of entrepreneurship at INSEAD (my business school) points out in his blog post:
Businesses built on network effects have customer loyalty that makes them valuable beyond what a simple examination of the product or the revenues would suggest. But they are not isolated from competition and they are not licenses to print money. A business built on network effects can be beaten by another business that also uses network effects, plus good product design.
So, again the big question remains: Is it worth it to spend $1 billion to buy a network effect? And, especially, if you are Facebook, with over 900 million users worldwide, is it worth spending approximately a quarter of your last year’s revenues to acquire 30 million users (many of which are already your users, as well)?
The really telling part of the Facebook-Instagram story is the out-of-this-world rapid explosion in the mobile app company’s valuation. In February 2011, Instagram was reportedly valued at north of $20 million. Thirteen months later, rumors of Instagram looking to raise a record $50 million in a new round of financing started spreading in the tech blogosphere. If that round of funding went through, Instagram’s valuation would sky-rocket to $500 million. Only a week or so later, Mark Zuckerberg rushed to get in on the “hot” deal and splurged $1 billion (two times the official expected valuation at the time).
Now, let’s put things in perspective. In February 2011, Instagram had 1.75 million members and was valued at $20 million. Simple math reveals that a member of Instagram’s community was then valued at $11.4. Fast-forward to March 2012, and Instagram’s rumored valuation had sky-rocketed to $500 million, while its base had approached 30 million. That meant $16.7 per member. Come April, and the valuation has risen to $1 billion (i.e., Facebook’s bidding price). Zuckerberg now values a member at $33.3. The same member that was worth $16.7 just a week or so earlier. Talking about inflation!
All this does not bode well for the start-up/social media/mobile app bubble. New York Times makes a very good analogy by bringing up the recent case of Groupon:
Groupon has seen its valuation skyrocket from a reported $250 million in December 2009 to as much as $20 billion when it began trading on the public markets last year.
But the online coupon site’s comedown has been almost as quick: Groupon’s market capitalization stood at about $9 billion as of Monday (April 9 2012) afternoon.
Judging from all this, I conclude that the bubble is very ripe to burst indeed. But then again, New York Times may be having its own self-fulfilling agenda by pointing out such inconvenient facts. Perhaps, the venerable newspaper’s journalists are not happy that their organization is worth $50 million less than a simple mobile app, such as Instagram. That may be (partially) true, but the alarming trends about the bubble ready to blow off remain.
To end things on a lighter note, here is an infographic by Joey Brunelle that shows what other, more socially responsible causes that $1 billion could be used for. My two favorite ones are 1) both Mars Exploration Rovers (Spirit and Opportunity), or 2) the money raised for every single one of the 20,000+ projects ever funded on Kickstarter, multiplied 5.7 times.
What do you think about this issue? Do you also see an imminent burst in the Silicon Valley bubble?