The question of whether or not we are in a tech bubble has been raised regularly for years now; 2012, particularly Facebook’s acquisition of an app called Instagram for a ridiculous $1 billion, was a particular high point. The fact that Instagram is now valued at $35 billion suggests the 2012 doomsayers were just a bit off.

Still, it’s possible to be off in timing but right in meaning; in retrospect Alan Greenspan was correct to, at the end of 1996, characterize what we now call the dot-com bubble as a period of “irrational exuberance”; the correction just took a few extra years to materialize, and it was all-the-more painful for having taken as long to arrive as it did. Might the tech industry be facing a similar reckoning?

I don’t think so.

Changing Markets

If you’ll forgive a brief diversion, a pet peeve of mine is when people analyze the mobile phone market, particularly iOS versus Android, through the lens of Apple versus Microsoft in the 80s and 90s. The issue is not the obvious differences — this time Apple was first, the absolute numbers are much larger, etc. — but rather the fact that many of these commentators simply have their facts wrong. Windows didn’t win because it was open or all the other nonsense that is ballyhooed about; it won because MS-DOS was the operating system for IBM PCs, and at a time when personal computers were sweeping corporate America, “no one got fired for buying IBM.” By the time the Mac arrived in 1984, the battle was already over: businesses, the primary buyers, were already invested in MS-DOS (and, over time, Windows), and not many consumers were buying PCs. Today, of course, the situation is the exact opposite: consumers vastly outnumber business buyers. Thus, the chief reason iPhone/Android is not Windows/Mac is because the market is fundamentally different.

I tell this story because I think a similar mistake is made when comparing today’s funding environment to the dot-com era: it’s easy to look at numbers, whether that be valuations, revenue multiples, or simple counting stats, but any analysis is incomplete without understanding markets. In 1999 most consumer markets were simply not ready, whether it be for lack of broadband, logistics build-out, etc., while most enterprise opportunities were in selling licensed software to CIOs. And, in this latter market especially, the competition was other tech companies.

Today, by contrast, many of the most valuable unicorns are consumer-focused companies like Uber or Airbnb. Moreover, these companies are competing not with other tech companies but rather with entirely new (to tech) industries like transportation or hospitality. And, even for more traditional pure software plays like Snapchat or Stripe the implications of mobile-everywhere means a whole lot more time — and contexts — to reach consumers. In short, the size of the addressable market for tech companies has exploded — why shouldn’t valuations as well?

Changing Business Models

Today’s startups also have very different business models than companies did in the dot-com era (to the extent they had business models at all, of course). The difference is the most stark when it comes to enterprise software: back in the late 90s enterprises bought software licenses that were usually paid for up-front. Thus, when a company closed a sale, they would get paid right away.

Today, on the other hand, most enterprise startups sell software-as-a-service (SaaS) which is paid for through subscriptions. In the long run this is a potentially more lucrative business model, as the startup can theoretically collect subscription revenue forever, but it also means revenue is much slower to arrive as compared to the old software licensing model. For example, suppose you spend $100 to acquire a customer who pays $35/year: in year one, for that customer, you will lose $65, but then profit $35 every year thereafter. It’s a great model, but it looks bad, especially when you consider growth:

Year New Cust Growth CAC Total Cust Total Rev Annual Profit/Loss 1 1 — $100 1 $35 ($75) 2 2 100% $200 3 $105 ($95) 3 3 100% $300 6 $210 ($90) 4 6 100% $600 12 $420 ($180) 5 12 100% $1200 24 $840 ($360)

No company, though, can double forever, so watch what happens when the growth rate slips to, say, ~30%:

Year New Cust Growth CAC Total Cust Total Rev Annual Profit/Loss 6 7 29% $700 31 $1085 $38 7 9 29% $900 40 $1400 $500 8 12 30% $1200 52 $1820 $620 9 15 29% $1500 67 $2345 $845 10 20 30% $2000 87 $3045 $1045

This is a simplistic example: there is no churn on one hand, and no decrease in CAC (which usually happens at scale) or increase in revenue/customer via add-on services on the other. The takeaway, though, is that particularly during a period of hyper-growth, SaaS companies need a lot of capital, and more pertinently, a lot more capital than a company that monetizes through up-front software licenses.

There is a similar dynamic for many consumer companies, particularly companies that monetize through advertising. Advertising works at scale, which in today’s world means hundreds of millions of users; getting all of those users requires years of operating without revenue, which means a lot of capital. All of this is magnified for companies that operate in markets that include network effects: network effects translate into winner-take-all opportunities, which significantly increases the growth imperative, requiring, again, significant amounts of capital.

Changing Nature of Capital

The question, then, is where does all that capital come from? Traditionally, from one place: the public markets.

There are multiple advantages to an IPO, for all of the various stakeholders in a startup:

The company gets additional capital to fuel growth, non-dilutive shares to use for acquisitions, and a bit of added prestige that can help with sales, particularly to enterprises

Founders and employees can finally be fully compensated (by selling shares) for their years spent building the company

Venture capitalists get a return on their investment that they can distribute to their limited partners

There are downsides, though, as well. The run-up to an IPO is very difficult, and requires a lot of attention from senior management, the disclosure of a lot of information, and a large expense that has only increased because of recent legislation. The disclosure and expense continues, too, on a quarterly basis, which brings its own pressures and risks, including activist shareholders and SEC oversight.

On the flip side, a number of IPO advantages have been peeled away:

The most important has been the emergence of a new type of capital: growth capital. Growth capital is less speculative than traditional venture capital; it seeks to make relatively larger investments for relatively smaller stakes in companies with provably viable businesses that are seeking to grow for all of the reasons listed above. Now an IPO is no longer necessary for growth

Secondary markets and special purpose vehicles that buy stock from founders and early employees give founders and early employees a way to realize some of their gains, again, without an IPO. This too removes a previous forcing condition for an IPO

Finally, more and more early investors have determined that doubling down on winners often provides a better return than spreading bets widely; indeed, an increasing number of venture funds are explicitly marketed to limited partners as a combination of venture and growth capital

Just as Arthur Rock and Fairchild Semiconductor birthed venture capital, Yuri Milner and Facebook deserve the most credit for the development of growth capital. In 2009 Milner and Facebook shocked the Valley with a $200 million investment that valued the company at $10.2 billion. This investment was the growth capital archetype: a large amount of money in absolute terms for a surprisingly small stake in a provably viable business, and it paid off handsomely. Facebook would go on to further expand the growth capital market, first to private equity (Elevation Partners in 2010) and then to Wall Street (Goldman Sachs in 2011): Facebook was clearly a winner, and if Goldman Sachs’ clients wanted in, then growth capital was the answer. Since then nearly every huge startup has followed the same path, and Wall Street especially has responded: growth is no longer found by investing in IPOs, but in private companies that need the money but not the hassle of an IPO, and any qualms have been drowned in an environment where multiple countries are issuing negative rate bonds (a big contrast from 1999) — growth is hard to find!

What’s the Downside

So to recount:

Today’s startups have massively larger markets than in 1999

Today’s business models require significantly more capital than ever before

Thanks to Facebook, funding this growth via Growth Capital has been established as a viable alternative to an IPO

In short — and I’m not the first to say this — it’s less that valuations are unnaturally high than it is the fact that there is a completely new capital market — the growth market.

There are, though, some downsides and new risks:

The most obvious downside is that the best growth opportunities are increasingly out of the reach of retail investors like you or I. Goldman Sachs Facebook Special Purpose Vehicle (SPV), for example, required a minimum $2 million buy-in

Companies like Facebook, Uber, or Palantir may be obvious winners, but the difficulty in investing in them creates a powerful sense of FOMO — Fear of Missing Out. This has the potential of pushing less sophisticated investors desperate for growth towards higher-risk companies

Relatedly, there is very little oversight around these investments, particularly when it comes to the disclosure of audited financial information. A lot of these growth investors are plunging in a bit blind

Bill Gurley, an investor I greatly admire and have learned a lot from (his blog is a must-read), is worried the last two points in particular are leading to a risk bubble:

All of this suggests that we are not in a valuation bubble, as the mainstream media seems to think. We are in a risk bubble. Companies are taking on huge burn rates to justify spending the capital they are raising in these enormous financings, putting their long-term viability in jeopardy. Late-stage investors, desperately afraid of missing out on acquiring shareholding positions in possible “unicorn” companies, have essentially abandoned their traditional risk analysis. Traditional early-stage investors, institutional public investors, and anyone with extra millions are rushing in to the high-stakes, late-stage game.

Read that carefully: much of the media has adopted Gurley as the apostle of the “here we go it’s 1999 all over again” mantra, but that was a valuation bubble. Companies simply weren’t worth what they were priced at. Gurley is arguing that the private market with its limited information and oversight is producing something very different: investors putting too much money in companies without enough information or enough potential upside to justify the risk.

To be fair, given that risk should be priced in, a risk bubble is a valuation bubble. The fact of the matter, though, is that it’s the word “bubble” that is mistaken. Go back to concern one: the lack of access for retail investors. It turns out this has its advantages, because the lack of liquidity is arguably a firewall against this truly being a bubble. For one, if everything goes sour, the folks taking a hit can very much afford it. More importantly, a bubble is less about companies than it is a bet on euphoria — the assumption that no matter how nonsensical your investment, there will always be someone on the other end ready-and-willing to buy. While many of these growth investors are arguably making such a bet on a future IPO that may or may not materialize, there is no question the combination of increased investor sophistication necessary to participate in this market and the lack of liquidity makes betting on euphoria a far more risky — and thus far more unlikely — outcome.

Or, to put it another way, bubble talk is less 1999 than it is Y2K: a potential problem, and some people will lose money, but in all likelihood a far smaller deal than many in the media are making it out to be.

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