A Private Bubble, and a Public Boom

At least once a day I hear someone saying that we’re in a new tech bubble. These aren’t lay people either, they are veteran¬†entrepreneurs and venture capitalists.

I was at an event last week called the¬†Entrepreneurs¬†Roundtable where Bo Peabody, formerly of Village Ventures, and now at Greycroft, was speaking. He said something very insightful that really stuck with me. Bo remarked that we’re in a private bubble, and a public boom.

He went on to say that there are companies recently which have come public, like Demand Media and GroupOn, who were not ready to be public companies. They had great growth, but their business models were flawed and they had not yet figured out how to turn a profit. Bo went on to remark that as long as firms like his are losing money, and not the public pension funds, mutual funds, and mom and pop, we’ll be fine.

Back in July I wrote a post titled “The Coming Tech Crash” in which I made the case that we were in fact not headed for a classic asset bubble, but would see many new tech companies come public, and flop, losing public investors a ton of money.

I wasn’t able to articulate it as simply as Bo, but it is true, we are in a private market bubble and a public market boom. Valuations for private tech companies are through the roof, beyond any rational metrics used to value companies, even very high growth companies with massive markets to execute on. Instagram gets bought by Facebook for one billion dollars without a stitch of revenue, enough said.

Interestingly enough, these valuations are not being driven by asset inflows, the cause of asset bubbles. In fact, venture funding has actually been declining recently.

Our private market bubble is being driven by speed and scale. Like no other time in history does a company have the potential to scale as quickly and to such great depth as they do now. This changes the game for investors, who in the past had the opportunity to jump in along the scaling process. Now, because a tipping point can lead to scaling so quickly, investors have moved up their time frames, and are pumping large sums of capital into companies at earlier stages.

These valuations are not being driven so much by classic valuations metrics as they are simply by venture investors wanting to pump large sums of money into companies which they believe have the ability to turn scale into profit down the road.

Bo is right, many of these companies are not ready to be public where they face a market which use classic valuation metrics to determine where they will trade. We’re seeing that in the demolition of Pandora, GroupOn, Zipcar, and Demand Media now. Scaling a user base to massive proportions does not equal being able to show stable growth in profit quarter over quarter.

And that is why we’re seeing these companies stay private for far longer market cap wise than we used to. While companies can scale a lightning speed, it still takes just as much time to build a real business, a business that can withstand the scrutiny of public markets.

One thing that the recently passed JOBSAct does is allow companies to stay private longer by raising the number of shareholders a company can have before having to file an S-1. Many in the market peanut gallery were dismayed by what seemed as giving companies a pass on transparency. While I didn’t quite voice this opinion loudly, I did agree. But, while the transparency issue is an unfortunate side effect, what I realized the other night is that it goes a long way to preventing these companies from coming public well before they should.

And as Bo said, the important thing is that its people like him who lose money on the inflated valuations of these companies, not public investors. While I strongly believe that individuals should be investing in startups at the earliest stages given they undertand the risks, the last thing we need is for these companies to end up in mutual funds. As long as we privatize the losses that this private bubble is going to create, we won’t see a market crash which has a material effect on our economy.

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