The Coming Tech Crash
- Posted by Leigh Drogen
- on July 24th, 2011
I sat down Wednesday night to write this piece, and found myself rambling forever, until the main point was completely lost in anecdotes. So my goal right now is to make this very simple and straight forward, if not boring. The thesis I am about to unfold before you, deals with the fact a few years from now, we will begin to see the collapse of many tech companies, on a monumental scale, larger than even the last tech bubble.
Have we entered a new tech bubble fueled by social media companies? No. 95% of the data does not support the notion that we are in a bubble, from VC fund flows, to the number of IPOs, to which market participants own which parts of the capital structure of these companies, to how many financial publications and pundits are currently calling this a bubble (when was the last time one of them correctly called a bubble within 6 months of its collapse). The answer is none.
So should you be worried about a tech bubble in terms of the valuations of tech companies across the board being highly inflated by a belief that everyone is going to get rich off these assets and a flood of money attempting to purchase too little inventory? No. We do not currently find ourselves in this situation. This will eventually take place, as all high growth assets eventually end their ascent in blow off tops (if you want to call them bubbles fine). How far are we from this taking place? That’s anyone’s guess, and really, it shouldn’t even be your focus. You should be looking for the clues that say bubble, not trying to predict when they ware going to show up.
I am now going to paint a picture for you of a disaster that I see coming down the road, produced by a change in the structure of our market over the past 5 years or so. I will also give you the red flags to look for which will signal when it’s time to take your foot off the gas, and bunker down.
Tech companies are moving faster than ever these days, with less money, and less resources, reaching more people, and drawing in more revenue. For many startups, what used to take a decade, takes 2 years. And because of the amazing rate of internet adoption, more industries then ever are being disrupted by new tech startups.
The result of the increase in speed, is far less need for companies to tap public markets. Going public is seen by many as a nuisance, not a badge of honor, or a necessity to raise capital for liquidity or growth.
The entrance of many institutional investment firms into the late stage venture capital market has all but removed the need for companies to come public in order to grow or get their early investors and employees at least partially liquid. The rise of secondary markets for these assets has changed the game. Companies can stay private longer, and attain far higher valuations than they once could before coming public, because the same money is there for them, except it’s coming from fewer people.
There are upsides and downsides to what has taken place. The upside is that companies don’t have to deal with the hassle of going public. The downside is that far fewer people are able to benefit from one of the only growth sectors of the economy. If companies were coming public far earlier in their valuation cycles, index and mutual funds would be able to get a piece, even ordinary brokers and investment management firms. They can’t, because many are not sophisticated enough to play in the private secondary markets. So the average investor misses out completely on all of this growth. The profits have been driven into fewer hands. This is a natural result of the current regulatory environment. It has also produced an environment in which many investors see the valuations of these companies as bubblicious. This is a natural reaction to the sticker shock of such young companies that have grown so fast, investors are not used to this, some don’t even understand the business models of these companies, and claim they are “pyramid schemes”. Rest assured, the majority are not. We can argue until the cows come home about what are fair valuations for any set of assets, frankly, it doesn’t matter, because there is only one valuation that matters, and that is the one that the market is putting on an asset right now.
But this change in market structure will eventually produce catastrophic consequences for the majority of investors.
We are at the very beginning of a wave of social media and new economy company IPOs. Over the next few years a few will trickle out here and there, GroupOn, Zynga, LivingSocial, eventually Facebook. Many many more will come down the road, and they will come at extremely high valuations. Many ordinary people won’t even know their names, because they have very little contact with these brands on a day to day basis. People will continue to scream bubble seeing these companies come public at valuations over 10 billion dollars. It still won’t be a bubble.
The truth is we may never have a typical “bubble” as you have seen in the past. What I believe we are going to experience, is a gradual handoff of risk within each individual company from the founders and early angels, to the venture capitalists, to the large investment firms, funds, and banks, and finally to mom and pop. Only this time, unlike the past, mom and pop are going to get screwed worse than ever. Why? Because the hand off to them, in the form of mutual funds and the like, will take place at valuations so high, so late in the stage of growth for these companies, that not much upside is left. These assets will be handed off when 90% of the growth has been sucked out of them. The early stage capital markets have become increasingly efficient at capturing more of the pie.
To compound the problem for ordinary investors, the rate at which the value of companies is being destroyed will also continue to increase. Disruption of business models and businesses will destroy most of the value of many companies that come public over the next decade. You may drink Coca-Cola for the next 20 years, but you may not be using Facebook in 5. The speed of creation and destruction will be mind blowing, and for those left holding the bags, it will be a catastrophe, one at a time.
I have zero doubt this will take place. We may even start to see it with the demise of GroupOn if they can not pivot their business towards local/mobile/social/realtime very quickly. GroupOn may come public at 30 billion dollars, and lose 90% of its value with a few years. Or they may be the ones to disrupt their own model, and continue to grow. My point is, that in this age where companies are able to scale so quickly, someone else has a large chance to disrupt them, or Facebook, any other company, especially those relying on being platforms. All platforms die eventually, its only a matter of time.
As I said, this will be a disaster for many individual investors, but it may not play itself out in a typical “crash”. I believe that this will take place one by one, each company will get picked off in its own time. We may never get that flood of assets to create the euphoria, but it will hurt mom and pop just as bad as the upside to these companies once they come public will be far more limited than the downside risk of them being disrupted.
I am not opposed to the argument that many of these companies will be “overvalued” at the time of their IPOs simply because of the increased risk of being disrupted these days. I don’t like the term “overvalued” because it denotes that the market is in some way wrong, no, the market is never wrong, it might change tomorrow, but today it’s always right.
So what red flags should you be looking for? Because this go around will be a little different due to market structure it may not necessarily be the typical flood of assets, I don’t think we will see that. What you want to look out for is insiders, early investors, and VCs taking massive amounts of money off the table early on and at the time of their IPOs. Now I don’t mean massive amounts of money in nominal terms, these guys are going to get rich no matter what, and there’s nothing wrong with founders, employees, and investors taking some off the table to protect themselves. I’m talking about relative to their holdings, how much are they taking off, 20%, 40%, 80%? How much are they selling into secondary offerings? You need to be aware of the capital structures of these companies and what the smart money is doing. Once you see them handing off to mom and pop, GTFO. Yes, the stocks may go higher, but your risk in holding these companies as investments is huge given their already massive valuations.
Remember as well, there are about 190 companies that trade on US markets (including ADRs) with a marketcap over 30 billion dollars. That’s rare air. There are huuuuuge companies, and it is not easy to maintain those valuations, you must be massively profitable or continue to grow at breakneck speeds.
All of you know I am extremely bullish on the prospects for many social media and new economy companies, especially ones that deal in the peer-to-peer economy. But that does not mean I would be an investor once they come public, the market is not the same as it used to be where companies came public at 200 million and had massive room to grow.
There will be great IPOs that succeed for many years and continue to perform well, in their businesses and stock price. I am very bullish on Zynga in this regard. But would I be buying a GroupOn or Facebook IPO, not a chance in hell.
Beware of the red flags, don’t be the bag holder for the big boys, it’s not valuation that matters, it’s risk and reward in the growth cycle of each company.
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Leigh Drogen is the founder and chief investment officer of Surfview Capital, LLC, a New York based investment management firm employing an intermediate term long/short momentum strategy. More »
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