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Tech Bubble: 5 Reasons Why This Time It’s Different

There was a palpable feeling that-–particularly for “break out” companies–we are indeed in some sort of reemergence or “Wave.” However, this upswing appears different, in substance as much as in attitude, when compared to the late 90s. Here were 5 takeaways from a panel discussion with the “VC Titans.”

In their December 2010 articles for DealBook, Heidi
Moore
and Jenna
Wortham
raised an interesting question: Are we re-living the tech bubble? The
“smart money” at the AlwaysOn
Venture Summit
would’ve answered, “It depends.”

Venture Summit was the place to be for firsthand
investigation of this question. Various panel speakers included 36+ CEO’s of
emerging startups as well as “VC Titans” such as Tim Draper (Managing Director,
DFJ), Todd Chaffee (General Partner, Institutional Venture Partners), and John Simon (Managing Director, General Catalyst Partners).

There was a palpable feeling that–particularly for “break
out” companies such as Groupon, Twitter, Zynga, and Facebook at estimated valuations
around $6, $4, $5, and $50 billion, respectively–we are indeed in some sort
of reemergence or “Wave”. However, this upswing appears different, in substance
as much as in attitude, when compared to the late 90’s. Early stage startups
will feel these differences the most. Here were 5 takeaways from a panel
discussion with the “VC Titans”.

1.”Prove it to me”


In spite of tales of VCs writing checks without term sheets
or proper due diligence, particularly in the early stages, many veteran VCs
remain cautious about jumping into the fray. They expect entrepreneurs to
demonstrate that their startups are viable with proven revenue flow, rapidly
increasing traffic or customers, unique assets and intellectual property,
and/or some combination of the aforementioned.

“We’ve gotten to the point where
the VCs are saying, ‘Prove it.’ And that never used to be the case. We used to
just sort of say, ‘Hmmm … .sounds like an interesting opportunity, what if this
works. If it works, then great.'”
– Tim Draper

Unlike the tech darlings of bubble 1.0, today’s startups at
minimum must have validated customers or a proven revenue stream.

“What’s a little different about
now verses the bubble is that these companies that are garnering these huge
valuations actually are immensely profitable. We missed Groupon, and I’m so mad
we didn’t see that one. But from what I understand, that’s an intensely
profitable business growing at an exceptional rate; so it might be worth $6 to 10 billion.”
– Todd Chaffee

With the bar set high, it’s not easy for early stage
companies to raise seed capital. Journalists love to write about the sexy dotcom
deals that are getting funded at wild valuations; but as the saying goes, for
every 1 you hear about, there are hundreds who didn’t make it through.

“I don’t feel like there’s that
much competition [among VCs] in the early stage. When we see an entrepreneur,
he’s usually been to 14 or 15 VCs or he’s about to go to 14 or 15 more. At the
early stage, if the business isn’t proven, it’s a really tough sale.”
– Tim Draper

The takeaway: If you’re an entrepreneur, don’t be misled by
the sexy deals everyone’s talking about. Validated customers and/or strong fundamentals
are still a prerequisite. Unless you’re on Dave
McClure’s
friend-list, no one’s going to eagerly fund your on-the-job
training or “me-too” idea. Let me recommend that you check out Steve Blank’s
write-up on customer
development
.

2. Find really big problems to solve


At the bottom of the innovation barrel, you’ve got everyone
and their grandmother with some offshoot idea for a dating site, video site, or
some other form of social networking. That sort of “me-too” innovation is like
a photocopy of a photocopy of a photocopy. In the late 90’s, such business
model inbreeding was rampant due to too much money chasing too few quality deals.
Total venture capital under management grew by a whopping 6 times between 1995
($38 billion) and 2000 ($233 billion). The cheap money fostered a sector-based
buy-and-flip investment climate. Things are a little different today:

“I try to avoid sector-investing
because you’re reliant on flukes [and fads] to be the big winners. Instead, I’m
looking for new technology that applies to an entirely new market. That is more
interesting to me than ‘hey, we’ve got a social network that’s 2.0 and all
those buzz words.’ Those are the [buzz-driven] ones that are ‘sector’. Instead, we’re trying to find things that are way out there.”
– Tim Draper

Investors today are looking for entrepreneurs who are
building solid companies based on solving real problems, and building value and
defensible competitive barriers over the long-term.

“If people are solving hard
technical problems, or a hard problem with consumer engagement, if people are
solving hard puzzles that don’t look easily solvable by other people, that’s
where we find long-term value can be created.”
– John Simon

Tim Draper sets the bar even higher. His challenge to
entrepreneurs is to topple kingdoms.

“I look for monopolies. They get
sloppy and lazy. Find businesses that have been kings for a very long time,
such as Oracle in databases. Look at spaces where there’s only 1 or 2 major
players, such as in investment banking or trading, education, transportation.”

The takeaway: Take on Tim’s challenge and find a real
problem you can sink your teeth into. Aim higher than “Dude, I’ve got an idea
for a dating site for one-legged midgets who love to Twitter while sky diving.”

3. Longer planning horizons


Businesses focused on solving bigger problems take longer to
build. But the other reason for longer planning horizons is the fact that
investors and founders can no longer count on IPOs as a short-term exit.

“If I fund [a startup], it’s going
to be 15-20 years before it’s public. I might be more willing to fund him if he
has an acquirer 3-4 years out, and that’s not healthy. Because you really want
to build great global companies of the world as opposed to being just a feature
on Google.”
– Tim Draper

The number of IPOs in the last 3 years are a fraction of
what they were during bubble 1.0 (see chart below). In spite of expectations
for a gradual ramp up in IPOs in the next few years, the majority of those
deals will be in Asia. North America accounted for only 16% of the deals in the
first half of 2010.

Global IPOs by number of deals and capital raised, by year


Source: Ernst &
Young, 2010

VCs are seeing more and more founders looking at M&A
and IPOs not as exits, but as additional financing for continued growth.
Founders often stay on board to see their visions through.

“A company looks out over the next
2 years and asks, ‘Can I get paid in an M&A situation now for what I’ll do
over those next 2 years?’ In addition, they’re looking at their own strengths
within the business because going public or getting acquired is seldom a
‘liquidity event’, it’s a ‘financing event’. So you have to not just think
about the IPO or acquisition, but what about the year or 2 afterwards. Can they
deliver that growth?”
– John Simon

In many ways, these financing events are happening opportunistically
rather than by design. Startups these days aren’t created to be later sold and
turned into a feature on Google.

“We’ve had successes in companies
that didn’t necessarily fit in a particular bucket, and we couldn’t necessarily
know for sure who the acquirer was going to be when the company was started.
It’s not like this was designed to be sold to Google or Microsoft.

“In the last 15 months, we’ve had
about $2.5 billion of liquidity events in our portfolio, and all were
M&A’s. In almost no case was the acquirer that bought the company one of
the ones that would be in our 4 or 5 potential acquirers at the time we made
the investment. And that’s because the startup operated in a unique space where
the entrepreneur found a whitespace. Acquirers were distantly adjacent and
later started to converge.”
– John Simon

The takeaway: Ditch your get-rich-quick notions, and plan on
sticking around for the long haul. And since you’re going to be eating peanut
butter sandwiches for a while, you may as well have fun and be passionate about
your startup.

4. Microclimates


Perhaps what we should really be asking is “Where are the bubbles?” not “Are we in a
bubble?” The latter question implies that we’re in some broad-based bubble
which, if popped, would have far-reaching impact. However, in spite of all the
excitement about heated valuations hovering above 25 times revenues, it’s still
fairly contained within pockets or “microclimates” of a handful of well-known
emerging startups.

“There are some microclimates where
valuations are a little high, particularly those closer to the public offering.
In fact, that’s where they are getting a little crazy. That’s because interest
rates are so low that there aren’t a lot of other alternatives for investments,
and so companies like Groupon and Facebook are trading in the private exchange
at crazy prices. Those in the seed level, there’s nobody who’ll fund you, so
there’s a big discrepancy. And those things swing back and forth.”
– Tim Draper

John Simon added a datapoint that seemed to corroborate the
idea of microclimates:

“The amount of consumer Internet
companies that are worth more than a $1 billion is surprisingly small. Probably
only between 10 or 20. Generally speaking, from a valuation standpoint, it’s a
relatively normal time at this point across most of the stages.”

Todd Chaffee shared his candid thoughts on the challenge an investor
faces–“the art” of the business–when dealing with hot startups.

“It’s probably a little more heated
in the later stage for the big franchise companies. It’s also overheated for
the ‘breakout’ companies. In our [IVP’s] business, we’re targeting the big
franchise companies that everyone knows of, with between 50 to 100 million in
revenues.

“The trickier part are the breakout
companies–the very best companies coming out of the early stage portfolios,
that suddenly get traction and start shooting up. With the velocity at which
those companies are moving up, you have to move really fast as they’re the deal
of the week. And all the top VC firms are competing intensely for them, so the
valuations are getting way ahead of themselves in terms of fundamentals. The
hard part of the business is when you see a company breaking out, there are no
fundamentals to support the valuations being paid, and you pass on it, and the
damn thing keeps going up. That’s the art. Knowing when you want to pay way beyond
the fundamentals.”

Todd later offered a contrarian investment approach which reminds me of a saying in Hong Kong about investing: “If the grandmas and cab drivers start talking about your stock, get out.” So what do you do when you hear a lot of chatter about mobile, cloud, and green tech?

“We have a few bets in mobile
infrastructure. Mobile content is overfunded and overhyped. A lot of VCs are
targeting mobile entertainment, while enterprise IT is considered the least
attractive. But that’s one of the secrets: go where they ain’t. I’d be much
more interested in the next wave of enterprise solutions.”

The takeaway: What we’re experiencing isn’t a bubble so much
as “bubblettes” here and there (Wow, did I just coin a new term? I’m gonna put it on a T-shirt and sell
it). If you’re a startup operating in an unsexy space, don’t be disheartened. Someone will eventually take notice.

5. SOX Sucks


That’s another slogan I’m going to put on T-shirts and
sell at Menlo Park. Of course, one
of the byproducts a couple years after the bust was Sarbanes-Oxley, an attempt to
hold executives accountable for what and how they report. The costs, in terms
of financial and executive energy, are so high that it has implicitly raised
the threshold for companies seeking to go public.

“The reason you don’t want to go
public unless you’ve hit at least a $100 million in revenue is because you’ve
got to be earning at least $10 or $15 million a year to pay for Sarbanes Oxley
[laughter in the room]. And that’s a big problem. It’s a lot of reporting, you
deal with a lot of individual investors, lawsuits, and all that stuff.”
– Tim Draper

SOX and the burden of hitting quarterly targets is a huge
deterrent to the IPO route:

“The real litmus test of whether
you should go public or not is ‘do we have control of our business? Can we
establish clear quarterly goals and hit them?’ Because in the public market, if
you miss your numbers, you’re gonna get slammed.”
– Todd Chafee

That’s sending investors and founders to other alternatives
(i.e., secondary markets) for liquidity.

“If you’re a good company and you
feel you’re in a great place and you don’t want to sell out (i.e. go public),
you didn’t have very many options. Either you go public, or some of these later
stage VC firms will buy founder’s shares; but they’re paying wholesale not
retail. Some time soon, there’ll be an opportunity where we’ll be able to go
‘Prublic’ and take an XPO rather than IPO. And you have high net worth
individuals, and possibly qualified institutions, buying and trading your
stock. That will become a fairly popularly option.”
– Tim Draper<

To find out more about what it means to go “prublic”, check out my other post.

So what’s remained
the same?

Well, what will never change is that you, the entrepreneur, are still the hero.
And even the VCs and angels (at least the down-to-earth ones) will acknowledge that.

” At the end of the day, there’s no
such thing as a VC titan or VC rockstar. It’s the CEO, the entrepreneur, the
CEO. We’re just a capital intermediary, trying to route capital to the most
talented entrepreneurs and management team. Once we get that capital in with them, we really work hard to help them grow their
business. That’s the way to generate superior returns.”
– Todd Chaffee

The A-Team


The recent movie “Social Network” may be perpetuating the
myth that all startups are operated by bright twenty-somethings with big ideas and
no operational experience. But to investors, anything less than an A-team is
still a dealbreaker.

“A dealbreaker is somebody who is starting
a business, but doesn’t want to get the world’s best people he/she possibly can
get. If a company is going to be the best in the world at what it does, one of
the things that gives us more comfort is if the team has gone out and found
people who’ve built similar businesses to get involved as advisors, head of
engineering, or whatever. If they’re just friends, it’s not the right approach
in today’s hypercompetitive world to building a phenomenal company.”

Jeffery To is an NYC-based corporate entrepreneur and IBM Innovator Award Winner who covers hot topics in Silicon Valley and Silicon Alley.

About the author

Jeff is a Certified Trained Lean Six Sigma Black Belt with a focus on finding new ways to apply technologies related to process improvement – situations which demand entrepreneurial thinking, a deep understanding of the financial impact of technology decisions, and collaboration with strategic partners. At IBM's Retail Emerging Business Opportunity Group, a corporate "startup", Jeff launched an SMB-focused business which later grew to account for 20% of EBO revenues worldwide.

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