Bubbles are a great way to make money if you can get in as they’re blowing up and get out before they burst.
I should know since I was lucky enough to make money investing in the dot-com bubble — three companies in which I invested were sold for over $2 billion – thanks to lucky timing. But I also lost money on three dot-com investments that ran out of money after the dot-com bubble burst.
That history makes me want to pay close attention to signs that the current tech bubble may be bursting. I see four weak signals that I think are going to become amplified over the next several months.
The good news about the bursting of the tech bubble in 2015 is that it will not hurt as many people as did the dot-com bust.
Here are the four signs that the current tech bubble is bursting.
1. IPO market is screeching to a halt
Up until last week, 2015′s IPO market had been a disappointment. According to Renaissance Capital, 60% of IPOs that went public in 2015 are trading below their IPO price; average IPO returns were down 4% from their IPO price in the third quarter, the first negative quarter since 2011; and the number of IPO deals was down 43%.
Then on October 7, Pure Storage — a fast-growing, money-losing storage technology company — went public. Valued in the private market at $3 billion in April 2014 — the last time it raised capital, Pure was burning through cash and decided it had to raise more.
Rather than seek private financing — which I am guessing would have forced Pure to cut its valuation, the company decided to take its chances with the IPO market. And the market’s verdict was to cut 5.8% from its $17 a share offering price.
For the most part, a strong IPO market is critical for attracting capital into startups. And I think that the busting of Pure’s IPO sends a chill through the hearts of other fast-growing, money-losing companies that wanted to line up for an IPO.
2. Tourists are taking the bus out of Silicon Valley
One of the big reasons for the blowing up of the latest bubble has been big money “tourists” — e.g., mutual funds, hedge funds and other institutions that are not experts in helping to grow technology startups.
These tourists know that is has been extremely difficult to beat the S&P 500 or to generate any yield for those who care about capital preservation.
But over the last few years, these tourists have gladly written checks for hundreds of millions of dollars to invest in startups that are poised for an IPO.
More money — largely from mutual funds, private equity and corporate investors — has been going into tech startups than going out in the form of IPOs. According to CB Insights, in the first three quarters of 2015, $42.5 billion was invested in startups and $26.3 billion came out through IPOs or acquisitions.
But with the IPO market window slamming shut, mutual funds like T. Rowe Price and Fidelity may find themselves writing off more of those investments than celebrating big short-term wins.
3. Money-losing startups are over-valued
Unicorns — private companies valued at over $1 billion, pentacorns (over $5 billion), and decacorns (over $10 billion) have become part of the Silicon Valley vernacular.
But most of those are losing money and have been driven up in value thanks to those tourists piling in at the last minute.
There are roughly 140 unicorns. And a few are tightening their belts — I am guessing that they tried to raise more capital and did not receive favorable terms.
On October 2, CNN reported that “E-commerce site Fab.com — once valued at close to $1 billion — suffered mass layoffs before it was acquired for an undisclosed amount in March . Evernote, valued as a unicorn in 2012, laid off 47 people and closed three of its global offices this week.”
4. Private companies aggressively sweetening the pot to attract fresh capital
This last one is fairly technical and insidery – but also one that emanates from the heart of venture finance — Silicon Valley’s leading law firm, Wilson, Sonsini.
As an experienced Silicon Valley investor and CEO told me last week, “A few months ago napkin stage [startups] got $10 million pre-money valuations. I was just in a board meeting with a Wilson Sonsini guy who said valuations — and terms – have changed dramatically in the past month.”
The change he referred to is making it tougher to get startup financing. Why? He said, “Sentiment — perhaps related to changes in public market sentiment for stocks; perhaps related to challenges new technology IPOs have been having.”
The implications for investors are clear. In exchange for their money, they will get “more protections, more board representation, and what I think is a pretty big deal – full ratchets – [100% anti-dilution protection for investors in the event that the company’s valuation goes down in the next round of financing].”
If you look at the latest available financing statistics from Wilson Sonsini, it looks like the trees were growing to the sky through June 2015.
But my source said that the changes he heard about last week will probably not show up in Wilson Sonsini’s statistics until early 2016 when it releases its full year 2015 report. My source said, The bad news” may not show up in the third quarter of 2015 — only modestly. I would expect a big hit in the fourth quarter of 2015.”
When the dot-com bubble burst, everyone and their mother was investing in Internet stocks. The NASDAQ plunged — wiping out about $10 trillion in stock market value. There were plenty of lenders to money-losing companies building fiber-optic networks– like Global Crossing — who also suffered.
This time around, the losers will be employees of money-losing companies in Silicon Valley and San Francisco — e.g., Twitter TWTR +1.72% announced it is planning layoffs and halting a plan to expand its San Francisco’s headquarters, according to Re/Code – that will not be rescued by investors.
With rents so high and fresh capital no longer pouring in to pay those prices, perhaps vacancies could some day follow. If so, I am guessing that some of the owners of those cranes spanning the San Francisco skyline may find themselves losing money.
And some local homeowners will take a bath. According to Harry Dent, after the bubble bursts, “there’s no way real estate’s going to hold up, especially in Silicon Valley,” he said. “A lot of people are going to lose money. People who bought $3 million homes at the peak are going to watch them drop 30, 40, 50%.”
If you run or own shares in a company that’s growing fast and making money, the bursting bubble may be an opportunity.
Indeed my source suggests that there is a silver lining to the change.
Struggling companies may get a second chance. “VCs have lots of committed capital. Therefore they are not completely pulling the plug. They are seeking better terms from companies that are not getting very strong market traction or, in the case of later stage rounds, are not close to break even,” said my source.
And companies that have good product profitability and can become profitable will be in the strongest position. “When they find the rare tech company that has demonstrated solid unit economics and is well positioned to quickly resort to a ‘plan b showing profitability’ they are treating these companies like favored sons and daughters. With so much capital still available, supply demand forces continues to dictate that these companies receive favorable deal terms.” (Forbes)