Scott Maxwell: What Prick Will Pop the Bubble?

In the late 1990’s, I heard a lot of “dotcom” mantras like “it is a land grab,” “get big fast,” and “get eyeballs.” What began as investing based on the bottom line (net income or free cash flow) slowly shifted into investing based on the top line (revenue, bookings, or billings), then shifted more into investing based on eyeballs (visitors or pageviews). Ultimately, it shifted further into projected eyeball growth before several pricks popped the bubble and investors shifted relatively quickly back to bottom line some level of top line investing.

This time around, it’s “Web 2.0” instead of “dotcom” and “user” rather than “eyeballs.” But it’s still investing based on tremendous projections (and hope) for what is going to happen in the future. The logic goes something like this: “We will have a lot more users in the future that will turn into revenue based (many times) on a to-be-determined model and a lot of that revenue will drop to the bottom line.”

Marc Andreessen recently wrote an article for the Wall Street Journal titled, “Why software is eating the world.” In it, he describes a world being transformed by software and why it’s different this time. He has a lot of good points and the article is very well articulated, as is typical for his ideas. It’s a must read that explains the current exuberance private investors have for what they believe will be the winning companies.

As a VC who has invested in the software and Internet industries for over a decade, I was reaffirmed by Marc’s piece, as we have a similar rationale for our focus. Software is eating the old world, and there are a lot of good reasons for everyone to consider participating in this new world.

That said, even great companies and industries can be overvalued – sometimes considerably. Valuation is only rationale if the organization can eventually become valuable from a bottom line perspective that supports the valuations plus the return the investors need. I believe that there is significant risk in this happening with many of the private market valuations today.

The problem with the current valuations is that they depend on extremely good future performance. Software is eating the world, including other software companies. This makes it much more difficult for every crop of software companies to realize their future expectations, regardless of how large the market is becoming or how good today’s businesses are.

For example, many of the current leading social media companies (Facebook, LinkedIn, Twitter, etc.) are doing great partly by eating the prior generation of social media companies (check out these seven formerly popular sites that are dead or dying). Yes, there has been incredible market growth as well, but my point is that the prior generation has stalled growth or is wilting on the vine due to new, innovative competitors. If the past is a predictor of the future, won’t the next generation of companies come along and eat the current generation too? Perhaps even before some of them ever get to a positive bottom line?

I am a huge believer in the growing importance of software and have bet much of my career and net worth on it. But that doesn’t mean we aren’t in a valuation bubble. The more today’s valuation depends on tremendous future expectations, the more unstable the valuations will be. A small change in expectations, perhaps based on not living up to them, can lead to a tremendous drop in valuations.

I think that this is the situation today. Simply stated, it is a bubble, at least in certain sectors of the private investing markets. It may continue feeding itself for months or even years, but at some point it will deflate or pop. There may be a few great winners, but there will definitely be many unhappy losers. What prick will pop the bubble? The prick that changes the future expectations of the group that’s currently investing in those future expectations.

Scott Maxwell founded OpenView Venture Partners in 2006 and has worked in venture capital for over 11 years. For more insight from Scott, you can visit his blog and follow him on Twitter @scottsnews. Opinions expressed here are entirely his own.

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4 Comments

  • SM,

    Interesting note and I concur with you that i) Andreessen’s piece was thoughtful and ii) even great industry segments with 10-15 year growth drivers can get over-valued (witness anything “Cloud” related today)……two things have always fascinated me about valuation in growth industries: a) the phenomenon that a company is, many times, worth more (at least in terms of private valuation) when it is EBITDA negative than when it becomes profitable……..when there’s no EBITDA, but much growth, investors seem to be comfortable valuing businesses with revenue multiples arriving at lofty enterprise values relative to the actual operational progress of the business…….but I’ve seen that first dollar of EBITDA, in that same rapidly growing business, shift the valuation metrics from revenue multiples to EBITDA multiples resulting in a significant difference in valuation (lower)……a most curious circumstance……..of course given enough time, the company can grow its EBITDA to a level where the valuation gap closes but many times that’s a 24-36 monthy affair……but shouldn’t a rapidly growing business with positive EBITDA be more valuable than one without?……empirically, I’ve seen much evidence that the answer is “no” and that has never made sense to me…..have been in board meetings where thoughtful (and successful) board members have actually argued to increase spending to avoid EBITDA positive for this exact reason….this valuation phenomenon and set of behaviors takes place most often in bubbles……….fascinating…..ii) re what’ll pop the bubble: hard to understand how any investor’s future expectations can be as distorted as they are, quite clearly, today in certain segments……as you well, know, multiples are simply a discounting mechanism for growth……….how an investor could believe a SaaS or Cloud company (am using this sector as an example because I love the sector, believe in it, but am a dispassionate evaluator of its risk/reward) could ever grow into a 15x revenue valuation (witness several of the publicly traded SaaS companies) in a period of time where the return to those dollars invested will be superior to other alternative investments is, well, not a participating member of reality………..I think what’ll deflate the bubble in time will be access to capital…….the exit environment is still very tough and LPs are demanding liquidity sooner……long gestation periods to grow into very high valuations, before an investors sees even the first dollar of return, will direct capital flows away from over-valued segments….so economic or capital markets force majeure may happen resulting in a violent “POP!”, but I think it’s likely restricted access to capital and capital redirection (due to difficulty in realizing returns in a reasonable period) will deflate the bubble…………….thanks again for your thought provoking piece above, I enjoyed thinking about it and penning this response……..have a plsnt Labor Day……….

    J. Ward

  • It’s always “different this time,” but the one thing that’s never different is that trees don’t grow to the sky. The Biblical builders of Babel showed this. Ponzi showed this. Dominant firms in their time, like Cisco and AOL have shown this. And, in the dotcom era, we coupled forgetting that growth is finite with the idea of “I lose a little on each one, but I make it up in volume!” Hence, many a company “grew” quickly by selling $1 bills for $0.95, with the difference made up by investor capital. The valuations out there today ave so many parallels to these previous examples, it’s remarkable. But I guess it’s different this time.

  • John, thanks for adding your perspective. My view is really similar and I always appreciate your thoughtful analysis of issues! I particularly like your idea that perhaps the capital flows will change for different reasons than a change in future expectations…it will be interesting to see how all of this evolves.

    Scott Maxwell
    OpenView Venture Partners

  • Dan, thanks for the additional color! So far “it has been different this time” has never turned out to be true, but maybe this will turn out to be the first time! I hope that it does…

    Scott Maxwell
    OpenView Venture Partners

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