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.