Photo: Aeioux
BY SCOTT KUPOR
With private tech companies pulling down billion-dollar-plus valuations with seeming ease, and shares of some newly public tech outfits soaring, talk of a tech bubble is on the rise again. Financial market prognosticators have declared that technology valuations defy logic and that Silicon Valley needs to be institutionalized before it becomes a danger to itself and investors everywhere.
All of this bubble-mongering encourages headlines, but it makes little sense if we look beyond the run-up in valuations of tech startups. Before we can say a bubble is brewing, we need to consider what’s causing the value of tech companies to soar. Here’s a look at three drivers:
Driver No. 1: Going public today takes a long, long time
For venture-funded technology companies, the time it takes to go public is inexorably longer today than in previous years. In the decades leading up to the “real” tech bubble of 1999-2000, the average venture-backed company went public soon after its fourth year in existence. Today it’s nine years or more. Not surprisingly, IPO sizes used to be smaller (80% were less than $50 million), and the companies were less mature (80% had annual revenue less than $50 million).
Today, these numbers have completely reversed. In 2013, the average tech IPO had annual revenues of $104 million and raised more than $200 million. What that means is that most of today’s “private billion-dollar babies” would have been public in the markets of old. Rather than question the value of immature public companies as we eventually did in the last bubble, today we wring our hands because they now achieve these valuations in the private markets. In reality, this is nothing more than a wealth transfer from ordinary individuals who invest their retirement dollars in the public markets to wealthy individuals, endowments, foundations, and public pension funds who can invest in private equity.
So how did we get here? The short answer is that decimalization and various other policies implemented by the Securities and Exchange Commission have destroyed the trading environment for small cap stocks. As a result, the prospects of being a small cap public company are truly daunting; private companies go public only at a much later and more mature stage.
No doubt this is an important public policy question, but it’s not a valuation question.
Driver No. 2: Growth is hard to find
Putting aside the IPO class of 2011-2013, the largest tech companies — Microsoft, SAP, Oracle, etc. — represent a combined $2.5 trillion in market cap. Yet, these companies are barely growing. The revenue growth rate for these companies is about 6%. At that pace the market values them at about two times their annual revenue.
Now compare this to the 25 companies in the 2011-2013 IPO group with annual revenues growing at more than 30% — what most investors would consider “high growth.” This group has a combined market cap of only $300 billion, half of which is represented by Facebook alone. Add in Twitter and LinkedIn, and these three companies make up roughly two-thirds of this total market cap. The market values these companies at eight times annual revenue.
Think about that for a moment. If you are a public tech investor looking to buy growth — e.g., T Rowe Price, Fidelity — you have about 25 companies from which to choose, three of which account for the vast majority of the total investment opportunity. This is basic Economics 101 supply-and-demand at work: Investors demand growth, but there isn’t a lot to satisfy this demand so the price rises.
Interestingly, this also explains why you see many of these mutual funds (and some hedge funds) investing in the private financing rounds of pre-IPO companies. There simply is not enough growth in the public tech universe to satiate their appetite. They must buy growth via late-stage private financings; therefore, pushing valuations higher.
So not all IPOs are on a rocket ride up — to name a few, just look at companies like Demand Media, Chegg, Violin Memory. Such companies that recently went public with annual revenue growth of less than 20% trade at multiples fully 75% less than their high-growth peers. This is a good thing -‑ investors are doing their homework, rather than putting money to a bubble. And they stand to do very well by their studiousness.
Driver No. 3: These are massive markets
Today’s technology companies are going after massive markets, the value of which dwarfs that of previous generations of tech companies. Simply put, the winners in tech today can become massively larger than the winners of yesteryear because the end-user markets into which they can sell are enormous.
Why is that? My partner, Marc Andreessen, likes to recount a simple stat that sums it up quite nicely. When his company Netscape was sold to AOL in 1998, the total size of the browser market was roughly 55 million users, nearly all were accessing the Internet via those ear-screeching dial-up connections.
Fast-forward to today, largely as a result of broadband penetration and the growth of smartphones and tablets, and there are 2.5 billion people with virtually ubiquitous Internet access. And that number is likely to exceed 5 billion in short order.
Is it really any wonder then why so many of the 1999-2000 bubble-era Internet companies failed? The markets into which they were selling were simply too small compared with both the costs of acquiring customers and the costs of the technology infrastructure (remember that $50,000 box called a Sun server?) required to support these customers.
By contrast, not only are the end-user markets today vastly bigger, but the technology costs required to support these markets (think Amazon Web Services, open source software components, etc … ) have plummeted. The economics finally work.
This isn’t to say that every new technology company being incubated at a university dorm will achieve the success and scale of Facebook. Nor is it to say that venture capitalists and public investors may not ultimately lose their minds and blindly pay 15 to 20 times revenue multiples for any dotcom company.
Bubbles can, of course, happen. But we simply aren’t there yet.
This story orginally appeared in Fortune.
