Tech Valuations: How Low Can They Go?

The correction tech companies have been experiencing since the beginning of 2016 may be the first symptom of the tech bubble bursting.

By: Maud Chiche.

1999-2000: The Dot-Com Bubble Burst

The 1990s were characterized by the excitement arising from the apparition of a promising technology: the internet. This innovation created for businesses the possibility to disrupt every single industry and this at a completely different scale, thanks to the creation of a new international market.

In the business world, everyone hoped to get the chance of surfing this new wave full of opportunities; tech companies multiplied, obtaining abundant funding from enthusiastic venture capital (VC) funds.

Most dotcom companies were far from being profitable, but speculative investing and positive market sentiment allowed them to go public before even having revenues to show their shareholders. Their valuation soon reached the skies. For example, in 1999 at the peak of the bubble, 240 internet companies went public, and the Dow Jones Internet index went up by 167% for the year.

As early as 1996, during a speech to the American Enterprise Institute, Former Federal Chairman Alan Greenspan warned that “irrational exuberance” had escalated asset values and that momentum investing was becoming the norm. But the mania only stopped when the bubble finally burst by the end of 1999: The Nasdaq composite lost, from peak to bottom, 78% of its value.


From Public to Private Tech Bubble?

In hindsight, it is relatively obvious that the trend of the 1990s was not sustainable. How could so many internet companies reach such impressive valuations, while not even securing revenues? It was at the time very difficult for investors to value internet companies because of the highly innovative and disruptive nature of services and products they were offering. With opportunity comes risk, as there were very few ways for investors to differentiate companies than would be highly successful from those that would fail dramatically.

Are investors any more likely today than they were in the past to successfully differentiate successes from failures? Many think that they are not; consequently, the rumor that a new tech bubble is currently growing, this time in the private sector, is on everyone’s lips.

In the public markets, tech companies have suffered greatly since the beginning of the year 2016. Tech heavy NASDAQ is down about 8%, and this despite hikes in the past week. Additionally, the “FANG” group (comprising Facebook, Amazon, Netflix, and Alphabet (Google)), responsible for most of the returns in stock markets in 2015, started showing signs of weakness in 2016 as the companies’ share prices fell.

Another area of concern is the fact that many tech companies are now trading at share prices below their IPO price, which tends to confirm that tech companies have been overvalued in the past few years. For example, according to Business Insider, seven of the top ten companies going public in 2015 were trading lower than their offer price.

In the private market, tech firms’ valuations are less vulnerable to markets volatility and changes in investors sentiment. Nevertheless, they are still under close scrutiny and some signs reinforce the belief that a start-up bubble has been forming and may be starting to burst.

The more obvious sign is the increasing number of the unicorns ; once a myth, those private companies whose valuation exceeds $1 billion became very common in business landscape. According to CB Insights, there are now 153 such companies (representing a total valuation of $536 billion dollars), more than three time as many as in 2013. We find in the top three: the mobile ride hail company Uber with a $51 billion valuation, the Chinese hardware company Xiaomi valued at $46 billion, and finally the Ecommerce company AirBnB with valuation $25.5 billion.

Why are those companies not going public? They may not have sufficient incentives to do so. In effect, VC funding has been abundant, and consequently start-ups have been able to finance their growth without an IPO; this allowed them to preserve the benefits of staying private (namely protection against the volatility of the markets and preservation of their financial information) while still having access to equity. Additionally, VC funds are now trying to exit by selling their shares privately instead of going through an IPO: This is because private valuations are inflated and consequently risk a revision downwards when the company goes public.  

Theranos: Unicorn Valuations May Hide Serious Uncertainty

It is tempting to draw a parallel between the increasing number of tech IPOs in the 1990s and the ever growing unicorn presence we are witnessing today. One aspect the two phenomena have in common is the gigantic valuations based on potential, and not on results, of tech companies during the two periods.

According to Nick Bilton, technology and business columnist at The New York Times, “The market for tech start-ups today may be just as speculative as it was during the first bubble”. Symptoms of the existence of a start-up bubble begin to appear: just like many public tech companies during the dot-com bubble, our unicorns today may be highly overvalued.

One example of the uncertainty lying behind the apparent strength of unicorns is Silicon Valley start-up Theranos. The unicorn, valued at $9 billion, convinced investors that its “breakthrough” technology would disrupt the market for blood test. However, more recently, negative press reports casted doubts on the actual potential of Theranos’ technology. In particular, they revealed that the firm was using its own technology only for some of its blood tests, and other firms’ technologies for the rest. In addition, an inspection report by Centers for Medicare and Medicaid Services found that one of Theranos’ lab facility is in violation of regulations on five counts, while another has been temporarily shut down for unknown reasons.

Because private companies can keep information secret, it is easier for them to hide their trouble for a longer period of time. As of now, nobody knows whether Theranos is actually worth anything, as there is no scientific proof available to attest of the actual potential of their technology. This is just one example among others, but it highlights the shakiness of unicorns’ valuations.

We are not exactly back to the Dot-Com Scenario

Despite some similarities, the situation today is still quite different from that of 1999. According to the team at Goldman, led by Chief U.S. Equity Strategist David Kostin, the main difference lies in earnings. In effect, during an interview for Bloomberg, David Kostin explained that “At the peak of the tech bubble, information technology never generated more than 16 percent of the S&P 500’s earnings. The profit contribution from [IT] increased over the past few years and the sector now accounts for 20 percent of S&P 500 net income.” It does not mean that valuations are accurate, since a correction has already started in public markets, but the situation may not be as dramatic as it has been in the past.

We are yet to see whether the current correction experienced by tech firms is going to be just that – a correction – or the beginning of a more significant burst. For now, the direct consequence of such uncertainty is that it is becoming more difficult for start-ups to access new funding. As for VCs, they seem to have covered their position and to some extent anticipated the coming correction.

According to Nick Bulton in an article for the Vanity Fair, “Ironically, whenever the kaboom happens, and in whatever form it takes, the people who are most protected will be the V.C.’s themselves. Most of them learned their lesson from the last bubble, and this time around have set up deals to ensure that if a company goes under, or has to sell itself for parts, any leftover money will go directly into their coffers—to “make them whole,” as the saying goes in the Valley, ensuring the investors get back what they put in.”

The victims of the burst may end up being individuals and small businesses who invested their savings in hot stocks, following the momentum.

Dobson Chronicles

The Dobson Chronicles is the official blog of the McGill Dobson Centre for Entrepreneurship.