Is tech in a bubble?

by Amitay Yamin,
General Partner & Co-Founder

While global economies are facing severe headwinds, and various industries are suffering the adverse effects of the ongoing pandemic, the domain of start-ups seems invincible in the face of such macroeconomic factors.

Due to the plethora of start-ups currently flooding the market, as well as mature start-ups progressing towards IPOs or merging with SPACs to be listed on the bourses, business valuations are at their pinnacle. What’s even more encouraging (or alarming, depending on what side of the pendulum you’re on), there is room for a further increase in valuations.

So, is technology a bubble like the housing market before the financial crisis? Or is it the dot-com bubble of the past century? If tech is not a bubble, how can unprofitable companies be more valuable than profitable ones? The answer to this paradox lies in a combination of perceptions and overly optimistic financial projections, coupled with favorable economic conditions.

Answering the Paradox

Traditional economics believes that for a business to be valued appropriately, it must develop its revenues and, in the end, its profitability. On the other hand, the innovation economy d values highly the “potential” and “technological capacity” of an enterprise in relation to its turnover. Both schools of thought are partly correct and partly erroneous when it comes to tech valuations.

Valuing a technological enterprise is a complex exercise of valuing the future, and that exercise becomes even more complicated when the start-up “creates” a new industry.

The creation of Uber, a shared taxi system, is a striking example of a start-up developing a new industry through its operations, i.e., a socio-economic system built around the sharing of resources. Airbnb would be another instance.

Valuing a Start-Up

So how are start-ups valued? All companies (except those under liquidation) operate on a going-concern basis, meaning they have the resources to continue operating indefinitely until proven otherwise.

Investors invest in a company’s current performance and growth prospects, as this is where the returns exist. The company’s recent performance piques the initial interest of investors but the underlying notion of an investment is based purely on future performance.

This fundamental metric also applies to start-ups though it is a bit more nuanced.

In technology, particularly with start-ups, the focus is on their ability to “disrupt” the current status quo of the market. The cost of such a disruption is generally not a factor, as investors are more inclined to plot a steep growth path than to encourage start-ups to be prudent. This idyll of innovation and opportunity overestimate valuation beyond a reasonable justification, paving the way for the creation of a bubble.

The Role of Venture Capitalists

How are the valuations for start-ups justified? Here is the irony: VC firms make little or no effort to justify the valuation of their investments. The chief motive of any VC company is to seek an exit at a multiple of their original investment, while largely disregarding the underlying economics.

This phenomenon is further aggravated by the current financial market being flooded with “easy money” in the form of low interest rates and access to large pools of funds, such as pension funds.

So, is Tech in a Bubble?

Going back to the original question, the answer is yes. Present evaluations are ripe for a correction but not necessarily a crash.

The eagerness to join the start-up movement has become a more decisive factor than the underlying business model itself, resulting in a situation of over-promise and underperformance for investors.

Nevertheless, there are booming start-ups with quality products and qualified management searching for funds to fuel their growth.

In the realm of start-ups, it takes a discerning eye and the ability to not be influenced by a potential rosy future to become a savvy investor. A one-size-fits-all profit approach doesn’t work with start-ups. Going by rule of thumb, 5% margin of profit is low; 10% is average; and 20% is high.

Maybe it is time to suggest that start-ups with actual earnings of $1 billion are the real unicorns, though even this is a statistical anomaly.

January 2022