I don’t want to believe that the tech industry is inescapably bound towards another dangerous bubble. I have been able to rationalize my denial with the idea that the Silicon Valley of the ’90’s is not the Silicon Valley now. We are smarter, more calculating, and led by veterans who know how to help nurture the sustainable growth of a global market.
Then I heard that among the panel of judges at Startup Weekend in Los Angeles were Ashton Kutcher and Demi Moore.
The Wall Street Journal recently published an article on how modern Silicon Valley is starting to look a lot like 1999. While the tech industry is more mature than we were 12 years ago, it’s hard to deny that tech’s rise from the recession could very well turn into another unsustainable bubble.
Enabling this exuberance is the return of ample sources of funding. With the defrost of credit markets frozen since 2008, venture capital and other types of funding are surging across the industry. In Silicon Valley alone, VC funding for 2011Q1 is up 142% of what it was this in the first quarter of 2010 according to the National Venture Capital Association.
Even traditionally frugal sources of funding are becoming wellsprings of capital. Thanks to Yuri Milner and the SV Angel group, the iconic Y Combinator (well known for its spartan infusion of capital) recently offered $150K to every company in one of its recent classes. This is well over ten times the average amount of funding a YC startup would usually get in previous years.
There are new sources of funding opening up in tech as well. Goldman Sachs, JPMC, and other major Wall Street banks have entered the fight too , opening funds targeting Silicon Valley high tech companies and pushing growth capital into more established tech companies like Facebook.
For a startup founder this is all great news. With more sources of funding available it is more likely that a startup will get the capital it needs to scale from a side project to become the next Dropbox. And indeed, unsustainable and dangerous tech bubbles do not form because of a wealth of funding.
They are built because of a wealth of bad funding. This occurs when investment begins to pour into companies that don’t solve a particular problem or otherwise have a sustainable means of survival beyond the financial support of their investors.
When the industry places its faith in companies that do not deliver value to the market or cannot compete effectively, we risk creating another unsustainable tech bubble.
Disturbingly, we’re starting to see this happen today across Silicon Valley.
The hallmark of such questionable investment practices has to be Color. The photo-based, mobile social networking app that premiered at SXSW garnered a whopping $41M in funding pre-launch from industry magnates Sequoia and Bain Capital Ventures.
With no clear business plan or strategy, Color’s investment indicates that its financiers valued the free app with the potential worth of half a billion dollars without the product having even been launched (assuming a valuation of 9-10x the investment). Color currently has a rating of 2 stars out of 5 on the iTunes store.
Sequoia and Bain Capital Ventures are some of the biggest names in our industry. For them to stake so much money on Color without seeing any sort of response from the end market (much less a clear indication of what problems Color will solve) is frightening given the position of these two firms and how much our industry trusts their portfolio companies to succeed.
Why this “free and loose” exuberance in valuation practices could lead us back into another dot-bomb is simple: we end up funding the wrong companies. If a startup doesn’t solve a clear problem, it won’t be valued well by its target customers. The market will regulate based off of the value of the company’s products, and the company simply won’t get off the ground or go far.
But if venture capitalists and other investors start funding companies who cannot compete or do not have a valuable product, it could be some time before the market’s realization of value and self-correction takes place.
During this time, the investment community could have poured a substantial amount of income into this company – thereby depriving these resources to other firms that could have used such capital more effectively. The flawed but funded company could have hired a substantial staff. Through press, the company could also become a household name and an indicator of the success of that firm’s market and perhaps even the entirety of high tech.
When the market later self-corrects (i.e.: the firm fails), the results could be catastrophic. The investors that placed themselves behind the company will suffer as their bet goes south. The company’s workers will be laid off or fired as the firm desperately tries to shrug off costs in order to stay afloat.
The firm’s demise could even affect its partners, its competitors, and maybe even completely unrelated companies if its death is misinterpreted as the declining health of the market. If the financial sector misreads the tea leaves here, the flawed company’s fall could prompt an evacuation of necessary VC and growth capital funding from what erroneously appears to be a dying market.
And so the bubble pops. As a plethora of flawed but funded firms fail, an already jittery financial sector could panic over what appears to be a market failure. This panic leads them to stop lending, the economy to stops growing, and we could potentially find ourselves in another recession.
In order to avoid another boom and bust cycle, we as an industry need to get better across the board.
Venture capitalists (particularly newcomers into tech) must be accurate in their valuations and not follow the urge to jump on whatever technology and firms are the flavor of the month. They must leverage veterans and experts from across the industry who understand the high tech industry. Without a proper understanding of the industry, VC’s and other investors risk making a variety of adverse investments with serious consequences.
VC’s must gather ground level intelligence on the market for that company’s product (and understand the resource markets that play into the candidate company’s production process), and understand the technology that the potential portfolio firms employ. The industry cannot afford to be funded by a bunch of rich cowboys who shoot from the hip and base all of their knowledge off of something someone from TechCrunch wrote.
Startups need to really think long and hard about whether or not they want to go for funding. They must have a clear, definitive problem they want to solve and an execution strategy that factors for their ability to grow.
Their founders also can’t simply be in it for the money. Just as bad as a VC community with poor valuation skills is a founder who secretly doesn’t care about the product. Running a company is a grueling enterprise, and as a founder and manager you must be incentivized to deliver valuable solutions to real problems – not to simply walk away a minted millionaire.
I still maintain that the modern tech industry is not the tech industry of 12 years ago. We are blessed with the experience and skills needed to not make the same mistakes that led to the dot-bomb of the early 2000’s. If we don’t get too drunk off of loose funding and power, I’m sure we can nurture the sustainable growth of our industry for decades to come.
SF New Tech Contributor Andrew “Andy” Manoske is a PM by day, hacker by night, and sometimes in the evening he fights crime. He currently serves as a product manager at NetApp – the youngest in the company’s history – and previously held technical positions at SAP, Microsoft, and Electronic Arts. He received his Bachelors of Arts in Economics and Computer Science from San Jose State University in 2010, and was a finalist in Microsoft’s Imagine Cup competition and the Silicon Valley Neat Ideas Fair.