Venture capitalists and angels are investing millions but are they creating a bubble or just transferring weath?
SOMETHING IS definitely stirring in Silicon Valley, the heartland of the US tech sector, but is it a bubble being inflated or simply another massive transfer of wealth to the technology sector?
All it takes is a drive down Highway 101, the moving traffic jam between San Francisco and San Jose which forms the main artery of the Valley, to know that things are booming again. Porsches, the preferred transport of the original dotcom mob, are increasingly common, although the real status symbol is a Tesla Roadster, the all-electric sports cars built by one of the founders of PayPal.
On either side of the road, massive billboards advertise the wares of tech giants like Intel, HP and Dell but also smaller online plays that you have never heard of.
If you are looking for harder metrics, just look at the valuations being attached to the new generation of Web companies that remain, in theory anyway, in private hands. Facebook, with a reported $2 billion in annual sales, is valued at $50 billion, more than aircraft maker Boeing.
Zynga, the online game maker whose hot property is the Facebook game Farmville, is valued at about $10 billion. Twitter’s latest fund raising put a price of $4.5 billion on the company despite an unclear business model.
Deal of the day voucher site Groupon, whose business model is easily copied, is rumoured to be planning a $25 billion floatation, even though 2010 revenues were less than $1 billion. LinkedIn, with its 100 million users, even looks a little bubbly at $2 billion.
It seems as if the internet is partying like its 1999 all over again and California is at the epicentre. Just don’t say that to venture capitalists on Sand Hill Road, the leafy drive beside Stanford University, who annually pour billions into start-ups in the search for the next big thing.
“There’s definitely a lot of money coming into technology but people are way too quick to call it a bubble,” says John O’Farrell, an Irish engineer who is a general partner with Andreessen Horowitz.
“There are great companies being formed. This is not pets.com or WebVan, for those who remember the dotcom days. Those will come and it will be entertaining to see what they look like this time around.”
If there is a bubble forming Andreessen Horowitz is in the middle of it – the two-year-old firm is an investor in Facebook, Zynga, Groupon, Twitter and Foursquare.
Down the street Draper Fisher Jurveston (DFJ) is a Silicon Valley institution which since 1985 has backed the likes of Hotmail, Skype and Overture.
While some companies are “definitely overpriced”, according to Don Wood, the managing director who oversees DFJ’s international network, “some great ideas are being seeded” in the start-ups.
Wood says that the multi-billion dollar valuations make it difficult for VCs to make a decent multiple return on their investment. Instead fundraising by the big players such as Facebook and Twitter is more like mezzanine financing or public stock investing than venture capital funding.
“Is there a looming crisis? No. When a few of these companies go public it will put more liquidity back into the market and re-energise venture capital,” Wood adds.
Talk to those who don’t invest for a living and you’ll get a much more direct view of what’s happening.
“The Valley is bubble central right now but with a rationale; there is real value being created,” says start-up veteran and former Yahoo executive Salim Ismail. “The valuations are crazy, which is not a good thing because exits have to be stratospherically high, but we go through these cycles here.”
Others believe that the valuation of the later-stage companies, which are staying in private hands longer than in previous cycles, can be justified.
Trevor Healy, the Irish man who headed up internet telephony company Jajah when it was acquired by Telefonica for $210 million, suggests there is a fundamental shift in value from other industries to technology, as it makes established business models redundant. This is benefiting not just Facebook, Groupon etc but the giants of the sector such as Apple and Google.
“A couple of years ago Blockbuster had a valuation of a few billion dollars and no one had a problem with that. It’s just gone bankrupt,” says Healy, who is now chief innovation officer for Telefonica Europe but continues to be located in California. “Equity value and wealth doesn’t go away; it shifts.”
One theory is that the bubble is not in fact forming around the companies with multi-billion dollar valuations but at the start-up stage. Practically everyone interviewed says investors are terrified of passing on a chance to back the next Twitter or Facebook.
Even in Silicon Valley, which from overseas can look like it is churning out a series of highly successful start-ups, there are only a small number of winning tickets in each year’s start-up lottery.
“Each year 15 great companies create 90 per cent of the value created by that year’s start-ups. We need to invest in as many of those as possible,” says O’Farrell, whose firm has made investments as small as $15,000 but which can go as big as its recent $80 million punt on Twitter.
However, as the cost of establishing a technology company – which was as much as $20 million in the 1990s – has dropped to a few hundred thousand dollars, angel investors have become the most common form of funding. Angels are wealthy individuals who usually have made their money in the sector and don’t just invest in start-ups but also bring their experience and contacts to the table.
The archangel is Ron Conway, which through his SV Angel fund was the first investor to attract the “super angel” tag. Individually, and through funds in which he is involved, he is said to have made more than 500 investments, but start-ups still covet his involvement as a seal of approval.
While Conway seems to be on a roll, though, there is strong evidence that other angels are less discerning and driving up valuations as part of a land grab.
Another investor who requested anonymity says he had been approached by graduates from a top US university with a good but little-developed idea. He says based on an existing angel investment, the pair valued their business at $8 million, which caused him to walk away. He subsequently found out they raised $1.5 million valuing their “pre-revenue” firm at $20 million.
The one that everyone is scratching their heads over is Color, the makers of a smartphone photography app, which has got $41 million in first-round funding from Sequoia Capital. Rather than creating yet another social network, it allows you to create an ad hoc network by sharing your pictures with everyone in your physical vicinity.
With a confusing user interface and no clear business model, few understand why it raised so much money. Robert Scoble, the influential technology blogger, believes it is a classic VC bet on a team of executives rather than a technology.
“The funding is based on Friendfeed, which was founded by the same team and was bought for $50 million by Facebook,” explains Scoble. “Sequoia sees a superstar team and know that even if it fails, it will be worth something.”
If that sounds like venture capitalists are taking even more risky bets than normal, Salim Ismail strikes an even more cautionary tone.
“The amount of money created by VC- backed companies in a bubble is nil, but during tough times they create a lot of value,” says Ismail, citing research from Stanford University professor Steve Blank.
To a man and woman, though, the VCs maintain that things are still in a pre-bubble phase.
“It only becomes a bubble if everyone who is convinced it is not a bubble says, actually maybe the rules have changed here, and decides to get into the market,” says O’Farrell. In his view, the dotcom bubble exploded at the turn of the century when the bears who had been betting against internet stocks lost their nerve and started buying them.
A similar scenario seems a long way off but there can be little down that a number of well-heeled individuals are gong to be feeling less than angelic about their investments in the coming years.
