Why It’s Not a Bubble

Like every technological revolution, the digital revolution was born in a bubble. Most of those who made fortunes at that time are still around. Some of them have gone on to found new companies, with spectacular success. Others have taken a step to the side and become investors, with plenty of time and excellent reasons to write books, contribute blog posts or tweet about their views on where the economy is going. And finally some others have become insufferable, patronizing wannabe mentors who think that just because they sold their ad-clicking / e-commerce company in November 1999, they have many things to teach us.

It happened 14 years ago, but the shadow of the previous bubble is looming over our heads in the startup world, inspiring the same old “here we go again” refrain. At TheFamily, we have to fight continuously to defend the valuation of our portfolio companies against those who would like to take advantage of the current bubble talk to bring valuations down. “A business has to be profitable, otherwise it’s worth nothing. Just look at the bubble bursting in Silicon Valley.”

Uber is one of the choice targets. Regarding Uber’s valuation, Bill Gurley’s argument is the strongest one: Uber is not so much a competitor of the taxi industry (a $100-billion opportunity) as it is a competitor of the car industry (a $6-trillion opportunity!). You can see this when considering the figures revealed by CEO Travis Kalanick in Munich 14 months ago: with an annual revenue of $500M in San Francisco and the surrounding area, Uber is already well above the revenue level of the traditional taxi industry (which generates an annual revenue between $140M and $300M in the same area). Because taxis continue to do business (even if a bit less), it either means that the addressable market has more than tripled in size… or that Uber operates on a different market. As Bill Gurley puts it, the tech giant has become a alternative to car-ownership: no wonder it’s worth so much!

Being worth a lot of money doesn’t mean that Uber will succeed no matter what. In fact, it will most probably fail at some point because it (rightfully) tends to take even greater risks as it reaches a larger scale. But raising a lot of money is what it takes to conquer such a large market (a $6-trillion market) at a global scale. Uber’s staggering valuation is NOT an anomaly—and it certainly should not be compared to small local players in the taxi industry.

Another argument in favor of the bubble thesis is that many of those companies with enormous valuations don’t turn a profit. Three things should be kept in mind in response to that.

First, most giant tech companies, notably Apple, Google, and Facebook, actually make profits. Amazon is the outlier in the story, for reasons explained in detail in a recent double issue of TheFamily Papers: see part 1 and part 2.

Second, it’s more difficult to make profits when you grow tech companies in more tangible industries or on more regulated markets. The Northern Side (parts of the business marked by diminishing returns) weighs heavily on those markets, and the increasing returns are harder to sustain even with a Southern Side (pure digital business): this is why companies such as Amazon don’t make profits… yet.

Third, a lot of fast-growing new entrants could make profits if only they would stop growing and settle for their current scale instead of expanding their operations globally. There are two reasons why they don’t stop: like Amazon, they probably are just beginning their conquest of a very large market; and if they stop growing, a faster-growing competitor will ultimately wipe them out from their market altogether. Frédéric Mazzella, CEO of Blablacar, made that point in an interview last year:

By definition a startup isn’t profitable, otherwise it wouldn’t need to raise funds from venture capitalists! We raised 100 million dollars to expand our operations globally. There are three steps in the life of a company: viability, profitability and expansion. We proved the viability of our business model: if we operated only in France today, we’d be profitable. But given the speed at which things are going today, if we aimed for profitability before international expansion, all the marketplaces would be snatched from us. So we swapped the steps and decided to aim for (expensive) expansion before profitability. We are scaling up right after starting up, which isn’t very common in France, or Europe for that matter.

There are many other arguments against the bubble thesis. Andreessen-Horowitz dedicated an entire slideshow to discussing the matter, with many convincing figures.

For those of you who are in a hurry, it probably suffices to say that there’s a bubble only if everybody who holds an asset loses everything when it bursts (as with the infamous tulip mania of 1637). In our current case, if we look at giant tech companies, it looks more like a race than a bubble: many participants (all those raising Series-B rounds and beyond) but few winners (those who survive the so-called bubble bursting). We should always bear in mind that the dotcom bubble gave us winners — and what winners !— like Amazon and Google. Similarly, the recent funding and valuation race has been instrumental in the rise of new-generation tech giants such as Uber and Airbnb. It’s not simply about speculation: it’s about concentrating enough capital to be able to fund the occasional, improbable outlier that will conquer a large global market.

Why the Bubble Has Nothing to Do With the Digital Economy

Another very interesting tale about the so-called bubble is related to the actual causes of the massive flow of capital in the tech industry.

The conversation around what is variously described as “secular stagnation” or “global savings glut” has been fueled by prominent investors and economists as diverse as Paul Krugman, Robert Gordon, Larry Summers, Thomas Piketty, and Marc Andreessen. You can read the latter’s ‘Secular Stagnation’ tweetstorm here.

The “global savings glut” was best explained a few months ago by Dominic Rossi, the head of global equities at Fidelity:

The thinking is that there are more countries with excess savings than there are with excess investment opportunities. With the accumulation of savings continuing, nominal and real yields will grind lower over time… Global gross savings are about 24% of global GDP and, when adjusted for depreciation of fixed capital (savings wealth consists of fixed assets as well as financial capital), we are still seeing savings of 11% to 12% on a net basis, which is substantively in excess of nominal economic growth.

This scenario describes a world where too much capital is chasing too little income. This realisation has a profound implication for asset values and investor asset allocation. If it is a persistent trend, then we will see a desperate search for yield, a bid for fixed income and interest in equity income as well as real estate and multi-asset income.

In other words, what happens in the digital economy in explosive proportions also exists for other asset classes, which only reveals that there is too much capital to invest and too few opportunities to secure sizeable returns. This may come as a surprise for Entrepreneurs who rack their brains in vain to try and pitch investors who refuse to deploy capital. But the commoditization of capital is a well-documented trend, and one which has been a key source of inspiration for TheFamily’s investment thesis.

The “global savings glut” has profound implications for both investors and investment targets far beyond the digital economy. It explains, for instance, why traditional players such as Fidelity or Goldman Sachs are diversifying in venture capital. It also explains why established corporations are currently paying record-high dividends, in stark contrast with the context of a deep economic crisis and enduring stagnation of their business. The reason for those high dividends are twofold:

• first, as Dominic Rossi puts it, “in a world where too much capital chases too little income, tomorrow’s returns are effectively being brought forward to today”. As investors are paying a high premium to buy those companies’ stocks (= they’re desperate to deploy their capital at any cost), they demand very high dividends in return, if only to maintain their P/E ratio at a reasonable level;
• second, return on invested capital is very difficult to achieve if you leave your money inside those companies which have almost completely renounced innovation. So investors prefer to get their money back, in the form of dividends, and deploy it in other asset classes. In short, investors take money from old, established, tired corporations who don’t innovate enough (if at all), and invest it in radical, fast-growing Uber!

This is an argument that has been made repeatedly by Clayton Christensen:

The ‘Doctrine of New Finance’ has diverted corporate focus from empowering innovation, which employs a lot of capital and creates many jobs. Instead, today’s corporate executives choose to favor efficiency innovation, whose main consequences are the freeing of invested capital (hence the record-high corporate dividends in the recent period) and a continuous increase in productivity that triggers massive job destruction.

In addition, valuations go higher in the digital economy because tech companies tend to remain private, and there are reasons to believe bubbles emerge more easily in private markets—because private capital markets lack a stock exchange that would impose short-term corrections on companies’ excessive valuations (and Fidelity marking down its own portfolio companies is certainly a novel moment in that world).

Here, too, the reasons are not specific to the digital economy: IPOs are happening far later in a company’s life — if at all. There are many reasons:

• the pitfalls of being public — It is difficult to be a public company when your highest stake is radical innovation, let alone when you are still searching for your business model. As public investors demand high short-term returns, CEOs and their boards prefer to delay their IPOs to make room for more risk taking and radical innovation;
• regulations — Since the Sarbanes-Oxley Act was implemented, it costs much more to be a public company, in terms of both compliance and risk management. As a consequence, it may not be rational for a fast-growing company to allocate capital for compliance rather than for growth and innovation;
• a concentrated banking sector — Unprecedented concentration in the investment banking sector has raised the threshold above which a big investment bank is willing to consider introducing a client on the public market.

As a consequence of the scarcity of IPOs, there’s not much value left on the public market (which actually deprives the middle class of a significant upside and concentrates wealth in the hands of more sophisticated investors — but that’s another story).

Why the Digital Economy Is All About Bubbles

This is probably the most important part, and the one about which little has been written so far (to my knowledge)—with the notable exception of a 1996 paper by economist W. Brian Arthur.

This so-called bubble reflects the economics of the tech industry. At the heart of every tech company’s business model are increasing returns. When a company is propelled by increasing returns, “gaining market share puts them in a better position to gain more market share”. That company is not competing with more or less equal players forming an oligopoly; rather, it is engaged in a battle for total market domination. The result is that there is usually only one winner (and its happy investors) and many losers (with a lot of people losing money, mostly on private markets). Once again, it is a race more than it is a bubble.

A part of today’s digital businesses come with diminishing returns, but, again, these form what I call the Northern Side of every tech company’s business model. For instance, the logistics business is Amazon’s Northern Side, on which “a simple slip would mean death” (Matt Dickinson): this is a side of business that is marked by traditional diminishing returns. On the Southern Side, on the contrary, many factors contribute to sustaining increasing returns and thus to making the company scalable. The overall result is usually a business marked by slightly increasing returns—just enough to comply with the winner-takes-most rule pointed out by Fred Wilson. No wonder investors are willing to invest at any cost the moment they sense that they may have picked a winner whose growth is driven by increasing returns!

As a result, the competition is so high to be part of the best deals that it takes valuations higher, thus absorbing the value that will be created tomorrow — “tomorrow’s returns are effectively being brought forward to today.” The consequence is less upside for late stage investors, especially, as pointed out by Scott Kupor, after the IPO.

And by the way, on markets so ridden with positive feedback loops, raising a lot of money is not only a way to finance operations, it is also a signal to all of your stakeholders (shareholders, customers, employees, analysts) that you’re on track to become the leader and grab most of the market. As explained by Babak Nivi, reaching that sweet spot is the surest way to make the traditional tradeoff between quality and scale disappear. This is the reason why a tech giant such as Uber advertises its funding rounds so noisily. When Uber customers, mostly ordinary people, hear that the company raises a lot of money, they don’t reflect on the so-called bubble: instead, they’re comforted in their feeling that they’re using the service provided by the market leader and that the quality is probably higher, at a cheaper price, than that provided by poorer challengers.

Why Bubbles Are the Marks of Healthy Ecosystems

Since investors are jostling one another as soon as a potential winner is detected, prices rise fast and high, absorbing tomorrow’s returns at an accelerated pace. There have been two main reactions to that trend. The first is that late-stage investors seek more and more downside protection, as described in great detail in this Fenwick & West paper.

The second trend is that investors are running up the value chain to try and invest at earlier stages. The harsher global competition that is currently mounting on early-stage capital markets should be interpreted as the sign that investors are feeling the consequences from the very high valuations at later stages. As more money flows in, the value is moving up the stream, all the way up to earlier stages. The earlier an investor takes equity in a company, the higher return on invested capital they are able to secure — provided they are the best at sourcing potential deals and they can negotiate with the right terms (notably pro-rata, as Fred Wilson discusses here, here, and here). Securing positions upstream earlier in the history of their portfolio companies allows capitalists to invest at the point of highest reward.

This trend will only increase in the future. The competition to capture value and secure an upside in tech companies’ growth exists mostly between private investors who have no reason to restrict their operations at later stages. On the contrary, players have to enlarge the battlefield and open other fronts to grow their deal flow. As new investors such as Goldman Sachs, KKR or giant family offices test the waters in later rounds without becoming LPs in a VC firm, both traditional VC firms and new entrants discover new competition up the stream, at the startup stage. There have been several consequences to this competition.

First, the importance of money is decreasing. Simply put: at earlier stages, what an Entrepreneur needs the most is not so much money as it is non-financial resources such as education, insight, network, etc. As they move up the stream to earlier stages, investors will have to learn to provide other resources than plain cash.

Second, the demand for liquidity in the absence of IPOs has triggered innovation and shortened time horizons. YCombinator, 500startups, AngelList, Rocket Internet and even full-service investment firms such as Andreessen-Horowitz all exemplify the search for a new business model in venture capital. While various incubators and accelerators grow from the early stage and diversify at later stages, traditional firms are moving upstream, raising seed funds and opening their own incubators.

Third, angel investment is under the major threat of irrelevance. As they’re replaced by professional, full-service investment firms exploring new models with early-stage Entrepreneurs, individual angel investors encounter major difficulties: they get evicted from the most promising deals and they face critical difficulties when trying to liquidate their shares in the absence of an active IPO market.

By the way, this is the reason why TheFamily, although stage-agnostic, likes to invest, no matter the amount, as early as possible in its portfolio companies. The context in which we have founded TheFamily is the global competition to secure the scarcest resource: ambitious and talented Entrepreneurs. As more players seek to generate and secure their own proprietary deal flow, this hunt for talented Entrepreneurs has intensified upstream. It’s not enough to invest capital at later stages, when valuations are already high and competition between firms is at its harshest. To secure a higher proportion of the value, firms have to enlarge their deal flow and engage with founders at earlier stages — when the founders are still far from launching their product, let alone proving their business model.

All in all, massive capital influx is the mark of a healthy ecosystem. It means local startups attract a lot of capital, all the more so in the context of low interest rates, and the balance between supply and demand shifts in the advantage of founders. As a result, founders raise more money at earlier stages, notably past product-market fit, and massive amounts of capital concentrate in tech giants that have the potential to become global players. The price to pay is some investors regularly losing money because they didn’t pick the winner. Fortunately, it’s mostly private companies that are affected nowadays, and their investors are sophisticated enough to deal with the consequences.

Bubbles Are Good Anyway

The final argument is that, whether specific or not to the digital economy, those frequent bubbles that we’ve observed in the (not so) short history of this economy are a good thing anyway.

They’re a good thing because they foster competition. The absence of a bubble would mean that dominant positions are impregnable. On the contrary, the abundance of capital enables new entrants or existing challengers to raise a lot of money and take over a dominant position at the expense of the market leader. This is a feature that exists mostly on markets driven by software technology — and it helps us understand how the so-called bubbles are healthy from an antitrust point of view. If there were no bubbles, nobody would enter existing markets and try to challenge the dominant position of giant tech companies. In other words, the investors’ irrational exuberance, exacerbated by the digital economy’s increasing returns, may be positive in terms of sustaining a high enough level of competition on the market. As Eric Brynjolfsson and Andrew McAfee wrote a few years ago,

The internet and enterprise IT are now accelerating competition within traditional industries in the broader U.S. economy… A company’s unique business processes can now be propagated with much higher fidelity across the organization by embedding it in enterprise information technology. As a result, an innovator with a better way of doing things can scale up with unprecedented speed to dominate an industry. In response, a rival can roll out further process innovations throughout its product lines and geographic markets to recapture market share. Winners can win big and fast, but not necessarily for very long.

Technology bubbles are also a good thing because they fuel innovation. This is the now-classical Carlota Perez & William Janeway argument, which I encourage you to discover here or here. Remember that technology bubbles, contrary to banking bubbles, are good for the economy: it’s only when investors renounce their rationality and cease demanding short-term returns on their investment that they are capable of pouring money into long-shot projects that end up transforming the whole economy. Once again, Amazon and Google were born in a bubble: where would we be without them?

If bubbles happen more often in the future—and Dominic Rossi predicts they will—there will be radical consequences for investors who will have to learn to deploy their capital in a world marked by increased uncertainty. This will probably have a major impact. First, private equity will rise as an asset class (we founded TheFamily to seize that opportunity). Second, even public market investors will have to learn to invest like venture capitalists. As I’ve written in a previous issue,

Stock market investors will have to begin to act like venture capitalists, even though they’re investing in liquid stocks on the public market. Like venture capitalists, they will have to learn to make their earnings with mostly capital gains instead of dividends. And like venture capitalists, they will have to learn to accept losing money on a lot of portfolio lines, if only to win even more money with the few remaining lines that will be exponentially successful.

Bubbles will also give rise to a new kind of financial engineering. There are many reasons why it’s difficult to short private tech companies. But the higher risks taken on capital markets rife with frequent bubbles will have to be hedged against by short positions on certain companies stocks. We expect a great deal of financial innovation in that field in the coming years (and we plan to take our part in the innovation effort).

Finally, what matters is not what happens during the bubble, but what comes next. After the dotcom bubble, Silicon Valley (and the US in general) chose resilience and continued to invest while other parts of the world relinquished any interest in the digital economy: that post-bubble period explains most of Silicon Valley’s competitive edge over other ecosystems. Difficult times lie ahead. But we shouldn’t be scared off or give up on the European digital economy.

You can count on TheFamily to keep on pushing and investing!