We’ve all heard the question of whether the current tech and venture Boom is indeed a Bubble. Marc Andreessen has terrific arguments for why “this time is different” – the world of tech users/consumers is several orders of magnitude larger than it was last time, tech businesses are much faster and cheaper to launch, and the business models are “real”.
Much of the discussion to-date, however, conflates two very separate, though sometimes correlating, factors: (1) the fundamentals of technology value creation and market opportunity and (2) the availability of financing.
The fundamentals for tech innovation are strong
On the fundamentals, it’s hard to argue with Andreessen. We are in a strong cycle of technology innovation and commercialization, a Technology Renaissance that is helping to drive the improving US Economy after the Technology Dark Ages in the early to mid 2000s.
To understand this better, I’ve overlaid venture capital, private equity and S&P returns with the major market-making tech innovations of the last 30 years.
Source: Cambridge Associates, S&P 500. Data only goes through 2010 because VC and PE returns since are yet too immature to draw conclusions. Vintage year means returns for funds started in that year. To match the ~5 year investment periods of vintage year funds in a given year, 5 year forward CAGR is shown for S&P 500 Returns.
The 90s Boom/Bubble was driven by the PC revolution and internet revolution. Then followed a lull in revolutionary technology commercialization until the launch of the iPod, which spearheaded the content revolution and seeded the Mobile revolution. The iPhone launch then put the mobile revolution into full swing. If you look at the grey venture returns swath (bottom is median, top is upper quartile), you’ll see it mirrors closely the overall economy as represented by S&P returns. Private equity returns tend to be counter-cyclical. The why behind this matters:
Valuing revenue or valuing EBITDA?
Technology innovation cycles create new and improved value propositions that grow revenues or create revenue where there were none before. In these eras, valuations are driven by revenue multiples and growth rates, and tech entrepreneurs and VCs have huge success. Financial innovation cycles focus on the financing structures and cost lines of businesses, and valuations are driven by EBITDA multiples to the benefit of PE investors. Why?
EBITDA is critical in a less innovative economy; it is how investors and operators drive shareholder value when revenue growth is hard to come by. When major tech innovations emerge, though, business models and the economy are shaken from a placid resting state. The rules of the game change for revenue capture, allowing massive shifts of revenues between competitors or from entrenched players to startups (re-slicing the pie). At the same time, new markets explode (expanding the pie). This is when venture returns are great. Inevitably innovation eventually stagnates again, and returns are found by innovating in the cost line. Outsourcing, which drove terrific counter-cyclical PE returns in the early-to-mid 2000s, is a great example. Hence PE and VC are somewhat counter-cyclical and VC and economic growth tightly correlated.
Neither cycle is “right”, a healthy economy balances both over time, but often not at the same time. Hence the cyclicality. While past cycles often predict the future, it is hard for me to see the negative slope on this technology innovation cycle yet. Whether it’s robots, rockets, IoT or the mass adoption of software by everyone, everything, everywhere, we are just scratching the surface of the possible on so many technology and commercial frontiers.
Financing risk: Enter the unicorn… the unicorn VC fund
While the fundamentals of technology innovation and commercialization are healthier than ever, there is a late stage financing boom developing around these fundamentals as the unicorn VC fund (VC funds >$1B) invests in late stage startup winners for window-dressing.
Five years from now when this chart shows 2011-2015 data, I would expect the venture return swath to show terrific performance over the 2010 to 2015 period as today’s unicorn startups exit. However, there will likely be a wide late 90s-like spread in returns. At the high end will be spectacular returns driven by smaller series A and seed funds who are investing in these tech fundamentals early, while unicorn VCs who chase logos could end up much lower, especially if there is a late stage “correction”.
A multi-stage venture correction seems unlikely but is the real risk. The Dark Ages of the 2000s were partly caused by natural ebbs and flows in tech innovation, but also by an over-correction of capital at all stages of venture after the 90s frenzy. This reached all the way to the earliest stages of venture funding, undermining the tech and startup pipeline needed to steadily sustain technology innovation. A late stage correction – if it happens – should not alone derail strong fundamentals.