Considering many people still haven’t found¬†financial stability after the financial crisis of 2007 hit the American and global economy, rumors that the super star growth of Silicon Valley businesses may be more of a tech bubble than a tech boom are, to say the least, worrying to the general population.

tech bub4Is it a tech bubble? If so, how did it get to the point that it is today? When will the bubble burst, and what will be the consequences? Not all of these answers are widely agreed upon, but there are plenty of highly-esteemed economists and investors who are coming out today and affirming that the tech bubble is indeed a tech bubble. As to when it will burst and what the consequences will be, people have predictions but no one knows for sure. What there’s more tangible information about is how the tech industry got to its current, bubbly circumstances, and what factors can be attributed to where we are today.

It’s difficult to know where to begin in this narrative, but as decent place as any would be when Doug Leone of Sequoia Capital gave a famous presentation titled “R.I.P. Good Times” in 2008, i.e. in the midst of the financial crisis. Leone warned entrepreneurs to save and spend conservatively due to a predicted major recession in venture capitalist funding. While his presentation ended up being defined as overly alarmist as time went on, older industry players are now counseling younger batches of rising entrepreneurs to follow that advice.

“The main thing we’re trying to impress on our CEOs right now is that the market is saying, ‘We want to see growth, we want to see geographic expansion,’ but that may not always be the case.” explains Scott Kupor, a managing partner at Andreessen Horowitz. “Investors change their priorities. Soon, they may be telling you, ‘We want to see profitability even at the expense of growth.’ So you need to think about the levers you can pull in your business to make that happen.”

chichiWhat does this all have to do with the bubble bursting? Kupor’s advice contradicts the logic of a technique that tech moguls like Microsoft and tech startups like Slack have been commonly utilizing for years: seeking the highest possible valuation for their companies. They do this with a number of positive outcomes in mind. High valuations minimize dilution and generates publicity, which then attracts talent, clients, and even more capital. The two-year-old, hugely successful startup Slack famously raised $160 million upon being valued at $2.8 billion, for example. And it’s not just new startups that profit from high (and potentially inflated) valuations. Uber was valued at $50 billion this year and AirBnb at $50 billion. In both cases, the companies were valued at extremely high multiples of their actual revenues. According to investors, this is because their enormous potential makes it illogical to put a ceiling on their growth.

When these overly-valued companies come back to earth (as they must inevitably do as a result of rising interest rates), founders who have overreached must then struggle to defend their valuations. In cases when founders have managed to finagle an extra 10 to 20 percent value to be attributed to their company by granting investors aggressive downside protections (which enable VCs to make reckless bets without risking real consequences), founders can lose control of their businesses all together.

So because so many tech companies have been valued not based on their revenue but on their projected revenue, a fair amount of investors have been conned into pouring money into places that aren’t equipped to generate more.

 

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