Bubble Bubble, Toil and Trouble – or Not?

Posted by | February 8, 2011

In the wake of bursting housing and financial bubbles, it is little wonder why there is widespread speculation throughout the venture capital and private equity communities of an emerging bubble in the valuations of technology companies.

Debate around Goldman’s investment in Facebook, as well as the ostensible speculation in the market for stocks of ‘nameplate’ technology companies yet to go public, has centered around price-to-earnings and price-to-sales ratios and other traditional valuation metrics.  That debate as well as its relationship to a “valuation bubble” has raged for time eternal.

We’ve been following the debate closely not only on an industry-wide basis in conjunction with TechAmerica, where Peter was recently been appointed Chairman, but on our own account as we evaluate prospective partner companies. In my opinion, we are not in a bubble, at least not yet.

Using some traditional valuation metrics, it could be argued that technology company valuations have become somewhat excessive, historically considered a signal that a bubble was building. However, we have to think about what truly constitutes a bubble and learn from the lessons of the past, examining what lead to the growth of past tech bubbles and what happened after they popped.

In the 1990’s, Wall Street financed a plethora of technology companies that ultimately failed.  Looking back, it seems the entrepreneurs, employees and friends of those companies, including their bankers, were the only ones to benefit from the financings as they traded their inflated “derivative” stock for cold hard cash.  The companies themselves mostly went bust, leaving investors empty-handed. The astronomical, inflated valuations of companies without any profit, or revenue, in certain cases, was simply unjustifiable from any fundamental financial perspective.

So when I think about today’s environment, I ask myself: “What’s going to drop dramatically if this ‘theoretical bubble’ pops?” And, I cannot identify anything that would dramatically fall. As I see it, these highly valued tech companies have leveraged successful revenue models and are rapidly growing, not just their top lines, but their bottom lines as well, which is creating and driving their value. Even if their growth rates slowed, and earnings faltered, these would still be viable businesses with enduring value.  Consequently, it is understandable why investors would want to own a piece of this exciting growth.  In contrast to technology bubbles past, investment dollars are going into these companies [not just the pockets of the bankers, owners, and employees] and are the impetus to produce a tangible financial improvement.

The same is true for the markets that have sprung up to trade the non-public shares of other “hot” technology companies. While much work needs to be done to analyze this phenomenon, maybe market bubbles can be better defined not by traditional financial metrics, but by the “real” purpose of the financings.

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