By Wladimir Hinz, RIC Centre Research Associate
With the memories of the dot-com and housing bubble still fresh in our minds, what have we learned about them?
The first thing about bubbles is that they burst. Most of the time without a clear needle, making it impossible to trace the precise moment of collapse. It’s a very subtle game to play. No one knows when markets will fall or if they will fall at all.
The second thing is that there appears to be a pattern. A bubble is typically characterized by a rapid increase in prices and a generalized feeling of regret from people who have missed out on profits.
As investors get into a new savvy idea, they tend to earn a lot of returns, which incentivizes other investors to get in too. As their number grow, there’s plenty of financing available and the market is suddenly flooded by funds and ideas (including bad ones). This usually goes on for some time, with investments being made almost blindly, as if inspired by the inertia of previous waves.
In a short time, market tensions grow too strong and everything collapses. ‘Something’ happens and the bubble bursts. A single event that takes everything with itself, and fast chain reaction ensues; prices drop drastically, there’s capital shortage and the value of the investments plummet.
Recently, the tech startup market in the U.S. has been feeling some of these symptoms. There are some similarities with the dot-com bubble, but there’s one important aspect that’s different that could play a crucial role: how funding is raised.
During the dot-com bubble, funding was widely available in equity markets for the public to invest. But not this time around. Right now, these new startups are being financed by private investors or ‘angels’, and have to go through various capital raises before they go public.
This difference helps isolate public equity markets from big movements in the tech sector, limiting the public’s over-exposure to condemned startups. If tech startups are going to fail, they would almost certainly do it in their earlier stages, and these don’t take place in regulated equity markets.
Having said this, investors are in a delicate situation. Liquidity becomes a problem when there isn’t a market available to sell stock and opt out. And this is not all, without markets there’s no immediate easy way to valuate early stage companies. It’s a solvable problem, sure, buyers and valuations can be found. The severity of this issue lies in the magnitude of the investments and the size of the market.
Billions of dollars are being poured into startup companies, causing incredibly high valuations, and an uncomfortable number of them are still years away from making a marketable product – if they can even reach this point.
The tensions for a bubble-like scenario are present, but there are other indicators that suggest that the future is not that grim.
What’s really good to see in a situation like this is that, underneath the thin layer of startups with disposable business models, there’s actually a very thick layer of startups that have sustainable and secure models, and will potentially last long enough to flourish. This is what will hopefully make the difference. Having startups with substance in their business models and not fly-by-night ideas, like most had during the dot-com bubble.
Nevertheless, angels better be wary and proceed with caution as not every unicorn out there is tameable.