Is the Bubble Ready to Burst?

A non-tech investor recently asked me if I thought the tech market was heading for a crash. "Yes" I replied without hesitation. 

The current tech market and environment has all the warning signs of a crash coming, its just a question of if we choose to get ready for it, or ignore it on the basis that there are still gains to be made right up to the moment it goes bang. It isn't the same as the dot.com burst of the late 90's but the same signs are there and a large part of the tech market seems happy to ignore what's on the horizon.

A combination of rapidly increasing share prices, market confidence that the companies will turn future profits, individual speculative activity in shares, and widely available venture capital has created an environment in which many investors were willing to overlook traditional metrics, such as P/E ratios, in favour of basing confidence on technological advancements.

So what am I basing my future prediction of a tech-bust on?

The current "Unicorns" need to go public to provide their investors with a return on that investment and keep confidence in the market. A small number could be sold but at a certain top-line valuation this is particularly difficult - there aren't that many buyers. The Unicorns are growing revenues very aggressively which is a positive but the question is more over their ability to generate a profit. They are raising new monies constantly and burning most of the money to maintain the growth curve. Ultimately they will need to show a path to baseline profitability with attractive margins to justify their valuation. Sceptical doesn't describe it with me, I'm sure that a lot will not end up being sustainable and its at that point that the confidence will collapse.

Many Unicorns - darlings of the stock market - and other privately held companies will be shutting their doors as they find it impossible to raise more cash with their bloated capital structure and their huge infrastructure costs. Any smaller or more nimble company that can actively cut costs to get at or near profitability will survive but many will not.

I still think that the best way to understand the current situation is to hark back to the last downturn. Mark Cuban (His Broadcast.com company sold for $5.7 billion several months before the dot-com bubble burst) recently said that there is no question whatsoever that we are in the midst of another one. The key piece of learning from the last one? There is no doubt that a lot of people will be devastated when it pops. 

“The biggest of all losers will be anyone who has borrowed money to invest in private companies,” he said. “You were stupid. You blew it. You lost. That simple.” - Mark Cuban

A Perfect Storm?

Absolutely. The start-up market is overheating.

Funding a tech start-ups has never been this easy! One of the prime causes has been because of mutual funds and hedge funds getting in on the action, altering not only the funding landscape for tech start-ups, but also the equation by which valuations are created and therefore expectations.

The concern is really around the valuations for businesses that are defying explanation and negating the established wisdom. Entrepreneurs and investors are deviating from more traditional valuation methods and performance metrics to more radical ones. Another cause quoted for increasing valuations is the trend of protections for late investors that cause valuations to inflate further. These conditions have put the market into a state of very inflated and artificial valuations.

The companies themselves are burning through cash like there is no tomorrow. Throwing money at every aspect of marketing, infrastructure and, in particular, salaries has become the accepted investment strategy for start-up growth - everyone wants a Unicorn. All this perpetuates the vicious cycle of raising more money and spending more money. For the amounts that some of these businesses have raised, there is extreme scepticism on actual profitability.

Where does this end?

As to if the unicorns are in some kind of tech-bubble - I'm not sure. There is so much money vested in their success its likely that more money will just find its way into their eco-system. I'm hesitant to say to-big-to-fail but close. Companies further down the scale are very likely to fail if confidence falls, new money will dry up or only go to the unicorns. Confidence is everything when it comes to investing.

In any gold rush the people who make the real money and the people who build the picks and shovels. A lot of the infrastructure providers have had a long stretch of capacity development through overspending by VC backed companies. They are the real winners.