While it makes for sensational headlines, we aren’t in any sort of technology bubble right now so let’s just stop calling it that. After watching The Big Short recently, I was reminded what a bubble actually looks like.
Exhibit 1: this is a tulip.
It’s a very nice looking flower and the family of tulips come in a variety of colors and shapes. While you might pay a good amount for a bouquet of tulips, it’s reasonable to think that there is a limit to how much someone would pay for even the nicest of tulips.
But that wasn’t true during the period of the tulip mania during the Dutch Golden Age. This period is now recognized as the first major economic bubble recorded in history.
At the peak of tulip mania, some single tulip bulbs sold for more than 10 times the annual income of a skilled craftsman.
The point is that people were willing to pay an increasingly large amount for an asset that clearly had very limited ability to increase in value. In fact, it’s likely to decrease in value because, well, plants die. That is a bubble.
Exhibit 2: this is a house.
It’s not a castle, but this would be considered a very nice house in the U.S. During the housing crisis, as detailed in the movie and book The Big Short, the value of the mortgages backing houses around the country would continuously increase. Mortgages would get refinanced by banks at ever more attractive rates with the logic that housing prices go up most of the time.
Yet, if you look at a house, it has a pretty limited ability to increase its value. The paint doesn’t get prettier, the wood doesn’t get younger, the yard doesn’t produce vegetables or fruit, the roofing doesn’t get nicer on its own.
During the mortgage crisis, people created layers upon layers of financial instruments on top of the underlying houses. For each house, there were hundreds of times the value of the house represented in other financial instruments. People were betting with 100 to 1 odds in some cases that the price of the house market won’t go down by a certain percentage.
To translate that situation to startups would be like me betting my friend $100 dollars that Fidelity won’t mark down a particular portfolio company next month but on top of that also gave her 100 to 1 odds. Meaning I’d be on the hook for $10,000 if there was a mark down. Multiple this by every startup you can think of and countless derivative bets between people all over the world on the prospects of these companies with 100 to 1 odds. Now that would be a real bubble.
While the values that we ascribe to technology startups seem very high today, the companies are working every day to increase the value of their products or services. Unlike tulips or houses, companies have the ability to constantly evolve and grow in value.
The value assigned to startups are a general prediction of their future prospects, meaning their future revenues and profits. Sure, some assignment of value for startups are wrong. And some companies will go out of business. But as a portfolio of companies for both an individual VC and for the market at large, the values are based on the dynamic growth of technology and the value of new products and services.
In five years:
Will we have fully autonomous vehicles on the road? Likely.
Will drones deliver packages? They already do. It just needs to be legalized.
Will more people using the Internet and mobile technology? Of course.
Will more business transactions happen digitally? Certainly.
Will more jobs be automated? Yes, it’s happening every day.
Will we go to Mars? Give it another ten years, but that’s also very attainable.
Will those tulips you bought be prettier in five years? No, they’ll all be dead.
Will your house’s shingles, paint, interior look better in five years without spending significant money cleaning and taking care of it? It’s nice to dream of this, but no, that won’t happen.
The housing crisis was a multi-trillion dollar global problem where the underlying assets were really worth a tiny fraction of that and had no hopes of increasing in value.
Luckily we have not created a gigantic, unwieldy, opaque derivative financial market for startups. Unlike mortgages, there aren’t $100 or $1,000 worth of side bets for every $1 of startup value. Instead, there is only an $1 bet for every dollar of startup value.
The term bubble implies a mania or a screwy way assets are being valued by themselves or through derivative financial contracts. Today, we are valuing technology startups the same way we have always valued companies, by their future growth prospects. Some valuations might be wrongly high, but that error could occur with any company.
There is a difference between companies with high valuations and a financial and economic bubble on a national or global scale.
Rather than worrying about whether we are in a technology bubble or not, I’m much more interested in finding the entrepreneurs and companies who will continuously build long-term value in the world.
— Li Jiang @gsvpioneer
