Bubbles: get used to them
Two interesting articles got me thinking about bubbles and the tech sector: “The logic of crazy valuations”, in Techcrunch, and “Do high valuations for Uber, Snapchat and BuzzFeed herald a new tech bubble?”, in The Guardian. Bubbles seem to have been an integral part of the tech sector over the last two decades, prompting many pundits to wonder when the next one is due.
Technology is more exposed to the risk of speculative bubbles than most other sectors. We are talking about complicated decisions in which hunches often play a big part, along with expectation management that rarely stands up to a rational analysis of the scenario in question, within a fast-moving context, adoption dynamics that have little to do with science and subject to all sorts of random factors, and exit procedures that are not easy to anticipate.
When it comes to getting somebody involved in financing a project, there is no knowing how a possible investor will react: some people will pick holes and find fault with an idea way beyond the scope of the devil’s advocate. At the other extreme there are people who get fired up, ignore the problems, and hope that magical thinking will see the project through regardless of the evident difficulties.
In large part, the decision to get involved in a project or not depends on an investor’s knowledge of the sector, previous experience of similar ideas, and of course the belief that there will be a sufficient return on investment, but in many cases it is simply a question of luck, or an investor’s ability to bring interesting advice or something new to the party (not just money, but smart money), or a range of dynamics related to the team.
The mechanics of investing in tech companies is similar to other business, only faster and more volatile. The balance between risk and profitability is still very much a question of timing: joining a project during the seed capital phase can be enormously profitable, but comes with greater risk.
From that point on, the successive financing rounds depend on more traditional factors: as an idea becomes better known it becomes easier to get investment banks involved, until such point as the company goes public or is bought out. In the former, somebody pays up, allowing anybody who wants out to leave, and sets new rules for the future. In the latter, a range of investors who could not have joined until that moment come aboard, some might leave, and the company is then subject to the dynamics of the stock exchange.
Along the way, all sorts of other factors intervene, and things are rarely stable: trends change, as do users’ preferences, and adoption is conditioned by new developments, products and services, along with acquisitions and investment by potential competitors, or simply by unpredictable events. For an idea to become a good investment depends on many factors, and curiously enough, we are seeing with each day how the traditional idea of future cash flows, however much we take into account risk indicators are less and less of a factor.
Traditional concepts such as discounted cash flow, multipliers or betas have little to do with analyses of what the market might do. A financial analysis of the investments in companies like Snapchat, Uber or Buzzfeed make little since to traditional economists, in the same way that some of the best performing companies today would have done a few years ago. Some will create value in the next stage of the process, others will fall by the way, and we will continue to assess them on the basis of our understanding of the factors involved. Are there any absolute truths that make these investments either a catastrophe or an unqualified success? It doesn’t seem like it.
Seen in this way, bubbles need to be seen as an integral part of the eco-system, part of the landscape. Does this mean that we will have to put up with periodic bursts? Aside from the regular financial bubbles, a kind of purge, we have to accept that no risk capitalist, not even the best or most astute really know if an investment is going to provide them with the profitability they want or not, and in the absence of a methodology that would do so, , they are led by factors that range from seeing an opportunity, the ability to provide synergies that could take it to the next stage in generating value, an analysis of future scenarios, perceptions about the team, or other factors bordering on the cabalistic.
Of these factors, only a few can really be “industrialized”: as an investors reputation increases, so does his or her capacity to provide unique resources to a company. The rest is basically luck, personal experience and perception, and other factors that cannot be expressed on a spread sheet.
Sometimes, it’s a simple as hit or miss. And as long as the risk capitalist knows how to manage this difficult balance by making better decisions, he or she will be part of the ecosystem, helping finance projects and redistributing resources.
Until somebody comes along able to systematize the process by which some ideas generate value above rational expectations, and frankly, I think we are still a long way off, bubble will continue to be part of the tech scene. As in real life, bubbles are not for everybody: the majority of us prefer our water still rather than sparkling; that said, some days the waiter pays no attention to what we ask for and brings us a bit of fizz. And you know what, that’s not such a bad thing.
(En español, aquí)
