Silicon Valley’s startups are being asked to justify investments that have valued them in the billions of dollars. Is this the next dotcom bubble?
The Bill Graham Civic Auditorium in San Francisco, a venue most often associated with rock concerts and sports events, has more recently been commandeered by Silicon Valley’s biggest names.
In September, Apple put on its glamorous iPhone launch event at the 7,000-capacity building. Jack Dorsey’s Twitter held Flight, its developer jamboree, there. And last week, as if to establish itself as another of the tech world’s most important players, internet storage business Dropbox took over the centre for Open, its first major customer conference.
Drew Houston, Dropbox’s 32-year-old founder, was flanked on stage by Silicon Valley big shots, including Apple’s Eddy Cue, HP’s Meg Whitman and Salesforce’s Marc Benioff, as he reeled off a series of statistics aimed at proving wrong critics of his business.
It was a rare defensive position for a private tech company, which attracted a $10bn valuation less than two years ago. But analysts are now questioning whether that valuation was deserved.
Some pundits have even predicted that Dropbox will be the most high-profile victim of a new kind of dotcom bubble, in which the cheap and easy money that has inflated private valuations runs out, leaving start-ups scrambling to adjust to a new reality.
In 1999, hundreds of tech firms flocked to the public markets, with a rush of investor enthusiasm valuing companies often without any real business model in the hundreds of millions of dollars. When confidence collapsed, so did share prices, with many shareholders losing their life savings and some companies folding.
This year, in comparison, has seen a dearth of floats, but dozens of start-ups achieving “unicorn” status, meaning a private valuation of $1bn or more.
While Amazon and Yahoo! floated at less than $500m in the Nineties, the combination of low interest rates hitting yields from other investments and the prospect of huge returns has fuelled an explosion of capital from private investors.
This has allowed companies such as Dropbox, Uber and Airbnb to stay off the stock market for far longer than they previously might have.
According to CB Insights, there are now a record 143 unicorns, with a combined valuation of $508bn.
While the mere existence of lots of highly valued companies is no indicator of a bubble, aspects of the environment are worrying some investors. Private valuations have become detached from public ones.
While a listed company’s market capitalisation reflects what shareholders value it at, private valuations work differently.
Most unicorn investments, rather than consisting of traditional risk-carrying equity, come with heavy insurance policies that allow investors to guarantee a return even if expectations are not met.
Late-stage investments come in preferred stock, giving investors special rights to assets if a company fails, as well as prioritised returns when it eventually floats or is bought. These insurance policies allow valuations to be jacked up tremendously.
“It’s all notional money, Excel spreadsheet money,” says one venture capitalist.
When a start-up is growing rapidly, this phenomenon does not matter too much. But should momentum stall, it can become a problem.
Dropbox, which has raised more than $1.1bn, grew rapidly after it was founded in 2007.
Hundreds of millions of consumers use its software, which is free up to a point, and then costs a monthly fee.
The company’s main target has become business customers, which pay a pricier per-employee rate.
Dropbox presents a vision of an effortlessly connected workplace, in which employees replace emails with online collaboration. But it has faced heavy competition from the likes of Google and Microsoft, which has dramatically driven down the costs of online storage.
Analysts have questioned Dropbox’s ability to convert its huge consumer base into paying businesses, and some argue that its key product has become commoditised.
Houston sought to dispel this scepticism last week. He announced that 150,000 businesses are paying for Dropbox’s corporate product, including big hitters such as Facebook, Spotify, and News Corp. “This is an incredibly powerful business model,” he said.
Other high-profile tech startups are facing questions about their viability. Evernote, an online note-taking app that received a $2bn valuation in 2012, has laid off almost a fifth of its staff recently.
Theranos, a blood-testing biotech startup with a $9bn valuation, has been hit by allegations that its tests don’t live up to the hype.
Of course, public companies have their downturns too. Twitter has endured a tumultuous two years in the public eye as a listed company, for example. And if startups have been valued too highly, it only really begin to matter when they need to raise funds again.
At this point, though, they run into serious trouble. On Friday, Square, the online payments company ran by Twitter founder Jack Dorsey, set its IPO price range at $11 to $13, below the $15.46 of its last funding round in October.
But to ensure that investors in that last round did not lose out, they were guaranteed a return of $18.56 a share. As a result, they will be granted more shares, diluting the stakes of staff and founders.
Deezer, the loss-making French music streaming service, delayed plans to raise €300m (£215m) in an IPO last month, blaming “market conditions”. This isn’t an isolated case. Tech IPOs in 2015 have made up the lowest proportion of all listings in the US for six years.
Should interest rates going up dampen demand for IPOs further, highly-valued startups could find themselves stuck in a valuation trap.
As Square has seen, going public without a valuation significantly above the previous funding round can carry its problems. But raising more money privately also means handing out even more of these preference shares, making an eventual IPO harder again.
Houston laughs off suggestions that Dropbox has been valued too highly, and says the company has no need to raise more money.
“This speculation [about private valuations] is like playing fantasy football without any of the statistics,” he says.
“It’s just everybody’s opinions about opinions. It doesn’t bother me. We’re in a huge market and this is super early. We’ve raised plenty of money so we don’t really need to [IPO]. The gas tank is full and we don’t obsess about when we’re going to go to the gas station.”
Investors, meanwhile, appear to remain supportive. One venture capital backer says that Dropbox can be a $100bn company, claiming that short-term discussions about valuation miss the enormous opportunity the company has to convert its almost half a billion users into massive revenues.
It is certainly true that sceptics have been repeatedly proven wrong about many tech valuations. Facebook’s $15bn valuation in 2007 raised eyebrows; last week it passed $300bn as a listed company.
Five of the world’s seven biggest public companies – Apple, Google parent Alphabet, Microsoft, Facebook and Amazon – are technology groups. Given this, perhaps it is no wonder that private investors are willing to put unprecedented cash into today’s tech startups.
For those that pick the winners, the rewards are bigger than ever, but there are likely to be a few dead unicorns along the way.