Bubbles are never strictly identical, as several elements of this five-part series will underline. Yet, this first article explains that there are striking similarities between the dotcom craze of the 1990s and today’s rearing of unicorns.
Twenty years ago, the Internet bubble peaked when the Nasdaq reached an all-time high of 5,048.62 on March 10, 2000. The index spent the ensuing two and a half years testing new lows, before hitting bottom on October 10, 2002. That translated into a 77% correction. It took more than 15 years – until April 2015 – for the Nasdaq to revisit its March 2000 levels.
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To this day, no one really understands why the cycle peaked then. The logical yet unsatisfactory cliché that prices stay high until someone has to sell might well apply to the current bull run.
The New New Economy
From dot-bombed (Webvan, eToys) to Uniconned start-ups (Theranos, WeWork), it is not unreasonable to draw parallels between the New Economy and the gig economy.
The digitization of products and services is an on-going process. In 2000 every pure Internet start-up claimed to be revolutionizing (today, we would say ‘disrupting’) the traditional (read, ‘bricks-and-mortar’) channels. But what the likes of ETrade, TheStreet.com and Amazon were doing was to migrate existing features and functionalities online. They didn’t kill Charles Schwab, the Wall Street Journal or Walmart, despite what was widely predicted at the time.
For the same reason, today’s fintech unicorns - from Robinhood and Ripple downwards - and platforms like Airbnb will not replace Bank of America Merrill Lynch or Hilton any time soon. At best, these technology platforms will become fierce rivals to the incumbents. In other cases, they will crumble under heavy losses or be absorbed by cash-flow-positive operators.
There are simply too many mobile-only banking service providers, just like there were too many online brokers in 2000. When day trading fell out of fashion, the industry experienced a phase of consolidation. The same is likely to happen to today’s mobile apps. Consumers register with several services the way they carry a multitude of credit cards in their wallet. It doesn’t mean that they use them all in equal proportion or that they are willing to switch bank.
Both dotcoms and unicorns are scale businesses. Customer acquisition costs are the key variable in a digital enterprise’s operating structure. Amazon, Facebook and Twitter eventually became profitable thanks to their large user base. The main hope for today’s start-ups to break even is to establish market dominance.
So they need to grow into their nosebleed valuations by outspending rivals. Whoever blinks (or runs out of money) first will perish. Few VCs have stopped to consider which fintech platform has the most compelling technology or strategy. They know that the operator able to attract the broadest user base is most likely to survive. That platform can then take the time necessary to fine-tune its business model, improve customer service and make it operationally efficient.
Once established as the leading provider in its vertical, a start-up can afford to reduce its advertising budget. By mid-2000, Amazon’s key competitive edge was not its marketing budget, it was word of mouth. At that juncture, half its new customers came through the website thanks to the strength of the Amazon brand. Airbnb and Uber enjoy the same advantage but the phenomenon occurs on a different scale. In 2000, when companies were being ‘Amazoned’, they were losing to a smaller, nimbler rival. Today, when they are being ‘Uberized’, incumbents are losing to a much larger competitor.
Piling Up Losses
The dotcom boom was a bit of a mirage, with many IPOs occurring pre-revenue cum operating losses. Today’s tech start-ups are better at generating sales, but they are also more inclined to rack up billions of dollars in losses.
It is a lot easier to generate revenues than to turn a profit. And it is a lot easier to manufacture a profit - by inventing new definitions of profitability as WeWork did by reporting a community-adjusted EBITDA - than it is to produce positive operating margins on a recurring basis.
So, for the time being, start-up entrepreneurs and investors have adopted the strategy of the dotcom days: launch innovative business ideas and grow the top line exponentially even if it means racking up losses. The secret behind such a strategy is to ensure almost unlimited access to financing. Excess is back.
Venture Capitalists As Sugar Daddies
Pundits rightly observe that 2019 did not record anywhere near the total sums invested in 2000 - $108 billion vs. $188 billion, respectively. They conclude that today’s bubble remains tame by comparison. But according to data compiled by CB Insights and PwC, the amount of venture capital invested across the US in 2015-19 totaled $446 billion, which exceeds the sums invested at the peak of the dotcom era - $338 billion between 1996 and 2000.
Expansion in early-stage funding is driven by the VC investors’ desire to grow start-ups while holding onto them longer, as the next few articles of our series will highlight. Logically, this strategy requires larger sums of capital since VCs back portfolio companies for several more rounds of financing. Nonetheless, given the level of overspending the early days of the Internet witnessed - from overbuilt dark fiber to obscene Super Bowl advertising budgets - there is a similar risk of overcapacity in today’s emerging technology sectors.
Unfortunately, raising larger amounts of capital is not necessarily good news for founders, for it usually has one major drawback: diluting the stake they hold in their own company. Luckily for some, much like deal terms became unusually advantageous to entrepreneurs in the late 1990s, similarly generous funding structures are currently being offered, especially to the most sought-after entrepreneurs. On paper, like their Internet predecessors, today’s wunderkinds are reported to be worth millions, if not hundreds of millions.
Deal competition, not just for the hottest Silicon Valley start-ups, but also across the country (as recently humbled New York-based WeWork and mattress distributor Casper demonstrate), has intensified. VCs are falling over each other to offer the most entrepreneur-friendly terms in order to gain access to the best transactions. Frequently, they accept terms that fail to protect the interest of the institutional investors whose money they manage, for instance by reducing their influence on the board.
Choosing Between Economics And Control
As was the case twenty years ago, some founders today argue that VCs should not be entitled to liquidation preference - the key equity instrument venture capitalists are issued as downside protection. But the purpose of liquidation preference is not just to make the economics more appetizing; it also enables start-ups to keep raising money in the later stages of development when valuation metrics can get off-kilter. SoftBank would not have agreed to invest in WeWork at a $47 billion valuation in late 2018 if the Japanese group had not been issued liquidation rights (and an anti-dilution ratchet).
Entrepreneurs also try to avoid excessive dilution by issuing convertible bridge loans, sometimes for multiple rounds, and pricing them at a discount to an upcoming round of equity funding, which should be closed at a much larger valuation. These sorts of inflationary practices occurred - to a lesser degree - during the dotcom days, and when the tide turned, VC owners reverted to pure equity rounds at more reasonable valuations.
For now, many start-up founders can take advantage of the desperate search for yield. When the funding cycle turns, as it is bound to do eventually, we should expect the balance of power to swing back in favor of investors. In the vortex of 2000-04, liquidation multiples of 2x to 3x the original investment were not uncommon. There were instances of 10x multiples in extreme situations as so many dotcoms failed to meet expectations. By March 2000, well over half the Internet companies floated on the stock market the previous year were trading below their offering prices. Recent tech IPOs have adopted that trend too.
In the next two articles of this series, we will review the main differences between the dotcom and unicorn bull runs