Technology Waves and Valuations: Are We in a Social Networking Bubble?
Note: This topic is partly related to the Hypernet but also related to where we are in the Social Networking cycle. It’s an atypical post for this blog, but a lot of readers asked me about this and how it might relate to my prior post on Technology Waves.
It was my last quarter as an Engineering student at Stanford. Since I had finished my requirements for a degree, I had a different academic and social focus than my first 3.5 years. I planned to go to Europe and stay in hostels with a Eurail Pass in the summer, so it seemed only natural to take a class on Italian Renaissance Art. Next up: Windsurfing for credit. Unfortunately, the course was fully booked, so I would not be able to benefit academically for my exploits on Lake Lagunita.
In what felt like a less exciting turn of events, an aspiring lawyer friend of mine talked me into taking an Intro class on Logic. I didn’t expect to like it very much, but since I was suspicious of lawyers for the most part, I thought it would be good to learn a few things about how they practiced their craft. I was really surprised at how cool it was. One of the topics that fascinated me was how people use logical and rhetorical fallacies to win an argument. My favorite example was the “false dilemma” which is also called the “either-or fallacy.” After that class, I learned to always be on the lookout for the various rhetorical weapons used by people to advance their agendas.
Are We in a Social Networking Bubble? A Question Based on a False Premise
In my opinion, “Are we in a social networking bubble?” is an example of a rhetorical fallacy. It assumes that social networking companies are either wildly overvalued like it’s 1999, or correctly/undervalued and there’s nothing to worry about. (As an aside, another favorite of mine is the question, “What’s more important, the team or the market?” The question falsely assumes that great teams aren’t more likely to find the better markets, but I digress.)
Framing questions honestly and in a truth-seeking way is one of the most important skills of the innovator or investor. My hope is to tackle the question of social networking valuations with this in mind. By mapping the typical progression of valuations and investor sentiment to technology waves, I hope to show that investors and the market almost never know how to correctly value important disruptive technology companies. I’ll also describe how I think investors make money during different phases in tech waves. Finally, I will suggest that entrepreneurs starting companies today are better served by finding the next coming wave, which Roger and I believe is the Hypernet.
Technology Waves Create the Fundamental Value
My point of departure for social networking valuations is the notion of technology waves, which I outline here. For those who want to skip that post, the core premise is as follows: The technology industry is unique because the exponential increase in performance of storage, processing and networking ensures that a new supply of game-changing companies will emerge on a regular basis. These companies usually cluster in waves, such as the PC revolution, client/server, the Internet, and social networking.
We have observed that these waves tend to follow a pattern. They start with infrastructure. Advances in infrastructure are the preliminary forces that enable a large wave to gather. As the wave begins to gather, enabling technologies and platforms create the basis for new types of applications that cause a gathering wave to achieve massive penetration and customer adoption. Eventually, these waves crest and subside, making way for the next gathering wave to take shape. (See the figure below)
In my view, technology waves are where the core value creation occurs in the technology industry. Value is created on the supply side because innovative startups create disruptive new products that exploit ongoing exponential price/performance improvements. Value is created on the demand side because customers come to recognize the value of the new innovations and incorporate it into their lives – gradually at first, and massively later.
Sentiment Waves Drive Valuations
But value creation is not the same as valuation. Valuations move like a sawtooth around the value that gets created when a new technology wave takes hold. (See the figure below)
In the early phases of a technology wave, massively powerful gathering forces exist below the surface, but only a handful of visionary technologists, entrepreneurs, and investors really see what’s starting to happen. I call this the Gathering Phase. At this point in time, new technology startups are typically undervalued and under-recognized, relative to their current and future potential value creation.
Eventually, people start to realize that something fundamental is happening. Many of us in the industry remember when people said, “Facebook may have a lot of traffic, but people are throwing virtual sheep at each other. How is that a business?” But in the latter half of the 2000s, people began to say, “Oh my gosh – Facebook is 1/3 of the entire Internet, is a monopoly private network, and will be a huge juggernaut.” This is when market sentiment and valuations transition to the Acceleration Phase. If strong but unseen undercurrents characterize the gathering phase, the acceleration phase is where sentiment catches up to and surpasses the reality of the technology’s value, creating varying amounts of “froth” in valuations.
Eventually, the wave of sentiment crests and people start to say, “These companies are comically overvalued. Time to sell.” This is the Correction Phase, which starts out with a correction back to rational valuations, but usually ends up falling even below what the companies are intrinsically worth. Eventually, the valuations bottom out and converge back upward to their rational values. But by then, the gathering forces of the next big wave are usually in place and the interesting opportunities for massive growth lie elsewhere.
Thoughts on the Gathering Phase
First off, I should go on the record and say that I really liked Fred Wilson’s post about “Herky Jerky” investing. In my opinion, great investors find a framework that plays to their strengths and stick to it in good times and bad, with occasional but infrequent opportunistic decisions to break the rules. Having said this, my favorite time to be a technology investor is at the Gathering Phase. Without getting too academic, I think this is the best time for investors and entrepreneurs to be non-consensus and right. An opportunity is created because there is a gap between the intrinsic value of new technology that’s being created and the World’s ability to recognize it. Since the world has not yet seen the future, there is an undersupply of startups and an undersupply of investors. In the social networking wave, the Gathering Phase started around 2002/2003 when the “PayPal Mafia” scattered and started exploring new concepts for the consumer internet.
The great opportunities during the ensuing couple of years were LinkedIn (well done, Reid Hoffman and David Sze), Facebook (kudos to Mark Zuckerberg, Peter Thiel and Jim Breyer), and Twitter (well-played Ev/Biz/Jack and Fred Wilson.) These visionary founders and investors saw the trend of social networking before others and had the conviction to back up their vision by building or investing in some of the early, defining companies of the wave.
Thoughts on the Acceleration Phase
Some founders and investors are better at playing the momentum game and this is where the Acceleration Phase comes into play. An opportunity is created because, even though valuations have become high, they are beginning to go even higher at a very rapid rate. Success in this phase involves three key factors: First, you have to have the ability to invest in the companies early enough in the acceleration phase so there is room for the valuations to accelerate upward quickly (congratulations Yuri Milner). Second, you have to have the “mojo” to get into the absolute best companies of the wave (way to go Andreessen Horowitz). Overpaying for close-but-not-good-enough is really dangerous and potentially fatal. Finally, you have to hope that you are able to exit in the acceleration window, before the correction occurs. Time will tell who exits at a profit if the acceleration continues and who gets burned if valuations correct.
There is a lot of evidence that we are in the Acceleration Phase of the social networking wave. Examples are an oversupply of startups, an oversupply of capital, faster investment cycles for venture funds, larger fund sizes for venture firms, the increased desire of public investors to buy into shares of private companies, and celebrities from Hollywood who have decided that they want to start tech companies and/or invest in them.
In my opinion, the Acceleration Phase of social networking started when Goldman Sachs bought a big chunk of Facebook in late 2010.
Thoughts on the Correction Phase
If valuations play out as I think they will, we will see a massive Facebook IPO, followed by many awesome exits by other compelling social networking companies. This will be followed by a set of exits and IPOs that are comically overvalued. Eventually the market will see this and the valuations will drop precipitously.
Emerging Tech Companies are Almost Always Priced Inaccurately
I hope that the scenario I am laying out does not seem alarmist. I am not worried about valuations per-se. In fact, my core argument is different. Namely, disruptive tech companies are almost always priced wrong. They are either undervalued because the mainstream does not yet have conviction about the value of new innovation, or they are overvalued because the world has become overly enthusiastic after understanding the implications. There are plenty of ways to make money during all of these times. The key is to be objective about what’s happening and about one’s own capabilities. In 1999, we had a bubble because the magnitude of the acceleration phase was extraordinary, but the cycle played out according to the same pattern.
Another related thought is that technology has been financed this way for the last 150 years. Railroads were financed this way, as was radio, TV, cars, and other technologies that eventually reached the mainstream. It seems that manias are the natural way for our economy to lower the cost of capital for innovative companies that emerge when a new disruptive technology takes hold.
Enter the Hypernet
What does this have to do with entrepreneurs and the Hypernet?
For entrepreneurs, the key message is to be really careful about doing a social networking startup in 2012. The social networking wave is about to crest. There are very few ideas and opportunities in this space that aren’t crowded. There will be many opportunities for “quick flips” based on momentum, but the oversupply of startups makes it a very risky time to start a company in this area.
Using the surfing metaphor from my previous post, we believe that the crowded beaches of social networking startups and the frothiness of the water make it more compelling to seek the next gathering wave. The Hypernet is still undersupplied and undercapitalized. But more importantly, it is a wide open, blue ocean opportunity that has not yet been defined and can therefore be the basis of huge companies in the future, rather than speculative startups that are trying to time an exit window before it’s too late.
- Value in the technology business is created by technology waves. The creation of value is driven on the supply side by the inexorable march of price/performance improvements in digital technologies. It is driven on the demand side by customers, who see the value slowly at first, but rapidly later, which leads to mass adoption.
- Valuations in the tech business start out by lagging the value that is being created in a new technology wave. This creates an economic “surplus” for people who are smart enough to perceive the wave before others. This occurs in the Gathering Phase.
- Valuations in the tech business eventually exceed the value that’s being created and reach a peak. This creates a different type of economic surplus for people who are able to invest in the very best emerging winners that are unavailable to typical investors. This occurs in the Acceleration Phase.
- Eventually, valuations come back to Earth in the Correction Phase. They fall to their rational values and even below for a while, but eventually converge back to their intrinsic values. However, by the time this happens a new wave is usually gathering.
- Entrepreneurs should be cautious about starting new companies in the middle of an Acceleration Phase of a cresting wave. Generally, they are better off finding the next gathering wave and a blue ocean of opportunity rather than building a speculative company in a sea of froth, based on a small idea that is designed to flip.
- The question, “Are we in a social networking bubble?” misses the point. The more important question is, “Where are we in the social networking wave, what is the valuation environment given where we are, what are the criteria for success, and what are the warning signs?”
After this post, I hope I never get asked about “bubbles” again :-)
For this post, I would like to offer a special thanks to the many legendary tech investors I interviewed in a 2011 “listening tour” about tech cycles. Specifically, I would like to acknowledge Arthur Patterson of Accel, Paul Ferri and Andy Verhalen of Matrix, David Strohm and Reid Hoffman of Greylock, Bruce Dunlevie of Benchmark, Dick Kramlich of NEA, Kevin Compton of Radar Partners, Peter Thiel of Founders Fund, and Marc Andreessen of Andreessen Horowitz.
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