Surviving a Coming Storm: Explaining the Unique Factors Driving a Tech Market Correction, and How Technology Founders and Investors Can Persevere Through It

A close examination of both quantitative and qualitative data suggests that the tech market is reaching its peak, and that a correction is imminent.

More importantly, we may be underestimating the extent of a potential correction. This may be because we are using the incorrect metrics to compare it to previous corrections, in particular the crash of 2000, rather than evaluating the factors that are unique to this period.

We need to apply different analyses that take into account the amount of capital that has been invested in the venture capital industry; the size of companies at IPO and their impact on public markets; the quality of their underlying business models; and the new corporate governance reality that has emerged.

This article is an attempt to unpack those factors, explain how they may manifest themselves in the technology market over the next few years, and describe potential implications for technology investors and founders.

1. Weak Business Model Quality of Several Newly-Public Companies, Combined with their Large Size, May Trigger a Public Market Correction

Many industry participants have suggested that the current technology boom is fundamentally different than the Internet bubble of 2000, and they are correct in many ways. As an example, Dana Cimilluca of the Wall Street Journal cited the size and age of newly-public companies to suggest that today’s IPOs are of much higher quality than their dotcom brethren. Compared to 1999, the median newly-public company of 2018 is more than 3x older, and more than 10x larger in revenue, than the median newly-public company of 1999 and 2000. [5] The chart below from the Wall Street Journal, shows the significant growth in median revenue at IPO between 1999 and today. Others have cited additional factors such as the quality of customers and sizes of addressable markets to argue why today’s crop of IPOs is fundamentally better than that of the 2000 timeframe.

The most relevant metric for comparison between the periods is one that reflects business model quality: profitability. On that basis, the two periods have striking similarities.

The 2019 class of IPOs is actually the least profitable since the tech bubble of 1999. Only 24% of the 2019 technology IPO companies have been profitable, compared to 21% of the 2000 IPO class. [6]

While unicorns are not as dramatically overvalued on a multiples basis compared to 2000, they are much larger in size. This increased size means that it doesn’t require nearly as many to decline in value or go out of business to impact the market.

As shown in the table below below, in Q2 2019 the proceeds of the average IPO ($669m) were more than 3x the size of the average IPO of 1999 ($197m). And the differences are much more extreme when it comes to the largest unicorns. As an example, Amazon’s valuation at IPO was $300 million, while Uber’s valuation was $82 billion. Uber was valued at almost 300x Amazon’s market cap at IPO.

2. Dramatic Growth in the Amount of Venture Capital Raised by Funds and Deployed in Private Companies May Erode Overall Industry Returns, Despite the Power Law Distribution

There is a simple mathematical equation between capital invested in the private markets and the capital realized via public and private exits. What goes in, must come out. Not only that, capital must come out at a multiple of what went in, to account for the risk.

When the amount of capital returned is substantially less than the amount invested, the market corrects via an exodus of capital out of an asset class.

However, there is a long lag time in this equation when it comes to the venture capital markets. This is due to the delay between the time when capital is invested in venture funds, then subsequently invested in private companies, and then finally realized via exit events. The typical life cycle of a venture fund is ten years, and it can actually take twelve to fifteen years for a fund’s total returns to be realized.

Even if VCs owned 100% of all exited companies, the class still wouldn’t reach a 3x overall multiple when comparing the amount of venture capital raised in 2018 to cumulative exit values in 2019, a peak year. Future years would have to generate a much greater level of exit value.

This doesn’t mean that all VCs will have poor returns for vintage years between 2017 and 2019. Venture capital follows a power law distribution, where the best funds capture the majority of returns of the asset class. This can be seen in the chart below, which shows the historical Cambridge Associates venture capital benchmarks from 1994 to 2017. As can be seen, top-quartile funds significantly outperform lower-quartile funds across periods.

3. Relaxed Financial Controls and Corporate Governance Have Made it More Difficult to Curb Excesses

An additional signal of an overheated private market is corporate governance controls becoming less stringent. Why does this occur? In a market where capital is scarce, investors can insist on governance controls because they have leverage. In a market where capital is abundant, entrepreneurs who don’t want these controls can seek alternative capital from investors who don’t require them. To win deals, investors are willing to set these controls aside.

4. How These Factors May Result in a Technology Market Correction

Several top tech investors have predicted a technology market correction for some time. Bill Gurley, for example, has been arguing for almost five years now that we are in a bubble, due to excessive capital and high valuations. So why hasn’t it happened yet?

The first reason is that the public markets are a much stronger corrective mechanism than the private markets, and companies are only now reaching the public markets due to the huge amount of capital that has been available in the private markets.

Founders and investors have argued for several years now that the proliferation of late-stage funding has been a good thing, because founders can grow their businesses without the constraints of reporting public earnings and short-term oriented investors. They also argue that the private markets are better at fostering innovation and risk-taking.

5. Important Implications for Technology Investors and Founders

There are many compelling arguments for why this period is fundamentally different than the dotcom bust, and why a tech market correction will be much more moderate in size in the coming years. At the same time, founders and investors should consider what a new normal might look like after this long period of market expansion.

  1. See “IPOs have their best quarter in years in terms of performance and capital raised”, CNBC, at https://www.cnbc.com/2019/06/28/ipos-have-their-best-quarter-in-years-in-terms-of-performance-and-capital-raised.html.
  2. See “Corporate Tech Spending Helps Lift the U.S. Economy,” Wall Street Journal, at https://www.wsj.com/articles/corporate-tech-spending-helps-lift-u-s-economy-11569367000.
  3. See “What Really Fueled the 2019 Unicorn IPO Funeral”, Yahoo Finance!, at https://finance.yahoo.com/news/whats-really-behind-the-ipo-unicorn-funeral-142210130.html.
  4. “Goldman Sachs is sounding the alarm: Tech stocks are overvalued,” USA Today, at https://www.usatoday.com/story/tech/2019/06/17/goldman-sachs-says-technology-stocks-overvalued/1483689001/.
  5. See “The 2019 IPO Frenzy is Different from 1999. Really.” https://www.wsj.com/articles/the-2019-ipo-frenzy-is-different-from-1999-really-11553918401.
  6. Kate Rooney, “This Year’s IPO Class is the Least Profitable of Any Year Since the Tech Bubble,” CNBC.com, at https://www.cnbc.com/2019/09/18/this-years-ipo-class-is-the-least-profitable-of-any-year-since-the-tech-bubble.html.
  7. See “Startups Selling to Other Startups: A House of Cards,” TechCrunch, at https://techcrunch.com/2016/02/11/startups-selling-to-other-startups-a-house-of-cards/
  8. “Quarterly U.S. Venture Capital Investments 1995–2017”, Wikipedia, at https://en.wikipedia.org/wiki/Venture_capital#/media/File:US_VC_funding.png.
  9. After reaching this high-water mark, the venture capital market cratered in 2001, with only $40B invested, and further shrunk to a little more than $20B invested in 2002 as the technology markets collapsed.
  10. See “Venture-backed Exit Activity Hit a Quarterly Record $138.3 Billion in 2Q 2019”, https://pitchbook.com/media/press-releases/venture-backed-exit-activity-hit-a-quarterly-record-1383-billion-in-2q-2019.
  11. Two articles are “The Perils of Lyft’s Dual-Class Structure”, by by Lucian Bebchuk and Kobi Kastiel, at https://corpgov.law.harvard.edu/2019/04/03/the-perils-of-lyfts-dual-class-structure; and “The Perils of Pinterest’s Dual-Class Structure”, by the same authors, at https://corpgov.law.harvard.edu/2019/04/10/the-perils-of-pinterests-dual-class-structure/.
  12. Kosmas Papadopoulos, “Dual Class Shares and Company Performance”, at https://corpgov.law.harvard.edu/2019/06/28/dual-class-shares-governance-risks-and-company-performance/.
  13. Ibid.
  14. Ibid.
  15. See “S&P and FTSE Russell on Exclusion of Companies with Multi-Class Shares”, Camberview Partners, at https://corpgov.law.harvard.edu/2017/08/05/sp-and-ftse-russell-on-exclusion-of-companies-with-multi-class-shares/.
  16. See “Softbank’s Plans for Second Mega-Fund Hit by WeWork Debacle”, Reuters, at https://www.reuters.com/article/us-softbank-group-visionfund-insight/softbanks-plans-for-second-mega-fund-hit-by-wework-debacle-idUSKBN1WJ0AA.
  17. See “Masa’s multi-generational vision is running into a brick wall: the public markets”, at https://www.cnbc.com/2019/09/07/uber-wework-and-slack-public-valuations-show-softbank-vision-flaw.html.
  18. See “The Twenty Minute VC: Bill Gurley”, transcript at https://davidsnotes.substack.com/p/bill-gurley-on-why-the-abundance-212.
  19. “The $1.7 trillion dot.com lesson,” CNN Money, at https://money.cnn.com/2000/11/09/technology/overview/.
  20. See “The 2019 IPO Frenzy is Different from 1999. Really,” Wall Street Journal, at https://www.wsj.com/articles/the-2019-ipo-frenzy-is-different-from-1999-really-11553918401
  21. See “3 Things Founders & VCs Should Know About Building Billion-Dollar Startups During Market Uncertainty,” 645 Ventures, at https://medium.com/@645ventures/3-things-founders-vcs-should-know-about-building-billion-dollar-startups-during-market-fdabeb72044e.

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