How the tech-stock valuation curve inverted

July 29, 2012

Is a bubble bursting in Web 2.0 stocks? The NYT says there is, and says indeed that this implosion is even more dramatic than the one we saw in 2000. In reality, of course, it isn’t.* In 2000, trillions of dollars of wealth evaporated as the share prices of thousands of companies plunged to earth; in 2012, by contrast, we’re talking about a mere handful of companies, including Facebook, which, with its $65 billion market cap, still looks pretty well valued to me.

That said, most of the public self-described “social” companies — with the prominent exception of LinkedIn — have indeed seen their share prices hit hard of late, to the point at which many recent private rounds look decidedly rich. The result is that there’s a pretty strong case to be made that we have what you might call a steep inversion in the valuation curve.

In general and in aggregate, corporate valuations are meant to rise over time. There’s a lot of volatility in the process, of course, and individual companies go bust all the time. But in the Silicon Valley model, companies begin as startups at relatively low valuations, and then as they raise more money in successive rounds, their valuation steadily rises. Eventually, if and when they go public, they’re worth so much that anybody who bought in during one of the private rounds will be sitting on a nice profit.

That’s not just a matter of growth over time, either: it’s also a matter of a much larger investor base. There are only a relative handful of individuals and institutions who buy into private rounds; in contrast, there are millions of investors around the world who can buy stocks listed on public markets. If the number of people bidding against each other to buy equity in any given company suddenly rises by many orders of magnitude, it stands to reason that the price is going to rise as well.

With the latest crop of tech stocks which have gone public, however, that hasn’t been the case — despite what seemed to be enormous appetite, for Facebook stock in particular, from investors all over the world. Instead, even if valuations are still getting steadily richer from round to successive round in the private markets, there’s no a significant drop at the end of the curve — the point where private markets go public.

So what’s going on? The answer, I think, can be found in the psychology of the dot-com bubble. Back then, there were a lot of people making enormous amounts of money by investing in technology stocks. You’d put together a portfolio of tech stocks, the portfolio would rise in value, and you would conclude that you were doing very well, and therefore buy ever more tech stocks. After all, your brokerage statements were proof positive that you knew exactly what you were doing, and were very successful at it. A bull market, especially a soaring bull market, creates confidence and momentum and inflows.

Turn that story on its head, and you wind up where we are today. There are still dedicated technology investors and funds in the public markets, but all the top technology investors have moved, at this point, to the private markets. If you’re in the public markets, your performance has been mediocre for over a decade, and you’re liable to take any brief buzz-induced inflow of funds into the sector as an opportunity to cash out and make a rare and precious profit.

In theory, the fact that the public markets are so much bigger than the private markets should be great for any tech company going public which cares mostly about its valuation. There’s a finite number of shares out there, and the demand for those shares is now vastly bigger than it was. Therefore, price must go up.

In practice, however, it doesn’t work like that. Instead, we have a very small pond of private investors, where valuation momentum can pick up incredibly quickly. But the minute the gates come down and the company’s valuation wave spills into the ocean of the public markets, it just gets absorbed into the broader tech-valuation sluggishness, and disappears.

Yes, Facebook had a very large IPO, but it was always a bit ridiculous to hope that a single offering could change the psychology and momentum of the entire technology sector — even if it had gone well, which of course it didn’t. Stock markets are moody animals, and they don’t like being told how to behave by Sand Hill Road types with an eye to a big payday. The tech sector might turn around and begin a rally at some point. But chances are, that point won’t come until after Silicon Valley’s VCs have been properly chastened.

*Update: I apologize for mischaracterizing the NYT article; it did not say that the current pop was as loud as the one we all heard so loudly in 2000. I misread the article, or read it too quickly. Sorry.


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