Is there a Silicon Valley startup bubble building? Control Shift

Imagine, for a moment, a company that has never turned a single cent in profit. It either has not launched a product yet, or it has a product it gives away for free to a growing user base. Either way, it currently has no viable business model.

By most traditional measures, such a company would not be classed as successful. After all, the most basic fundamental of a successful business is that it sells goods or services to customers for more than the cost of production or procurement.

So how much would such a company be worth?

In the world of Silicon Valley, potentially well over a billion dollars. In the case of WhatsApp, Facebook’s answer was a staggering $US16 billion ($A17.3b)

It’s not surprising that a growing number of analysts are warning there’s a bubble in Silicon Valley.

So what are the factors driving such ridiculously high valuations for businesses with no proven business model, and what are the risks ahead?

To understand the answer, it’s important to look at the three key ways investors hope to cash in on their tech startup investments, even if those startups have no established business model, and examine the vulnerabilities at play.

Selling to a tech giant

The first way investors in tech startups seek to cash in is by being bought out by another tech company.

The likes of Apple, Samsung, Google, Facebook, Twitter, Yahoo!, Intel, Oracle, Microsoft and others have all purchased tech startups in a bid to either acquire or “acqui-hire” key engineering talent, secure new products and services, or to shut down possible disruptors to their existing businesses.

In the case of Apple and Samsung, this has been fuelled by the ridiculous margins of smartphones and tablets, with Apple recently reporting a quarterly profit of $US10.22 billion.

Another major revenue source for established tech giants, in the case of Google, Facebook, Twitter and Yahoo!, is online advertising. Facebook reported quarterly net income at $US642 million, while Google reported a “disappointing” $US3.35 billion.

The big risk to tech startup investors on this front is that smartphones and tablets increasingly become low-margin commoditised products, wearables and other new classes of gadgets fail to catch on with consumers, the online ad market dries up, or that increased competition reduces profitability of cloud service providers.

A weaker tech market for any of these reasons would reduce the ability and willingness of established tech giants to buy promising tech startups.

There are potential feedback loops as well. For example, during the ’90s, many tech startups opted to advertise online, boosting the bottom line of online ad sellers like Yahoo!, which in turn used the increased share valuations and revenues from online ads to buy out tech startups. It’s not surprising to note the online ad market imploded with the tech bubble, taking several previously profitable online companies along with it.

Selling to a non-tech company

It’s not just the tech giants in the market for tech startups, however.

Many non-tech companies are buying out startups that are disrupting their businesses. Examples here include traditional media companies buying digital publishers or the recent acquisition by Walmart of a little known food app developer in the US. On this front, existing investors will want to see a return on investment and will grow increasingly wary of such deals if no returns are delivered.

Going to an IPO

The third way investors cash in is by listing on the stock market. On this front, especially when it comes to social media stocks, the markets have been jumpy of late – and with good reason.

The price earnings ratio of a stock is its current stock price divided by its earnings per share.

Despite recent falls, LinkedIn closed on Friday with a price/earnings ratio of an eye-popping 709.28. This compares to an established tech company like Google at 27.04 or blue chip retailer Wesfarmers – the parent company of supermarket chain Coles – at 20.83.

In effect, the market is betting that LinkedIn’s earnings will multiply by 34 in order for the company to achieve the same stable level of a blue-chip like Wesfarmers.

In short, the price of some recently listed tech and social media stocks have prices suggesting some heroic assumptions about their future earnings.

If the price of some of these social media stocks flatlines, it will not just hurt the market’s appetite for future tech initial public offerings. It will also hurt the social media companies’ ability to use their stock to buy out tech startups.

Consider, for example, Facebook’s takeover of WhatsApp consists of $US4 billion in cash, alongside $US12 billion in stock. As of Friday, Facebook’s stock was trading at a price/earnings ratio of 74.66.

Deals like that in the future will depend on Facebook’s stock price remaining high.

Conclusion

When a venture capitalist invests in a tech startup, she or he is ultimately betting on the ability to cash out down the road, either by selling that business, often to either another tech company, a non-tech company, or through an IPO.

However, it is by its very nature a highly speculative market. For every investment ending in an IPO or a major takeover, nine will fail.

Currently, there are a number of factors, from the stability of the online advertising market and smartphone profit margins to the price-earnings ratios of social media companies, which are putting those slim chances of a big payday in further jeopardy.