History Never Repeats: When The Tech Bubble Bursts

There's recently been a fair bit of discussion in the tech and finance sectors regarding currently being in the middle of a 'tech bubble', similar to the 'dot com boom' experienced during the late nineteen nineties. We all know how the original tech bubble ended and there are warning signs we're not far way from the next crash. I thought I would take a look at the differences between the two tech bubbles and what the ramifications might be this time around. 

The dot com boom - A recap

During the mid nineties, the 'internet sector' of the stock market began to experience extremely high growth rates. These were the tech companies which had been fuelled by large amounts of venture capital and successful IPO funds. This became known as the 'dot com boom'. The reason for this was simple enough - the internet was creating a new and untapped part of a global economy.

What we had was a new, high potential industry that everyone either wanted to be a part of or invest in. Problem was, in the early days no one really knew exactly what this potential actually was and the infrastructure to support some of the known potential wasn't there yet (e.g. fast internet connections). This made stocks difficult to value but investors had FOMO so were desperate to get in early. The high demand for these stocks led to overvaluation of many companies who were making little to no revenue and in some cases had not even worked out a revenue strategy. People were not investing rationally and often throwing money at things they didn't understand.

By the late nineties there were some ominous warning signs. Some of the companies who had seen their IPO value double after their first day of trading were already starting to report large losses. The NASDAQ (America's heavily tech weighted stock index) peaked at a little above 5000 points on March 10, 2000 (double it's value from a year earlier). The following day, the value of many tech stocks began to free fall as investor confidence disappeared with the realisation that these companies were never going to show a positive return. As confidence and investment in tech waned the funds of many of these companies started to dry up and they began to go bankrupt.

By October 2002, the value of the NASDAQ was down to around 1,100 points. It wasn't just the tech companies being wiped out either. Communication companies had also taken on large amounts of debt to build the network infrastructure to support these unsuccessful tech companies - and they now weren't going to see any return to cover that debt in the near future.

So what did we end up with? Billions of dollars of 'value' wiped out in a very short amount of time.

There were many casualties during this period. Not all of them were necessarily bad ideas. However, the timing or strategy wasn't right or there was no way they would ever be able to grow at a rate which gave shareholders a return on their investment.

are we in a TECH bubble now?

There's growing concern that we're currently experiencing another tech bubble. You don't have to be in the tech industry to hear stories of the latest startup with a billion dollar plus valuation (known within the industry as 'unicorns'). Forty seven unicorns were created in 2014 compared to eight the year before (source: TechCrunch) which gives you some idea of the increasing amount of money being invested. Raising venture capital is easier than ever and steadily increasing each year although still not at the levels hit during the peak of the dot com boom.

Although any struggling founder will hit you with a dose of reality, the movie 'The Social Network' and TV shows such as Shark Tank are making startups look glamorous to would be entrepreneurs. Investors are on the hunt to find the next Facebook. Indeed, companies such as Facebook, Twitter, Uber and AirBnb are all household names used by millions of people worldwide. It's now cheaper than ever to start a tech company and there are a number of them that actually  earn revenue or have revenue strategies in place. However, the amount of money being thrown at them means they are under considerable pressure to grow at remarkable rates in order to be profitable and offer a return on investment.

There are prominent players within the industry, from venture capitalists warning of seeing startups increasingly burning through cash and showing low returns to entrepreneurs such as Mark Cuban predicting that an upcoming crash will be worse than the dot com crash. I don't think many people disagree that we're currently experiencing another tech bubble. Where opinions differ are as to what will be the effect of the crash.

the differences between then and now

Although there are some ominous signs and it could be viewed that history looks like repeating itself I think there are some distinct differences in the landscape between the original dot com boom and the current tech bubble. By highlighting these differences I'm not suggesting that we're not heading for a crash or correction but I do think the ramifications will be different this time around.

Difference 1: The internet isn't new anymore.

As mentioned earlier, part of the reason for the high valuation of tech stocks during the dot com boom was that the internet was relatively new and much of its potential was yet to be realised. The fear of missing out of getting in early with tech stocks led investors at times to think irrationally and with less sophistication than they would assess the sector today.

Obviously these days the industry is more mature, there is greater understanding of its strengths and limitations and methodologies have been developed to tackle the issue of rapid growth a highly funded startup need to achieve. The rise of smartphones and the shift of the internet from the desktop from mobile arguably helped kickstart the current bubble and has created many new business opportunities. None of this guarantees a startup any type of success but it's worth noting. 

Difference 2: Approach to scaling

It's also worth noting that a number of unicorns already have strong revenue. Although some companies still take a 'build a huge user base and work out how to monetise them later' strategy (i.e Twitter), many of today's startups have had earned revenue from day one (think Uber, AirBnb and Slack). Their funding is being used to scale a successful revenue generating product or service.

In contrast, a lot of the dot com companies had it backwards. Their funding was being used to scale unproven models early, hoping it would then be able to generate huge amounts of revenue so it could make a significant return.

Difference 3: How startups are funded is different now.

Both then and now tech startup funding has been predominantly fuelled by venture capital. One of the key differences now though is if and when a startup decides to go public.

The recent Mattermark: Q1 and Q2 State of Startups report suggest the number of IPOs are in decline (and certainly way below the IPO levels of tech startups during the dot com boom). Instead they are being replaced by what they call the 'private IPO phenomenon' - large amounts of venture capital funding in late stage investment (post Series D) rather than going for public funding.

This change sees the risk profile of the average investor change (they are less likely to be 'mom and dad' investors). The venture capital firms also protect their 'downside' in case of failure better these days with more sophisticated term sheets stacked in their favour including preferential liquidation preferences which improves the chances of their investment at least being returned if things go badly.

The successful startups who get past the late round 'private IPOs'  are now more established and proven before they do go public, potentially making them less risky. 

Difference 4: Investing in startups is now not all about tech.

During the dot com boom, a lot of the companies created took the concept of existing bricks and mortar businesses and replicating them at a greater scale due to the potential global reach the internet could provide (think Amazon as a successful example). That didn't necessarily work for everyone and the public was not yet ready to embrace it across some sectors.

Today the tech is more likely to be aimed at 'disrupting' the traditional way things have been done in an industry. Think being able to create and then instantly purchase personalised clothes or furniture or Uber instead of traditional taxis. Or can big data and wearable tech have positive affects for health and medical research or diagnosis? Tech has now reached a level where it can have stronger and more meaningful impacts across a range of industries.

So what does it all mean?

History shows that stock prices can't continually go up and things are starting to get a little crazy in the tech sector. There will be a correction. However, outside of external factors such as war or the economy collapsing I think this time around that's what it will be - a correction rather than a crash. There are definitely over-valued tech companies out there where it's hard to see how they can continue to grow and make a positive return on investment. Conversely, there are now tech companies that have very solid and scaleable business models who investors shouldn't abandon just because they're 'tech'.

With the relative ease there is to raise funding today there are now simply too many startups. If you're just another photo filters app 'with a twist', things are likely not going to end well for you in the wash-up. A lot of these types of startups are bound to fail with venture capital being thrown around too easily just to see which ideas stick.

That being said, the internet and tech are now too ingrained in the economy and everyday life for there to be a simple black and white crash as there was during the dot com boom. This time around we are likely to see a correction whereby some of the overvalued companies may have to pare back but will survive and adjust their growth rate. Some will definitely disappear if they have tried to scale too quickly without the revenue to back it up when funding starts to desert them. Lower valued companies who cannot monetise will disappear but this is already happening today - we don't need a crash to correct this.

There will always be funding available for truly disruptive ideas that solve a real problem or advance the world in a positive way. This is where significant funding is now being invested and will be pushed even further towards when a correction highlights and shuts down some of the more questionable startup ideas currently going around.