Worries about a financial bubble in Silicon Valley are growing. In a Monday piece for the Wall Street Journal, Christopher Mims compares the current crop of dozens of "unicorns" — tech companies worth more than a billion dollars but not traded on any stock market — to the subprime mortgage market a decade ago.
He argues that the same kind of complex, opaque financial engineering that caused people to overestimate the value of mortgage-backed securities a decade ago may be inflating the value of technology startups today. And he worries it will lead to the same kind of financial meltdown.
If the pessimists are right, the technology implosion of 2016 won't look like the one that started in 2000. That's because the market has changed a lot since the 1990s. Back then, companies tried to offer their shares to the public as quickly as possible. That meant people could watch the stocks of duds like Pets.com, Webvan, and eToys crater in realtime.
But today's hottest startups aren't traded on any public stock market. With more rich people around, it's easier than it used to be to raise money in a few big chunks from private investors. So the bubble — if there is a bubble — is mostly in companies whose stock is closely held.
The good news here is that this means ordinary investors are less likely to be burned. Joe Investor can't lose money on overvalued tech stocks because he never had a chance to buy them in the first place. The bad news, though, is that the proliferation of gigantic, privately held companies could make Silicon Valley as a whole more brittle.
There's growing talk of a technology bubble
When I visited the San Francisco Bay Area in May, everyone was talking about whether there was a tech bubble (and also, not coincidentally, about how expensive San Francisco real estate was). Since then, bubble talk has only gotten more common.
Last week the Wall Street Journal reported there was a "chill" among private companies trying to offer their stocks to the public for the first time. Some privately held companies have been finding that they can't get investors in the public market to pay as much for their stock as the companies were expecting. That could be a sign that the private market is getting out of whack.
But the Journal's evidence was highly anecdotal, focusing on a handful of startups with disappointing fundraising efforts. That might signal that technology stocks are overvalued, generally. But it might just reflect that those specific companies aren't doing well.
The respected venture capitalist Fred Wilson argues that one big problem is that companies are spending one another into huge losses in an effort to capture new markets. He points particularly to a new wave of new smartphone-based delivery apps (he didn't mention any specific companies, but Instacart and Blue Apron are two well-known examples) that seem to be offering their services at below-market rates. This obviously can't last, and Wilson predicts that some will run out of money in the next year or two.
Privately held startups can be fragile
Taking a company public has some real downsides. Last year investor Marc Andreessen told me that when you run a public company, speculators can "bat your stock around like it's a chew toy" and that volatile stock prices can be bad for the morale of employees who are compensated with stock options.
Also, public companies face more regulation now, thanks to the 2002 Sarbanes-Oxley Act, than they did in the 1990s. And public companies are increasingly targeted by activist investors who buy up a company's stock and then try to force its management to change how they do business.
But it also has a huge upside: You always know exactly where you stand, and you can easily raise more capital if you need it. Anytime a public company needs more cash, it can sell stock on the open market, getting the current market price.
By contrast, private companies raise cash in huge fundraising rounds that usually happen every year or two. If the company is doing well, each round will fetch a higher price than the one before, allowing earlier investors to make a healthy return and boosting employee morale. But if the opposite happens — known as a "down round" — it can be devastating. Not only is a declining value bad for previous investors, but it can shake the confidence of employees (who are often compensated with stock options) and customers, who might wonder if the company will still be around in a couple of years.
Because a down round can be so devastating, companies work hard to avoid them. That might mean delaying a much-needed round of fundraising in hopes of getting a better price later. And Mims says that some companies have been offering investors ever more favorable terms in an effort to inflate their paper stock values and keep up the illusion of upward momentum.
All of this means that the private venture capital market may be brittle. Public stock markets, of course, are prone to irrational swings due to investor psychology. But the tightly knit and closed-door venture capital market can be even more prone to mood swings. It could just take a few failures by overvalued "unicorns" for the venture capital world to reevaluate their entire portfolios and decide that many are overvalued.
No one knows what will happen if the venture capital market implodes
In the past, it was rare for a venture-backed tech company to stay private for more than a few years. Either it would grow rapidly and become a publicly traded company (or be acquired by one), or it would flame out and go out of business. Silicon Valley has never had so many companies that are as large as conventional public companies but still privately held. We don't know how Silicon Valley will cope if there's a broad downturn in the value of these big, privately held technology stocks.
The optimistic view is that a downturn among private technology stocks will just mean a bunch of rich people (as well as some pension funds and university endowments) will lose money. Ordinary investors aren't allowed to invest in venture capital markets, so they won't be directly harmed the way many investors were harmed by the bursting of the dot-com bubble at the turn of the century.
Also, while some companies are struggling, others may still be doing well — so perhaps we'll see a wave of failing companies alongside others that continue to thrive.
But the pessimistic view holds that an imploding technology bubble could bring down technology companies in general — and perhaps other parts of the US economy as well. This is where the analogy to the housing markets gets scary. In theory, there was no reason falling housing prices in 2007 should have triggered a global financial crisis in 2008. But the economy is interconnected, and if venture capital firms start losing boatloads of money, it could cause a broader financial retrenchment.
And unfortunately, we don't really know when — or even if — a technology downturn will happen. Private companies only get valued when they raise money, and most companies only do that every year or two. So there's no index of private company technology stocks we can watch to see if it's falling. We just have to wait and see.