Are we in a tech bubble and will it burst?
I’ve heard this question since 2011. It has been the “b” word that shall not be named. The conventional wisdom is you can’t call a bubble unless you’re prepared to say what quarter (3 month period) it’ll occur.
I’m not going to do that. There’s two reasons why.
The first is my brother’s recent explanation of chaos theory, which is any system or pattern where a very small change in one of many variables can create an exponentially different result. This is apparently the reason why short term weather forecasting is virtually impossible. The same applies to short term movements in the stock market.
The second reason relates to the story of Dr Michael Burry, who’s portrayed by Christian Bale in “The Big Short” movie. He picked the subprime crisis in the US as Q2 (April to June) 2007. He was wrong by one quarter, it happened in Q3 and the 3 month delay was tense. He’s a very smart man. If he can’t get it to within one quarter, I’m not even going to make the attempt.
What I will talk about is what may drive a change in the funding model that supports the tech sector currently, and which every tech founder needs to be aware of if you’re looking for funding in 2016.
If you look at tech in isolation as an asset class, we are only at the beginning of an unprecedented change cycle. Change cycles create wealth generation opportunities for those companies at the pointy start of the cycle who survive the disruption phase and effectively “create” the new way we do things.
Hence the underlying value drivers in the tech business model haven’t changed, and probably won’t any time soon. For those who don’t believe tech has a business model, check out my article published last year.
What may change is the supply of funds fuelling that innovation. At the moment it comes from VC’s, high net worth individuals or families, or corporate investment arms. These new ventures need that funding to grow at the pace that's happening at the moment.
That funding requires a very high risk appetite and a substantial confidence level on the part of the funders. To understand how this may impact tech companies, we need to understand where the money is coming from that is pouring into the sector.
The VC’s have to put together funds from various sources. In the last couple of years, the size of the funds has been driven by private equity firms looking to get into successful tech businesses. This has moved the VC’s further along the curve to later stage funding rounds (these rounds are considered early stage by the private equity firms), which has been a feature of the last two years that has not been the case in prior economic cycles since 1999.
For those private equity firms to do that, and the pension funds, and the high net worth individuals, they need a level of confidence in both the venture, but also the macro economic conditions.
Financial markets run on fear and greed. This is well documented.
Subprime in 2007 was a trigger that led to an undermining in confidence in the banking system in general (the banks stopped lending to each other). This is why they were “too big to fail” and got bailed out, to ensure the funds would start flowing through the economy again.
There are several triggers in the macro economy right now:
- Commodity prices are on the floor and this has happened in 12-18 months. This substantially drops asset valuations, which may trigger debts to get repaid. That was Glencore’s issue last year and the stock market reaction was indicative of nervousness about the level of debt tied up in mining assets.
- Housing prices have risen around the world, in many places driven by Chinese investment. This has happened in Sydney, in San Francisco, in London and New York , among others.
- Wages haven’t risen substantially in many years, which means there are a large number of people with potential mortgage distress.
If any of the above lead to widescale unemployment, then traditionally the flow of funds through the economy comes to a halt, as the disposable income for a large number of people drops.
When that happens, the risk appetite of every private equity firm, every pension fund and every high net worth family changes. There are a few who can buck this trend and that is often why they do very well (they are known in polite company as opportunistic buyers).
Hence while I’m not seeing the triggers within tech itself, if the flow of funds that supports tech & innovation stops, that it itself may create a “correction” within the tech sector due to a simple case of demand and supply of funds. The reduction in valuations can be managed. The flow of funds coming to a halt is a very different matter.
For any tech founder, it is a great time to do a little contingency planning. Like everything else in tech startups, now is a great time to question every assumption you've ever made about funding as it’s times like this that the rules tend to change and those who can adapt to those changes often come out the other side much stronger.