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Is there a bubble in tech?

It may not resemble the first .com bubble, but the valuations being given to some of the hottest internet startups, from 'mature' companies including Facebook and Twitter all the way down to upstarts like Quora, is producing plenty of skepticism.

The bubble/no bubble debate is a heated one, but one man who credit his fortune to an acquisition windfall in the first .com boom has a different take.

According to Mark Cuban, who sold Broadcast.com to Yahoo in 1999 for close to $6bn, what we're seeing today isn't a bubble, it's a Ponzi scheme. peHUB quotes Cuban:

Remember the old chain letter, where you put up some money, then you got other people to put up some money, and you gave it to the people who were in the deal before you? That’s what’s happening today.

The early [VCs] are getting the new [VCs] to invest enough money at high enough valuations that they get most, if not all of their money back. Then the next round [sees] someone else invest more money at a higher valuation, returning cash to the last two rounds of investors.

By the time you get to the last [VC] standing, those last few rounds hope they can get a return from the public markets. That may be very tough. But the only players really on the hook are the guys from the last rounds. Just like in a chain letter.

Given the large sums of money that are being tossed around for shares of Facebook and Twitter on an increasingly frequent basis, Cuban's argument is hard to dismiss out of hand.That doesn't mean, of course, that there are plenty who would disagree with it.

Some, like YCombinator's Paul Graham, don't see a problem at all:

What's happening now is a lot more localized. A few professional investors are paying higher valuations for startups than they were a few years ago. But the number of participants and the amounts of money moving around are both very small compared to the 90s. Plus the companies are better.

In the 90s, it was the dumb leading the dumb: smooth-talking MBAs were raising money from hapless LPs and investing it in startups run by other smooth-talking MBAs. Now it's Yuri Milner investing in a company run by Mark Zuckerberg.

In my opinion, Cuban's reasoning seems a lot more sensible. The question isn't whether companies like Facebook are "better" than their now-deceased counterparts from a decade ago, or who is raising money from whom.

The question is how much companies like Facebook and Twitter are really worth, and whether or not the newest investors in them are motivated more by their long-term potential or by making a quick buck selling to even greater fools (perhaps retail investors) in a year or two.

If VCs, investment banks and institutional investors want to invest billions in a handful of high-profile startups at exorbitant valuations hoping that they'll avoid being the one left standing when the music stops, more power to them.

There's an old saying on Wall Street, "Pigs get fat, hogs get slaughtered." The primary characteristic of a hog: unbridled greed. Right now, anyone paying through the nose for a stake in Facebook or Twitter in hopes that he or she will make a quick buck when someone else invests at a higher valuation looks more like a hog than a pig.

But none of this really matters unless you're a VC, investment banker or institutional investor, or can't wait to invest your entire retirement savings in a Facebook IPO that values the company at $500bn.

As I wrote before, the good news is that whatever you want to call the froth, it has little to do with the internet's viability. That's because the rest of us don't have to participate in the game to try to capitalize on digital opportunity.

Unlike in the first .com boom, when the value of the web was largely perceived to be correlated with the immediate prospects for overhyped, overvalued companies, the internet's worth today isn't determined by the value of Facebook, Twitter or the 'next big thing'.

Plenty of entrepreneurs, developers and companies are profiting daily from the internet using proven online business models, and the vast majority of them wouldn't lose a wink of sleep, or a penny, if Facebook and Twitter folded tomorrow.

Photo credit: Shiny Things via Flickr.

Patricio Robles

Published 18 February, 2011 by Patricio Robles

Patricio Robles is a tech reporter at Econsultancy. Follow him on Twitter.

2429 more posts from this author

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Niranjan Sridharan

Niranjan Sridharan, Digital Auditor at ABC

Bubble Schummble.. And we all fall down!!

almost 6 years ago

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the cynical investor

Spot on article !
Facebook another hype that will fade like MySpace

almost 6 years ago

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Francis Moran

Every time a share, whether publicly or privately traded, is sold for a higher price, the buyer is counting on eventually finding someone to pay an even higher price. If this constitutes a Ponzi scheme, then the whole market is implicated.

So it's not, as Cuban suggests, the mechanism that's in question here; it's the inherent value of the underlying asset that's in question. And on that front, caveat emptor.

almost 6 years ago

Ed Stivala

Ed Stivala, Managing Director at n3w media

Good post Patricio and I also find Cuban's argument sensible and realistic.

As we all know there are some very well established metrics for valuing a business. In my opinion .coms and their investors would do well to wake up to the fact that thy are no different to any other commercial organisation.

almost 6 years ago

Stephen Thair

Stephen Thair, Director at Seriti Consulting

@Francis I am not sure that's correct - the difference is how over-inflated is the price/earning ratio.

When what's being paid for a stock (tech or not) moves so far away from the basic fundamentals (e.g. it's earnings, profit margin, growth and potential market, underlying asset capital etc) that the PE ratios are ridiculous then calling it a game of Ponzi pass the parcel is a fair call.

It's probably fair to say that in a digital environment it's probably worse than if a bricks&mortar company fails. At least if a physical company goes under you might have (if you're lucky) some real estate, remaining stock etc to liquidate and get something back.

For most online companies you are left with precisely zip.

almost 6 years ago

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Phil Gainley

This post made me laugh.... why? because funny things always have a strong element of truth.

however a couple of these companies like facebook actually turn a profit, twitter doesnt as far as i know.

So I think some of these big social companies have learnt something since their last dotcom boom

almost 6 years ago

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Phil Gainley

This post made me laugh.... why? because funny things always have a strong element of truth.

however a couple of these companies like facebook actually turn a profit, twitter doesnt as far as i know.

So I think some of these big social companies have learnt something since their last dotcom boom

almost 6 years ago

Guy Harvey

Guy Harvey, Marketing Consultant - Social Media and Media Relations at Human Factors International

I miss the good old days of the dot com boom. I got to work on making deals with wonderful companies like Infospace and Excite which had multi-billion dollar valuations. I think someone picked Excite up for $1 million or similar.

almost 6 years ago

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Oto Hlincik

Could not agree more with the article and with Mark Cuban's position. Facebook and Twitter are so incredibly overvalued that it borders or ridiculous. As far as I know, Facebook never turned profit (it almost came close to breaking even for a couple of months). If a company/service like Facebook is not able to make enough money to pay it's expenses, how it's ever going to pay back the billions of dollars invested in it? Oh, but wait. It's not just about paying back, the people that invested in it actually want to make some profit, not just get their money back. How is that going to happen if FB is not capable of making enough money now, at the height of it's 'hype'? The real test would be if FB asked whether anyone using FB would be interested to pay $5/month for an FB account. From the 500m registered users MAYBE 1/2 would be willing to pay. But, the problem is that the 1/2 that would be willing to pay are on FB only because they want to connect with the 1/2 that would not pay. So inevitably the second 1/2 would not stick around. Think about it. If you have a company for who's product/service the customers are not willing to pay, how can be that company so valuable? I just don't get it.

almost 6 years ago

Patricio Robles

Patricio Robles, Tech Reporter at Econsultancy

Francis,

There are huge differences between public markets and the private secondary markets through which sales of Facebook, Twitter, et. al. are being conducted. For starters, public markets have a far higher number of participants and far more liquidity.

More importantly, the public markets permit short selling, and the purchase of put options. Currently, investors who have the financial resources to buy Facebook shares at $52bn don't have the same ability to short Facebook shares at $52bn. This means that it is quite easy for a small group of "investors" to overhype and pump the valuations of these companies in the secondary markets, with a dump scheduled to take place when the issues hit the public markets.

Finally, I would point out that not every purchase of a share of stock is made with the intent of profiting when its value rises. Stock is often purchased by more sophisticated traders in conjunction with an option strategy. Some of these strategies, such as the iron condor (which doesn't require ownership of the underlying stock) allow a trader to profit from buying and selling options when price movement is neutral.

almost 6 years ago

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