Repeat after me: “It’s not a bubble”

Questions are starting to be asked seriously about whether we’re in the middle of a second internet bubble. Some say No: PwC, Fred Wilson, Sarah Lacy and Paul Graham strongly deny the existence of a bubble. On the other hand, some say Yes: Mike Arrington and Don Dodge think there is one.

So what’s really happening. Is there or isn’t there a bubble?

First, what is a bubble? It’s when lots of people (investors) pay more for stuff (companies) than they’re really worth. For instance, if you buy a share in a company for 1 Dollar, you expect that share to be worth, say 2 Dollars after a few years. At which point you can sell your share and make a 1 Dollar profit. What happens in a bubble is that investors and entrepreneurs misjudge the worth of the shares they’re buying and expect a 2 Dollar share to be worth 5 when in fact it later turns out to be worth 10 cents. The bubble is said to ‘burst’ when shareholders realise this and suddenly there’s a mad rush to sell stock as fast as possible to at least recoup some money, which drives value and prices further down.

This is what happened in 2000 and I think there’s a strong possibility of a repeat in the next couple of years. Probably not as disastrous as last time but still pretty serious. Here’s why:

The Basis of Valuations
The key question to ask here is: What were company valuations based on that it went so wrong? Well, the situation 15 years ago was that there was this exciting new thing called The Web and nobody really had any experience of valuing web-based businesses. So investors made mistakes (to the tune of 4 trillion USD). They were faced with a game-changing technology, misjudged the way it delivers value and got bitten. Lesson learned right?

No. Just a couple of years later there was the lesser known (because less people got bitten) WAP fiasco in which mobile operators sunk millions of Dollars and Euros into a new technology because they misjudged the way mobile delivers value. Lesson learned right?

No. Even later, we get the housing bubble, one we know pretty well because we’ve just lived through it. Now, surely, lesson learned right?

Hmmm. If we look around us, is there any game-changing technology that we might be misjudging because we’ve no experience of valuing it? My bet is on social media. If we were to be brutally honest with one another we’d have to say that we have no idea of how to value companies that operate in this space. Irrational exuberance has taken the place of revenue and, therefore, there’s a strong possibility we might be making a few mistakes.

A Misunderstood Business Model
Another problem we had 15 years ago was that entrepreneurs fundamentally misunderstood how to make money on or from the web. We thought that a business could be profitable just by virtue of being online and if we could get enough traffic – eyeballs – to our website everything else would fall into place.

Today we are seeing the mirror image of this and it’s called Free. The mad rush to $0.00 peaked with Chris Anderson’s book Free (currently retailing at £15.19 on the Kindle) in 2009 and hasn’t abated since. The thinking around the Free business model is that there’s a huge psychological jump from $0.00 to $0.01 and users are more likely to adopt if the price is Free. So we build and give stuff for free and then figure out how to monetise later. Basically, we seem to think that a business can be profitable just by virtue of being online and if we can get enough traffic – eyeballs – to our … hang on a minute. How is this different to 1999?

Free is a woefully misunderstood business model. There’s no doubt that it works for some companies but its not for everyone. Free works well when you can deliver a large and engaged audience to an interested third party: Google, Facebook, TechCrunch, (possibly) Twitter, blogs and newspapers operate this model successfully. It pretty much doesn’t work anywhere else.

That’s a possibly controversial statement and I plan to elaborate in a separate post but, in a nutshell, if people only use your stuff because its free, you don’t actually have a business and its likely that your product doesn’t embody enough value to generate profit down the line.

Recent Acquisitions, Investments and the IPO Market
When you think something’s too good to be true, there’s always the possibility that you might be right.

Twitter just purchased TweetDeck for $40 million. I read that as “company that makes very little money buys company that makes no money”. More shockingly, Color Labs just raised $41 million to develop a mobile photo sharing app. That’s $1M more than what Twitter paid for an app that at least has a large user base. Last week LinkedIn IPOed and in one day its stock more than doubled in value valuing the company at almost $9 billion. eBay bought Skype a few years ago for $2 billion ($4.6 including non cash value), sold it a while later because it wasn’t performing well enough and now, Microsoft buys Skype for $8 billion.

And these aren’t isolated data points. Start-up and non-start-up valuations are going up across the board, smaller investors are getting squeezed out of deals and the tech IPO market is on the rise again.

So where does all this value come from? Answer: nowhere.

It’s another gold rush. This time its not for domain names but its for the “social graph“. Everybody wants a piece of it but, and here’s the catch, nobody can explain why. Oh sure its “game changing” and “disruptive” and “it’s changing the way the world works”. What it really really means though is that, once again in the space of a few years, you can get $40 mil for a business plan.

And that’s what we all promised ourselves would never happen again after the dotcom bubble.

Repeat after me: “It’s not a bubble”
The thing is that nobody will actually tell you there’s a bubble. It’s not in the interest of the investors who’ve put their money into these ventures to do so and it’s most certainly not in the interest of the entrepreneurs who’ve placed their bets on somehow monetising the social graph.

For every one of the reasons I’ve mentioned above you will find a counter argument. And certainly a strong one is that I haven’t a clue what, for instance, Color’s business plan is. Or what Twitter’s monetisation plans are.

All I can point to is a remarkable resemblance in the current turn of events to what happened last time.

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