Dispatches From The Dark Side

Yahoo!-Tumblr: Not So Great for the NYC Tech Scene

For year's we've been hearing about how the ascendant tech startup scene in NYC is going to rival Silicon Valley's tech-hegemony.  It's a story the MSM has run with hard because, after all, NYC is the apex for the main-stream media and, who doesn't like rooting for the home team.  For those NYC cheerleaders (I'm talking to you Bloomberg and WSJ), Yahoo's purchase of Tumblr was solid confirmatory evidence of the momentum-shift they've been trumpeting.  Yet, while the acquisition was clearly a good thing for Tumblr's founder and early backers, it was at best OK and at worst a bad thing for NYC's quest to challenge Silicon Valley's tech-dominance.

The confluence of elements at the core of Silicon Valley's vibrant tech scene have been long discussed - fantastic universities, access to capital, and access to a strong startup support system.  NYC long had great universities and human capital (although not as much tech-DNA), but somewhat surprisingly for the financial center of the world, NYC just didn't have a strong startup funding culture.  To be clear, there is plenty of wealth to be invested in NYC - somewhat ironically there are 5-NY-Metro-Area hedge-fund titans who each made individually more in 2012 than the entire purchase price of Tumblr.  Lots of money, just not lots of it going to tech startups.  Another way to put it is that there are lots of billionaires, just no tech-billionaires.  In the last 10 years, at least the money side of the equation has been looking better for NYC.  According to the PWC/NVCA MoneyTree, NYC's share of venture investment dollars grew from 5.8% of the US total in Q1 2003 to 9.8% in Q1 2013.  NYC is taking venture investment share from other markets.  But it's not taking it from Silicon Valley.  Over that same period, Silicon Valley's share of US venture investment dollars went from 32.5% to 37.9%.

So what is NYC missing and in what alternate universe could the Tumblr acquisition be bad for the NYC tech ecosystem?  What Silicon Valley has in abundance that no other tech-center rivals is what I will refer to as the anchor-tenant companies.  Anchor-tenant companies are those that become large independent and growing tech leaders.  They continue to generate wealth; their alums continue to spawn new companies; and and they continue to buy interesting startups fueling the cycle.  There are tech giants in places other than Silicon Valley (Microsoft, Amazon, IBM), but no area rivals the valley for the sheer number of these tech titans.  Silicon Valley has them in every corner of tech and continues to create them.  Just since the tech bubble burst, we've added LinkedIn and Facebook (started post bubble) and Google and Salesforce (IPO post bubble) to name just a few.

This brings me back to Tumblr.  A great company and a great outcome.  But now that the music has stopped and Tumblrhas taken a chair, the company has stopped playing for the big leagues.  Tumblr may ultimately become as meaningful toYahoo as YouTube has become to Google as Yahoo CFO Ken Goldman implies, although I'm skeptical.  But even if it reaches that lofty status it will be bitter-sweet for the NYC tech community.  Because instead of having a large independent tech giant around which an ecosystem can flourish, NYC will have a large satellite division of a Silicon Valley based company.

The Silicon Valley Diaspora

I wrote the following piece after returning from a trip to India in 2004.  This is as urgent an issue for Silicon Valley and the competitiveness of the US Economy today as it was then.  While I wrote this about India, we need to be just as concerned about China and Eastern Europe.

February 23, 2004 

Silicon Valley is suffering a brain drain that is just going to keep getting worse.  Historically the valley has been the beneficiary of brain drains from around the world.  The diasporas of China, India, Russia, etc, all came to sunny California to start their companies and make their fortunes.  Companies like Juniper, Q-Logic, Exodus, and Silicon Labs are among the hundreds of companies that have generated billions in sales and wealth started by the best and brightest from around the world.  Now some of those great minds are packing up and heading home.

I spent the first week of February in India with a TiE delegation of other venture capitalists and TiE Charter members.  Everything you’ve heard about how exciting and dynamic things are in India today is true – if anything, it’s understated.  Politicians and labor unions who are expressing concern about US call center and SI jobs going to India are focusing their energies on the wrong problem.  The problem is not the inevitable transfer of certain business functions to where they can most efficiently be performed, but the migration of the entrepreneurs and experienced workers who create the companies (and the wealth) to their ancestral homelands.

We’ve all heard the stories about the quality of the Indian workforce.  They’re smart, they’re well educated, and yes, compared to engineers in Silicon Valley, they’ll work for peanuts.  But there are two critical pieces of human capital that India (and countries like it) lack that Silicon Valley has in spades.  The first is years of relevant experience – each new generation of technology building on the successes and failures of the one that came before it. The second is the high-tech entrepreneurs – the people who have worked in an industry for long enough to know how things are done and to know where the problems are that are worth solving.  But there’s nothing genetic that leads these shores to produce more entrepreneurs than anywhere else.

For the last 30+ years, the best and brightest from around the world came here.  They first came here to get educated.  That’s why the graduate programs at our top engineering schools are filled to overflowing with the best and brightest from India, China, Russia, and everywhere else around the world.  The world’s Diaspora came to the US to get educated.  And then once educated, they realized that the companies that would put all that good education to best use were companies right here in the good ole U-S of A.  If they happened to be in an area where companies are started as fast and furious as they are in Silicon Valley, they may have gotten the idea and tried to start one themselves.  They built up that critical experience and some even became one of our most treasured natural resources: the entrepreneur who innovates, creates jobs, and creates wealth.

Now some of those people are heading home.  So now those bright engineers who graduate from IIT with arguably the best engineering education in the world won’t be forced to reinvent the wheel.   They’ll have mentors who learned their trade through years of hard work in the valley and elsewhere.  And some of those that head back will be the entrepreneurs with the ideas and the initiative to start high-tech companies that are ready to compete on a global scale.

We now have our own Silicon Valley Diaspora to moan about - the best and the brightest leaving these shores for bigger and better opportunities elsewhere. So watch out.  While the first wave of Indian high-tech startups was dominated by call-center and IT outsourcing firms, the next wave is likely to be dominated by software and hardware companies that build their entire companies – not just their call-centers and back-office – somewhere other than Silicon Valley.

The JOBS Act Is Good, But SarbOx Shouldn't Get All The Blame

The JOBS Act is a good thing for Silicon Valley and the whole startup ecosystem.  Josh Kopelman is correct when he points out that IPO's over the last 10 years have happened later in companies' development than was previously the case and this has taken from public market investors the opportunity for tremendous value creation.  Dan Primack also makes a valid point that VC's have three options for exiting their portfolios: sell them, take them public, or shut them down.  But making SarbOx the sole scapegoat for why IPO activity has been anemic since 2000 is just as wrong as claiming it's the savior that has kept the public markets from suffering losses from failed companies that manage to go public.  Like @pkedrosky, I still believe Groupon will end up with gnashing of teeth and tears for investors of all stripes.

It's an oversimplification to blame the IPO market of the 2000's on SarbOx.  To understand the market during this period, you have to first remember what happened before it.  Anyone who was a part of the startup ecosystem during the bubble was, at least up until now, permanently formed by their experience.  It's like my grandfather, a child of the great depression, who 60 years later was still untrusting of banks and more frugal than anyone 10 years his junior.  The memories of public market investors aren't quite as long, but the hangover from the crash certainly lasted well into the 2000's.  When you think of how high the bar was for tech companies to go public post the bubble, just remember how big Google was when they finally went public – they were almost $1B in revenue in the fiscal year before their IPO.  A size that was completely unheard of in the venture-backed IPO world prior to Google.  In fact, the year that SarbOx passed, Google's revenue was $348m – a number that was well beyond what was needed to go public for any venture backed tech company up until that time.

At the time of Google's IPO, many were hopeful that it would usher in a new era of venture-backed IPO's.  Sadly, it did not.  And while the hangover was partially to blame, and SarbOx played a role, there was more to it than that.  Three other major transformations of the landscape, both before and after the bubble, have helped to make early venture-backed-IPO's more than a little challenging.

The first of those challenges was the "death" of the Four Horsemen.  During the 80's and early 90's, the bulk of venture-backed IPO's were done by four west-coast boutique investment banks – Robertson Stephens, Alex Brown, Hambrecht & Quist, and Montgomery Securities.  These banks made a great business out of doing smaller IPO's and the then denizens of Sandhill Road didn't see using them, versus a bulge-bracket firm, as a sign of weakness.  The late 90's changed all that with the larger IPO's that were able to get done during the bubble.  Once the fees got bigger, the bulge-bracket firms swooped in.  As they did, it became a badge of honor to have a bulge-bracket firm lead your IPO squeezing out the boutiques.  Over time, the Four Horsemen were all bought and no boutique-banks have managed to fully take their place – at least not to the extent that the Denizens of Sandhill road will allow them to lead their companies' IPOs.

The next two challenges were more structural changes to the market.  The first of those was the Global Settlement between Elliot Spitzer and the 10 largest investment banks, a topic Henry Blodget is all-too familiar with.  In an attempt to remove the inherent conflicts of interest that existed between investment banking and research at these firms, they managed to throw the baby out with the bath-water. What small IPO's need is marketing, and research is marketing.  If you try to take a company out and no one is talking about it, no one will trade it.  That tends to tilt the field towards companies going public only after they have become household names which usually implies much larger companies.

 The last nail in the coffin (not necessarily in chronological order) of smaller venture-backed IPOs was decimalization.  In late 2000, the NYSE started to move from trading in 8th's to trading based on decimals.  The biggest impact of this was on the spread between the bid and the ask.  If you're trading in 8ths, the spread scale can be 12.5 cents at a minimum and go up from there and when you trade in decimals, the spread between the bid and the ask can be as little as a penny.  Market makers, the guys who keep a stock trading, make their money on the spread between the bid and the ask.  And when that spread is squeezed, they make less money.  This is all good and well for a company like Apple who trades upwards of 20m shares a day, but for a small-cap stock that trades <100k shares a day, what they really need are market makers.  And if you can't make money on the spread, who wants to make a market in the stock.

 There's a lot there, and I'm sure there are other subtle changes in the market and landscape that I've missed. But on the bright side, we're finally getting over the hangover and the JOBS Act may have come along right at the perfect time.  There are more and more players every day who got into the game after the bubble.  What we need now is for a few of them to take their companies public early and be successful for public market investors.  Once that happens, all these challenges will wash away and we'll have a healthy venture-backed IPO market again.

 

Bubble 1.0 -v- Bubble 2.0

While there certainly are some frothy valuations in certain parts of techdom, it's difficult to call it a bubble -­ at least not when compared to the Internet Bubble.  The Bubble 1.0 tide rose all boats.  It didn't matter what sector you were in, if you put “.com" at the end of your name, you immediately achieved valuations that you wouldn't have imagined in your wildest dreams.  It didn't matter if you were selling low margin products like aspirin or pet-food; Dot-Com-it and you were a darling.  Bubble 1.0 was also characterized by an obscenely large amount of venture capital.  At the height of the Dot­Com mania in 1999, venture firms invested $100B. As a result of this flood of investment dollars, every good idea had 10 well-funded companies chasing it.

As has been often pointed out, a large portion of Bubble 1.0 companies didn't even have business models.  They were valued on such esoteric metrics as eyeballs, clicks, or page-views.  For the few who actually sold things and generated revenue, their values seemingly were higher the more money they lost, as long as they could spin a story about how losing even more money allowed them to grow faster.  I remember well a conversation I had at the time with Pat Connolly, the CMO of Williams-Sonoma who was bemoaning the fact that Wall Street measured him on boring things like gross-margins and profits, but all of his startup competitors weren't held to the same standard.

Finally, during Bubble 1.0, public market valuations were bubblelicious even for large non-Dot-Com companies.  Cisco, Microsoft, and Oracle had P/E ratios of 150+, 78 and 120 respectively (I can't say how high Cisco actually was because my reference source stops at 150!).  Even GE, hardly a fast growing tech company, sported a PE north of 45.  For large-cap companies, those are impressive valuations indeed.

Fast forward to the "Bubble" many commentators are claiming we're now in, Bubble 2.0.  By virtually any measure, if you use Bubble 1.0 as your yardstick, we're not in anything close to a Bubble.

 The primary argument that is being made for a new bubble are the fantastic valuations that the big 5 ­(Facebook, Twitter, Groupon, Zynga, and LinkedIn) ­are getting on the secondary market.  In these markets, buyers and sellers don't have access to the same information.  For most of the buyers, it is a momentum bet on the assumption of the existence of a greater fool.  That said, unlike the last time, with the exception of Twitter, these darlings all have business models that are generating tremendous revenue growth and, if the buzz is to be believed, are incredibly profitable.  We'll see when their numbers all become public whether these secondary market buyers were all "greater fools" or savvy trend pickers.

Go beyond those 5 and the signs of a bubble are pretty weak.  Starting with the amount of money that venture firms are investing, today it is fully 1/5th of what it was the last time,­ a "mere" $20B. As a result, there aren't 10 well-funded companies chasing every great idea. What about all the "super-angels" you ask?  They certainly make getting capital to start a company much easier, but once the company starts growing, in all but the rarest of cases, it still needs capital to grow. With less venture capital going in, there are fewer competitors with the capital to effectively scale their businesses.

Aren't VCs paying crazy valuations again?­  What about FourSquare's rumored $400m valuation, or Quora's rumored $85m valuation for their first round when they had just a few people and an idea.  Heady valuations for sure, and not having been a part of the partner discussions when those decisions were made, I don't know what arguments used to justify them - but I can guess. Heady valuations for "Hot" and "Darling" companies are nothing new in Silicon Valley.  And sometimes they even pay off.  Google was a "hot" company with a seemingly outlandish valuation at the time and that seemed to work out just fine for everyone.  There are always a few companies that, based on the charisma or track record of the founders or some particular set of stars aligning correctly get fantastic valuations.  There are always the exceptional startups that generate the exceptional venture valuations.  As I discussed previously, this sort of exceptional valuation is far from a guarantee of investment success.

Finally, look at public market comparables: they aren't even close to flashing red, I don't think they are even yellow.  Back to the big three last time around and their average P/E, today the three highest profile public tech companies (who also happen to be the largest by market cap) are Apple, Google, and Microsoft, which together have an average PE ratio of 17.6.  Far, far below the levels reached during Bubble 1.0.

Silicon Valley has been built on a series of major innovation waves.  With each new wave comes some new mega-winners.  We're in the opening stages of waves in social-media, hand-held computing, the consumerization of IT, Infrastructure 2.0, and the move of many IT functions and services to the Cloud.  We haven't even scratched the surface of these opportunities so it seems a bit premature to be calling it a bubble.  So for all those people paralyzed in fear of a Bubble, stop being a Chicken-Little and go out there and innovate!