Michi Knows

Everybody, listen. There’s a Web 2.0 bubble right now. I know it’s difficult for some people to acknowledge, and many people may even casually agree with me without actually believing the statement in full. But it’s true, and the quicker you realize this, the better it will be for your pocket books.

Lately, I’ve been doing stock trading, and have come to learn first hand about the energy and commodities bubbles that were slamming the market. And when that thing was going crazy, it helped deflate the banking bubble, which was a direct result of the housing bubble. And in many ways, the housing bubble was a result of the dot-com bubble bursting due to people exiting the stock market in search for a new investment. And everybody in the web industry likes to think they are wise to bubbles because they learned their lesson in the dot-com boom. But it is increasingly evident that this is not the case.

As we know, Facebook has a supposed valuation in the double digit billions, thanks to Microsoft’s minority stake investment in that company. And just the other day, it was news that Google was seriously considering buying Digg for $200M (the deal ultimately fell through).

There is a clear bubble here, but it’s sometimes hard to see because most startups are at least producing some revenues.

An Example Exercise

The problem here is that people are approaching this with the mind set of “this will be somebody else’s problem after I sell it.” It’s important we try to figure out what happens to the eventual owner of the startup.

1. Take your favorite Internet 2.0 “company”: Digg, Myspace, Twitter, etc. Decide how much you think that company is worth. $5 million? $10 million? $50 million? $500 million? The sky is the limit!
2. Take half your life savings. Take all your discretionary spending money for the next 5 years and take it out of your budget.
3. Now imagine there is a company that exists that has some money to throw around into a startup. The company is, at least for now, profitable. You will now put the funds from step #2 into the stock of a subsidiary of this company. This subsidiary will be exposed to 100% of the gains/losses that will arise from this takeover.
4. Remember that number you threw up there in step #1? That’s how much your new company is going to pay to acquire that 2.0 startup. Your stock’s valuation is now 100% tied to the income generated by this newly acquired startup. If the startup loses money, your stock goes down and if the startup makes money, your stock goes up.
5. Nobody will accept an offer to buy the startup from your company at a break-even or higher price until it has reported a yearly net revenue of 10% of the purchase price and is profitable.

That last part is the key because it effectively stops the hot potato game and forces you to examine if the company is truly viable. Some people would accuse that of being an unfair restriction, but I will show you why this is the key part in understanding why there is a 2.0 bubble.

Defining the Bubble

Let’s take a second to define a bubble:

An investment yields a return, much like a chicken can produce eggs, a savings account produces a yield, and a farm produces crop. This return is not always immediate, and is not always in the same terms as the input. Also, it is almost a law that returns are proportional to risk (some investments have negative returns). But ultimately, it is called an investment because it will (usually and) eventually generate more value than what you put in.

Now consider an investment that does not create a return. Such an example would be the web stocks of the dot-com boom. Back then, fundamentals like earnings, operating margins, and profitability were ignored when evaluating a stock. Companies that bled millions of dollars a year saw their stocks rising at record levels. This is because the investment - the stock - was being traded to somebody else for a profit because that next person believed they could trade it for an even higher profit.

A bubble is defined as a trend where merely owning something long enough to sell it is profitable. It is a giant game of hot potato. Everybody is essentially a middle man between the original owner and the eventual owner — adding to the price tag at every step. Eventually, people wise up and no longer want to trade the hot potato, causing the bubble to burst.

And most importantly, let’s define a bursting bubble:

A bubble is defined as bursting when the value of the traded item reverts to its true market value.

Understanding the Exercise

So let’s talk about the exercise again: if you thought the company was worth a paltry $50M, then your assets are stuck inside that stock until the startup can earn $5M in revenue AND be profitable while doing so. Why did I pick such restriction? Because those are reasonable things to assume when buying any other type of company. Why would another company offer to buy the startup if it failed to produce respectable profit margins or revenues?

Given this extremely reasonable reality-check requirement, would you want to tie your personal investment to the startup being able to produce a profit? Would you end up selling your stocks in fear that they would go to zero? I know some of you would still blindly accept this gamble, but I am sure it helps you see the absurdity of at least some of the valuations that are going on right now. How can Facebook be worth over $10B if it isn’t producing revenues somewhere in the $500M-$1B range? Reality check: Facebook has revenues of $150M a year.

Speculation Should Still be Grounded on Fundamentals

These types of companies are “worth” that much because the valuation is highly speculative. People aren’t investing for what Facebook and other 2.0 companies are worth today, it’s all about tomorrow. I agree that it is important that tomorrow’s profits are taken into today’s valuations, BUT isn’t this reasoning eerily similar to the reason people listed as to why they bought over-priced houses and profitless dot-com stocks? Both were purchases made while completely disregarding the fact that the *current* valuation of the items were negative.

But since that day of profitability is so far away into the future, you end up playing a giant game of corporate hot potato. Most people would agree that a profit of 10% is far better than a loss of 90%. So as soon as you find a sucker to pay 10% more than you paid, you bail. And of course that guy who bought your stake is thinking the exact same thing — sell this to somebody else for 10% profit before something bad happens. That’s a bubble, my friends.

In Conclusion

In 2001, the bubble was all about going IPO so that the general public could hold the hot potato.

Today, the bubble is all about selling to a big corporate entity that will hold the hot potato.

There is no difference.

If you are currently thinking about entering the 2.0 scene, think carefully about what your end goal is. If it isn’t “to be profitable and retire”, then it’s likely just another bubble startup that will become completely worthless (and your invested time and money completely wasted) once the bubble pops. And believe me: given our current economy, that bubble is going to pop in the next year or two.

Finally, an extremely interesting speech about bubbles given in 2006 (gets good around part 2):

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6