On the Web 2.0 Bubble

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.

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. Decide how much you think that company is worth. $5 million? $10 million? $50 million? $500 million? The sky is the limit!
2. Imagine now that you are going to trade your life savings for a current minority chunk in the company. If the company doubles up, so does your savings, but if it goes under, your savings are wiped out.
3. Remember that number you threw up there in step #1? You aren’t allowed to cash out ANY PROFITS until the company is sold to a buyer.
4. Your startup may not sell until it has reported a yearly net revenue of 10% of your purchase price.

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 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? If the startup you chose has revenues and is profitable, then this article doesn’t apply to you. =)

Speculation Should Still be Grounded on Fundamentals

People aren’t investing for what 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”, then it’s likely just another bubble startup that will become completely worthless 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