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Welcome to the Bubble No One Is Talking About - The Income Bubble - And It's About to Pop

The US, and the tech hubs in particular, are experiencing a bubble whose proportions have never been seen before. No one is discussing this bubble, and I'm sure after it pops (likely momentarily) you're likely to hear that no could have seen it coming...

In recent years household income in California has witnessed a sharp increase....

In 2012 the household income increased at 6.8% annually, with this growth continuing in 2013 at a rate of 0.9%

House Prices Index in San Francisco (2000 = 100) and Household Income (in US$) in California

 This sharp increase seems to be driven by the rising valuations in tech companies in the area. 

Valuations of start-ups in the Silicon Valley have reached very high levels over the last two years, many of which can make even dot.com valuations blush...

Some of the major Silicon Valley start-ups have soaring valuations

 

Source: CB Insights

-          In February 2015, Snapchat, which makes a mobile application for sending photos and videos that disappear within seconds, was seeking a new round of funding that would value the company at US$19 billion

-          Same month, Pinterest, a web and mobile application company, was in talks to raise US$500 million valuing the company at US$11 billion (55 times the estimated 2015 revenues)

-          In December 2014, Uber, an international transportation network company, raised US$1.2 billion based on a US$40 billion valuation of the company. A recent Reuters press release highlights the company’s value at US$50 billion (25 times the estimated 2015 revenues)

Moreover, recently this trend of high valuations is also being seen for some of the new start-ups

In 2014 some of the Silicon Valley based new start-ups were valued more than a billion dollars:

  • Instacart, a same-day grocery delivery service based in San Francisco, began a $100 million fund-raising round valuing it at $2 billion.
  • WeWork Companies, a company that provides shared office space, closed a $355 million funding round valuing it at $5 billion. WeWork focuses on the start-up space, and is particularly sensitive and vulnerable to any dip in start-up valuations.  A valuation compression will be felt by WeWork nearly immediately, and it serves as a valuable barometer for the start-up space in general.
  • Stripe, an online payment company, completed a $70 million investment round that valued it at $3.5 billion, double its $1.75 billion valuation earlier in 2014.
  • The mobile games maker Kabam announced that employees and investors were selling $40 million in shares to a group of investors. After an earlier round of investment last summer, the company was valued at more than $1 billion, up from $700 million last year.

Mutual Funds, Hedge Funds and the ZIRP environment in which they currently operate are driving these valuations

According to Terry Schallich, Pacific Crest’s co-chief operating officer and co-head of investment banking, “Mutual- and hedge-fund dollars coming is one of the main things driving these higher valuations and larger deal sizes. You didn’t use to see that before. The trend is accelerating.”

During 2014 US start-ups received the highest investment of US$59 billion (most since the dot-com era)

  • Late-stage companies received two-thirds of it, with a record 62 firms raising money at valuations of $1 billion or more, almost three times as many as in 2013.
  • Investors - About half the investors weren’t venture-capital firms

... Which could be on their way for a crash....

However, the key point of concern here is that in most cases, these valuations are not justified by company fundamentals

According to Steven Davidoff Solomon, a professor of law at the University of California, Berkeley, “It is not just about apocalyptic valuations. Companies are going from zero to billion-dollar valuations faster than ever before, despite a lack of revenue and, perhaps, even a market plan. In the frenzy, ideas that once were discarded as failures are being recycled into billion-dollar start-ups. Remember, same-day grocery delivery is nothing new. Kozmo.com and Webvan were same-day delivery services that failed when the dot-com bubble burst, losing hundreds of millions of dollars. Yet Instacart, a company with service in only 15 areas, is hurtling toward a valuation in the billions. “Vox Media, the Internet media start-up, closed a funding round that valued it at $380 million, $130 million more than Jeff Bezos paid for The Washington Post, while Change.org, the online petition service, raised $25 million at an undisclosed valuation from a number of investors..... When media start-ups can raise millions just because they are new companies, rather than the old struggling ones, you know the froth has spread

This particularly holds true for mobile internet start-ups where valuations for around 90 start-ups have crossed US$1 billion mark with a combined valuation of US$800 billion, making it difficult for venture capitalists to find an exit

According to Rajeev Chand, managing director and head of research at Rutberg & Co. LLC, “Mobile is frothy and bubblelike. Companies that would have gotten $8 million to $10 million in investments a few years ago are now getting as much as $50 million. There’s way too much money going into mobile delivery companies. The economics are fundamentally not sustainable”

Signs of worsening returns have already started to show – the ratio of mobile internet exits i.e. start-ups sold/go public –to – investment has plunged over the past six quarters

Source: Digi-Capital

Note – fourth quarter of 2014 excludes Facebook’s acquisition of WhatsApp for US$22 billion 

The premise is further strengthened by the fact that a number of companies have gone  public in 2014 at valuations lower than their last private-funding rounds

Last year Cloud-Storage Service Box Inc; and Hortonworks Inc., a data-services provider backed by Yahoo! Inc., went public at valuations lower than their last private-funding rounds.

In December 2014, app-analytics firm New Relic Inc. also proposed to sell shares to the public at a 25% to 50% discount to the roughly $1 billion valuations that some venture-capital firms and big mutual funds paid earlier during the year

Key Start-ups IPO in 2014 – At a discounted value compared to private funding

According to WSJ’s December 2014 press release, “There are now at least 48 private U.S. companies valued at $1 billion or more by venture-capital firms, versus 27 at the start of the year, according to Dow Jones VentureSource. That is a record number—during the height of the dot-com boom in 2000, there were 10 such companies.”

All this highlights that the Tech start-up market could be in for a crash in the near-to medium term but the debate remains how severe the fall be

One hint at the severity of the fall could be gleaned from the WSJ chart above where public market investors are paying discounts to the private market valuations, and traders are paying discounts to both of them. If public market investors are paying discounts to private market valuations (it used to be the other way around) and secondary market public traders are paying discounts to IPO valuations (it used to be the other way around), then – pray tell - what happens when the public markets correct sharply?

A Twitter post of Marc Andreessen, a venture capitalist and co-founder of Netscape Communications Corp says “When the market turns, and it will turn, we will find out who has been swimming without trunks on. Many high burn rate co’s will VAPORIZE.”

The wait is on particularly for some of the high profile mobile companies including Uber Technologies Inc., Snapchat Inc. and Square Inc., as to when they go public.

As per Tom Taulli, an M&A consultant in Los Angeles, “If one or two of these will evaporate, that’s going to create a lot of fear in the market. I see few signs that the IPO market is going to accommodate many heavy-losing companies with inflated valuations”

All of this ZIRP/QE-infused VC, hedge fund and mutual fund money going into tech startups is being filtered through personal incomes, and it shows.

This the first in a series of research articles aimed at supporting the use of Veritaseum Swaps for investment, speculaton and hedging. Individuals and financial entities interested in purchasing said research can contact me here.