Burst this bubble! In praise of market downturns

A stock market in free fall could have a chilling effect on Silicon Valley startups. It could also bring a return to rational investing and a renewed focus on good business plans

Burst this bubble! In praise of market downturns
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Investors are still reeling from the sudden dive they took on the stock market roller coaster this past week. The plummet in value of some publicly traded companies looks likely to have a longer term, knock-on effect in Silicon Valley -- and on privately financed tech startups in particular. But is that entirely bad?

Whereas the tech bubble of the 1990s was created by a flood of overpriced IPOs for Web companies with no profits (see: Pets.com, eToys), there has been a building drumbeat from venture capitalists like Bill Gurley and Fred Wilson warning about the runaway valuations of today's mature, pre-IPO startups.

In June, Gurley warned of the "dry bubble" in the tech industry -- a bubble in valuations where there's no clear exit strategy for investors to create cash. Or as Jason Lemkin, managing director at Storm Ventures, said: "It's a roach motel.  All this money is going in at higher, all-time higher, valuations -- but very little is coming back out."

CB Insights currently lists 131 "unicorns" -- privately funded startups with billion-dollar valuations -- and that number has been growing at a rate of more than one a week this year. But with the market downturn, unicorns may become rarer. A widely quoted series of tweets from Gurley last week predicted that tumbling tech stock prices would call inflated valuations into question.

Market uncertainty could not only lead to revaluations that force many late-stage startups to delay their IPOs, it might also cool the crazy-hot market for earlier-stage venture funding. "The number of $50 million [funding] rounds went up dramatically two years ago. A lot of people perceived that as a signal that things are not really in a normal state," said Tomasz Tunguz, a venture capitalist at Redpoint.

While uncertain market conditions may have a chilling effect on tech funding, some savvy startups saw the bubble building and stockpiled cash. Stewart Butterfield, CEO of Slack, told Mashable that his startup raised more than $300 million, but spent almost none of it. "We have decades and decades of runway," Butterfield said.

Indeed, some see less rosy times ahead as a chance to correct the excesses and weed out poorly managed startups. Lemkin predicts the market plunge will mostly affect startups that are burning through cash. And Steve Schlafman, an investor with RRE Ventures, believes Silicon Valley investors will become more disciplined, and early-stage startups raising tens of millions will become rarer.

Many would applaud a return to rational investing with a renewed focus on metrics, which more reasonably determine a startup's value and potential, and a decline in what Eric Paley, managing partner at Founder Collective, calls "keeping up with the Startup Joneses." Gurley tweeted last week that after the downturn, "Investors are likely to refocus on business model viability and path to profitability. This will seem like an abrupt sea-change to many."

The New York Times' Farhad Manjoo is another who sees an upside to the downturn in Silicon Valley.   

The boom has made Silicon Valley soft: Companies are spending too much, investors are funding too many me-too ideas, and most founders have never had to confront any limits to their overweening ambitions. Venture capitalists won't quite say they are looking forward to a correction, but some do say that a bust could toughen the place up.

Others, such as Business Insider's Matt Rosoff, are optimistic that "instead of the tech startups vaporizing, the old inefficient businesses they've started to replace will finally topple over and die." He cites unicorns Uber and AirBnB as two such startups that save consumers money and could thrive in a downturn. On the enterprise side, Rosoff thinks companies looking to cut costs are "more likely to give newfangled services a serious look" to help squeeze more cost out of their IT infrastructure. "[If] the current tech darlings are actually disrupting older industries, why would that disruption suddenly stop just because the economy turns down?"

In the end, startups with good ideas will still prosper. After all, Google and Salesforce were born out of the dot-com bust. "This is a paradox of invention as well as of investing," writes Manjoo. "Bad times feed good ideas, which in turn lead to good times, which breed complacency, waste, and lots of bad business plans."