VC chorus: Wild spending signals bubble trouble

Wild spending by startups and ludicrous valuations of companies with no profits threatens to stifle the tech job boom

Man under umbrella raining money

Bubble, bubble, toil and trouble. No, we’re not talking about Macbeth. It’s Silicon Valley that’s bubbling -- and not in a good way. Valuations of startups with minimal business plans have gone beyond ridiculous. Young companies are spending like teenagers set lose in the mall with Daddy’s credit card. Even the professional optimists in Venture Capital Land are getting worried.

Chances are you’re not pouring your money into startups, so why should you care? It’s simple: Startups have been a great source of jobs for ambitious IT pros. When that bubble pops, those jobs are going away.

Even worse is the prospect that a downturn will hit more than silly startups dedicated to making life easier for the overprivileged and lazy, which is exactly what happened during the implosion of 2001. Even big companies with real revenue were hurt then, and when money gets ultratight, innovation suffers, as good ideas get tossed out along with the frivolous ones.

Take the routine announcement of Facebook closing on its acquisition of WhatsApp this week. The final price was $22 billion, $3 billion more than the $19 billion deal struck in February. Why $3 billion more? Because Facebook’s stock, which accounts for the majority of the purchase, has appreciated. That $3 billion bump, which is worth more than many businesses that employ lots of people to create valuable goods and services, has absolutely nothing to do with the value of WhatsApp.

That logic makes sense only in a bubble economy.

Venture capitalists change their tune

Venture capitalists are a wily bunch, always looking to gain a psychological edge, and you have to take everything they say with more than a grain of salt. But when they all start singing from the same hymnbook, it’s worth paying attention.

The change in tone in the past few months is striking. Back in March, for example, Marc Andreessen, co-inventor of the world's first commercial browser and co-founder of a leading venture capital firm, poured cold water on the notion that a bubble was forming, let alone that it was ready to pop.

Far from being at risk of a bubble, the tech industry is, by some measures, "still in a bust," he said during a talk at the Stanford Graduate School of Business. Contrast that with some of his recent tweets:

New founders in last 10 years have ONLY been in environment where money is always easy to raise at higher valuations. THAT WILL NOT LAST.
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 capitalization is Andreessen’s; his handle is @pmarca)

Let’s be clear: A high burn rate is a lot more serious than some 20-year-old CEO spending too much on foosball tables and catered meals for the staff. Startups are filled with very highly paid engineers and developers working in places like San Francisco where commercial rents are exploding.

At the end of 2013, average salaries at tech startups were close to $86,000, and nearly a third of employees surveyed by said they were earning bonuses on top of their regular paycheck.

A few weeks ago, another high-profile VC, Bill Gurley, was downright foreboding: He told the Wall Street Journal that Silicon Valley has taken on too much risk, and he anticipates seeing high-level failures in the next year or so. That level of risk, he said, is “unprecedented since 1999.”

He went on to say, “More humans in Silicon Valley are working for money-losing companies than have been in 15 years. In '01 or '09, you just wouldn't go take a job at a company that's burning $4 million a month. Today everyone does it without thinking.”

Hear that? Taking a job at a company that’s making no money but persists in spending wildly is not a good bet -- unless you like to live dangerously.

Since we journalists like to say it takes three to make a trend, here’s yet another prominent VC weighing in: “At some point you have to build a real business, generate real profits, sustain the company without the largess of investor’s capital, and start producing value the old-fashioned way.” That comes from a blog post ominously titled “Burn Baby Burn,” by Fred Wilson of Union Square Ventures.

It's worth noting that Andreessen correctly pointed out that the valuations of mature tech companies are fairly reasonable, a big difference from the late 1990s.

Valuations reach the absurd

Startups aren't alone in spending wildly. Google paid $3.2 billion for Nest earlier this year; Apple made the largest acquisition in its history, buying Beats for $3 billion; and Facebook paid $2 billion for Oculus Rift, a virtual-reality startup barely out of the Kickstarter stage. Don’t forget the aforementioned $22 billion the social network spent on WhatsApp.

Speaking of Kickstarter, Oculus Rift raised $2.4 million from investors, while offering them T-shirts and other trinkets instead of an equity stake. BloombergView columnist Barry Ritholtz righteously labeled this arrangement a scam.

There's an undercurrent of nervousness about the economy as a whole, and investors are already pulling money out of the broader market, which makes the climate for startups even fouler.

The tech press isn't helping in glorifying useless little companies that have made their youthful founders fabulously wealthy. Alfred, for example, was the first-place winner at the TechCrunch Disrupt conference. It’s a service designed to make it easier to hire minions who will take care of chores, like laundry, you’re far too busy and important to handle yourself. Contrast that with the real innovation I wrote about a few weeks ago: tech companies creating products and services that will make American manufacturing more competitive, while creating new jobs

I don’t like to be the voice of doom and I don’t think there will be an explosion -- or, more accurately, an implosion -- in the near future. Andreessen's point about current valuations makes the current bubble somewhat different than the last one. But you don’t need a coven of witches to tell you something stupid is going on in the startup world and bubbles based on wishful thinking always pop.

Copyright © 2014 IDG Communications, Inc.

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