Silicon Valley’s Next Bubble Could Be an Even More Destructive Burst

One would think that Silicon Valley and the tech sector at large would have learned from the dot-com bust of 1999-2001. But the money thrown at companies such as Uber and Airbnb makes backing for the likes of Yahoo and eBay in the 1990s seem like the spry social enterprises we often write about on TriplePundit. Of course, some tech companies, such as Google, eBay and venerable Yahoo before its recent struggles, ended up faring spectacularly well. Of course, there were also the doozies such as eFrenzy.com (find someone to do a home repair for you), Pets.com (not even that sock puppet could save the company from its spending ways), Webvan (it collapsed as quickly as this grocery delivery service reached its billion dollar valuation) and GeoCities (if you had a GeoCities website then, you’re loathe to admit it now).

Well, some of the recent failures in Silicon Valley make those aforementioned digital ghosts seem like a bad night of poker. There was Shuddle, the Uber-like service perfect for parents who were hell-bent on laying out their kid’s long-term plans to get into Harvard starting at the age of three — the service moved kids to all kinds of extra-curricular activities around town, so they could build their college applications while sparing their parents the hassle of driving to chess and Minecraft-programming lessons. On the murkier side there is Theranos, the miraculous blood-testing company that landed its founder and CEO, Elizabeth Holmes, on all kinds of impressive lists before it turned out the technology was not exactly peer reviewed and tested . . . and is now being investigated by the Securities and Exchange Commission (SEC). Those who live outside the Bay Area bubble have guffawed at the ridiculous amounts of money that has chased many a startup and entrepreneur, or as the cantankerous New York Post recently described, “any college dropout who’s got a nice smile and a fancy smartphone.”

Okay, so maybe describing these “slicksters with their matching T-shirts, hoodies and sneakers,” is going a bit far, but that New York-based tabloid has made a point—they have built what many have called the “unicorn” economy. These privately-held companies, which boast a valuation of over $1 billion, often have dubious business models and sketchy revenue streams, in turn have nudged the Silicon Valley economy close to the edge of a cliff. Of course, some observers will point out the successful unicorns can turn into a success story such as Facebook. Add up the successes when you include companies such as Salesforce, and of course, internet giant Google, and you more than wipe out some losses that occur along the way.

The problem is that as VentureBeat has noted, there are well over 200 unicorns across the globe that together, are worth about $1.3 trillion—with about $175 billion in investor funding. Half of those companies are in California. And these companies’ spectacular valuations are in part why the average home price in Cupertino is almost $1.9 million, while up the road on I-280 in Palo Alto, the average home is selling for over $2.5 million.

So as venture capitalist Bill Gurley discussed last week in a 5,000+ word op-ed, there is cause for worry. Silicon Valley, and its unicorns, are ensnared in a vicious circle: these companies are taking investors’ money at valuation rates that make no sense; those venture capitalists that were the first to sink in money don’t want to see those valuations decrease as that could hurt the quest to raise more funds down the road; the companies can’t or won't go public because that means far more disclosures (as in the truth) are required. That in turn can lead companies to become desperate and borrow money from the savviest investors, or who Gurley describes as “sharks.” These sharks will only release funds if they are granted “dirty term sheets,” as in preferential liquidity rights, ratchets (when a company must dole out the difference between an earlier higher valuation and the later lower valuation) and guaranteed IPO returns. The result is that if a company goes south, the sharks will win any feeding frenzy, leaving the initials with the crumbs, or as the saying goes, completely screwed.

There are alternatives to that nightmarish scenario. Gurley explains that companies need do what they should be focusing on in the first place: make money. Forget the moves taken to soar to a sky-high valuation, as a multibillion-dollar valuation does no one good if it goes belly-up. And ditch that ego, and seek funding at a lower valuation. And of course, become a public company: everyone laughed at Facebook when its first several months as a public company were rocky, but few are laughing now.

Some say that the tech sector in Silicon Valley is more of a leak than a bubble as startup money has already slowed down this year. And as some companies fall by the wayside, others pick up where those companies have failed, making markets more efficient. After all, a metropolitan area needs only three or four food delivery services, not the 30 or 40 that dot the Bay Area landscape now.

But the fact is that many of these unicorns have not been transparent about how, where and the amount of money they are making. As as we’ve seen in the tech, real estate and even the energy sector, it only takes a few dominoes to tumble before many fall. But many Bay Area residents are already over-leveraged in a very overheated real estate market. And these unicorns have more than their fair share of suppliers and service providers, who will suffer a boot on the neck if these companies go down. It’s time for these companies to let go of bragging rights and get expectations back down to earth. After all, a soft landing in any situation is far more comfortable than a crash.

Image credit: Shuddle