The Long Fall

Bearish talk in the tech industry of an overinflated bubble is the new cause célèbre. Skeptics point to towering valuations of startups without revenue and the ability for some companies to command similar prices for their equity despite posting massive losses in the name of growth.

Why would the fun stop? Despite the economy of the United States posting anemic growth in the aftermath of the 2007-8 economic crisis, its stock markets are trading near record highs in some cases, and local maximums in others.

Money is cheap, companies are flush with cash, job growth has somewhat picked up after a host of setbacks, and there are signs here and there of a stiffening economic comeback. Given that, it might seem almost odd that a correction could be on the way for the industry of young, and young-ish technology companies — if things are getting better more broadly, why are things going to get worse in tech?

There is no single answer, but a few facts are worth noting, given their potential to upset the economic balance that has funneled so much external cash into the technology space.

The Federal Reserve’s program of quantitative easing is coming to an end, and investors expect that, at some point in the future, the Fed will start to raise benchmark rates. That action will have the result of raising the price of money.

If things are getting better more broadly, why are things going to get worse in tech?

Money has been incredibly cheap in recent years. The government, desperate to bolster a disintegrating economy, lowered the benchmark rate to a razor-thin 0.25 percent. Essentially, the cost of borrowing money for some parties — banks, for one — was reduced to nearly zero. In theory, this boosts liquidity by encouraging banks to loan more, spurring demand and, thus, the larger economy. That rate is going to go up. No one knows when, but there is noise coming from the Fed that interest rate boosts could start in the not-too-distant future. Expect the incline to be slow — the fragility of the economy is well known.

When the price of money goes up, several things happen:

  • The Fed raises the benchmark rates, leading to increase in rates across debt varietals.
  • This makes interest-bearing assets, such as bonds and corporate paper, more attractive.
  • When an asset class becomes more attractive, money moves from other asset classes.
  • The impact of currently less desirable asset classes becoming more attractive is that currently attractive classes will see a reduction of inflow, and perhaps even negative flow, of dollars.
  • Stocks, which are, as we noted, trading at record or near-record levels, could become less attractive.
  • This leads to a decline in share prices.

It’s not too hard to understand: If I take my dollar from that and put it over there, where I took it from becomes less valuable.

This is not a quick process. Do not expect a 5,000-point decline in the Dow Jones Industrial Average, but a decline in the value of technology companies, our subject, has a number of impacts.

A venture capitalist once told me that his industry operates merely as an amped version of the tech-heavy NASDAQ. The impact of a weaker NASDAQ, even if modest in the public market, could therefore have an outsized impact on private companies and how they are invested in.

A company whose stock price declines is a company that has less purchasing power. Many large acquisitions are executed with an amount of stock as part of the deal. When equity loses its value, when the share price of large tech companies declines, what they can, and may be willing to pay for other companies is reduced. This lowers venture capital returns.

Adding to that, provided a large enough correction in the price of technology companies’ shares, the IPO window could close. And with exits to public companies already under pressure in terms of terms, another exit possibility for venture capitalists would slow.

And if you’re a venture capitalist and don’t think that you are going to be able to generate a positive return on an investment because there is no viable exit point, you don’t pull the trigger. From the other side, if limited partners (LPs) see slipping share prices, falling deal sizes, and more malaise and miasma than mouth-watering returns, they may shake up their asset allocations.

Less LP money means smaller venture capital funds, and thus less available cash for startups. Great companies will still be able to get money. It will become harder the further down you slide on the quality scale, which isn’t such a bad thing, given that we’re in a bit of a startup silly season.

This all comes at an awkward moment for some companies that continue to build themselves as if money were going to remain cheap. They have high burn rates, in other words. This is a lot of companies, and not just one, mind you.

Bill Gurley, a venture capitalist at Benchmark, rang that particular alarm in a recent interview. He has a point: If you were hoping for several more nine-figure injections of cash to go public, let alone profitable, that cash that you expected to be waiting for you just might not be there.

None of this is to say that a large number of incredibly valuable companies aren’t being built at the moment. It means that the price floor that the Instagram-Facebook deal set, and that has been used to price a handful of other mega-deals, might need some correction. More than a haircut, I’d imagine.

So things are great at the moment, and they have the potential to be pretty good for some time. But as the price of money picks up, and some money leaves tech, things could become colder over time.

People keep going to work, companies keep getting started and evolving, consumers keep buying what they need and want — we muddle through. Marc Andreessen

If that sounds modest, it’s worth keeping in mind how great the tech industry has had it in recent years: Ever larger venture funds; blocks of cash from non-tech companies in the form of fleets of new accelerators and incubators; an IPO-willing public market with a taste for revenue growth in the face of expanding losses; and, of course, cash and equity-rich large tech companies who are so afraid that they’re nailing down billion-dollar deals in rapid succession.

Unsurprisingly, there are optimists in the mix. Marc Andreessen told Alexia that he doesn’t have a “crystal ball,” and that while “anything is possible,” he sees “no reason to have some elaborate negative theory at this time.” Gurley’s worries about risk don’t seem to faze Andreessen.

Specifically, Andreessen doesn’t take the above argument too seriously, saying that “way too many people are wrapped around the axle on [quantitative easing], Fed policy, inflation fears, etc.” According to the venture capitalist, “[n]egative macroecon[mic] theories are everywhere.”

Why is Andreessen bullish? “Reality is pretty prosaic.” By that, Andreessen means that “[p]eople keep going to work, companies keep getting started and evolving, consumers keep buying what they need and want — we muddle through.”

That’s a decent encapsulation of a market economy, but it doesn’t deter the fact that macroeconomic and financial shifts can impact sectors and industries that have enjoyed a very long summer indeed.

“Tech works better than ever and markets are bigger than ever,” said Andreessen. Again, correct. But that doesn’t mean there isn’t a bit of froth in tech that could be shaken out when money gets a bit more expensive.