High-risk startups as high-leverage investments

Nobody can go far without hearing discussion about startups or speculation about bubbles:

http://www.businessweek.com/smallbiz/content/mar2011/sb20110329_239744.htm
http://dealbook.nytimes.com/2010/12/03/a-silicon-bubble-shows-signs-of-reinflating/
http://www.businessinsider.com/a-few-points-about-the-tech-bubble-debate-2011-3
http://blogs.reuters.com/mediafile/2011/03/24/the-41-million-mobile-app-or-the-web-bubble-debate-now-in-full-color/

In this post, I'll talk about why we're in a bubble. In the next, I'll talk about why people are still founding startups.

I'm not sure what to make of the startup market either: is it really a bubble? I'll argue that it is. I'll give non-rigorous arguments that (A) tech startup investments tend to be highly leveraged against the broader stock market and (B) our market has at least two factors which might contribute to bubbles. I encourage any readers to contribute market data or ideas.

(A) To see why tech startups are a highly leveraged against the broader stock market, consider that many tech startups are eventually acquired by other companies. In many recent cases (at least in the Web- or consumer-facing cases), they are acquired by large companies like Google, IBM, Apple, or Facebook. These acquisitions, however, typically come when the acquiring firm is flush with capital -- and have enough that they can comfortably afford to buy entire companies. Now, a 10% increase in the stock price of Google might give it $18B extra to spend. Surely not all of this will go towards startups; say just 5% of it does. Even that would generously buy about ten $100M startups. In short, a 10% increase in the stock market is enough to promise 10 great prizes to 10 great entrepreneurs. VC firms see this, so they're willing to fund 10 companies -- or more. After all, if they miss on a few but are reasonably accurate, they'll be fine. In fact, they'll be better than fine.

Added 30 March 2010:

The leverage part comes here: say the market increases 10% again. Google can now buy about twenty $100M companies. The market for startups has doubled, on a 21% increase in the stock market. This example is exaggerated, since there's always a market for startups, but it's reasonable to assume that, if tech companies' stocks dropped to 50% of their current value, they wouldn't be acquiring anything for a while. Going by this assumption, the leverage is at least double the stock market.

I've also realized that "beta" might be a more appropriate term to use than "leverage".)

(B) The stock market has bounced back in the past two years, with indices such as the S&P having risen by about 60%. Naturally investors are feeling cushy again (I am, even as a novice investor: I bought an unnecessary car a few months ago). Part of this increase is due to low interest rates: stocks are simply more attractive than bonds right now. Add to this the fact that banks are able to borrow money at record-low rates, and in many cases they're re-investing it in exactly those VC markets that we are talking about.

Here's how it will happen: once our stock market dips again, say 15% (and it's bound to happen eventually, even if it goes up before), Google and other established companies will pare back their acquisitions -- even if it's largely an emotional move. It won't be terrible for them, since they have clear business models and low burn rates. VCs will realize -- from market data, industry hearsay, and experience -- that it's not worth investing as freely in high-risk startups. After all, their hundreds of $100B tech startups no longer have buyers. This won't be the end of VC capital, but it will be enough for a number of tech startups to log off. Of course, many VCs will be hurt by this, which will have second-order market effects as some go bankrupt, and the stock market will drop further, as value is lost overnight. And that's how the bubble will burst.