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Silicon Valley venture capital investors — the people who pour millions into tech startups in the hopes of selling them later for billions — are beginning to worry that low interest rates might be inflating a tech bubble.
Fred Wilson, founder of Union Square, recently wrote that spiraling valuations placed on brand-new companies seem to be reflections of low interest rates, because as a rough rule of thumb, the two move in opposite directions. “Valuations are at extreme levels because you cannot get a decent return on your money doing anything else,” he wrote. And Bill Gurley, a partner at Benchmark Capital, recently said that tech employees did not appear to understand the risks they were taking by working for companies that don’t actually make money.
Those are startling discussions to hear, because venture funders have most to gain from low interest rates and the investment bubbles they tend to cause. And of course, VC funders tend to be older, and thus remember the disastrous tech bubble crash of 1999 — unlike the 20-somethings they are giving money to right now.
So what we’re listening to are the people who are essentially fueling the bubble worrying aloud that they are fueling a bubble.
Why low interest rates can be scary.
If you’re not an economist, the link between low interest rates and tech bubbles is not obvious. Here is how it works, and then we’ll explain why it’s so serious that venture funders are talking about this now.
Generally, investors have a choice if they want to use their money to make even more money. They can save it in interest-paying, risk-free bank accounts or invest it in riskier assets that may pay more money over time. When the interest on cash that banks pay is close to zero, virtually any other kind of investment is likely to pay more because the risk-free alternative is so lousy. Money is also cheap to borrow or lend, precisely because interest rates are so low. So investors take their money out of cash savings, and dump into into … pretty much everything else. Stocks tend to go up. And investment asset bubbles get created, even in sectors like tech startups, which don’t have stock that is traded publicly.
This has macroeconomic knock-on effects, which you can see in these two charts. First, this is the Federal Reserve’s target interest rate for the last 10 years. It’s the rate that sets all other rates, including interest on cash savings in the bank. As you can see, it’s been close to zero for years:
With no money to be earned from interest on cash, money has poured into stocks, pumping up their prices. Here is what has happened over the same time period in the NASDAQ, which has a preponderance of tech stocks within it:
Investment money doesn’t just go into stocks, of course. Investors — particularly institutional ones and private equity funds looking for something more than the ~8% average that U.S. stock indexes gain every year — look far and wide for new investments.
Now, $US1 billion looks modest.
That’s why you’re seeing tech companies with no revenues and no profits get hundreds of millions in investment funding on “valuations” in the billions. The most infamous of which, of course, was Facebook’s $US19 billion acquisition of WhatsApp, a company that makes only a tiny fraction of that in revenue and has no intention of monetizing itself more aggressively anytime soon.
A couple of years ago, people gasped when Tumblr and Instagram were both bought for $US1 billion, even though they had no revenue. Now those valuations, dizzying then, seem almost modest by comparison.
RRE investor Steve Schlafman recently pointed out that cheap capital does in fact create nonsensically high valuations out there in the real world (i.e. Silicon Valley):
When one of the big players emerge [in a market], then you have these big firms that need to deploy a lot of capital … A lot of these companies don’t need to raise more money … the only way these companies are going to raise more money is on a much higher multiple. But I wouldn’t call it irrational exuberance. These are big spaces with likely one or two winners (transportation, music, discovery, messaging).
What is unspoken in that quote is that investment firms only “need to deploy a lot of capital” because keeping it in the bank earns 0%.
What happens if money begins to flow in the opposite direction?
This week’s IPO of healthcare software maker Castlight Health — a company with just $US13 million in revenue in 2013 and $US62 million in losses — provided the clearest indicator yet of unabated investor appetite for all things tech, even at valuations with no connection to earnings. The shares rose 149% on its first day of trading, giving the firm a market value of about $US3 billion.
The unspoken corollary of a low-interest-rate environment is that when the Fed decides to tighten the money supply by raising interest rates, all that money starts to flow in the opposite direction. People begin selling stocks and other riskier investments in order to enjoy the risk-free interest rates they can get by keeping their cash in savings and CDs. Money suddenly becomes more expensive to borrow and lend, and therefore more scarce. Venture capital dries up.
Companies with no profits or no revenue will suddenly run out of the investment funding that kept them alive. And the bubble … pops.
Why employees decide to work for companies with no profits.
That’s why it’s interesting when VCs start saying things like this, from Fred Wilson:
… the multiple of earnings one should pay for a business is roughly the inverse of interest rates.
… valuations are at extreme levels because you cannot get a decent return on your money doing anything else.
Ask yourself this question. What is the percentage of employees in Silicon Valley that are working at profitless companies (i.e. companies that are losing money or have negative cash flow)? And how has that trended over time? What was that percentage in 1999? What was it in 2003? And what is it today? An employee’s decision to work for a company that is losing money is an implicit decision to discount risk. If the macro environment changes, that company is under much greater stress than one that is profitable. Yet many individuals are making just such a decision today.
And then The Information stated the obvious about Pinterest, another company with zero revenue (but $US338 million in investment funding):
Cash in the bank yields almost no interest. Cash in Pinterest produced a 52% return, at least on paper, between the company’s series D and E funding rounds, according to media reports.
Pinterest is reportedly beginning to sell advertising, and may yet create a revenue model that can work off that investment or make it attractive enough for an IPO or an acquisition. Both scenarios would make its investors whole.
In the meantime, those gains are, as The Information puts it, merely “on paper.” The Fed is believed to be likely to raise interest rates starting in 2015.
Investors better hope it doesn’t fast-forward that schedule.