Opening the valve

For quite some time I’ve been a strong opponent of the notion that we are in a new dotcom bubble. While there has indeed been a significant raise in the starup investments and valuations, my position has been based on the facts that this time the things are a bit different: there is only a handful of companies getting seemingly insane valuations, and none of them are available to the public market.

However, today I have ran into a few articles discussing the plans of the SEC to loosen the rules that define who can invest in non-public companies and how. And if these plans become reality, I am willing to bet that this will very soon lead to a new tech bubble, which might pop even stronger then the Y2K one…

For one, startups are inherently risky, but the media is emphasizing the most successful ones, and the public perception is that one can make a fortune on the right ones, like the current media darling Facebook. So when the gates are opened and the public is allowed to invest there will be a rush, which will create a bubble effect we have all seen ten years ago. But this time it will be even worse, as the private companies are not required to have as many disclosures and reports as the public ones, so it will be almost impossible to have the right information. It is safe to predict the it will end up with a lot of small investors blowing up their savings on the gold rush of overblown valuations.

Second, one of the greatest effects of current rules is that most of the funds available to startups are the “smart money”, i.e. they come with experienced investors (VCs and angels) who add quite a lot of value besides the cash itself. Small-time investors mostly don’t have that added value, and the money is usually not enough, as we could have learned on the Diaspora’s case. In fact, we will most likely have the least experienced founders seeking funding from the least savvy investors (as those with experience will by definition have better access to mentors and investors), and without the guidance they will be more likely to fail, taking their investors with them.

Third, even though there is a lot more money available today, there is still some kind of filtering process before the startups are funded. Hell, even Yuri Milner doesn’t throw his money blindly to anyone who knocks on his door – he has relegated the process to the Y Combinator team, who have so far proven that they can pick the best teams. But unsophisticated investors don’t have the skills to pick the wheat from the chaff; instead they have only one tool to help them decide: social proof. And as they mostly don’t have direct access to the experienced pundits, they need to use a proxy, which is the mass media; and we all know how accurate its reports on startup valuations are. So it comes down to only two kinds of companies they will shoose to invest into: either the booming behemoths everyone is talking about, like Facebook or Groupon; or, failing that, any small seed-stage startup dabbling in the field which is hot in the news these days, be it social media, mobile, geolocation or whatever.

And lastly, one of the worst situations a startup can find itself in is to have more money than it needs. (And I’m talking about investment money, not revenue; the latter is a good problem, and when you get there you’re not really a startup anymore.) This is something we have seen in late nineties, when the bubble was at its height, with money being blown on expensive cars, designer chairs and weekly parties. A startup thrives when it has just enough money to scrape it through, and overfunding makes it sluggish and drowsy.

So I believe that the last thing we need is making funding for startups easier, especially if that means involving a wide audience of unsophisticated investors. I’m still certain that we are not in a real bubble yet, but these new regulations will certainly mean opening a valve to the air tank which will blow it up. And this time it might be even worse than the last.

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