From Dotcom to 2022: Is This Another Bubble?
Are we in another tech bubble similar to the dotcom bust?
In August 1995, the web browser company Netscape held its initial public offering (IPO) and went public, despite the fact that it had no clear streams of revenue and was operating at a loss. By the end of the day, it had a market capitalization of more than $2.5 billion. The IPO of Netscape is often thought to be the catalyst for the dotcom bubble, and this company along with the entirety of the period (1995–2001) offers important lessons for today’s investors. In fact, some investors today are wondering if we could be in another tech bubble.
An asset valuation bubble is an economic cycle in which the price of assets traded is far higher than their actual value. Like other bubbles, the dotcom bubble was characterized by rapid, exorbitant growth. And thanks to Netscape’s success, other significantly overvalued companies were encouraged to issue their own IPOs.
During the late 90s, I was a young technology professional who just earned my CPA. I was working at Price Waterhouse and left the company to join a start-up with a friend. I remember it as an exciting and explosive time, as my technology roots and financial training were combining in an emancipating way. At the time, I was focusing on business-to-business internet, an area where the economics of technological innovations made sense to me. I remember that after the Netscape IPO, it seemed as if everyone, no matter their profession, suddenly became an “expert” on technology and its potential. Many other financial professionals were gung ho about investing in these overvalued companies, yet I was quietly apprehensive. I simply couldn’t understand why and how companies were being taken public despite the lack of a solid business model and the lack of clearly identifiable revenue streams. My fears were realized when, after rising five-fold in a short period of time, the Nasdaq dropped by nearly 77% and wiped out billions of dollars in value.
Before the recent pullback in technology stocks, investors were writing larger checks with values and multiples that eclipsed even the dotcom days. The question people started asking is whether this, “is the beginning of the end of another bubble?” I do see a few similarities between today’s climate and the dotcom bubble. By July 2021, start-ups around the world had already raised $292.4 billion, which promises to dwarf the amount raised in 2020. By that same time period, the number of mega-rounds ($100 million-plus venture deals) totaled 751. Compare that to the 665 mega-rounds throughout all of 2020. As we head into 2022, these trends certainly demand closer scrutiny. Despite these concerning numbers, however, I am confident that today’s investment landscape isn’t quite the same as that of the dotcom bubble.
Similarities: High Market Values and Low Interest Rates
First, let’s take a closer look at the similarities between today’s investing climate and that of the dotcom bubble. There are indeed several similarities, which have given rise to the speculation that the clock is ticking on another bubble. It can be said that the dotcom bubble was a perfect storm — the combination of technology becoming widely available with the release of user-friendly web browsers, plus low interest rates that increased the availability of capital. With more capital at their disposal, investors succumbed to a herd mentality. Since it seemed that everyone else was giddy about the digital gold rush, investors didn’t hesitate to put their dollars into virtually anything tech-related.
As a result, tech companies found it easy to attract venture capital, and the subsequent rush of IPOs greatly benefited investment banks. Unfortunately, it was all built on a house of cards. Investors became so confident in the promise of technological advances that they were willing to ignore traditional metrics, such as price-earnings ratios. In retrospect, it seems foolish to invest heavily in a company that still hadn’t managed to turn a profit, yet the dotcom investors did so on a routine basis.
In 1995, the Nasdaq index was under 1,000. By 2000, it had grown to more than 5,000, reaching its peak of 5,048.62 in March 2000. By October 2002, the Nasdaq had fallen to 1,139.90. The majority of dotcom businesses did not survive, including such notable defunct businesses as Pets.com and eToys.
There are indeed similarities between today’s landscape and the dotcom years. During the past five years alone, we’ve watched the Nasdaq nearly triple in size, and several large-cap tech stocks have crossed the $1 trillion threshold (e.g. Amazon, Google, and Facebook). The two tech giants Microsoft and Apple are worth over $2 trillion. It isn’t only long-established tech firms that have enjoyed rapid growth. During the first half of 2021 alone, there were a record number of firms (249) that achieved the “unicorn” valuation status of $1 billion. That’s nearly twice as many unicorns as were produced during all of 2020.
The low interest rates we’re currently seeing are a major factor in the willingness of investors to write ever larger checks. However, the red-hot labor market and rising inflation could prompt the Fed to raise interest rates. On the other hand, we’ve been thrown one of the largest geopolitical overhangs in recent memory, which has added additional uncertainty to the market as of late. That said, I still believe it’s possible we could see a 0.25% interest rate hike by March 2022. Some might say these combined factors could lead to the bursting of another tech bubble.
Differences: 2022 — More Private Equity and Delayed IPOs
There are certainly similarities between 2022 and the dotcom bubble, but the differences between these two investment landscapes are reassuring. First, let’s consider the sky-high valuations. It’s true that we’re seeing far more high-valuation unicorns than ever. However, the difference between today’s high-valuation companies and those of the dotcom era is that today’s companies do indeed have value to match the hype. As a result, investments in these companies are not equivalent to the speculative investments of the ‘90s.
Second, unlike the rush to take companies public during the dotcom era, today’s companies are remaining in private hands longer. This is due in large part to changes in legislation. Previously, companies were legally required to go public once they crossed the threshold of 500 shareholders (including employees). In 2012, then-President Obama signed the Jumpstart Our Business Startups (JOBS) Act into law. This law increased the threshold to 2,000 shareholders, enabling companies to stay in the private market far longer. As a result, we aren’t seeing the mad dash of companies issuing IPOs before they have even developed a solid business model or turned a profit.
Because companies (particularly tech companies) are delaying their IPOs despite higher-than-average valuations, they are looking to private investors to fuel their growth. These private investors are entering into investments with the understanding that public investors will be their exit strategy. Furthermore, private equity firms use a rollup strategy in which they acquire multiple small companies and merge them. This private equity landscape is significantly different from that of 2001. Today, there are far more private equity firms investing greater amounts of capital. In other words, there is more competition and fewer sky-high returns.
It’s worth noting that at my company, Black Dragon Capital, we prefer to avoid the rollup strategy. This is in part because we take a long view, preferring to invest in technologies that we believe will demonstrate robust long-term growth, as opposed to building companies by combining several with the intention of selling them. This reflects our roots as entrepreneurs who share the same mindset as the executives in our portfolio companies.
To sum up, the increase in private equity and the delayed emergence of IPOs are two significant reasons why I do not believe we are currently in another bubble about to burst. Furthermore, in today’s investment landscape, the hype of a new unicorn tends to be comparable to its value.
Lessons Learned from Over Two Decades of Investment Strategy
The dotcom bubble had devastating consequences. Collectively, investors lost billions of dollars and many companies went bankrupt. Early stage investing felt the ripple effects along with the overall economy. Yet, I believe there is a silver lining. While I was one of the lucky ones having exited in 1999 before the bust, due to my work as a startup executive in finance and technology in the dotcom era, I’ve personally learned valuable lessons from the experience. Considering that others have raised concerns about the similarities between today and the dotcom era, it’s clear to see that others have learned from the experience as well.
We can use these lessons from the past to guide decision making and invest more wisely today. For example, at Black Dragon Capital, we look to combat speculative investing by only investing in areas in which we have extensive operational experience. Since our focus is on tech companies, we want to see that the technology is proven effective. I define “effective” as being able to solve a real problem or challenge, as this creates the potential for industry disruptors. Although our investment team needs to see that the technology is proven, we understand that the company leaders have likely not yet worked out the right strategy and execution. We also need to believe in proven teams with strong track records. Above all, the value of the transaction must reflect the work we’ll put into the company.
Tips for Adapting to Today’s Investment Environment
We can take the lessons learned from the past and apply them to today’s landscape. During the dotcom era, low interest rates added fuel to the fire. Right now, interest rates are still fairly low, although signs point to an increase. However, macro trends such as low interest rates should not be a determining factor in an investment decision. Instead, it’s necessary to take a close look at each company on a case-by-case basis to assess the problem its technology can solve, the viability of that technology, its scalability, and the company’s executive team.
Above all, I urge investors to remember the fundamentals and prioritize traditional metrics above hype. In the dotcom bubble, investors were so awestruck by the promise of technological advances of the internet that they ignored traditional financial metrics. However, we can still invest in the promise of tomorrow in a practical and responsible way. It’s an exciting time for technology and we will continue a long-term bull run if we apply important investment scrutiny marinated by the promise of tomorrow.
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Louis Hernandez Jr. is the Founder & CEO of Black Dragon Capital, a minority-led investment capital company focused on software and technology. With a commitment to supporting future leaders, Hernandez is also Founder of the non-profit organization, For a Bright Future.
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