This episode originally aired Oct. 4, 2019.

This holiday week, we’re taking a look back at some of our shows from 2019 that explore topics we’ll be thinking more about in the year ahead. That includes the way tech companies are valued and how it can affect all of us. Tech valuations were soaring for most of 2018, and then, in the fourth quarter of this year, things got messy.

WeWork, valued at $47 billion, pulled its initial public offering, partly over corporate governance concerns, but also because it just isn’t making money. That capped a string of disappointing IPOs from Uber, Lyft, Slack and pseudo-tech companies like Peloton.

Why did people think these venture-backed companies were worth so much? Also, what’s it going to mean for how they do business in the future?

Earlier this year, I asked Alex Wilhelm, editor in chief at Crunchbase News, why these private valuations have risen so high. The following is an edited transcript of our conversation.

Alex Wilhelm: There’s a lot of money sloshing around in the private market, which means that companies that are still private, that haven’t gone public yet, have access to an almost historically high amount of capital. When capital fights for the same number of deals — there’s only so many good companies out there at any given time — prices go up. Today, venture capitalists are forced to pay much more than they used to for companies of similar quality. The concern is that this price inflation, this valuation increase that startups are seeing, will eventually not bear out, and these investors will have overpaid and not be able to generate the kinds of returns they used to.

Molly Wood: So then you have this scenario where these companies — in order to achieve the growth that would return the amount of money these venture capitalists are hoping for — are essentially forced to overreach, right? Like, expand globally, even if the business isn’t ready for it?

Wilhelm: That happens quite a lot. If you raise a lot of money at a very high valuation, you want to go out, use that money and then try to earn yourself into the number you’ve been valued at. But if that number gets too high, you have to be more aggressive, less patient and maybe take on more risk. A lot of these companies that have very high valuations are simply just very, very expensive wagers that different venture capitalists and private investors have made. You can think about aggressive valuations as optimism, or you can view them as delusion. I think currently, given what we’ve seen from some recent IPOs that have struggled, is that some of these valuations set by private investors were more delusion than optimism.

“If you’re a big pile of money, you can write yourself rules to make sure that you make money, no matter what.”

Alex Wilhelm

Wood: I know that there’s a lot of private money sloshing around in general, but how much of this is the SoftBank effect? When you have one fund coming in and saying, “Our minimum investment is $100 or $200 or $300 million,” how distorting has that been on these valuations? Was this already happening?

Wilhelm: The distorting effects were already happening. SoftBank certainly made everything worse. SoftBank was willing to come along, look at two different companies that were competing and say, “We’re going to pick one, we’re going to give you so much money that you’ll have a cash advantage so large that you’ll be able to grow more quickly and essentially win your market.” Now, if that will work out, isn’t quite clear. At the late-stage of the private capital or private markets, SoftBank has really changed everything. The question is: Is what it has done actually good? Some venture capitalists will say no, but we have to keep in mind that it’s not just the late stage of the startup market that’s overheated or possibly inflated. This is true at the middle of the market and at the early stage. Prices have gone up for seed-stage startups, early-stage startups, late-stage startups and these growth-stage companies that could go public.

Wood: And again, just to reiterate, that’s because there’s just so much money around, or is it because there are fewer deals still? Is this like the lemming effect? Everybody wants to find the same thing that is a proven winner or they hope is a proven winner.

Wilhelm: It’s the lemming effect., and you can see that in companies like Notion, which just raised a very interesting round. It’s also the [fear of missing out] effect — everyone wants to get into a hot deal. That’s how Uber kept raising money deep into its slowing growth curve. And it’s also the SoftBank money piling into late-stage and driving everyone else to pay more if they want to get into any deal. It’s hard to say any one particular factor is the sole cause, but certainly too much money, aggressive valuations, founder-friendly terms that [don’t] fit into historical patterns. All of that comes together to form a moment in which valuations for a lot of private companies simply look too high compared to anything we’ve seen since at least 2000.

Wood: That gets us to the bubble question. [We’ve seen] WeWork pull its IPO. We’ve seen the Peloton IPO really disappoint. Will we look back and say WeWork was our Pets.com like it was in the first dot-com boom?

Wilhelm: I think WeWork will be a high-water mark for the current cycle’s craziness. But I don’t think it’s fair to say that all these companies that we’re discussing that had troubled IPOs were failures. If you think about Slack, which has gone down dramatically since its early trading days as a public company, it’s still up very sharply since its last private valuation. Peloton, which has struggled as a public company, is still up from its last private valuation. Some of these companies are seeing that they reached too far as public companies, but they’re still worth more than they were before they went public. It’s certainly fair to say that some companies are seeing their valuation decline. WeWork is going to be a business case for the ages. We will talk about it until we’re done talking about business. But some of these companies are a bit healthier than you might otherwise expect, because they were actually seeing valuation gains through their IPOs, even if those IPOs disappointed.

Wood: What do you think happens now long term? There’s still the same amount of money rolling around. SoftBank is raising another Vision Fund. Is any of this likely to change? Is it going to become like a big reality show where we just see what happens with the IPO?

Wilhelm: I’ve been unsuccessful at calling for the top of the market since early 2016. I have been incredibly wrong. Things have just proven to be more resilient than I expected. We’ve seen bits of panic occasionally. There was the early 2018 [software as a service] crash, if I recall correctly. But really, the market has been shockingly stable and very welcoming to more private capital and many IPOs this year than I would have expected. I’m just hesitant to say today is the time, this is it. What I do think we’ll see is companies that are going to go public that don’t have the same financial profile as a software company, which is very good, will shoot for lower valuations to avoid IPO embarrassments. That’s where the lesson of Peloton, I think, comes to play. That company didn’t have the same margins that software companies have. Therefore, it wasn’t worth as much, and therefore it really just reached too far when it went public.

Wood: That is a really interesting point. There was a blog post last weekend. Fred Wilson, a venture capitalist, wrote this post saying that part of the problem is that companies like Peloton, which are complicated but ultimately hardware-based, or WeWork, which is ultimately a real estate company, are being valued as though they are tech companies. Talk to us about the difference in margins there and why that’s such an important distinction.

Wilhelm: The reason why software companies are worth so much money is because their revenue is very profitable. That’s a fancy way of saying that it doesn’t cost a lot of money to generate software revenue, because you’re just selling bits. It has a very high percentage of revenue that you can use to pay for your operating costs. Think about it this way: If you’re an oil company, and you have to pay a lot of money to drill oil out of the ground, you’re going to have lower gross margins than a software company giving you a service over the internet. That means that software companies enjoy higher revenue multiples. If they have a billion dollars in revenue, they might be worth $10 billion. In the grocery business, you can trade for 0.5 times your revenues. This matters for startups because often companies that don’t have software-like gross margins or software-like revenue get valued as if they did. And when those companies eventually reach the public markets, the public markets say, “Well, that’s not right. We’re not going pay that much for that because it’s not quite as good as software revenue.” And that’s where the disconnect between the private market optimism and the public market reality can really come and bite you.

Wood: Let’s talk about winners and losers. When there’s a WeWork pop, or an IPO doesn’t go as expected, it doesn’t seem to me like the venture capitalists who made these big bets and inflated this bubble necessarily end up losing out. Right?

Wilhelm: No.

Wood: The money guys are always fine.

Wilhelm: The money guys are almost always fine. Keep in mind that a lot of investors put money into these companies we’re seeing just now much earlier on. They put money in when the company was 1, 3, or 4 years old, and we’re now seeing it [as a] 7, 8, or 9-year-old company. The price they paid back then is far lower than the IPO price that we see, even if the company struggles. Often the investors do better than you’d expect, and sometimes late-stage investors like SoftBank, like the Vision Fund, get special terms when they buy — downside protection. If the IPO doesn’t go as well as they’d hoped, they can still be made whole and still profit off the deal. Essentially, if you’re a big pile of money, you can write yourself rules to make sure that you make money no matter what. This ends up diluting and harming regular employees. But like you said, the money people tend to always win.

Wood: Does any of this have implications for your everyday consumer?

Wilhelm: I think the implications for everyday consumers would be that we may see these heavily venture-backed companies pull back on discounts, pull back on promotions, shoot for something closer to profitability. What that will lead to is higher prices for us, the consumers. If you think back to using Uber in 2014 or 2015, it was almost shocking how inexpensive it was to get around town no matter where you were. Now taking an Uber is much more expensive because the company’s focused on profitability and more traditional accounting metrics. I think the days of the spigot being turned on and venture dollars flowing down and us, the consumers, enjoying those discounts and underpriced services, are going to go away.

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