Tech bubble 2.0 - Jonathan Watson
The successful flotation of LinkedIn and the purchase of Skype by Microsoft may suggest tech companies have come of age, or is another tech bubble on the way?
‘Tonight we’re going to party like it’s 1999,’ says one of the best-known songs by the artist formerly known as Prince. One person probably doing exactly that at the moment is internet entrepreneur Reid Hoffman, whose business networking website LinkedIn made an extraordinarily successful debut on the New York stock exchange in May 2011.
The company, founded by Hoffman in 2002, raised $353 million through an IPO that valued LinkedIn at $4.3 billion. This was more than double the $175 million that the company said it expected the offering to raise. Soon after the flotation, its value soared to more than $10 billion. This made LinkedIn the highest valuation of a US internet firm since Google raised $1.7 billion in 2004. Pretty impressive for a company that made a profit of just $15.4 million on revenues of $243 million in 2010.
Earlier in May – the day after LinkedIn set the terms of its IPO – Microsoft said it was buying internet calling and video service Skype for $8.5 billion. The price, three times more than its valuation at the end of 2009, raised eyebrows. Why pay ten times the company’s revenue for a business that has changed hands many times, never made money, and comes with substantial debt? Peter Bright, an analyst for technology news service Ars Technica, described it as ‘a deal that’s hard to understand’. One could argue that this is analyst-speak for ‘crazy’.
The LinkedIn IPO in particular brought back uncomfortable memories of the bubble in technology stocks that took hold at the end of the last century. LinkedIn’s $10 billion valuation was 40 times the sales it achieved in 2010, a multiple ‘as silly as any in the late 1990s dotcom frenzy’, wrote Nils Pratley, financial editor for UK newspaper the Guardian. ‘It implies explosive growth for years and years and years... what are they smoking?’
According to Bart van Reeken, head of the information, communication and technology practice at De Brauw Blackstone Westbroek and Co-Chair of the IBA’s Technology Law Committee, the LinkedIn IPO ‘shows a marked belief in a yet-to-be-developed earnings model, which in my opinion is a clear sign of a bubble’. However, he does not feel quite the same way about Microsoft’s acquisition of Skype. ‘One must assume Microsoft is not buying Skype for resale but for integration into its business; the sale price reflects Microsoft’s strengths at least as much as the value of Skype and is thus not in itself indicative of a bubble,’ he told IBA Global Insight (IGI).
One lawyer contacted by IGI argued that the acquisition of Skype was a clever piece of business. ‘The $8.5 billion was doing nothing sitting in Microsoft’s bank account,’ the lawyer said. ‘There’s no point giving it back to the shareholders, because that would make no difference to the share price, and they can build it into their mobile platform, which is where that feature has to be. I don’t think that acquisition can be used as evidence that there is a tech bubble.’
Vagn Thorup, a partner with Kromann Reumert in Denmark and Co-Chair of the IBA Technology Law Committee, believes there is a short-term ‘price bubble’ but not necessarily the beginning of a tech bubble. ‘LinkedIn achieved a high price because social media platforms are growing in importance, and no one wants to be left behind,’ he told IGI. ‘Things can change very fast in the technology market. Look at Nokia – it dominated the mobile handset space until about five years ago but is now the shadow of its former self. The old players want to make sure they don’t miss the boat.’
Thorup does not expect a repeat of the previous bubble, which was characterised by ‘a large number of start-up companies appearing and suddenly exploding or imploding’. Technology companies launching IPOs in the coming decade will be ‘big players operating well-established sites, not new names with unproven business models,’ he says.
Yvan-Claude Pierre, a corporate and securities partner with DLA Piper in New York, also believes that LinkedIn’s valuation was driven by investors’ fear of missing out. ‘When Amazon went public, there was a lot of scepticism at first, but that company has performed well,’ he told IGI. ‘Because of successes like that, people are willing to invest at a premium in certain sectors, including technology and the internet. The successes that have happened mean people don’t want to miss out on any available opportunities. The big players are trading up and pricing high.’
Victor Shum, corporate and securities partner with Jeffer, Mangels Butler & Mitchell in San Francisco, does not think a new IPO boom is under way. ‘There is simply a lot of excitement about internet and social media IPOs because the IPO window has been closed for so long,’ he told IGI. ‘The difference between many of the companies now compared to the dotcom era is that most of the companies today have revenues and profits. Back in the dotcom era, people were more interested in eyeballs.’ As for the high valuations, Shum believes the public market will have limited patience for a company to grow into its valuation. ‘At some point, its valuation must confirm to fundamental market metrics,’ he says.
Recent signs that the market’s enthusiasm for technology stocks is cooling seem to confirm this point. Although LinkedIn has performed well since flotation, others have achieved mixed results. Renren, a social media firm often described as ‘China’s Facebook’, debuted on the New York Stock Exchange in May and raised $743 million. However, the shares are now trading below their initial price of $14. US mobile and web streaming music group Pandora Media saw its shares rise by as much as 60 per cent on its debut trading day in June, only for them to fall back below the IPO price the very next day. Pandora has yet to make a profit in the decade since it was founded, and about half of its sales revenue is used up by fees paid to music companies.
In general, tech IPOs have outperformed in first-day trading in the US this year, with an average jump of 24 per cent, according to research firm Dealogic. However, they are up just 15 per cent in trading since their IPOs. By contrast, US healthcare deals are on average up 23 per cent since their IPOs, despite a first-day jump of just 12 per cent.
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John Kay, Financial Times columnist and a visiting professor at the London School of Economics, believes the key difference between the dotcom frenzy of the late 1990s and the present day is that the tech businesses being floated today are real businesses – even if they are quite small businesses – with customers and revenues. ‘However, they have the bubble characteristic that many of the people buying these stocks are buying them in the hope that they can sell them fairly quickly at a higher price to somebody else, not because they are expecting to realise the cash flows that these businesses will ultimately generate,’ he says. ‘Viewed in these terms – the values of the cash flows they might generate – the valuations seem as absurd as the valuations in the tech bubble.’
Pierre notes that technology companies are stronger than they were a decade ago, not only from a financial perspective, but also from a brand perspective. ‘Technology companies with strong brands, wherever they are located, are very interesting to investors globally,’ he says. ‘It’s reassuring for investors to know that everyone recognises LinkedIn and that there is a high probability that new users will utilise the services it provides in the future.’
Another key difference between the late 1990s and now is that the technology industry is much more globalised. Many more internet-based businesses based in countries like China, Russia and Israel are bound to come to market in the coming decade. Reports suggest that following LinkedIn’s debut, Russian internet company Yandex decided to raise its price guidance for its planned New York flotation. There are claims that Yandex, founded in 1997 and often described as ‘the Google of Russia’, will sell shares on the NASDAQ exchange at between $24 and $25, higher than the previously planned range of $20–$22.
‘Social media platforms are growing in importance, and no one wants to
be left behind.’
Co-Chair, IBA Technology Law Committee
At the higher range, a Yandex IPO could raise $1.3 billion, valuing the company at up to $8 billion. Those prices would make the IPO the biggest by an internet company since Google and draw comparisons with Chinese search engine Baidu, whose shares leapt 354 per cent on its debut in August 2005. Yandex controls 65 per cent of the Russian market for internet searches, far outpacing global leader Google. Its earnings rose 90 per cent last year to $135 million on sales that grew by 43 per cent to $445 million.
Russian President Dmitry Medvedev has made his country’s ambitions clear by placing strong emphasis on his plan to turn the village of Skolkovo into Russia’s version of Silicon Valley. He hopes that eventually, more than 40,000 people will live and work in the area, which has been designated ‘Innograd’ (a contraction of the Russian for ‘Innovation City’). It should act as a focus for a mass of Russian – and, if it takes off, multinational – high-technology companies. Medvedev initially approved the project in February 2010, although its development may depend on whether he wins another term in the 2012 presidential election.
‘The technology landscape appears to be more global, with Asia included, while it was much less so last time around,’ says van Reeken. ‘In addition, the offerings now include countries with a significant political risk. Moreover, there appears to be a larger risk that pension funds and other institutional investors are now buying into the bubble, too. All this may make the bubble even riskier than the last time around, and the potential consequences dearer – and more likely to fall on those not making the investment decisions.’
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A new IPO boom in the technology sector would not have major implications for the work lawyers do, van Reeken says. ‘An IPO boom primarily means more IPO-related work and does not necessarily cause that work to change much,’ he told IGI. ‘Although this time, to protect themselves and their clients, lawyers are likely to be even more explicit in the warnings to be included in prospectuses. This shifts more of the risk to such buyers, which they appear to be happy to take.’
Shum believes that lawyers and law firms are much more conservative than they were ten years ago. ‘There is still a lot of nervousness about the general state of the US and world economy which directly translates into the state of the legal profession,’ he says. ‘The number of attorney lay-offs and law firm implosions are still too fresh in many people’s minds to make them believe that happy days are here again. Law firms today are more interested in getting paid cash for their services and any equity investment they may have made would just be considered a bonus.’
‘The LinkedIn IPO shows a marked belief in a yet-to-be-developed earnings model.’
Bart van Reeken
De Brauw Blackstone Westbroek; Co-Chair, IBA Technology Law Committee
As always in the legal profession, attention to detail is crucial, says Pierre. ‘At one point during the dotcom boom there were just so many deals that it was very difficult to keep on top of everything,’ he says. ‘There is also now a heightened level of due diligence and a flight to very experienced lawyers who know the sector well because people are very careful about global transactions and want more certainty that the deal is done correctly. Underwriters are prepared to spend to make sure they have dotted their ‘i’s and crossed their ‘t’s.’
One thing worth remembering, says John Kay, is that bubbles do not start for no reason. One of the lessons of all stock market bubbles is that there is almost always something real behind them. ‘In the South Sea bubble, the idea that international trade was going to be a big deal was right,’ he says. ‘The idea that the railways were going to make a big difference in the 19th century was right. Radio and television were big things in the 1920s. What happened in all of these was that people absurdly exaggerated the pace and extent of these developments – which also happened in the internet bubble.’
The other typical characteristic of a bubble is the exaggerated extent to which investors believe benefits will accrue to particular companies, rather than consumers. ‘The truth is in all of these things, whether we talk about trade or electricity or railroads, the reality of a competitive market is that most of the benefits go to consumers rather than shareholders,’ Kay says. ‘People often neglect that point. Too often in the dotcom boom, the purpose of the exercise was to take money off gullible investors, not to build real businesses’.
Despite that, the dotcom boom did produce a handful of real businesses. Now it seems a second wave of even stronger technology companies is ready to emerge from the wreckage it left behind.
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‘Without a doubt, Facebook will be the most hotly anticipated stock debut at least since Google, and maybe ever,’ said one recent article in the Wall Street Journal. People close to the company believe it is growing fast enough – it has now signed up more than 600 million users – to justify a valuation of $100bn or more when the company goes public, possibly in the first quarter of 2012. Although founder Mark Zuckerberg has been non-committal, Facebook’s chief operating officer Sheryl Sandberg has said an IPO is inevitable. However, there have been suggestions recently that the number of people using Facebook is falling in markets like the US, UK, Canada and Norway.
Twitter, which allows users to send short, 140-character text messages (‘tweets’) to groups of followers, is one of the internet’s most popular social networking services and had 175 million users by the end of September 2010. However, co-founder Biz Stone said earlier this year that Twitter had no plans to go public any time soon and did not need additional funds, because it is making money. The company, created in 2006, employs about 350 people. In December 2010, Twitter said it raised $200m in a deal that valued the company at $3.7bn. Silicon Valley venture capital firm Kleiner Perkins Caufield & Byers was the lead investor, which included existing Twitter investors.
The loss-making discounts website says it intends to raise $750m on the US markets at a price that could value the two-and-a-half-year-old company at more than $20bn. However, Sucharita Mulpuru, an analyst at Forrester Research, said in an open letter that there is ‘no rational math that could possibly get anyone to the valuation Groupon thinks it deserves’. He estimates its true value, based on financial information released with its flotation proposals, at closer to $2bn. Last December Andrew Mason, the 30-year-old founder of Groupon, rejected a $6bn offer for Groupon from Google.
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Jonathan Watson is a journalist specialising in European business, legal and regulatory developments. He can be contacted by e-mail at firstname.lastname@example.org.
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