The Vexing Issue of the Bubble in Startup Land

This article first posted in the Wall Street Journal's Accelerator Blog. You can connect Fred on Twitter.

Few people generate as much passion these days as 28-year-old ex-Google product managers who sell their company for hundreds of millions of dollars mere months after launch. To young immigrants dying to go to Stanford, they are heroes. To venture capitalists, they are “10X'ers” to hang on the wall. But to those who believe in cash-flows, five-year plans, or price-earnings ratios, they are merely children of the bubble, riding a wave of insanity, devoting their great talents to the pursuit of vacuous social apps designed to deliver early retirement and a profit to those lucky VCs who bought the right lottery tickets.

When winners emerge and go global, they generate value fast.

Ah, valuation bubbles! Black tulips! The topic perennially divides the so-called “Valley Visionaries” from those who yield to the “true gods” of cash-flow and profits. How, they lament, could a company like Snapchat turn down an offer from Facebook in November and be valued at a cool $10 billion when it has no revenue? They shake their head in disbelief when they see a three-year-old startup valued as much as a good old telecommunications company. Surely, the world has lost its way.

Slamming zero-revenue companies happens every single time a large, zero-revenue company emerges. As I have argued in the past, being zero-revenue, by choice, lets you focus solely on hyper-fast customer growth and rely on the financial markets for funding. It is a perfectly acceptable and sound strategy. It worked for Amazon, YouTube, Twitter and many others.

It’s also myopic to say Instagram cannot possibly be worth $1 billion, because it’s the wrong way of looking at the problem. If photo messaging is strategic to Facebook, do you think it makes sense to dilute 1% to get your hands on the most promising new service in the field? Smart companies like Facebook understand that the future is around the corner and even one billion users cannot protect you from the next wave.

In an age where we build on top of platforms like cloud and mobile, where everything from customer acquisition to payments is essentially frictionless, the progression of valuations is completely nonlinear. When winners emerge and go global, they generate value fast.

We’re not used to thinking nonlinearly about things like price and valuations, but the world we live in is far from linear. New companies emerge that shake entire industries. I know people looking at Airbnb statistics to build property portfolios of the future.

The primary job of a VC is to find great entrepreneurs and to give them reasonable amounts of money at reasonable valuations. Statistically speaking, price inflation is a returns killer.

To the outside world it may look like bubble investing but top VC investors are not stupid. They know what unlimited upside looks like — they are being paid to find it. For Accel, it’s a Dropbox or a Supercell.

When success is fast and unpredictable, you either need the chops to get into any deal and the guts to pay up, or you need to find your way in early. Some investors likes to get into enterprise startups really early but intercept consumer companies only when they scale, even if this means paying up for success.

Inflated valuations can make life hard for entrepreneurs too; it’s often hard to carry the return expectations that come with high share prices, and there is nothing like a big down round to see your equity share get diluted to zero and removed from the helm of your company.

There are many reasons why price inflation can be hurtful to startups and investors alike. There are many signs prices are incredibly tense. But to look at the mouth-watering valuations achieved by an Airbnb, Uber or Snapchat and conclude that there is a bubble is to be missing the point.

In the age of platforms, new global leaders can emerge fast and capture value incredibly quickly.

Welcome to the age of chaos.