Wednesday 4 February 2015

How Might the Tech Bubble Burst?

Tech company valuations are through the roof right now, and many people have been questioning whether we are presently living through a tech bubble. In this blog post I set to one side the thorny question of whether we are in a bubble or not. Instead, I go through a thought experiment: I assume that we are in bubble, and play out a few scenarios for ways in which it might burst. Here are my top three:

Scenario 1: A Rising Star Falls
Present tech valuations are only warranted if you believe in the fundamental quality of their management teams. A high level of future growth is already priced into current valuations. This will only be attainable if they can expand their horizons, for example by expanding internationally. Such expansion puts a lot of pressure on organizational infrastructure. It is hard for a Silicon Valley-based headquarters to ensure that every local subsidiary maintains the quality standards they aspire to globally. Businesses who scale up slowly often have problems; those doing it at an accelerated pace (such as Uber) are even more likely to trip up. If too many local scandals mount, the managerial quality of the whole enterprise will get called into question, as will its valuation. The bold, fresh-faced management team will suddenly look hapless and inexperienced, flailing in the midst of a crisis, or riven by internal politics.

We only need look at Enron to see the risks that free-wheeling growth can expose an organization to. Now I am categorically not saying that every tech start-up is an Enron.  waiting to happen. What I am saying is that it could take just one high-tech corporate implosion to cast doubt on all the others. And once investors start to doubt the fundamental managerial quality of these tech ventures the game is up for the whole pack. Let me be totally clear: this line of argument is about perceptions. In the context of venture capital investments ‘risk’ is highly subjective, in other words it is a matter of perceptions. One dramatic fallen star could change the perceptions of investors about the risk of all the other stars, leading to the tech bubble deflating.


Scenario 2: The Advertising Pyramid Collapses
Many tech ventures rely on advertising as their main (or sole) source of revenue. Advertising is the bedrock of the tech sector, worth an estimated $43bn in 2013. It has allowed the industry to evolve in such a way that consumers expect services to be free. Take it away and those apps and websites suddenly don’t look like such appealing investments anymore.

Where do the pressure points lie when it comes to advertising? I see two potential sources of strain. First is the question of the proportion of advertising accounted for by tech companies and websites themselves. Apps tend to display adverts for other apps; websites display adverts for other websites. Webmasters buy ads to drive eyeballs to their site, where they hope people will click on ads. When this kind of behavior occurs, the online sector is feeding on itself – it is autophagous. Here we are in classic bubble or pyramid territory. The pyramid is sustained as long as it draws more people in to play the game, but once it is revealed to be hollow, it vanishes at once. I don’t have data on how much advertising is of this nature – so I can’t truly judge the extent to which this is a problem. However, just from my personal experience of browsing the web it appears that a lot of advertising is of this autophagous nature.

The second pressure point is the difficulty of measuring the return on investment (ROI) of online advertising. Web-based advertising platforms throw off a lot of data. The funnel from views-to-clicks-to-purchases can be tracked, so in principle a marketing manager can attribute a given online sale to a given online advert. However, things are far from simple. A customer who clicked through a pay-per-click advert may have still made exactly the same purchase even if the advert hadn’t been there. And a lot of online advertising is bought primarily to promote offline sales (think of, e.g., car adverts). However the effects on offline sales are much harder to track. Interestingly, while online advertising opens up the possibility of using randomized experiments to measure the effect of adverts, research so far has found that the effect size is so small it is hard to reliably measure from a statistical standpoint.

The upshot of this: the online advertising industry, while huge, is not yet in a long-term, stable equilibrium, and it’s not clear whether the stable market size will be larger or smaller than the market that exists now.


Scenario 3: Silicon Valley Disrupts Itself
To disrupt an industry is the bold aim of many of Silicon Valley’s start ups. It typically entails finding a way to deliver the same service the industry presently delivers but at a fraction of the cost or at a step-change improvement in quality or convenience.* It is often said that to disrupt you need to offer something 10x better than what presently exists, in order to overcome people’s inertia and lock-in with present systems.

The industries targeted for disruption are typically of the staid, old-school variety, perhaps dominated by some entrenched rentiers – think of Uber disrupting the taxi / car industry, or TransferWise disrupting the foreign remittance industry. The narrative of disruption underlies the massive valuations these companies receive. To take Uber, for example, in debates about its valuation have moved from comparisons with the entire global market for taxi services to discussion about how it might act as a subtitute for car ownership.

But there's no particular reason only old industries are vulnerable to disruption. It is perfectly conceivable that one of the current tech giants itself gets disrupted. People appear pretty locked-in to social media platforms such as Facebook, but if a company were to come along with an offer 10x better than one of these, it is easy to see customers switching. And, in fact, many already did: in the last few years plenty of people switched from Facebook to Twitter or Instagram as their primary social media feed, and in future something even better than either of these may come along. Well aware of this fact, Facebook paid a billion dollars for Instagram and $22bn for WhatsApp primarily because of the threat that these businesses posed to its dominance.

I can’t predict what a social media platform 10x better than Facebook would look like, but then neither could I have predicted Facebook’s creation before it existed. And, as with Scenario 1, it only takes one giant to fall asunder for many of the others to lose their appeal to investors.
 

So, there we have it, three scenarios for how the tech bubble might burst. Which do you find the most plausible? What other scenarios sounds realistic? Answers in the comments below! 

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*Note: this is a fairly colloquial definition of disruption. It is a somewhat warped version of its original academic usage by Clay Christensen, which referred to creation of new performance dimensions for emerging market sub-segments that eventually become large markets in their own right. Here, the colloquial meaning is the one I intend.