This is a two-part post series reasoning the causes for high startup valuations within the tech industry.
If you’ve been following the tech ecosystem in recent years, you’re no stranger to recently minted startups announcing multi-billion dollar valuations (Fig 1). Dubbed “unicorns,” these industry-upending companies include the likes of Uber, Snapchat, and AirBnB. To put things into perspective, in September 2014 Uber announced a $40B valuation, when only months earlier it received a valuation of $17B from various well-known venture funds. Snapchat, infamously declining a $3B deal from Facebook, has exploded in growth as well, receiving another $485.6M in funding with a valuation of $10B+ at the close of 2014. Each investment in a high-potential company represents a financial Holy Grail for venture investors. Even sector and industry-focused firms reserve a portion of investment capital for identifying and investing in these promising companies early in their life cycle.
In addition to a growing roster of unicorns, many technology companies are raising multiple hundred-million-dollar valuations pre-IPO. Some pundits believe the recent bevy of inflated valuations indicates a growing tech bubble on the verge of collapse reminiscent of the dot-com crash in the early 2000s.
What factors are contributing to increased valuations?
I believe there are three primary factors contributing to the spiral of inflated valuations and will cover the first factor in Part 1 of this post series.
1. Following the Leader: A Herd Mentality – Snapchat was valued at billions before receiving a cent of revenue. Only since November 2014 has it unveiled plans to offer mobile payments via Square and multimedia advertisements. Most of its value can be derived from scalable architecture and rapid, unprecedented user traction and engagement. Combined with positive press, high retention, and effective word-of-mouth syndication among young demographics, Snapchat’s proliferation seemed guaranteed even without a traditional business model. The consequence of this is a surplus of consumer-oriented social applications attempting to mimic Snapchat’s success. This includes competition from well-known entities including Facebook which developed its own ephemeral messaging app, Poke. By the time Poke was released, however, Snapchat had already established a loyal user base (Fig 2). Facebook subsequently abandoned development of Poke and began work on their latest competitor, Slingshot.
Parallels can similarly be drawn between unicorns and their direct competitors within other industries, including the battle between car ride services Uber and Lyft. Even in a congested competitive landscape, smaller startups such as Gett continue to vie for an ever diminishing portion of the market. While Facebook has cash to burn on experimenting with new applications, venture pockets are not as deep. Startup saturation creates the illusion of a larger market need and thus higher and higher competing valuations and burn rates to maintain a competitive edge.
Nevertheless, many investors are attracted to unicorn doppelgangers, companies they hope will demonstrate similar user growth rates and mindshare presence as previous billion-dollar companies. Riding in the wake of juggernaut predecessors including Snapchat, many of these startups continue to receive financial validation as long as they demonstrate some combination of sufficient user metrics, top-tier investors, or all-star founding teams. Little research, however, correlates these factors definitively with industry-disrupting success and abundant financial returns. Amidst the search for these ingredients, where is the product and the innovation?
Many of these problems seem to affect consumer-oriented startups that rely on overnight customer adoption and syndication. The technical and financial barriers to entry are low for aspiring entrepreneurs. The cost of user acquisition is oftentimes nonexistent. Why not build the next WhatsApp or Snapchat? But do we need another chat application? Is there truly enough value to warrant high-risk valuations in applications reliant on fluctuating user bases, especially when a substantial fraction of apps are only opened once ever? At a certain point, humans have limited mental bandwidth and attention (Fig 3). Everything is fighting for their attention: Netflix subscriptions, transportation, computers, tablets, Kindles, and multiple social media accounts, each of which must be checked daily.
This past fall, I had the opportunity to attend TechCrunch Disrupt, one of Silicon Valley’s most publicized startup competitions. Walking through the aisles of startups, I saw entrepreneurs pitching new chat applications, mobile game dashboards, and company tracking software. One European entrepreneur quickly took a photo of my face with his iPhone and demonstrated how his facial mapping software would allow me to apply a series of realistic morphs to my face in real-time. I was amazed by the precise geometric mapping of my facial features, a capability I wasn’t aware the iPhone possessed. I asked what the use applications were going to be. The CEO smiled and said he hoped to get it approved by Apple so they could add the morphs as an add-on to the camera filters. His long-term vision was to eventually integrate with a monolith chat application such as Snapchat or WhatsApp. “But what about facial recognition?” What about the multi-billion dollar opportunity and need for this technology in the healthcare, security, and civil service industries? Apple seems to have already recognized this value, acquiring Israeli firm, PrimeSense, and filing a patent in 2013 for iPhone facial recognition capability.
Smartphone penetration is rapidly reaching market saturation in developed economies and word-of-mouth expansion continues to validate a few technology leaders. It therefore seems worthy to consider diminishing returns and a diminishing number of IPOs for new consumer startups as established incumbent leaders become further entrenched. Recognizing this pattern, some high-profile investors have become more critical regarding investments in unproven consumer startups reliant on tenuous business models. They have begun to shift early-stage focus toward enterprise startups, postponing investments in consumer companies for later rounds when the business trajectory is more certain.