When the Bubble Bursts: How Tech Start-Ups Are Hurtling Towards a Crash

May 12, 2015

At the turn of the 21st century, the internet had become a new market for individuals of all backgrounds and experience to begin online companies. Backed by venture capitalists and millions of dollars, dozens of internet companies such as Amazon, Yahoo, and Google were launched, and the dot-com era was born. These companies would go on to continue to grow and become extremely profitable. However, a trail of corporate husks lay in their wake, the little known victims of the infamous dot-com bubble. GeoCities, Boo.com, Broadcast.com, Kozmo.com, and innumerable other internet companies were destroyed as the stock market turned on them early in the 2000’s. Despite this recent history, the current trends of the start-up market are mirroring those of the late 90’s to the point that many economists are wondering not simply whether there is a bubble, rather when will the bubble burst?

Before looking at the current tech climate, one has to understand why the dot-com bubble formed and then burst in the 90’s and 00’s. The strategy of a dot-com company was to get big fast. The goal was to build a large market share by operating at a sustained net loss. They would accomplish this by raising millions in venture capital and then burning through it rapidly either by focusing on product development, like Google, or marketing, like Amazon. Once achieving a large enough market share (often by offering free services), the company would shift gears and start charging profitable rates. Despite operating at a loss, market analysts often valued these companies highly based on perceived long-term potential profitability. Over time, though, many of these companies would remain unprofitable. Analysts that saw them as overvalued grew louder while supporters faded and capital dried up. Looking back at price/earnings ratios, HSBC Holdings found that these dot-com companies were often overvalued by as much as 40%. To become properly valued, the companies would have had to increase revenues by 80% a year for 5 years, an impossible feat when tech giants like Microsoft only averaged a little over 50% a year. As a result, many companies were never able to make the shift to profitability before the market turned on them.

A good example of this failed process is former Swiss company Think Tools AG.  The company was created to provide consultancy and some rudimentary software designed for corporate problem solving. It expanded its market share by selling its software license for a cheap, onetime fee. It operated in the red, but was still able to generate enough interest for its Initial Public Offering (IPO) in March of 2000. At the closing bell of the day, the company was valued at about $2.5 billion with a stock price peaking at $1,050. While the company was profitable leading up to the IPO, the profits only played a small part in the valuation of the company. By the end of 2000, their software was no longer selling at a profitable volume. Despite $25 million in sales, the company posted a $19 million loss. The company’s previous strategy for expansion had actually exhausted and saturated its market. As allegations of plagiarism and false advertising began to swirl, Think Tools’s shares had fallen from $1,050 in 2000 to $8.20 in 2003. In 2004, the company merged with another Swiss IT company and the Think Tools assets were sold for $350,000.

Today, the market for tech and internet companies has returned as the new Start-Up era. Twitter, Facebook, Instagram, and many other internet start-ups compete for the same market of consumers that the dot-coms did a decade before. The common theme of these new companies is to operate in the red to seize the market. Both Twitter and Facebook, along with countless other start-ups, started by operating off of venture capital while offering a free product. However, when Twitter and Facebook went public, the companies struggled to find their footing as their respective stocks fluctuated.  Twitter opened at $45.10 before peaking at $50.09 and closing at $44.90. While it did not fall much, many investors were (and still are) wary to hold it for too long as the company had not been able to deliver on profits. Twitter’s struggles have not subsided. Despite self-reporting a $7 million profit this last quarter, the company actually lost $175.4 million based on the accounting rules for public filings.  The stock price sits around $39.00 and has been suffering bad press as a result. Facebook also faces the potential of falling stock prices as data comes out that US teen usage of Facebook is decreasing.  When Facebook announced a drop in usage in Q3 of 2013, the share price fell. Since then, Facebook has remained quiet on the subject, which is causing uneasiness amongst analysts.

As start-ups raise hundreds of millions of dollars, the specter of the dot-com bubble looms ever larger. Increasing burn rates of capital and the lack of profitability is slowly turning a favorable market hostile to new start-ups. Both Facebook and Twitter are still generating sufficient buzz to keep their stocks afloat, but with analysts and venture capitalists at The Wall Street Journal, Forbes, Bloomberg, and other publications sounding the alarm, the question is quickly becoming not if the bubble will burst, but when. While it seems as though there will always be money to be made in the tech field, these facts simply highlight the need for savvy investors to thoroughly assess the risks and properly conduct their due diligence, particularly with newer start-ups. The attorneys at Rock Fusco & Connelly, LLC, can assist investors and business owners in analyzing and completing these transactions to reduce risk and maximize potential profitability.