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Will There Be Another Dot-Com Bust? Stanford Finance Professor Ilya Strebulaev Answers

This article is more than 7 years old.

The spectacular valuations popping up in Silicon Valley are nothing new -- everyone wants to be a unicorn, and will do almost anything to get that distinctive valuation. But the looming shadow of another dot-com bust has been just around the corner, as VC funding becomes more scarce and difficult to obtain for startups. Companies in the tech sector want to know what’s coming down the pipeline, and Professor Ilya Strebulaev is the man to tell you.

Professor Strebulaev is a tenured professor at Stanford who has spent his life studying economics, corporate finance, and credit risk. The focus of his work is venture capitalism, and locating himself in the heart of Silicon Valley has given him the connections and insight to study the tech sector in earnest.

I contacted Professor Strebulaev for some insight into just what to expect in the coming months and years, and what startups can do about it.

Murray Newlands: Tell me a little about yourself.

Ilya Strebulaev: I am an economist by training, completing my first degree in Moscow and then a PhD in finance from the London Business School. I came to Stanford in 2004, and have been a Professor of Finance at Stanford for 12 years. My expertise is really on how people make financial decisions, especially dynamic financial decisions, meaning how people make decisions based on their previous behavior.

My training has naturally led me to an interest in innovation, Silicon Valley, venture capital, and angel investing. I’ve done a lot of research on venture capital, and I follow the trends and try to explain what is happening in Silicon Valley and around the globe. I also lead teaching workshops for senior executives and decision-makers from around the globe in decision-making and funding innovation, and I also teach about venture capital at Stanford. I developed an MBA venture capital course for Stanford students who would like to become venture capitalists and entrepreneurs, and also for those who would like to learn about venture capital and how to deal with VCs. 90% of my students would like to start a company and want to know how to build more effective relationships with investors.

Newlands: What is happening in the market, given the current climate? What should tech entrepreneurs be aware of?

Strebulaev: Currently, there is a great disunity in the venture capital market. In the early stage, especially at the angel level and seed level, there is a decline in activity. It’s becoming more difficult to get better terms and funding, and I expect that the market will be getting even cooler in the next twelve months.

On the other hand, at the spectrum of very high-rated companies there are two forces in play right now. The first force is the many investors in the world who are trying to find risk because of very low interest rates and the way that stock markets perform. Therefore, a lot of people who have traditionally not been very serious about Silicon Valley, either because of Silicon Valley’s relatively small size or because it was too risky for them, are now coming over. The headlines say that Saudi Arabia is investing in Uber, but beneath the headlines there is a very substantial increase in investors who traditionally would not have come to Silicon Valley. This of course, increases valuations.

What many people, especially outside Silicon Valley don’t realize is that financially, Silicon Valley is a relatively small market. For example, if you take a very large private equity fund or a very, very large mutual fund, one of these funds would be larger than all of the money that is under the management of institutional venture capital in Silicon Valley. There’s a relatively small amount of money in play every year and, therefore, it’s easy to change the equilibrium valuation.

The second force happening simultaneously is that these changes are making the valuations become overheated. When they become overheated -- and arguably, I think they’re overheated now -- what comes up must come down. Overall there has been a lot of disappointment with the performance of very high-valued VC-backed startups in Silicon Valley. People talk about Unicorns: highly-valued companies with a more than $1B valuation. However, the valuation reported by these companies when they’re raising funds isn’t really the fair, true valuation of the company; even the fair valuations of these companies are likely much lower than what the investors think. Recently I co-authored a study that surveyed more than 1,000 venture capitalists about their decision-making. One of the questions was on unicorns, and 92% of VCs believe that unicorns are overvalued. In fact, most of them believe that unicorns are significantly overvalued.

So, my prediction is that despite the inflow of money that supports and sustains this overheated market, at some point the market will either demand that these startups show profits or exits, or the valuations will decline. While it is impossible to predict the exact timing, one of the reasons why it is so difficult to predict is that it depends on the trends outside of Silicon Valley, the global macroeconomic trends. But inevitably, it will happen, likely over the next two years.

Newlands: What about the differentiation between American valuations and Chinese valuations? I’m hearing that Chinese valuations are still much higher than American valuations -- what impact does that have and where do you see that going?

Strebulaev: Chinese valuations are high even though there are less Chinese unicorns than American unicorns. China is a very large market, and also the VC-backed chinese market is relatively immature when compared to the U.S. market. It’s even easier in an immature market to build enthusiasm. Also, China faces its own investing problems; many Chinese investors have difficulty investing outside China for regulatory reasons, leading  to even higher valuations. It’s likely that the Chinese market is also overvalued.

Newlands: Where does that leave the United States?

Strebulaev: Several years ago, a lot of VC funds here in Silicon Valley were very active abroad; their funds were open and they had divisions in China, Brazil, India, and more. Recently, funds have been retreating from many of those countries. I think that funds find that it’s difficult to make money there. What’s happening now is that very, very top funds will effectively share their brand with the local Chinese funds in a mutually beneficial way, but the question is who makes the decisions? Something else that is important, though, is that many local investors who went abroad are now coming back.

Despite what I said about valuations, it is a very exciting time to be in Silicon Valley. First, because there are a lot of disruption going on in sectors that have traditionally never been disrupted technologically. For example, one sector that is as far away from the thoughts of as many people in Silicon Valley as possible is agriculture -- food. There are many more industries that can be disrupted.

Second, it’s important to realize that the cost of experimentation has fallen in almost all of the fields of human endeavor. That increases the number of people who are ready to experiment, especially ones who will experiment with crazy ideas who would have never been funded before. Now they don’t necessarily need a huge amount of funding, you just need to find one crazy angel who believe in you. That angel may be lucky or a visionary, and thousands of startups will fail, but that one will succeed which has never been funded before.

Newlands: What is some advice you can give to young entrepreneurs?

Strebulaev: There are several financial pitfalls there. The first is that young entrepreneurs typically delay thinking or doing anything about funding until it is too late. My recommendation -- based upon my teaching and research -- is to meet with potential investors very early in the process of working on their startup because potential investors know the industry, have expertise, and can very often direct what people should do very early on in the process. Also, founders typically have a very narrow expertise. They may be the best in the world at their idea, but they know very little outside of that, especially if they are first time founders, and investors are going to help them quite a bit. If you meet with investors too late then you will pass a number of milestones where important decisions will have to be made; many potentially successful startups fail because of that. Or you just won’t have time to choose the best investors who can show you the best deal.