Market Crash = End of Web 2.0?

Probably not, but it's worth considering. 

Using cyclically adjusted valuation measures (those that take into account today's record-high profit margins), the U.S. stock market has been overvalued for years.  The Internet sector is not particularly stretched, especially not relative to the multiples of the late 90s, but if the entire market goes into the tank, the 'Net stocks will go with it.  Any number of factors could end the party--housing, flattening corporate profits, recession, China recession, etc.  Whether the market will actually tank is anyone's guess, but it could drop another 30% and still not be "cheap" using cyclically adjusted measures.

For the past few years, meanwhile, Internet entrepreneurs have become ever more brazen about not needing a business model in order to cash out big (and who can blame them, given the bounteous rewards that have gone to Google, MySpace, YouTube, and dozens of other companies that postponed revenue for as long as possible--not to mention the vast amounts of venture capital that keep pouring into the sector?).  This is reminiscent of the late 90s, when all that was needed (apparently) was a business plan. 

In the late 90s, of course, the early stages of the market crash revealed that much of the Internet economy was dependent on public-market leverage (10 companies a week going public, raising $100 million each, and spending it on advertising, software, real-estate, accounting services, etc.).  When the IPO market dried up, so did the Internet sector.  Today, the situation is different--today's start-ups aren't usually "exiting" via the public markets but by acquisition, and a fraction of the number of companies are competing to win the entrepreneurial lottery.  But a crumbling of the public market would still have a significant impact on the industry. 

Reduced market caps and multiples would mean lower acquisition prices and, likely, a more cautious approach to risk-taking (no more $4B eBay-Skype fliers, for example).  This, in turn, would mean more caution on the part of the angels and VCs who are funding the revenue-less prosperity of many Web 2.0 companies.  And a slowdown in the economy (either as a result of or as a cause of the market decline) would mean that revenue of all types would be harder to come by.  So, just when they needed it the most, many emerging companies might find that the AdWords bounty they had always kept tucked in their back pockets might amount to less than they had once imagined.

A disaster scenario?  Not likely.  But a scenario that would lead to another cold winter for the Internet start-up ecosystem?  Very possible.  Possible enough, certainly, that conservative Netrepreneurs (and their backers) might want to hit the summer-time bids while they still can.

Comments

[King Troll]

Henry how do I take a company public bro? How big should my company be? You know I have the retail stores. I have 5 now with $2mill in sales. Net income is about 8-10%. Can I go public if I had 15-20 stores? $5 mill + /year in revenue, zero debt. I know that's not much but I could use the money for acquisitions like those fuckers from American Apparel. There was an article in Fortune about something called a PAC or some shit.

[Victor]

Boohoo, there was a market "crash" of a few percent. Relative to the unremitting bull market we've seen over the last 3-4 years, this is nothing but a blip. The S&P hadn't had such a long run without a 2% correction in its entire history. So let's just keep things in perspective, shall we? We're still in a secular bull market and as much as the bears would like to find baleful signs in the financial runes, there really isn't too much too fear right now.

Things will get scary if the Democrats are able to take full control of government and ratchet taxes back up and impose universal health care on the country.

[C. Fischer]

Victor,

Not to turn this into a political debate, but that fear of the Democrats ratcheting taxes back up (where they rightly need to be to balance the current account) probably would be less of an issue if the current administration hadn't raised the debt by 3 Trillion or so by giving huge tax breaks to the upper 1% and startimh an unnecessary war that we won't be done paying for for a long time. Buying tons of foreign oil to fuel SUV's for soccer moms with a devalued dollar I don't think is helping the situation either, and I think that one is hard to pin on the Democrats as well.

PS, I'm a Republican.

[Victor]

C.Fischer, deficits are not a problem per se. They are only a problem to the extent that growth isn't sufficient to match payments. There's absolutely nothing wrong with running a deficit. Running a massive deficit is a bad idea, I agree, but the right way to solve that problem is to pare spending, not to raise taxes.

ps Saying you're Republican means nothing these days. Republicans were even more profligate than Democrats in the last few Congresses. Saying you're a small-government conservative, as opposed to a social conservative would be a bit more encouraging.

[sigma]

Henry, Henry, Henry, you're making a really big mistake, perhaps understandable for parts of Wall Street but wildly wrong for venture capital and Web 2.0 entrepreneurs.

Sure, if on Wall Street believe the W. Sharpe Capital Asset Pricing Model (CAPM) and believe the 'efficient market hypothesis' (EMH) that everyone has all the information and that it is used appropriately in the market instantaneously or some such, then a 'sector' such as Web 2.0 can be meaningful. That is, there really can be some reason for the market to regard all the Web 2.0 companies as related.

But, for venture capital and Web 2.0 entrepreneurs, the context and assumptions of the CAPM and the EMH clearly are wildly wrong! Instead, there is a very 'illiquid' market with a lot of information known only to the entrepreneurs and their venture backers. Then, GIVEN that information, that in addition the company is in Web 2.0 is next to useless (recall Radon-Nikodym and Markov).

So, the Web 2.0 entrepreneurs and their (informed and wise) venture backers will charge forward one business plan at a time. In brief, good plans should get funded and bad ones shouldn't, and either way Web 2.0 will be nearly irrelevant.

If the companies reach Wall Street, then, sure, apply the CAPM and EMH and pay attention to the Web 2.0 'sector'.

Yes, it may be that some venture general and limited partners do not understand this point, either, but YOU should!

[Henry Blodget]

The theory that a public market crash will have a dampening impact on VC investments has nothing to do with the Efficient Market Hypothesis. It's just an observation that when it gets harder to make 100x your money, VCs tend to be more careful about how much they invest and what they invest it in. We saw this in spades back in 2000-2003. I doubt it will be as harsh this time, but there will certainly be some correlation.

[Rick]

It feels JUST like March of 2000.

[sigma]

"The theory that a public market crash will have a dampening impact on VC investments has nothing to do with the Efficient Market Hypothesis."

Of course.

The EMH is meaningful on Wall Street.

But you concentrated on the 'venture sector' of Web 2.0, and, given what venture investing is doing, e.g., from a "public market crash", that Web 2.0 is a 'sector' has nothing to do with venture investing in Web 2.0 companies. That is, in venture investing, given the details of a business plan, 'sector' doesn't mean much.

Again, 'sector' means much less in ventures than in public equities.

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