SME final report- Venture Capital Group Internet Bubble, Again?

Tak Wat July 11, 2011 Recently many hot digital new media companies have been on spotlights. Almost all investors are looking close at what's coming next from new media companies. Some companies have been evaluated sky-high in the market. Digital new media is now a hot topic not only in Silicon Valley but also in Wall Street. For instance, Linkedin, which went public on May 19 2011, had 45 dollars per share at IPO, meaning that its market value was 4.25 billion dollars. Pandora, which also raised capital with IPO, had 16 dollars per share, 2.56 billions even though it was not yet profitable. Some may say this is similar to the dot-com bubble in 2000, others may say this is real and the digital media has unimaginable potential. Are we going into another dot-come bubble? According to our SME weekly report, I figured out an important fact: This hot trend among new digital companies is strongly related to what is going on in private equity market. Although IPOs usually attract attention, in fact, private equity market is even hotter than IPOs. Some super angels, such as Aydin Senkut, a former Google employee who runs Felicis Ventures, and Mike Maples, a software entrepreneur who oversees a firm called Floodgate, are occasionally making bets comparable to those of conventional venture funds, which gather and invest money from a wide range of institutional investors. Individual investments of up to $1million are not uncommon. Sometimes angels are clubbing together to provide young firms with even larger sums. The financing of more mature tech start-ups has also changed. Elite venturecapital firms such as Andreessen Horowitz and Kleiner Perkins Caufield & Byers have raised billions of dollars in new funds in the past year or so. Some of this money has been pumped into late-stage investments (eg: Twitter and Skype), allowing companies to remain private and independent for longer than used to be the norm. Unlike IPOs, in which any investor can participate, private share deals are typically arranged through third parties who have access to shares in a company. The deals aren't subject to normal regulatory disclosures, since the company isn't issuing the shares. Investors can turn a profit when the company goes public or is sold, or if they resell their shares to other buyers at a higher price. SecondMarket, for example, founded in 2004, has become a driving force in valuing hot Internet companies like Facebook Inc. that are taking longer to go public. SecondMarket's private transactions$400 million worth last year, up from $100 million in 2009have helped fuel the tech boom and have drawn scrutiny from regulators. Hedge-fund also fuels this trend. Spurred by their appetite for technology companies and seeking higher returns, a growing number of hedge-fund managers have started to invest more in private Internet companies. When daily-coupon website LivingSocial Inc. said it raised $400 million in April, the firms putting up cash included hedge-funds Tiger Global Management, Lone Pine Capital and Brookside Capital. Tiger's name popped up again in late June, when the New York firm grabbed a piece of the $100

million financing round for Square Inc., a mobile-payments start-up led by Twitter cofounder Jack Dorsey. The current tech boom is attracting deep-pocketed hedge funds, which are ramping up investments in emerging tech companies like LinkedIn, Facebook and Zynga. A handful of hedge funds already had a history of such investments, but the activity has increased recently as investors try to cash in on the surging valuations of Facebook Inc., LinkedIn Corp., Zynga Inc., Groupon Inc. and a smattering of smaller companies. The inflows are giving young companies access to big pools of capital and the Rolodexes of some sophisticated investors. But they are also pushing the already frothy valuations of some companies even higher and rattling the clubby venture-capital scene. Hedge funds have typically invested in ventures that they can sell at a moment's notice, while venture-capital firms are known for advising start-ups and taking a longerterm view. "Hedgies investing in start-ups directly is scary," says Jeff Clavier, founder of SoftTech VC, a small but influential seed-stage venture firm based in Palo Alto, Calif. "They are the antichrist of patient, supportive early-stage investing." As I mentioned so far, because investing into private equity is really so earnable, growing amount of money is flowing into this market. The following two examples show how earnable investment to private equity is. The Linkedin case: David Williams, a San Francisco-based start-up investor who had purchased 20,000 LinkedIn shares in private transactions last year for $18 and $21 apiece. He calculated he had made around five times his money in just over a year of holding the stock. After all, shares of LinkedIn, which operates a professional-networking site, opened at $83 on the New York Stock Exchange, 84% up from its initial public offering price of $45. By the market's 4 p.m. closing, the stock had soared 109% to $94.25. At the end of the day, LinkedIn was worth $8.9 billion. David would earn more than half a million dollars, if he sell his shares at the initial price. The Facebook case: Facebook hasn't gone public yet. However competition of obtaining its equity is more intense than Linkedin. Tiny GSV Capital Corp. made what seemed the most modest investment Monday: Plunking down $6.6 million to purchase private shares in Facebook Inc. Investors' response was anything but subdued. They pushed up shares of GSV by 42%, adding $14 million in new market value in just one 6.5-hour trading day, more than twice what the thinly-traded, two-month-old investment fund had paid. GSV is something of a throwback to the publicly-traded venture-capital firms of the late 1990s dot-com bubble era, such as Internet Capital Group Inc. The fiveperson operation, which is located next to a local pub in the affluent Silicon Valley town of Woodside, Calif., went public on April 28 and has since invested in digital textbook start-up Kno Inc. The $50 million fund said it completed a deal to purchase 225,000 shares of Facebook at an average price of $29.28. Facebook now represents about 15% of the fund's portfolio. By the end of Monday's trading, GSV shares were at $14.57, $4.30 up. About 500,000 of its 3.3 million shares traded hands. In recent months, Facebook shares have traded on private-company exchanges at prices in the low to mid $30s, valuing the company at $70 billion to $80 billion. GSV already earns around 2.5 million dollars as a capital gain. However, are these above valuations right or wrong? Is this just a bubble that speculations give in or an appropriate market price that reflect potential of new digital media companies? Some investors support these valuations for the following reasons. 1) The internet world is being transformed by a number of powerful forces, three of which

stand out. First, technological progress has made it much simpler and cheaper to try out myriad bright ideas for online businesses. Second, a new breed of rich investors has been keen to backup those ideas. And, third, this boom is much more global than the last one; Chinese internet firms are causing as much excitement as American firms. 2) Some of todays tablet computers and smartphones are more powerful than personal computers were a decade ago. IDC, a research firm, estimates that around 450m smartphones will be shipped worldwide this year, up from 303m in 2010. 3) Moores law also underpins the growth of cloud services, such as Apples iTunes music store, which can be reached from almost any device, almost anywhere. Such services are hosted in data centers, the factories of the cloud, which are crammed with hundreds of thousands of servers, whose price has plunged as their processing power has soared. Everything is connected ever faster, with ever fewer wires. 4) These technological trends have given rise to new platformscomputing bases on which other companies can build services. And these platforms are vast spaces of digital opportunity. In contrast, other investors say these valuations are ridiculous. They insist that these companies are growing at much faster rates even than in the 1990s. However, whether such growth can be turned into profitable and sustainable businesses is a different matter. Only five to 10 market-leading, cash flow-generative, high-growth companies with strong brands are likely to emerge worldwide from the current generation of internet concerns, says Egon Durban, an investor at Silver Lake, a private equity firm that led a $2.75 billion buy-out of Skype in 2009, before selling it to Microsoft for $8.5bn this year. The rest, he adds, will be concept stories the sort of companies that talk ambitiously about the size of the market opportunity before them, or the ways they might make money, but never live up to the promise. The key is picking the right companies. Thats where it gets tricky. Many including some household names with tens of millions of users have yet to show they can live up to their potentials. Skype has only recently embarked on a concerted effort to find ways to make money from its 145 million active users, nearly 95 per cent of those who use its service free of charge. Twitter, which has yet to make moves towards an IPO, is likely to produce revenues of only $100m this year. The microblogging service is a by-word in internet circles for a company that has proved unable to turn its popularity into a paying proposition. After all, only time will tell whether this is another bubble or not. However in my opinion, we may be heading into another bubble. Its possible were already in it. The news we see each day suggests all the right elements are in place: companies valued much higher than their profits would suggest and old world investors looking to pump money into a growing market for easy returns. And as we start to talk more about a new raft of stock market flotations, the bubble will move from professional investors towards the public market where it can have really disastrous consequences. But it doesnt have to happen. Bubbles are not inevitable. So when you see information about valuations, investments and rumored deals, then remain skeptical: Why is this here? Who gains from this? What else is going on?