George Zachary On Silicon Valley Bubbles (Recorded June 2012)

Back in 2012, right before the Facebook IPO, CRV’s George Zachary sat down with me to discuss the history of bubbles in economic history, including Silicon Valley. Zachary has been through a few tech cycles and he’s studied the history of bubbles, so this is an interesting time to revisit his thoughts. Video above, transcript below. Again, bear in mind this conversation happened in June of 2012.

@semil: We’re in the TechCrunch studio today with George Zachary, partner at Charles River Ventures and an early investor in Twitter, Yammer and Millennial Media. George, welcome to the studio.

George: Thanks for having me here.

@semil: Very soon, Facebook is going to go public. There’s a lot of talk about bubble talk in Silicon Valley and the tech world. You’ve been around the block a number of times. How do you view the world right now in terms of technology and the whole scene?

George: I’ve been in tech personally since ’77. In venture capital, I’ve been an investor since 1995. The plus side is, I’ve studied the history of bubbles. There’s actually 600 years of human history with bubbles. It’s actually a human phenomenon. It’s not just a short-term thing over the last 20 years.

@semil: Tell us a little about that. I didn’t know that you studied bubbles.

George: There’s some great books to read if people are interested, such as Manias, Panics, and Crashes. It reads like a description of a bipolar person. It also talks a little bit about a bipolar society. The tensions that get created are basically socioeconomic in nature, where people feel like they’re missing out and that fuels the end of the bubble.

We’re not quite there. We’re getting there, but there are just some fantastic books about how bubbles start. There’s the South Sea bubble, where people give money to the adventurers on boats, and then you get this bubble of people over-funding the boats. There’s also the tulip bubble. There are plenty of bubbles, and it’s just driven by the fact that people are seeking treasure.

@semil: Walk us through an earlier bubble that the Valley went through and what that looked like. Start to explain where you think we are now.

George: To preface this, if you look at the last 150 years of stock market history, you see an annualized return of 6.7 per year. That’s on a real basis. Without dividends, it’s closer to five-ish.

One of the things you’ll see is that the bubbles come in waves. You see 15 years of sideways appear in the stock market with this up and down volatility, and then 15 years of up, with up and down volatility. In the year 2000, I told my partners, “We are in it for another 13 to 15 years, where the market’s going to be tough.”

We can talk about that later, but we’re nearing the end of this bearish period. We’re starting to see a bubble emerge. For me, this Facebook IPO has a lot of similarities with the Netscape IPO of 1994, and a lot of differences.

At that time, no one was saying it was a bubble. People weren’t going around saying, “Oh, my God. Netscape is going to go public. It’s a bubble.” Actually, people were looking forward to it. People didn’t know how it would price. It went out. It priced. The price jump was astronomical. That started people talking about that there might be a bubble.

The real bubble in the ’90s really didn’t start until the late ’90s. While people call it a dot-com bubble, it was actually a bubble fueled by the Fed. The Fed pumped a ton of liquidity into the system towards basically the guarding of the catastrophic meltdown of the United States due to the year 2000 problems, in terms of people’s clocks resetting.

It pumped the market full of liquidity and that came out into the market in 2000-2001. It actually caused a catalyst for the final part of the bubble up and then, it’s basically popping. It always pops when there are no more buyers. Boom and bubble is basically that last phase where it starts to become unsustainable. You see exponential and ballistic rises in stock prices. You see it across the entire landscape, from the leaders in industry to the seed-stage company.

We’re not quite there yet. To me, there’s a Netscape feeling about it because people feel like it’s a brand new era. Back then, people weren’t talking about a bubble. People now are talking about a bubble. I think the question is, “How do you define a bubble?” That something is over-valued? Value in monetary systems is only really relative. There’s no idea of an absolute wealth. Bubble value is really relative value.

I do not think we’re in a ’99 kind of bubble time period this way.

@semil: It’s a different beast.

George: It’s a different beast. The end of all bubbles is always marked by people borrowing money and taking on debt to buy equity or to buy assets. The last time we saw this was 2007-8 with the end of the real-estate bubble. We just ran out of buyers. The last ones of those buyers were people who were faking their liar loans and making unsustainable commitments. There were no more buyers after that so it just ended.

To me, there’s a little bit of talk about that going on, but I don’t see founders, I don’t see investors, I don’t see landlords or service providers basically borrowing money to buy equity.

@semil: They’re using their own.

George: They’re using their own capital, which they have, to put into equity. I don’t see the individual investor increasing their margin account at stock brokerages. In the last week, we had a reduction in terms of the investor sentiment to the lowest suggested amounts of holdings of NASDAQ tech companies.

There’s enough fear in the market that it tells me that we’re not at a bubble yet. When there’s no fear, that’s when we’re near the end of the bubble.

@semil: Here in mid-May 2012, at what phase or at what point in the curve are we in your mind?

George: If you look at the phases of tech bubbles, the first phase is when a leader in the space does something breakthrough and gets an extraordinarily high valuation. That was Facebook in one of its first rounds, when they decided to not take the buyout offer and raise money at a higher price.

It wasn’t the Greylock offer when Greylock offered $500 million valuation, because that was high but it wasn’t ridiculous. It was when Yuri Milner and DST invested and everyone said, “Whoa, it’s a bubble.” It’s when Microsoft invested in Facebook and people said, “Whoa, that’s a bubble.” How can this ever be worth $10-15 billion?

Now that characterizes the first phase,where the first leader has this very high valuation and people say, “Oh, it’s a bubble.” It’s not really an indicator that the bubble is about to break. Usually when the bubble is about to break is in the second or third phases.

The second and third phases look like the following. In the second phase you have the competitor companies. I’m an investor in one, which is Twitter, where people apply a high valuation to Twitter and they say, “Well, relative to Facebook, it should have this valuation.”

You have this set of leading companies. They have good metrics, they have good users, they have real engagement, and they carry a mark-to-Facebook, a mark-to-leader kind of valuation. That’s when you know you’re in the second phase. At the end of the second phase, you start to see that a couple companies get bought.

The one that’s very obvious to me that defines this delineation between the second and third phase is the Instagram purchase. It wasn’t an irrational purchase. It looks irrational. Why is it worth $1 billion? It’s worth one percent of Facebook, which is different from it being worth $1 billion.

You’re starting to see some mark-to-market of the companies that were not the leaders but became the leaders, and then you saw this transaction that happened. The ideal point to being an investor, is still now, and actually still is for awhile. The reason why, is that there a set of follow-along companies, the HootSuites of the world and other people that are saying, “Hey, we’re going to raise money at a $500 million price tag.”

Why? Because these other companies which aren’t Facebook or Twitter but may be right underneath them in terms of leadership, they have valuations. You see this cascading multiple that goes to the leader, to the second tier, to the third tier, then to the fourth.

@semil: So, you’re saying that there are a number of companies underneath layers above the leaders and since they’re not having real revenues, or you can’t really price, select and value the user, you’re marking it to the market leader, which in and of itself, isn’t being priced according to the public markets.

George: That’s right.

The Instagram purchase really reminds me of the same feeling I had when Microsoft acquired Hotmail, in I think January of 1998. People said, “Microsoft, the leading software company, bought this webmail thing for $400 million?” A lot of people were astounded.

They thought, “It has no revenue. It just sends messages to people. People use it to communicate with one other…” People were astounded. People said, “Oh, that’s a bubble. I’m so pissed off that Hotmail got bought for $400, my message being…” I heard the exact same things with Instagram.

Instagram is interesting because the leading web company, Facebook, is now trended by the leading mobile app player. You can debate whether it’s the leading mobile app player. I see that it’s incredibly parallel.

Back in 1998, we were still not in this full-fledged bubble. We were still in this boundary between second phase and third phase. That Hotmail transaction is what started it. When you look back at it, Microsoft doesn’t complain that it bought Hotmail for $400 million because it was a great customer acquisition tool for them.

@semil: Now, the Facebook IPO is going to happen very soon.

George: Next week. No, this week?

@semil: Yes. I am going to ask you a two-part question. What does the rest of 2012 look like to you as an investor? Then, what does 2013 look like?

George: What does 2012 look like? We’re in this eye of the hurricane period, where everyone right now is just battening down the hatches, and wondering what’s going to happen the day of the IPO and what’s going to happen after the IPO. How are people going to price this? That’s going to be the second part of the hurricane.

I don’t know how people are going to act. But looking at the public market, you can see that the small cap stocks have started to lose some relative power, relative to the whole market. That’s usually a sign that you’re in an aging bull market. But it’s not always a sign, statistically.

I think what we’re seeing is that there is still reluctance on the part of the public to believe that everything in the world is fine. We’re climbing that wall of worry. The wall of worry is not over. People still have worries. As long as there are worries, you’re not at the end of the bubble.

My belief is that the Facebook IPO will do well. I don’t know if it is going to go to a $200 billion valuation. I know lots of people I know, and myself, we all have biases wanting to believe that because then, cash will be raining from the sky.

@semil: Let’s rephrase the question a little bit differently. For other startups out there, other people with companies that have gained some traction, how should they be thinking about 2012? Some of them are going to be going for financing, some of them are going to be looking at M and A. How do you think that leaders should be thinking about that?

George: It matters what stage you’re at.

@semil: Let’s say early stage.

George: Early stage, so past seed stage.

@semil: Yes.

George: But they might have a million users or 10 million users.

@semil: I’m going to assume that for the best founders and best companies, seed capital is always going to be available.

George: That’s right.

@semil: Let’s say between A and C.

George: I think what you’re going to see is that financings are still going to be strong, they’re still going to be taking place. There are lots of public market investors and limited partner investors that will invest into venture capital. That’s going to continue. You’re seeing a winnowing of the amount of firms that are profitable.

Out of 800 firms in technology venture capital, 30 are profitable over the last 10 years. But remember, in Hollywood, there are lots of movie production studios that are unprofitable for a long period of time, but they don’t go out of business because people still want the dream of funding the next big movie.

This phenomenon is going to continue for a while. People are chasing these legends and myths. Not even myths, they’re the realities of “this could be the next humongous thing.”

@semil: Maybe the players will change, but the money will always be there.

George: That’s what I think.

I think the rest of the year, if you have any traction, you should be able to be financed. But people are looking for growth on growth transaction. People are looking for the exponential curves because the exponential curve is a strong indicator that you have product market fit. If you have product market fit, you should be able to monetize it in a certain way. If you don’t have an exponential curve, either you won’t get a valuation, or it’s not going to be good.

@semil: Understood. Here’s the final question. With the last breakout social application, let’s say Pinterest or some of the communication apps or what’s going on with Vox or things like that, do you think the next one will be mobile?

George: Yes. Mobile is the platform that we will be with for quite a long time. Whether it is going to be a mobile phone or a Google Glasses kind of thing, it’s still going to be mobile because it goes with you wherever you are. You don’t have to be chained to your desk.

@semil: But I’m talking about the next exponential breakout, where you see the user growth kind of go like this.

George: Yes, it will be mobile. We’re going to have more people come online in the next 10 years than are online right now. That’s a huge opportunity.

I think we’ll see Twitter have a billion users in the next couple of years. That’s the ratchet of how many users you have and what’s successful. When I got in this business in 1995, there wasn’t Web 2.0 or even, really, Web 1.0; it was like Web 0.1. If you had 50,000 users, that was considered awesome.

Now, to be considered awesome, you have to have some amount of millions of active, engaged users. Not downloads or registrations, but people who love the product and are engaging in it. You look at the ratio of DAUs, daily active users, to monthly active users, you get a sense of that excitement.

You also look at the churn rate. We’ve done some work, and we see that there’s a correlation between churn rate and exits.

@semil: Actually, this is an interesting question. Do you think that some of the companies right now, let’s say on the communications side or on the social video side, that’s what everyone is talking about right now in terms of applications? Do you think that growth is organic or sustainable? Or, are they piggybacking off of Open Graph and Twitter?

George: I’m inclined to believe more of the latter, which is, you’re likely to have these impulse waves up and another competitor can come by with a slightly better product and you can have an impulse wave down. Founders should be looking for how to implement switching costs into the product, how to build network effects into the products that shut down the users’ desire to switch out.

@semil: All right, George. Thank you for coming in and sharing your knowledge.

George: Sure, thanks for having me.