The Rise and Fall of a Bubble… 2.0?

Every time there is a large mass of credit expansion, a “bubble” as it were, in any particular industry, people either jump on board, or are hesitant, asking “how long will it last?”. After all, if one knew how long a bubble lasted (as differentiated from a market self-correction), one would know the right time to seek out funding for their business idea, or when to sell their existing business for the best price. (Those are just different sides of the same coin).

Personally, having been party to 2 “bubbles” now (though I think the second one is more of a correction, I’ve observed that bubbles more or less follow the Venture Capital. You see, VC’s are not leaders, nor market leaders — they are lead followers. When a profitable technology or market starts emerging (through the work of the market-leading entrepreneurs), VCs take a team with more business experience, a better technology (as the market leaders broke the ground & established parameters), and give them more money, and count on that the combination has far more capacity to capitalize on a proven market than the now-bleeding on the edge entrepreneurs did. Its a great strategy.

Even so, only about 1/10 businesses invested in this way yield the necessary returns, meaning that the businesses are forced to have an exit strategy (usually to the market, or other lower return, later stage VCs) within about 5 years. That said, there are several stage VCs — early stage, middle, and later. Early/seed stage funding is typically very small (couple hundred thousand $), and rarely makes the news. It is the mid and later stage VCs (couple M to $50M) that make the headlines that you hear about, though they are rarely investing for as high returns as early/seed stage.

What is happening should be becoming clear. Mid stage VCs follow seed stage by a couple years, which means that by the time you start seeing the big bucks in the news, the bubble isn’t “beginning”, its well into full swing. By a year or two after that, the many businesses funded by seed stage are dying out, and seed VCs are concluding that the market isn’t as lucrative or full of opportunities anymore. At that point, the small businesses are going bankrupt, which sends a signal both to the banks and the mid-sized VCs. Credit expansion is over.

By the time you start seeing the multimillion dollar deals, the “bubble” only has about a year-two left before the market contracts and investors run home to lick their wounds. If the expansion is big enough, and involves enough external parties acting as investors, then contraction means the Fed has to step in and protect certain parties vis-a-vis… Fannie Mae and Freddie Mac. (FYI insurance companies regularly diversify their portfolio, partially by investing in various VC firms. If they were to say invest in other seeming “stable” parties to the bubble — say pharmaceuticals or biotech…) Now, this isn’t a perfect causal relation — in fact, it may seem like there is none at all, but credit contraction changes interest rates, inflation rates, and can expose heavily leveraged firms to a great deal more risk than they are prepared for.

But anyway, I digress, the point was, a bubble lasts for about 5 years — the VC return window, but by the time you or I “hear” about it on the news, it is already half over. The right time to get funding? Obviously right in the middle, at the peak — before businesses are substantially failing, and valuations are highest. Of course, the real trick is to be in the right place at THAT right time, which takes a lot of preparation and work beforehand.