Signs of a Bubble

As we near the end of the year, I real­ized that it’s been about half a decade since the bub­ble burst on the dot­com world. At the same time, it seems that a num­ber of sim­i­lar bub­ble signs may be show­ing up again. Based on my per­sonal expe­ri­ence, I’d like to present what I con­sider the top five signs of a bub­ble being in place. Some may over­lap but I’ve tried to define some generic rules that can be applied to all bub­bles, not just the ones in technology.

5. Lit­tle atten­tion to infra­struc­ture problems

Dur­ing a bub­ble, atten­tion to bor­ing details like capac­ity plan­ning, infra­struc­ture man­age­ment, secu­rity, etc… some­times take a back seat to new fea­ture intro­duc­tion. Those, how­ever, are a sub­stan­tial por­tion of what makes a com­pany sur­vive. One can try to sell a prod­uct to hun­dreds of peo­ple but what hap­pens when thou­sands show up? At that point, much energy must be devoted to rethink­ing and rebuild­ing the plat­form while it is run­ning, gen­er­ally at a higher cost than would have been required if plan­ning had been done properly.

When fea­tures take prece­dence over infra­struc­ture, you’re deal­ing with a clear sign of fail­ure down the road. This may not kill a com­pany out­right but, when the bub­ble burst, the ones who have not paid enough atten­tion to such things are gen­er­ally among the first to go as they find them­selves in the dif­fi­cult posi­tion of need­ing cap­i­tal out­lay when money becomes more scarce.

Signs of such fail­ures can show up early and should be mon­i­tored by man­age­ment: they gen­er­ally include things like slow response times, users get­ting rest­less, and out­ages that gen­er­ally can be seen as too long.

4. Poster child can do no wrong

At the bot­tom of the list is the belief that the poster child for a par­tic­u­lar bub­ble can do no wrong. This is gen­er­ally a feel­ing that starts within a com­pany, as it starts believ­ing its own slo­gans and press. As the bub­ble starts to inflate, the poster child tra­di­tion­ally starts receiv­ing more cov­er­age from the main­stream media and being pre­sented as a new type of com­pany that can do no wrong. Through telling perks (Aeron chairs in the 90s, Free food and time for per­sonal project in Web 2.0, concierge ser­vice in the hous­ing bub­ble), the main­stream media start show­ing an image of the ideal in that new bub­ble world.

Things gen­er­ally start tak­ing a turn for the worst when a por­tion of the pub­lic starts look­ing at that poster child and ques­tion­ing some of its prac­tices (“Can you build a busi­ness around sell­ing pet sup­plies?”, “Does this search com­pany have access to too much per­sonal infor­ma­tion?”, etc…)

3. Fea­tures and me-too solutions

Dur­ing a bub­ble, some fea­tures are often sold as the whole pack­age (“This apart­ment has sub-zero appli­ances”, “We’re build­ing a busi­ness around the con­cept of giv­ing every­thing for free. When we have lots of peo­ple, we’ll mon­e­tize our audi­ence”) The prob­lem with such approach is that it builds pack­ages (com­pa­nies or other por­tion of a bub­ble) which are essen­tially one trick ponies. If that one trick starts fail­ing (tastes change, a com­peti­tor starts offer­ing a bet­ter ver­sion of it, or the under­ly­ing fun­da­men­tals are wrong), the busi­ness is in danger.

In tech­nol­ogy bub­bles in par­tic­u­lar, com­pa­nies are built to flip (although, look­ing at some of the new apart­ment con­struc­tion in New York city, one might say that the same is true in real estate). This works as long as the founders and ini­tial investors can sell out quickly enough. Most of the peo­ple who make money dur­ing a bub­ble phase are the peo­ple who man­age to flip things quickly enough or try to go the other, less trav­elled and much longer, route of try­ing to build a busi­ness around strong fundamentals.

How­ever, another ele­ment of a bub­ble is when sec­ond gen­er­a­tion built-to-flip com­pa­nies enter the mar­ket. Those are not even pre­sent­ing new mod­els, they are just repro­duc­ing the model of a com­pany that man­age to sell out in the ini­tial phase of the bub­ble. Gen­er­ally, you’ll hear them say things like “we’re the [insert first gen­er­a­tion built-to-flip com­pany that was sold at a huge pre­mium] of [insert what­ever area the sec­ond gen­er­a­tion built to flip com­pany is going after].” Those com­pa­nies are gen­er­ally the most endan­gered ones as their propo­si­tion is based purely on the fact that the model they’re copy­ing worked once as a poten­tial sale.

2. Money, money, money

Val­u­a­tions, rev­enue mod­els and met­rics fall in this category.

Val­u­a­tions of com­pa­nies out of line with their earn­ings can rep­re­sent one of two poten­tial trends: either the com­pa­nies are too young to eval­u­ate and the ini­tial start-up cost were high, requir­ing a higher val­u­a­tion to enter a mar­ket­place; or the com­pany is grossly over­val­ued and we’re in a bub­ble. In the first case, the investors are smart and real­ize that the busi­ness will gen­er­ate solid rev­enues in the future that jus­tify the ini­tial invest­ment. This is gen­er­ally based on more con­ser­v­a­tive pro­jec­tions that show returns in the mid to long term. In the lat­ter case, the issue often arises as a result of invest­ment money being so read­ily avail­able with so few deals to chase that investors are will­ing to pay a pre­mium to get in on a com­pany. This is a very dan­ger­ous thing as it leads poten­tial investors to drop money in a com­pany that may not have solid fundamentals.

Among some of those fun­da­men­tals are things like what the rev­enue model of a com­pany is. Words like “Let’s build it and we’ll fig­ure out how to gen­er­ate rev­enue from it down the line” are dan­ger­ous. An unclear busi­ness model rarely gets clearer as time goes on and, if the com­pany does not offer a solu­tion that can be eas­ily mon­e­tized, its chances for suc­cess are slim. Run­ning a com­pany is gen­er­ally a dif­fi­cult endeavor and run­ning a start-up is even more dif­fi­cult as smaller com­pa­nies can eas­ily be tram­pled by giants. Hav­ing no rev­enue goal in mind at the onset is gen­er­ally a pretty bad propo­si­tion. If you look at com­pa­nies that have weath­ered a bub­ble and burst cycle, it is gen­er­ally because they were focused on meet­ing some rev­enue tar­gets. Com­pa­nies that did not gen­er­ally dis­ap­pear when the bub­ble bursts.

A dan­ger­ous item in this area is the con­cept of using things other than rev­enues to cal­cu­late the value of a com­pany. I was sur­prised recently when my analy­sis of the cost of a link (which was sup­posed to be more of a humor piece) became the talk of the blo­gos­phere, with many peo­ple look­ing at it as the new met­ric for valu­ing blog (next time, I’ll post a big fat dis­claimer at the top of the arti­cle instead of bury­ing it in the con­clu­sion). When items like links, traf­fic, eye­balls (square footage, river views, num­ber of trees, etc.. in real estate) or some­thing else become more impor­tant than rev­enue, a com­pany may be in trou­ble and an indus­try may be expe­ri­enc­ing a bubble.

1. “The rules are dif­fer­ent now”

And for my num­ber one is the sim­ple belief that the rules are dif­fer­ent now. I’ve been guilty of say­ing it in the 90s and it makes me cringe when I hear peo­ple say it about the real estate mar­ket. The rules may be dif­fer­ent but the fun­da­men­tals of the busi­ness world sel­dom change.

Deliv­er­ing a product/service to your cus­tomers at a fair price does not change. Mak­ing a profit on what you’re sell­ing does not change.
Hav­ing to pay sup­pli­ers and employ­ees does not change.
Hav­ing to deal with com­peti­tors does not change.

Add to this last one that larger play­ers also gen­er­ally have an advan­tage in that they already have rev­enue sources to fund their own effort ( and words like “The larger play­ers are dead” do not change it. To the con­trary, it helps them notice that they need to change some­thing or deal with an issue).

Con­clu­sions

So there you have it, my top 5 signs you’re in a bub­ble. I may be off here and there but at this time, hav­ing thought about it, it’s what I think one should con­sider when eval­u­at­ing a bub­ble. Some of those signs may be show­ing up in the indus­try (still need to work out the map­ping) and some may be way off.

What are other signs that should be con­sid­ered? Post them in the dis­cus­sion thread and let’s see if we can set up a way to eval­u­ate bub­bles before they burst and help them ease into softer landings.

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