Tristan Louis (TNL.net)

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.