Dotcom frenzy sparks warning of bubble

Two years ago, anthropologist Sekai Farai was awarded a grant by Columbia University to study the technology start-up community.

Her timing couldn't have been better: a new goldrush is under way as 20-somethings from New York, London and San Francisco dream of making their fortunes from a new generation of internet companies.

Sitting in the lobby of Manhattan's Ace Hotel, one of new-school tech's favourite hangouts, Farai predicts the boom has just begun.

"People who not long ago started start-ups because they couldn't get a job are turning down jobs now," she said. "There's so much money about. The idea that your idea could be the next big idea is very real."

Could it all end in tears? "It always does."

Right now, though, who wouldn't be excited? Every week, one of the new generation of internet firms seems to attract a sky-high valuation. Zynga, the social-network games company that has tempted millions to grow virtual vegetables in its FarmVille game, has been valued at US$9 billion ($12 billion).

Profitless Twitter is said to be worth US$10 billion. Groupon, vendor of online discounts, rejected a US$6 billion offer from Google and is considering a flotation with a potential valuation of US$15 billion.

Tech-watchers say this is just the start: the real boom will come when Facebook, the head boy of the new dotcom frenzy, goes public, probably next year.

This month it emerged that Facebook staff are planning to sell US$1 billion of private shares at a price that values the private company at US$60 billion - that's US$10 billion more than January's valuation and close to 10 times the price Russian investor Digital Sky Technologies paid employees who sold shares in 2009.

The leaps in valuation are dizzying. At its current on-paper price, Facebook's value is somewhere between that of Ford (US$55 billion) and Visa (US$63 billion). But that's still less than a third of Google's value, Facebook's arch-rival in the battle for domination on the internet.

Alan Patrick, co-founder of technology consultancy Broadsight, says we are at the beginning of another bubble and that the first breaths have been blown: "A bubble is defined by too much money chasing assets, greater production of those assets, then the need to find a greater fool to buy them."

So far, money is chasing a small group of companies - Facebook, Groupon et al - that could prove to be good investments, says Patrick, who also writes the Broadstuff blog. That was true of other bubbles, too: at the start of the United States property boom, for example, it was the best houses in the best locations that took off first. Only later did people start speculating on grotty flats in Florida.

According to Patrick, there are 10 tell-tale signs that a bubble is being blown:

1. The arrival of a "New Thing" that cannot be valued in the old way. Dumb-money companies start paying over the odds for New Thing acquisitions.

2. Smart people identify the start of a bubble; New Thing apostles make ever more glowing claims.

3. Start-ups with founders deemed to have "pedigree" (for example, former employees of New Thing companies) get funded at eye-watering valuations for next to no reason.

4. There is a flurry of new investment funds catering for start-ups.

5. Companies start getting funded "off the slide deck" (that is, purely on the basis of their PowerPoint presentations) without actually having a product.

6. MBAs leave banks to start up firms.

7. The "big flotation" happens.

8. Banks make a market in the New Thing, investing pension money.

9. Taxi drivers start giving you advice on what stock to buy.

10. A New Thing darling buys an old-world company for stupid money. The end is nigh.

This time social media is the New Thing. Its most earnest acolytes claim that the likes of Twitter and Facebook are a revolution in human communications unseen since Gutenberg started printing the Bible.

They aren't making money but they are worth a fortune. Two smart cookies - Arianna Huffington, founder of the Huffington Post, and Michael Arrington, creator of the influential technology blog TechCrunch - have sold their publications to AOL, a company not noted for the astuteness of its recent decisions. Tick off stage 1.

The second stage looks tickable, too. Fred Wilson, investor at Union Square Ventures and a veteran of the 1999/2000 dotcom bubble, has been sounding the alarm for some time.

In a recent interview with TechCrunch, Wilson said he was worried that a two- or three-person start-up could get a US$50 million to US$100 million valuation.

"To me that's not in the realm of reasonable," Wilson said.

He even went as far as to name names - in particular Quora, a questions-and-answers site set up by Facebook alumni Adam D'Angelo and Charlie Cheever that raised US$11 million in funding last year at a price that valued the company at US$86 million. Now it is reportedly fending off offers for US$330 million. See stage 3 above.

Mark Cuban, the investor who made a fortune in the first dotcom boom, has compared the current funding frenzy to a pyramid scheme. In another recent interview, David Cohen, managing director of the well-known Silicon Valley start-up fund TechStars, says there is a bubble in the number of companies financing start-ups. Cross off stage 4.

The last dotcom boom really took off after the flotation of the internet software company Netscape in 1995. Patrick says this time it's likely to be Facebook that lights the fuse. So far, private investors have been locked out of the New Thing.

But JP Morgan is setting up a fund and Goldman Sachs recently tried to get its clients' money into Facebook. That would take us all the way to stage 8, in which case we're just waiting for stages 9 and 10 - where cabbies get in on the act and the game goes into reverse.

Not everybody agrees. Sumon Sadhu, director of intelligence at Quid, a Silicon Valley consultancy, sees a lot of money but no bubble. He calculates that in the fourth quarter of last year, consumer internet firms attracted US$2.5 billion in new investments, up from US$949 million for the previous quarter. But the number of companies getting the cash rose from 226 in the third quarter to just 252 in the fourth.

"The money is following the money," said Sadhu. Something new is happening, he argues: social media has created a vast new source of information about the people using the internet. Sites such as Facebook are building a far more rounded picture of a person's identity - and that is worth a fortune.

"The first wave of internet firms gave us an explosion of information. Now we need filters - we need to trust where that information is coming from," said Sadhu. "That's what's being monetised now. With any business cycle it's going to be evolutionary, but there is seldom excess with a total lack of fundamentals."

Farai is not so sure. "There are elements out there that are pyramid-esque, Ponzi-esque, maybe even Kafkaesque," she said. "There's a sense that this isn't real money. In the long run, that can't be good." Maybe, maybe not. The sad truth is, we'll only really know this was a bubble if it bursts.

SKY HIGH

Latest dotcom valuations:

Facebook - US$60 billion
Groupon - US$15 billion
Twitter - US$10 billion
Zynga - US$9 billion

- OBSERVER