The Facebook IPO’s Effect on Software Startups

The Facebook IPO’s Effect on Software Startups

Two of the heavyweights in the startup world have now weighed in on the Facebook IPO and how it impacts the early stage software world, so I figured it’s time I did to.  Paul Graham has warned the companies in Y-Combinator about the dangers of needing money at a time like this (implicit in that advice is a fear that Facebook’s valuation will trigger the popping of a bubble in startup land).  Fred Wilson reacted by pointing out that Facebook is still trading at roughly a 25x multiple on earnings and 10x on revenue.  That’s still pretty frickin optimistic.

My reaction to both of these posts is to take Fred’s reasoning one step further, what if we can learn from the Facebook IPO without popping a bubble (or I guess, pop this bubble while it’s still tiny).  By this, I mean that the early stage software community can look at what happened with Facebook and not over react.  We can learn that the market as a whole is not as bullish on web/social as we are, but also learn that the market is not bearish on it (or early stage software in general) either (this is Fred Wilson’s point).  We can adjust our models and while some investors and companies will leave our space, there won’t be a stampede.  If this is the result of what happens with Facebook, it could end up being the moment that our market became less speculative and far more sustainable.

That’s the good news—the bad news is that the last couple weeks may have marked the beginning of a larger correction.  How will we tell the difference?  Well, this will take time, but we should start to see answers pretty quickly.  Here are the indicators that I’m looking at:

  1. The stock market—Take a look at the chart above.  It shows Facebook, LinkedIn, Groupon (the unlabeled bluish line), and Zynga over the last month compared with the NASDAQ as a whole.  Watching this chart will be very interesting over the next few months.  Zynga is so closely linked to Facebook that its not surprising to find it falling right alongside Facebook.  Look at LinkedIn though, it’s following a path that is roughly half way between Facebook and the NASDAQ as a whole.  If it starts to resemble Facebook more than the NASDAQ as a whole, it will be a sign that the market is lumping recent software startups together and thinking that they are all overvalued.  If, on the other hand, LinkedIn recovers to be more in-line with the NASDAQ, it will signal that the market believes that Facebook was overvalued, but that young software companies generally are not unhealthy.  The fact that Groupon is actually up over the last month is a great sign that this latter scenario is prevailing, but only time will tell.
  2. Real World Results—Companies like Facebook, Groupon, and LinkedIn need to continue to have good results.  A major drop in earnings or profits for any of those four and about half a dozen others would signal to investors that their worst fears are true and that there is a bubble that needs to be popped.
  3. Private Software Industry Investments—There were 231 venture software deals in 1Q 2012 totaling over $1.6B (an average size of around $7M).  That will, of course, fall (if it somehow goes up then we can kiss the bubble popping conversation goodbye).  The interesting part will be how it falls.  I would think that it’ll be a good sign for a correction rather than a bubble popping if the average deal price drops more dramatically than the number of deals and the total value doesn’t drop more than 20% by the end of 4Q.
  4. Acquisitions—With the public market looking less and less likely for software startups, it will be important to see IBM, Google, Microsoft, and even Facebook continue to acquire early stage software companies.  This is harder to track than the previous three, but if you know what you’re doing you can find ways to keep an eye on it.
The bottom line is, whether you’re an entrepreneur or an investor…it’s not quite time to panic, but it’s time to be cautious (as Paul Graham points out the best way to survive troubled times is to not need any money).  It’s also time to keep an eye on the world, because if a bubble pops the game will change quickly.