Are we in a tech bubble?

Not so long ago, that was a question for Wall Street analysts and venture capitalists to debate among themselves, being of little interest to anyone else. But that was before recent investors valued Uber at $50 billion and Airbnb at $25 billion. It was before mutual and pension funds became leading players in colossal late-stage funding rounds, linking the retirement accounts of middle-class Americans to the fates of hot but unpredictable startups at a rate not seen since the dot-com crash of 2000. It was before the collective work force of on-demand services like Uber, Lyft, TaskRabbit, and Instacart numbered in the hundreds of thousands. It was before Federal Reserve chairwoman Janet Yellen broke the customary sphinxlike silence of her office to observe that valuations in some tech categories have become "substantially stretched," before the tech sector eclipsed financial services as the leading destination for elite business school graduates, and before tech money made over large swaths of New York City, Los Angeles, Seattle, and Austin, and, of course, the entire San Francisco Bay Area, where one in five working adults is employed by a tech firm. Whatever your opinion on the bubble question, you can't ignore it.

So are we in a bubble? Yup.

"I define a bubble as something where assets have prices that cannot be justified with any reasonable assumption," says Jay Ritter, a professor of finance at the University of Florida's Warrington College of Business Administration who studies valuation and IPOs. While definitions of reasonable assumption vary, historically bubbles have occurred when, in an economic sector's development, the last money in is highly unlikely to realize a return that justifies the risk it has taken. How do you know when that moment has arrived? It's when those billion-dollar unicorns, as they're known among venture capitalists, begin to insist that their ultrahigh growth rates should not be subjected to conventional P/E-based valuation analysis. (Not that they could be, anyway, since their earnings are almost always a closely guarded secret.)

When their valuations are scrutinized, the results can only be called bubbly. The research firm CB Insights calculated recently that Uber was being valued by its latest investors at a multiple of 100 times its sales. To put that into perspective, Zipcar, the hot sharing-economy startup of its day, commanded around a 6x multiple at its peak. Microsoft fetched a similar one when it went public in 1986, achieving a market cap of $778 million on its first day out. Today's pace­setting enterprise software firm, Slack, is valued at more than 90x sales. Airbnb's $25 billion valuation works out to a 28x multiple; most other big hospitality providers are in the 1-to-2x range. And since it has barely started selling ads, you could argue that Snapchat, at $15 billion, is even more richly priced. Facebook hit that valuation milestone only after it had been selling ads for three years and had hit $153 million in sales. In all of these cases, investors will say it's foolish to set a ceiling on how big these young companies might become, as though a brief curriculum vitae were grounds for exuberance, not caution.

"This is late-stage venture capital doing what it was created to do--keep risky companies out of the public markets. The people who stand to get hurt are in the business of getting hurt." Barry Schuler

"Private valuations have become disconnected from public reality," says Jules Maltz, a general partner at Institutional Venture Partners. In a recent letter to his firm's limited partners, First Round Capital's Josh Kopelman suggested that the "extreme end of a cycle" is fast approaching. Bill Gurley, a partner at Benchmark Capital and a member of Uber's board of directors, has urged caution for the past year, believing late-stage investors have "essentially abandoned traditional risk analysis" and are pouring money into companies with unsustainable burn rates.

So the question isn't if, but when, this bubble will pop. If, as seems likely, it happens when interest rates rise and investors chase higher returns, how bad will it be? Some say not so bad. The aggregate funding of technology firms is well below what it was in 2000, when a Nasdaq collapse kicked off a broad, long recession. Back then, the risk was concentrated in the public markets, which included millions of relatively novice investors in mutual funds or newly opened online brokerage accounts.

"There was a saying then: Put dot-com in your business plan, stick a mirror under the nose of your entrepreneur, and, if you see signs of life, IPO," says Barry Schuler, a managing director of the venture firm Draper Fisher Jurvetson's growth fund (and an columnist).

Now the risk, and the growth, is almost entirely borne by private companies backed by private money. While 2015 has seen a surprisingly small number of tech IPOs, the number of private companies valued by investors at more than $1 billion has more than doubled in the past 18 months. A full 75 percent of the largest private tech-company financings ever were made in the past five years, and the number of startups raising funding has more than doubled since 2009.

DFJ's Schuler readily concedes that the valuations attached to most recent funding deals are excessive, but says there's nothing especially problematic about it. Unlike 15 years ago, if this bubble goes pop, it won't cause serious collateral damage.

"This is late-stage venture capital doing exactly what it was created to do--keep risky companies out of the public markets," he says. "The people who stand to get hurt are the people in the business of getting hurt."

But that's not strictly true. As the private deals get too big for VCs to underwrite on their own, some public money is making its way into them, through direct investments from mutual funds like Fidelity, Janus, and T. Rowe Price, and indirectly via pension-backed hedge funds and private equity. Most of these funds say they're allocating only 1 to 2 percent of their assets to private tech firms, ensuring that no one's 401(k) or IRA is too dependent on them. But as the boom goes on, they're getting more aggressive: The five mutual funds that are the most active startup investors made 45 investments in 2014 compared with 18 in 2013.

While Schuler would argue that the damage of the inevitable bubble bursting will be limited to companies that have received, or want to receive, funding and to the private investors and those funds invested in them, there is always the potential for a much wider impact on employment and real estate values. Economists like Christopher Thornberg of Beacon Economics say asset bubbles become dangerous when they lead to other imbalances in the economy. This one, he says, is isolated. If it imploded, "all these millionaires would suddenly have to rein in their spending some. But IT investment in the global economy is not going away." Then again, economists have missed the ball before--most recently before the recession of 2007.

There will, however, be very real effects for both entrepreneurs who take funding and those who haven't and don't intend to. First, there will be some upside. Sky-high home and office rents in certain cities and neighborhoods will drop, and if you're not in the market yet, you'll have a great buying opportunity. If you're hiring, the drum-tight talent market for anyone with programming skills should loosen up considerably, although big companies may reap the benefits more than small ones, says Oliver Ryan, founder of the tech recruiting firm Lab 8 Ventures. "The 'war' for engineering talent is primarily a supply-and-demand issue, so a widespread pullback of venture capital would likely diminish demand to a point," he says.

But a burst bubble could also create new types of adversity. All that venture capital may be pumping up the cost of office space in San Francisco and Manhattan, but it's also effectively subsidizing services that make it cheaper and easier to operate your own non-venture-backed startup. Maybe you're an online retailer that uses Shyp to handle customer returns and Postmates to make local deliveries. Maybe you've found you can save money by managing payroll through Zenefits and boost productivity by replacing email with Slack. Chances are these well-funded companies would be among the survivors of a downturn, but if they went away or hiked their prices, life would be that much tougher.

Of course, if your company is one of the few that have taken venture money, or is considering becoming one of them, the bubble question takes on a much greater and more personal urgency. When the 2000 bubble burst, private tech funding fell by more than 80 percent and didn't recover for a decade. That's not to say it was a nuclear winter; Facebook, Twitter, SpaceX, and Dropbox were a few of the companies founded and funded during that stretch. But the future availability of capital is a crucial consideration in every startup's business plan.

"Investors change priorities. Soon, they may be telling you, 'We want to see profitability at the expense of growth.' So you need to think about the levers you can pull to make that happen."Scott Kupor

When Slack, a two-year-old startup, raised $160 million at a $2.8 billion valuation in April, its founder, Stewart Butterfield, said he did so not because he needed to but purely because he could. "This is the best time to raise money ever," he told The New York Times. "It might be the best time for any kind of business in any industry to raise money for all of history, like since the time of the ancient Egyptians." Butterfield's hyperbole was meant not as an expression of bubble mentality but as a sensible precaution against it: Make hay while the sun shines. In Silicon Valley today, the wisdom of socking away a little extra "bubble insurance" is unchallenged.

"The advice you always get from more seasoned entrepreneurs is to take the hors d'oeuvres when they're passed," says Marco Zappacosta, CEO of Thumbtack, a local services platform that raised $100 million from Google Capital and other investors in August 2014. That is, raise money when you have the chance, because if you wait until you need it, it might not be there. Investors may be greedy, and markets may be delusional, but money is time, and the best way to ride out a downturn is with a couple of years' worth of cash stashed in your mattress. Just be sure you're prepared to deliver a couple of extra years' worth of growth, because you'll need to if you follow the raise-more-than-you-need plan. "It's not without risk," acknowledges Zappacosta. "You'll have to make the numbers to justify your valuation at some point, so you're raising the hurdle on yourself."

For the confident, it's a great time to raise money--provided your company fits one of two profiles: big and well on its way to market domination, or tiny, lean, and nimble. As big institutional investors dump money into the Ubers of the world, traditional VCs are also ramping up their activity at the other end of the spectrum. The number of $1 million to $2 million funding rounds has grown sevenfold over the past decade.

"All of the growth in venture capital has been in the seed market," says Scott Kupor, a managing partner at Andreessen Horowitz. In fact, setting aside those megarounds, the average size of a round has been falling as cloud computing and other innovations make it ever cheaper to start a tech company. But cheaper to start doesn't mean cheaper to bring to fruition. In a frictionless, borderless world of winner-take-all natural monopolies, no sooner does a startup get its product right than it must begin working on its international rollout, with all the new investment that entails.

"It's true that it's cheaper to start companies," Kupor says, "but it's also true that companies that grow require a lot more capital to do so, and they require it earlier in their life cycles."

For several years now, entrepreneurs have been talking about the "Series A crunch," or the "valley of death" between seed and growth funding. As the number of initial fundings balloons, and as nontraditional money creates a powerful updraft for companies that make it through the initial cull, the imperative to cross the valley by any means necessary becomes ever more urgent.

"It's becoming shockingly binary," says Zappacosta. "Either you have product-market fit with great growth and you're in the club and you can raise all the dollars you want, or you don't and can't raise any." That dynamic will only strengthen in the event of a general pullback of private funding, predicts Jeff Grabow, Ernst & Young's Americas venture capital leader. "If that scenario played out, I think it would affect people in the midrange the most."

To make it over the chasm, you have to show investors traction and momentum--a PowerPoint slide with a line pointing up and to the right. A startup can often manufacture these things by spending enough on advertising and customer acquisition. But the attributes so richly rewarded in the current environment aren't necessarily the same ones that will be selected for once the bubble bursts.

In October 2008, as the financial crisis bore down on the U.S. economy like a speeding semi, Doug Leone of Sequoia Capital gave a famous presentation titled "R.I.P. Good Times," in which he counseled entrepreneurs to squirrel away their nuts for winter and "spend every dollar as if it was your last." Venture capital funding did recede for the next two years, but it wasn't the apocalypse Leone forecast, and his warning came to be seen by many of his peers as alarmist.

But many older industry hands are now quietly drilling their protégés with a softer version of Leone's admonition. Even at Andreessen Horowitz, the most vocally bullish of the top-tier VC firms, the partners are explaining to portfolio founders who were in grade school during Bubble 1.0 that they should be careful about swimming too far from the beach, P&L-wise, because the weather can change fast. "The main thing we're trying to impress on our CEOs right now is that the market is saying, 'We want to see growth, we want to see geographic expansion,' but that may not always be the case," says Kupor. "Investors change their priorities. Soon, they may be telling you, 'We want to see profitability even at the expense of growth.' So you need to think about the levers you can pull in your business to make that happen."

Strong as the impulse may be to build up a war chest, you also have to be more careful about the terms on which you raise money as that "extreme end of a cycle" approaches. Typically, you'll seek the highest possible valuation for a number of reasons: It minimizes dilution and generates publicity that attracts talent and clients and even more capital. But as valuations settle--and the inevitable rise of interest rates all but guarantees they will--founders who overreached will struggle to support, or defend, those valuations. In the worst instances, if you finagled an extra 10 or 20 percent of paper value by granting investors aggressive downside protections--the "features" and "ratchets" that VCs use to make reckless bets without incurring real risk--you'll find yourself downgraded from owner to employee. "The highest valuation isn't necessarily the best one," says DFJ's Schuler.

Unfortunately for them, some founders are taking just the opposite tack, accepting less than ideal terms merely to push their valuations over the magical $1 billion mark. It's precisely such bonehead behavior that makes IVP's Maltz hate the unicorn label. He'd prefer to save the term for those companies that reach a billion dollars in revenue. "Now there's a real unicorn," he says.

Better yet, we should just retire the word unicorn altogether. The time for magical thinking is over. It's also end of days for startups whose big idea is to raise a mountain of money now and figure out a business plan later, and for investors who think clever deal terms or the wisdom of crowds is a substitute for diligence and judgment. Those things fly for only so long. That's not to say it's a time for fear. Plenty of great companies have started up in downturns. The end of this bubble won't wipe out everyone. But it will wipe out many who don't see it coming.