Is Another Internet Bubble Filling Up?

As Internet company valuations reach astronomic new heights, it’s easy to conclude that Silicon Valley has spawned another giant bubble, one that will eventually bounce its way onto the public market and soak investors.

Consider that between November and mid-April, Facebook’s valuation has soared from $33 billion to about $80 billion when T.Rowe Price became the latest investor, injecting nearly $191 million into the social networking company. Twitter, whose value was pegged at $3.7 billion in December, when it raised $200 million in a financing led by Kleiner Perkins Caufield & Byers, has since skyrocketed to about $8 billion, and numerous media outlets have been “leaked” information that potential acquirers think it’s worth north of $10 billion.

With so much apparent zaniness taking place, you might think it’s universally accepted that the market has grown overly optimistic. Yet there’s surprisingly little consensus on the matter.

Perhaps it’s no wonder. Unlike the dot-com bubble of the late ‘90s, which involved hundreds of tech companies that went public, valuations today mostly center on a comparatively narrow list of privately held Silicon Valley companies.

What’s more, rather than involve dozens of venture capital firms, and thousands of public market investors, valuations are being driven sky high exclusively by the rich. Among the players are traditional late stage venture capitalists, hedge funds and high-net worth individuals who are either shopping through private placement platforms like SecondMarket, or connecting with shares through ritzy banks, such as JPMorgan and Goldman Sachs.

They seem to be following firms, such as Kleiner Perkins, Andreessen Horowitz and Greylock Partners, which have all raised funds for late stage investing, to chase what Greylock Partner David Sze has dubbed “winners’ circle” companies.

But all are ultimately following in the giant footsteps of Digital Sky Technologies, the Russian investment firm that began placing outsize bets on Zynga Game Network and Facebook more than two years ago. DST is also apparently raising a new, $1 billion venture fund, according to some reports.

Whether they’re collectively driving valuations to unsustainable levels is hard to say, given that they reflect investors’ vision of the future, rather than quarterly numbers. But plenty of people are trying to figure it out.

It’s almost the 2011 version of a private equity chain letter. The early [VCs] are getting the new [VCs] to invest enough money at high enough valuations that they get most, if not all of their money back.”

Mark CubanOwnerDallas Mavericksand former Internet executive

“I don’t know if we’re in a bubble, but certainly, these valuations are based on some notion that this [momentum that hot startups are enjoying] will last forever, and it won’t,” says technology pundit and angel investor Esther Dyson.

Groupon, whose valuation has reportedly hit $25 billion, will run out of new customers at some point, says Dyson, who adds that “Groupon may enjoy great margins today, but they will shrink as advertising gets more efficient. You’re not going to triple your sales in a finite market. You can move people from Coke to Pepsi, but in the end, they aren’t going to drink more than 8 glasses a day.”

Dyson is far from alone in her skepticism.

“It’s almost the 2011 version of a private equity chain letter,” says Mark Cuban, who sold Broadcast.com to Yahoo in 1999 for $5.7 billion and then used the proceeds to buy the Dallas Mavericks basketball franchise.

“Remember the old chain letter, where you put up some money, then you got other people to put up some money, and you gave it to the people who were in the deal before you? That’s what’s happening today,” Cuban says. “The early [VCs] are getting the new [VCs] to invest enough money at high enough valuations that they get most, if not all of their money back. Then the next round [sees] someone else invest more money at a higher valuation, returning cash to the last two rounds of investors. By the time you get to the last [VC] standing, those last few rounds hope they can get a return from the public markets. That may be very tough. But the only players really on the hook are the guys from the last rounds. Just like in a chain letter.”

Others are markedly less dramatic about soaring valuations. Attorney Michael Sullivan of Pillsbury Winthrop Shaw Pittman, who represents emerging growth companies, is among them. In a recent phone call with VCJ, Sullivan shrugged off talk of greater fools left holding the bag.

“Valuations have been heading higher for early stage companies, but we’re nowhere near a 1999-type bubble,” Sullivan says.

The difference, according to Sullivan, is that the “companies that are getting financed now are much more likely to have a real business model than in past bubbles. They’re capital efficient, generating real revenue, and have better prospects for reaching profitability.”

Valuations have been heading higher for early stage companies, but we’re nowhere near a 1999-type bubble.”

Michael SullivanPartnerPillsbury Winthrop Shaw Pittman

But Steve Eskenazi, a VC-turned-angel investor and advisor to numerous startups, offers up the most specific arguments for why what looks like a bubble might not be.

For one thing, Eskenazi says, “The companies during the 2000 era needed years to grow into their valuations.”

Given Facebook’s supercharged growth (estimates put its earnings before interest, taxes, depreciation and amortization at $2 billion for 2011), “you just have to put a 20 or 30 multiple on it to get to [its soaring valuation],” Eskenazi says.

Today’s market also features “fewer one-trick ponies,” Eskenazi argues. “In 2000, it was desktop only.” Now, a company has many more ways to reach an audience, including mobile.

Eskenazi also points out that in 2000, “You didn’t have all these big, acquisitive companies with enormous cash reserves.” Now, “the Googles of the world will remain acquisitive because they’re sitting on huge piles of cash and trying to protect their momentum. So are IBM and Microsoft, and Facebook, which is swinging for the fences and has plenty of cash.”

Although it’s hard to escape the feeling that every investable dollar is trying to find its way into today’s consumer Web superstars, Eskenazi maintains it’s all relative.

“If these were all multi-billion dollar funds” that VCs and banks like Goldman have been raising, “it would be one thing,” he says. But [what they’ve raised] is really a fraction of the amount of money [available in the world]. It’s a small piece when you think about what’s really out there.”