We may never see his like again.

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Worried the Tech Bubble Will Burst? Keep Calm

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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I’m seeing lots of news reports about the end of the new Silicon Valley tech “bubble.” I put that word in quotes because the current situation doesn’t look much like the bubble of the late 1990s. But there still might soon be a broad drop in funding for startups, and a fall in the valuations of these companies. 

For example, the Wall Street Journal reports speculation  that enthusiasm is falling and valuations will soon be lowered. Tech industry bigwigs are warning startups to focus on “unit economics,” a euphemism for “actually making money.” Not a lot of tech companies are pursuing initial public offerings these days. The revelation that Theranos Inc., a medical testing startup, probably exaggerated the efficacy of its technology might turn out to be merely the most flagrant case of overhype. 

Initially, the IPO drought looked like it was happening because private markets were so much more attractive -- big mutual funds have been ponying up cash for equity in so-called unicorns, or startups valued at more than $1 billion. Tech IPOs that did go through tended to have poor returns -- a signal of excess demand in the public markets. 

But sentiment may be shifting, and public markets may no longer be willing to pay those premium prices. That would leave late-stage investors, like the aforementioned mutual funds, with the choice of accepting a writedown or holding onto illiquid private equity for a long time. Even if they take the second option, there will probably be a pullback in funding for tech startups. 

If this happens, though, we shouldn’t be worried. Almost no one will be hurt very much by a drop in startup valuations. 

Tech founders, of course, will take a hit. Instead of being billionaires, many of them will have to settle for being eight- or nine-figure multimillionaires. Others will go bust and try again, or go get jobs. Imperial dreams will be dashed, but that’s only to be expected in the high-risk startup world. 

Mutual funds will get bruised if the tech sector takes a hit. But they won’t be hurt too badly, because they generally apportion only a relatively small percentage of their capital to “alternative” investments like venture capital. At worst they will have a year or two of blah returns. And since Main Street investors -- your grandmother’s pension or your retirement account -- usually only invest in tech startups indirectly, via these mutual funds, a tech bust won’t hit individual investors hard. 

Venture capitalists won’t be in a bad way either. Early-stage VCs and angel investors got in on the ground floor, when equity was cheap, so even if companies are forced to take writedowns, they will probably still make money. Late-stage VCs will take more of a hit, but they often have what's called liquidation preference, antidilution provisions and other safeguards to make sure they don’t lose too much in the event of a turn in the market. After a bust they will simply pick up and carry on doing their thing. 

In other words, the tech startup industry is dreaming big right now, but if those dreams are cut down to size, not much will be lost except for castles in the clouds. 

What this means is that the economy itself won't suffer from a tech bust, the way it did in the early 2000s. There are basically two ways that drops in asset prices feed through to the economy -- liquidity effects, and wealth effects. Neither one is in much danger of happening here. 

Liquidity effects happen when falling asset prices force financial companies to sell other assets to stay afloat. That triggers a fire sale that ends up pushing down asset prices even more, and gums up the financial industry as well. But the U.S. financial industry as a whole hasn't made big leveraged bets on the tech sector at this point, so a liquidity crunch probably isn't in the cards.

 Wealth effects happen when falling asset prices make people feel poorer, causing them to stop spending, reducing aggregate demand. That is also unlikely to happen here, because the main people whose wealth will be affected by tech startup writedowns are funders themselves. Funders are hoping for big payoffs, for sure, but they are not going out and consuming whatever newfound wealth they have earned. Main Street, which does tend to consume more when investments rise in value, isn't very involved in this tech boom; hence, we are in little danger from this quarter either. 

These both boil down to the fact that there is just not that much money invested in this tech boom. A slide presentation from venture capitalist Andreessen Horowitz demonstrated that in June, and the situation hasn't changed much since then. 

So if a tech startup crash comes in the next year, don’t worry. The economy won't be badly hurt, if at all. And the tech industry will just pick itself up, dust off its hoodie and jeans and get back to work. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net