Why the Tech Bubble? Fewer Startups, Higher Valuations of Course!

See, everyone’s talking about the emerging (or emerged) bubble in startup valuations. My thesis: there are now far fewer startups so valuations have to go up. Duh.

So you thought the number of startups was rising? All those Silicon Valley startups, every university having courses in entrepreneurship? Think again. You are totally wrong.

Check out this piece of research from the Brookings Institution. The proportion of older companies has been steadily increasing over the last few years and they employ a higher proportion of people. The higher proportion of older firms is displacing startups aged 5 years or less. It’s happening all over the US, even in Silicon Valley. Company formation rates are declining and company exit rates are increasing. Not good right?

This is not the only straw in the wind. The Kauffman Foundation’s index of new entrepreneurial activity shows a decline over the last few years although not as dramatic as the ones showed by the Brookings study.

We are starting to look like those geriatric and rigor-mortis-bound Europeans. At the beginning of the 2000s, 69% of Americans preferred to be their own boss, compared with 55% today. That compares with 45% of Europeans.

So things are not looking good for entrepreneurship and all the frenetic activity in Silicon Valley is making us complacent when we should be very scared.

I can see three main reasons why people are not becoming entrepreneurs:

1. Flight to job safety; it’s easier and less risky to work in a big company or government; you’ve got a dramatically lower chance of failure, you even get benefits, more so they are regular; of course its less fun but what’s that got to do with life?
2. Higher risk aversion generally in US: check it out; Dodd-Frank; Sarbanes-Oxley. Generally the Feds are anti-business even though they profess not to be. Why not just collect a pay check? It’s a lot easier than actually leading the charge.
3. Fewer STEM graduates; yep folks, that old canard yet again. If you go into engineering and computer science classes these days you need to speak Mandarin or Hindi. There are not too many Americans doing them. But these are the disciplines that actually invent things.

The graduates in business and liberal arts figure out how to make the innovations into philosophy and art. Business and the liberal arts are the easy subjects; science and especially engineering the tough ones.

Also in liberal arts and business you generally get an A or B+ but in engineering and the sciences that’s not the case. Grade inflation has generally occurred in the soft courses. So it’s just far easier to stay out of the tough bits; but they are the ones that result in the innovations that fuel startups.

But maybe I’m wrong, who knows? But that still means we have to explain why startups are declining proportionately and people are shifting to working in large companies and governmentinstead of starting up new companies themselves.

As we know the literati are starting to get worried again about yet another tech bubble. Of course we are now in one. They only issue is how it ends.

But the issue here is really one of supply and demand. One of the reasons for high stock prices has nothing to do with fundamentals. Rather it has to do with supply of stock and demand for it.

We know that the supply of stock has fallen precipitously in recent years due to fewer companies going public. This really all started with Sarbanes-Oxley and has been exacerbated by increased regulation which gives investors a strong reason to keep companies private rather than having a lifelong tussle with regulators by going public.

So much of the current high stock prices have nothing much to do with fundamentals but a lot to do with a drastically lower supply of stock as companies don’t go public and public companies increasingly prefer to go private.

I suspect this is the same issue with startups. There are proportionately less startups so the value of those that remain has to increase.

What this is likely telling us is that the incredible valuations for many startups has nothing to do with their real-world potential, or even with South Sea bubble manias. It has its roots in the supply and demand for startup investments.

Now we have a voracious industry of venture capitalists that have raised huge amounts of money and have to put it somewhere. But there’s simply fewer places to go. Voila, tulip-mania without the tulips.

None of this is good. Fewer startups. More like Europe. Startup valuations occurring simply because we have collectively lost courage so we pay more and more for less and less.

Personally I am an optimist. And I am also a founder of a startup, so I speak from the heart.

But it’s hard to see the good in this set of facts.