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Square is letting some air out of the tech bubble, and it’s high time

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Turns out most unicorns are just horses with fancy sponsors

Honestly, does @jack look happy to be there?
Honestly, does @jack look happy to be there?

Square went public today, raising $243 million, a price that values the company around $3 billion. That's about half the $6 billion valuation it received during it's last funding as a private company. That makes Square a reality check for a tech sector that has produced a massive herd of startups, dubbed unicorns, with valuations of $1 billion or more. It's painful news for many of the investors and employees of these companies, who will have a harder time justifying their own valuations now. But the humbling of Square is a healthy correction for the tech sector overall.

Increasingly it's become clear that investors in the public markets don't agree with the astronomical valuations assigned to private companies that lack a semblance of profits. In the past, startups like Twitter and Box had completed strong IPOs despite their ongoing losses because they also had good revenue growth, but the weak performance of those companies after going public has made investors more cautious. That in turn has caused investors to doubt the valuations of companies who aren't yet considering going public. Mutual funds like Blackrock and Fidelity, who helped pump up the bubble in startup valuations, are now marking down privately held startups like Snapchat and Dropbox.

The bubble isn't bursting, but its slowly deflating

Luckily this bubble isn't bursting so much as letting off some hot air. Square already had enough cash to keep the company running for several quarters and will have more runway after today, even with a disappointing IPO offer. Some of Snapchat's current investors may now be underwater, but that doesn't mean it's not a viable business. The company has a massive and highly engaged user base, a young but growing advertising business, and plenty of time to rightsize expectations.

We have seen startups grow back into their valuations after poor IPOs before. LoudCloud, a startup which went public back in 2002, got less than half the valuation when it went public as it did when it was private. But it kept growing the businesses, and eventually sold for more than its private valuation, rewarding investors who held on.

That is not to say this correction won't kill some startups. As Warren Buffet famously said, when the tide goes out, you can see who's swimming naked. Companies with broken business models — those who have been surviving by lurching from one funding round to the next, burning cash to create unsustainable growth — will most likely be acquired or shut down for good.

Venture capital is meant to have multiple failures for every big success

Is this a massive indictment of the Silicon Valley model? Not exactly. It's called venture capital because it's by nature a risky business. This is the approach that produced public companies like Apple in 1980, Microsoft in 1985, Amazon in 1997, Google in 2004, and Facebook in 2012. Think of the combined impact those companies have on the US economy, and the dominance they have around the world. For every one of these success stories, the same investors backed a bunch of promising startups that failed.

Tech valuations got out of whack in recent years because a lot of investors from outside of venture capital began pouring into the market. Private equity firms and mutual funds, sovereign wealth funds and Hollywood celebrities all wanted a piece of the action, and were far less concerned about the price they had to pay. Startups, meanwhile, started seeing a billion dollar valuation as the norm — something, in fact, that might even be required if you wanted to woo the best talent. (Vox Media, the parent company of The Verge, reportedly entered the unicorn club during its most recent funding round, joining competitors like BuzzFeed and Vice.)

vc money over time

But the backlash from this current correction will be nothing like the bursting of the dot-com bubble back in 2001. Even without adjusting for inflation, more money was invested in startups during that time period than this current bubble. Tech startups also accounted for nearly 60 percent of all IPOs then, compared to less than 20 percent today. That's doubly insane when you consider that there was a fraction of connected customers that exist today, both in the US and especially on a global level. Many of the companies that went public at the time didn't just lack profits — they lacked revenue of any kind, relying instead on the promise to monetize eyeballs down the road.

Silicon Valley startups are the stem cells of the US economy

A lot of well-respected venture capitalists have been saying for some time that tech, and specifically private tech startups, were entering an unsustainable period of ballooning valuations. They were right, and that party seems to be coming to an end. It won't be a painless correction, but it won't be a crippling one either. That's a good thing, because the tech sector, and Silicon Valley, have become the stem cells of the American economy. In the US, VC backed companies created since 1979 represent less than half the public companies and around one third of total employees. Yet they amounted for more than 80 percent of the research and development spending, according to a recent study by a pair of Stanford economists. VC backed companies are most often the ones creating new industries even as they disrupt the old, birthing companies that don't just profit, but invent the way we live, work, and play.