How Stupid Money Is Killing Silicon Valley Innovation

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Spotify is one of the better known unicorns—private tech companies valued at $1 billion or more—clocking in at $8.5 billion, according to "Fortune" magazine. But the easy tech money that has fueled the blowup in market values of companies like the streaming music service and Uber is drying up, foretelling a shakeout that will see many companies that don't have viable business plans fail. Britta Pedersen/picture-alliance/dpa/AP

The fascination with technology "unicorns" seems about to go the way of Bigfoot sightings, Area 51 aliens and Furbies.

And tech startups will be better off for it. Really.

At the moment, a lot of Silicon Valley is in a panic. There's been a party going on for the past year, and it apparently just ran out of beer.

Huge rounds of financing have been inflating the value of startups, creating a herd of billion-dollar private companies popularly labeled unicorns. According to CB Insights, in April there were 57 unicorns with a total value of $211 billion. Now that has shot up to 144 valued at $505 billion. These companies range from Uber (valued at $51 billion) to Spotify ($8.5 billion) to companies you've probably never heard of, like Quikr, Kabam and Farfetch ($1 billion each).

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Pretty much everyone you ask in tech says the crazy money is drying up. Startups looking to go public are finding that their private valuations don't hold. Square's initial public offering this month was supposed to be the crystal ball that would foretell the fate of all unicorns. Well, Square's last private round valued it at $6 billion. Post-IPO, its market cap is more like $4 billion. Some $2 billion went poof.

The troubles look worst from up close, especially in Silicon Valley. The pre-IPO funding flood encouraged a good deal of sloppy management, overblown egos and stupid expectations, so there will no doubt be layoffs, underwater options and fortune-seekers moving back to Oklahoma. For a little while, there will probably be crying.

But the damage from a rupturing valuation bubble isn't likely to be anything like 2000's tech apocalypse.

For starters, the total value of all the unicorns put together is barely more than Microsoft's $432 billion market cap. If the unicorns lost a third of their total value, it would be the equivalent of the $182 billion AIG bailout. All in all, the unicorns are a small group with an outsize image, like the Kardashians.

Back in the late 1990s, exuberance over the Internet caused the building of dot-com and telecom companies that promised way more than the technology could do and got way ahead of what people actually wanted—Webvan, Flooz and the infamous Pets.com. They weren't real businesses. When funding withered, many closed.

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This time, though, most of the companies are building products and services people desire. The companies have real business models. Five years ago, it was nearly impossible for a craftsman at a street fair or a piano teacher making a house call to take a credit card. Now thousands of small businesses rely on Square, changing the nature of transactions. For the first half of 2015, Square brought in revenue of $560.6 million, at a healthy growth rate. In that way, Square is very much a fortune-teller for other unicorns. It operates a fine business. It disappeared $2 billion because the financiers screwed up when they invested.

As the valuation spiral unwinds, a relatively small circle of private investors will get seriously whacked, and some million-dollar Wall Street bonuses won't get paid. But since the unicorns aren't public, the financial fallout won't blow far. The companies that have built real businesses won't go away.

And then it will be better for startups—possibly much better.

Startups will benefit as office rents tumble and good people become easier to hire. The cost of starting a tech company and launching a product has dived by something like a hundredfold since the dot-com era, thanks to the emergence of things like cheap cloud computing and open source software. Private money raised has been far outpacing the cost of developing a business. Less money in the system is not going to result in less innovative technology getting built.

The influx of so much private money screwed up the natural metronome of the tech startup universe. Huge funding rounds convinced a lot of founders to stay private too long. Data analysis of post-2000 tech IPOs by Play Bigger advisers (for an upcoming book I co-authored with them) shows that almost all of the most enduring and valuable tech companies went public when they were between six and 10 years old. Facebook, Google, Twitter, VMware, Red Hat and others all fit that model. Companies that rushed to IPO earlier or waited until later almost always created very little long-term value.

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So there is a pace that works in tech. It starts with a gestation period. By years six to 10, it becomes obvious that a new company and its new category will firmly take hold, and the company then goes public and ramps up. History suggests that companies will benefit if that pace returns.

Moreover, the billions of dollars pumped into tech startups don't help. The data analysis shows that money raised by a company while private has absolutely zero correlation to its long-term performance as a public company. In other words, the gigantic private financing rounds of late are like participation trophies in kids' soccer. They're meaningless and send the wrong signals.

Some of this helps explain why a lot of great tech companies get started on the backside of exuberant times. Uber was founded in 2009, just after the 2008 financial crisis. Google blossomed in 2000. Microsoft was founded in 1975 in the midst of an oil crisis. Give the private-valuation nuttiness a moment to clear, and it should be the sanest time to start a tech company in years.

And then we can stop this obsession with unicorns and get back to looking for Tupac.

How Stupid Money Is Killing Silicon Valley Innovation