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3Qs: Tech sector ‘bubble-ing’ over?

The leading social-media news site, Mashable, recently released an infographic comparing the successes and failures of new new-venture companies today to those in the dot-com era of the late 1990s and early- 2000s, begging the question, “Are we in a tech bubble?” John Friar, an executive professor of entrepreneurship at Northeastern and an expert in technology strategy for start-up companies, explains what it means to be in a tech bubble, if the world is in fact in one, and how start-ups can avoid the worst fall-out from a bursting bubble.

What is a tech bubble?

A tech bubble is a bit of a misnomer in that it means that investors overvalue technology-based companies regardless of whether the underlying technology is any good or not — a bubble is a financial phenomenon rather than a technology one. For instance, the dot-com bubble that burst in 2000 hurt investors and marginal companies in the industry. Yet, in 2011, the Internet is bigger and stronger, with more companies making profits than ever before. There was no technology bubble, purely a financial bubble.

Are we in one?

Probably, because investors are notoriously bad at valuing new technologies, as they do not understand how the markets for new technologies develop. With every new technology comes the promise of world-changing effects, and sometimes that does happen. However, it takes longer than anticipated for revenues to materialize and profits to be generated — think cell phones and biotech, two other tech bubbles in which investors way over-valued the early company stocks. Financial models depend on assessing future cash flows, which is difficult to do when positive cash flows may be a decade away. This is a recurring theme and one of the reasons we started the School of Technological Entrepreneurship – to create better financial models for early early-stage technologies.

What can emerging companies do to avoid major failure?

Early-stage companies need to be careful when raising money in speculative markets. The dot-com companies did not fail because their technology or business ideas were poor (you can still buy whatever you want over the Internet). How companies got into trouble was when they raised money at too high a valuation and then did not get to positive cash flow, necessitating further rounds of fund raising. The later investors did not accept the earlier high valuations, which wiped out the earlier investors. So, entrepreneurs need to understand that they must manage the “step up,” or increase in valuation, from round to round. Believing the hype at an early stage can sink a company at a later stage.