Siren Songs of Sexy Startups: The Perils of Tech Investing

When startups tell their story, the future is always now, and it's always brilliant. Beware flying hot potatoes, though.

Dreamstime.com and Haaretz

A funny thing happened to Medivie Therapeutic over the past couple of weeks.

The tiny biomedical company debuted on the Tel Aviv Stock Exchange at the beginning of June after merging with the shell company Glycominds.

For nearly three weeks the stock behaved as you would expect any micro-cap to – no trading at all on many days and sharp movements on the days when a small number of shares changed hands. Then suddenly on June 19, Medivie stock shot up 82% in fairly heavy trading, followed by several more days of double- and even triple-digit gains as trading volume spiked from nowhere to as much as 41 million shekels ($12 million) a day.

Medivie also suffered two sessions of double-digit losses, but by the end of June its market cap was close to 92 million shekels, 13 times what it had been two weeks earlier.

What had Medivie done to merit such attention?

The answer is: Nothing that would be obvious to the ordinary person. The company makes a device called Laboraide, that women giving birth can bite on to help alleviate labor pains.

Although it expects sales to rise to 5.6 million shekels for all of this year, the company had revenues of just 787,000 shekels for all of 2013 and the first quarter of 2014. The only news about the company in the second half of June that it met with investors ahead of (an ultimately failed) offering of stock and that a Tel Aviv hospital had cleared the way for a clinical trial of Laboraide to commence.

When to get into technology

There are some very good questions to ask about the timing and size of Medivie's rally, but more importantly it raises serious questions about the nature of technology investing along the lifecycle of a company from startup, to initial public offering and life as a publicly traded company.

These are especially important question to be asking as the TASE's director, Yossi Beinart, aims to make the bourse a home for small tech and biomed companies like Medivie.

Apart from veterans like Apple and Google, the majority of tech companies are in the business of selling investors a brilliant future based on very skimpy present.

In spite of its geekish roots, the industry indulges in the kind of hype that more traditional industries wouldn't dare. Thus in the late 1990s, before the tech bubble exploded, it was the "new economy" that would enable tiny startups with zero revenues or often no clear business strategy to topple "old economy" giants. Today, it is startup "disrupters" that will do the same thing.

An app worth more than Hertz?

Thus we've seen startups like Uber, which offers a peer-to-peer to app for getting and taxi or ride-sharing, valued last month at a stunning $18.2 billion (including the $1.2 billion in cash it raised in the now infamous fundraising round).

Uber can at least count $200 million in revenues, but to support such a valuation that makes it worth more than the car rental companies Avis and Hertz, Uber will have to enjoy a very impressive run of growth.

Yes, social media of the kind Uber uses is the future and will change the way we do just about everything. But Uber has competition (not the least Israel's GetTaxi) and a slew of regulatory obstacles to overcome. Uber might succeed in conquering the taxi world as Facebook did personal communication, but for every Facebook there are dozens of Myspaces that failed to win the revolution. Nothing short of major success will ever justify Uber's current value.

This same dizzy atmosphere prevails in the public markets, too. According to the Renaissance Capital, which tracks public offerings, $29 billion in IPOs had been priced in the first half of this year, up 55% from a year ago. Another 200 are in the pipeline, 87% up on 2013.

Renaissance says the average deal has returned 19% from its offering price this year, more than three times the S&P 500s 6% gain.

The secondary market isn't immune either, though investors have plenty more time to ponder the risks they are taking on. According to Bloomberg, Tesla Motors – which is promising a future of electric cars, not unlike the failed Better Place – is trading at a ratio of 850 times its enterprise value to earnings before taxes, interest, depreciation and amortization. It's not alone: the S&P 600 Biotechnology index trades at 350 times EV to Ebitda.

The S&P 500, which includes the whole gamut of companies, trades at just 11.

When a potato fails

You could look at all this as a game of investor hot potato, in which cynical venture capital and hedge funds pay outsize valuations for startups, passing on the risk to the institutional investors that buy into these companies' IPOs at even more excessive valuations. The institutions then toss the high-temperature tuber onto retail investors, who bid up the price even more.

Eventually, the potato falls and someone loses, but by then the smart money has long ago moved on.

But this kind of irrational exuberance isn't just a matter of the naive being sold a bill of goods by the cynics. The phenomenon of eye-popping valuations for tech companies reflects a dangerous combination of both that draws even the most sophisticated investors into bubbles. Today they are being driven into tech and stocks generally by very low interest rates and the fact that the world's key economies are still struggling to shake off the great global recession of 2008. The brilliant future promised by high-tech outshines the massive risk.

Thus, according to the market research firm CB Insights, the number of $1 billion-plus startup valuations was running at a rate one to four deals a quarter in 2012-2013. Suddenly the number jumped to 11in the first quarter of 2014.

The industry landscape for mobile apps or the "Internet of Things" hasn't suddenly taken a turn for the better. What happened is that Asian investors, hedge and mutual funds have been pouring money into companies, increasing the competition to get into deals.

U.S. venture capital funding has reached levels not seen since the last tech bubble burst.

Unbounded confidence in the future is the stuff of all revolutions, whether they're political and technological. It's what drives innovators, entrepreneurs and venture capitalists, God bless them. But for financial markets, it's a curse.