Opinion

That's Not a Tech Bubble on Wall Street, It's a Ceiling

The plunge by tech stocks is not good news for Israel's Startup Nation, which has been thriving thanks to ever higher valuations for companies. That era is over

People pass the New York Stock Exchange, October 24, 2017.
Richard Drew/AP

Startup companies aren't just about cool new technology but about making money. But in the final analysis, it's Wall Street that decides what the technology is worth.

When the dot.com bubble burst in 2000, Israel's technology sector burst with it. That year startups had raised a then-record $3.1 billion.Over the next three years, that number fell by two thirds, and it was only in 2014 that Israeli startup companies managed to pass the record set fourteen years before.

In the last three years, fundraising for Israeli startups has grown by leaps and bounds, reaching nearly $5.3 billion in 2017. In the first half of this year, it reached $3.2 billion, putting Startup Nation on target to raise twice the amount it did during the heady years of the dot.com bubble.

Suddenly, a downturn seems to have materialized. Tech stocks on Wall Street tumbled 5.3% during a tense three days this week and last. Investors pummeled Facebook and Netflix, two of America's technology super-stars, after they turned in disappointing second-quarter figures. In a day Facebook shed 20% of its market value, or $119 billion on paper. Twitter repeated the act this week. Netflix also sank 16% in a day, lowering its market cap by$30 billion.

By Tuesday, tech shares had stabilized, and after the market closed for the day, Apple turned into unexpectedly good earnings. That enabled everyone to take a deep breath and try to forget about the carnage that had just proceeded.

But the fact is that there are problems at Facebook and Netflix, and they threaten to reverberate across the entire high-tech world, including Israel.

Growth story

From the investor point of view, the tech story is about growth. The audience for social media, online entertainment and for digitization of everything from legal services to automobiles has been regarded as limitless.

That's why even as Facebook staggered from one embarrassing scandal to another, shares in the company had risen 23% this year, until last week's blowout.

Other tech superstars also enjoyed double-digit gains this year – Apple added 15%, Amazon 50%, Netflix soared 90% and Alphabet (Google's parent company) gained 20%.

However, among other things, Facebook admitted in its second-quarter report that the problems over privacy and fake news are going to cost it as it takes measures to screen content and enable users to opt out of tracking. Advertising revenues and profitability will suffer in  years to come the company admitted.

But the deeper problem for both Facebook and Netflix,that user growth is slowing, or even declining.

In North America growth was flat and in Europe it actually declined. Worldwide both companies reported that growth continued to expand, but at its slowest pace since 2011.

Netflix's subscriber base was still growing in the second quarter, but much more slowly than the company itself had expected.

For those looking for justice, it would be nice to think that Facebook is being punished by angry users. But the slowdown isn't a comeuppance for arrogance or greed.

Facebook is encountering a hard ceiling to growth because just about everyone in North America and Europe who could be a Facebook user is one.

Netflix faces much the same problem, where it has already captured 40% of the market for online entertainment 18-24 age group.

The bottom line is that the story of seemingly unlimited growth for the tech world's top companies is coming to an end. They aren't going to be living happily ever after. And, that's going to undermine the tech story that has driven stock prices higher.

Valuations on Wall Street are going to start coming down, which is going to percolate down to startup companies in Silicon Valley and in Israel. And that will in turn expose the rickety foundations of Israel's high-tech boom.

Startup Nation should more probably be called Startup Factory: the industry is about forming new companies, developing their tech and then selling themselves to the highest bidder.

Thus, startup fundraising is probably the best barometer there is for the state of the Israeli high-tech industry, since Israel has relatively few mature tech companies that, say, sell products and services. So, the fact that Israeli startups have been raising record amounts of capital would ordinarily be a strong bill of health for the industry.

But look behind the topline number of $5.3 billion in startup capital raised in 2017, and things look less good.

The number of fundraising deals hasn't grown over the last five years: it even took a big dip in 2017. Government figures show the number of new startups actually declined in 2016 (the last year the data are available) and the number that have closed has been growing. The reason for the high 2017 figure, and for the seeming growth of Startup Nation, is higher valuations.

But if company valuations start falling, the economics of the business will grow worse. It will mean less money for research and development and for hiring, and companies will have to scramble to raise more capital. 

Tech giants like Facebook that have used their deep pockets to buy startups in Israel and elsewhere won't be spending as freely as they once did.

Unlike 18 years ago, there's no dot.com bubble to burst because today's Wall Street tech companies are profitable. But the gloss is fading rapidly.