Is Technology Venture Capital Entering a Bubble?

Today's episode looks at the "Billion Dollar Startup Club" and how a subset of tech start-ups are attracting venture capital and valuations in the billions -- with a B -- even though some of them have yet to pin down the monetization question.

Sean O'Reilly and Dylan Lewis look at some examples, delve into what VC players see in these social media start-ups, and who's doubling down even as this isolated but high-stakes phenomenon begins to look more and more like a bubble.

A full transcript follows the video.

Fool.com content from the Peter Thiel interview is available below:

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Peter Thiel Exclusive: Why You Shouldn't Buy Index Funds

Peter Thiel: When the Next Bubble Bursts, "Risky" Stocks Like Tesla Could be the Best Bet

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Sean O'Reilly: Dylan Lewis and I are launching a Kickstarter campaign to buy our own Hawaiian island. Will you contribute? On this tech edition of Industry Focus.

Greetings Fools, I am Sean O'Reilly, here with the one and only Dylan Lewis, joining you from Fool Headquarters in beautiful Alexandria, Virginia. We are talking tech, venture capital, and insane valuations.

How are you doing today, Dylan?

Dylan Lewis: Doing all right Sean. First time in a long time!

O'Reilly: This has been a long time coming.

Lewis: It has, yes.

O'Reilly: I was actually surprised you'd never been in the radio studio here. Did you know we had this?

Lewis: No! I wasn't sure where you guys recorded these.

O'Reilly: Yes, we actually just go down to a creepy closet down in the basement ... no, I'm just kidding!

We're talking about venture capital, and if it's entering a bubble. For our listeners that don't know, the Wall Street Journal just came out with this great graphic and there are about 80-83 companies that have all recently gotten valuations of over $1 billion, and they may or may not even generate any revenues.

Lewis: Yes, the billion-dollar start-up club.

O'Reilly: It's funny because it obviously draws parallels with what happened in the year 2000, but it's kind of isolated to just venture capital. Basically none of these companies are public.

They may be public someday; obviously Facebook (META -4.14%) started out as a public company. I'm probably going to go watch "The Social Network" this weekend because this has got me thinking about it again.

Lewis: Well, you're also seeing some public companies acquire these VC-funded companies, so it's making a transition into public eventually.

O'Reilly: Slowly but surely. You've got Uber ... I wanted to start it off on a good note.

I first and foremost want to talk about some of the valuations just to give people an idea of what we're talking about here, but this doesn't seem that crazy to me -- which is Uber.

It was recently valued at $40 billion -- that's "billion" with a B -- and it actually doesn't sound that crazy because they basically take 20 cents of every dollar in transaction, so when you go out this weekend with your friends and you pay the Uber guy $20, Uber gets $4.

That means they're generating about $2 billion, and it doesn't cost that much to run an app, so they're kind of profitable. That's not absurd to me.

Lewis: Yes, and it's a business that's projectable.

O'Reilly: Right. It actually has a social utility!

Lewis: And it's easy to get your head around. It's something that you can project based on current iterations of transportation, whereas something like Snapchat, seeing how it's going to be monetized is a lot tougher.

O'Reilly: Did you look on my computer? I've got this over here!

Lewis: Look at that transition.

O'Reilly: I can't even deal with this!

Recently valued at $15 billion, Yahoo! (NASDAQ: YHOO) was in talks to value them at $10 billion six months ago, so 50% return there. Good for them. I don't think they bought into it yet, though. Oh, wait, they did.

Anyway, it raised $815 million last month, and it essentially generates no revenues. Everybody uses it -- my sister in law uses it all the time -- but their current goal is to try and generate more revenue without falling out of favor with its current users.

They're trying targeted, non-invasive ads. Maybe they'll pull it off.

Lewis: Yes, I don't know. They're moving over into content a little bit with the Discover part of the app.

O'Reilly: Have you used that? What do you think?

Lewis: I've played around with it a little bit. I guess it's good if you want two sentences and then to check out some video on something. But looking at media providers at $15 billion ... there's got to be another way to monetize that, to justify that valuation.

O'Reilly: We'll talk about him in another minute because he's the king of venture capital right now, but Peter Thiel was a founder of PayPal (EBAY 1.02%), he was the first outside investor in Facebook, he's a billionaire, he's very good at this stuff.

But even he admits that the idea with venture capital in any business is that you're trying to maximize future cash flows, so the discounted present value of Snapchat is, you're going to tell me, $15 billion?

Maybe. I don't know. On the flipside, Uber ... I don't know.

Actually, speaking of Peter Thiel, this was the other example I wanted to talk to everybody about. It was a company that he helped found, which is -- I might be saying this wrong -- Palantir.

They are basically big data for the government. They helped find Osama bin Laden using computers. They've got some contracts. They've had, according to USAspending.gov, $215 million in contracts from the NSA, CIA, and Defense Department since 2009.

Fiscal year 2014 revenues -- this is a guess, mind you; we're all just guessing -- between $500 and $600 million, and it was recently valued at, also with Snapchat, $15 billion. It's not profitable. It's a bunch of people in a room with computers. Peter Thiel is an investor in it. I don't know.

Lewis: Yes. I think "a bunch of people in a room with computers" is a terrifying and really exciting proposition.

O'Reilly: Yes! It's drawn the ire of people that are like, "You are all spying on us, and making money doing it!"

Lewis: Yes.

O'Reilly: I don't know. I don't know.

Obviously you're talking about multiples of revenues here, mostly unprofitable, but it seems like the current social media trend between venture capital and all these start-ups has a potential downside that you were talking about before we went on the show.

Lewis: Yes.

O'Reilly: They're all dependent on each other now.

Lewis: They are. They're all very dependent on each other. I think if you want to look at recent news, specifically at SXSW Interactive, you had Meerkat.

O'Reilly: The cutest app ever.

Lewis: Yes! This nascent mobile streaming app, and it was the darling of SXSW Interactive. But I think midnight struck a little early for Cinderella.

O'Reilly: And then everything turned to pumpkins and mice.

Lewis: During the festival, Twitter (TWTR) announced its acquisition ...

O'Reilly: It happened during the festival?

Lewis: During the festival.

O'Reilly: I'm sorry to interrupt you. Go on!

Lewis: Yes, Twitter announced its acquisition of Periscope for $100 million.

O'Reilly: A competitor of Meerkat.

Lewis: A competitor of Meerkat.

O'Reilly: Game over.

Lewis: And the plot thickens. Meerkat was heavily reliant on Twitter, essentially piggybacking on the social media network's platform. Users sign in via Twitter, the app connects you with all the Meerkat users through Twitter, and the same follower/following relationship that you do on Twitter.

O'Reilly: I'm just stunned here. What were you telling me, was it Periscope or Meerkat, when somebody had the idea it raised $15 million or something?

Lewis: Yes, I think they were able to acquire $15 million in funding within maybe a month of becoming a start-up.

O'Reilly: What am I doing working? I'm just going to go create an app. Good lord. RetailMeNot (SALE) has had some rough times with Google (GOOG -1.26%) (GOOGL -1.36%) as well, as I understand it.

Lewis: Yes. Using Meerkat as a parallel here, we're looking at companies that are highly reliant on other platforms for their business.

O'Reilly: So rule number one of venture capital investing is, don't invest in a company that's super-dependent on another social media bubble-y valuation.

Lewis: Yes, or have a way to move past it at some point and migrate to a more self-sufficient model. The big news with RetailMeNot was Google had reconfigured its search algorithm.

O'Reilly: RetailMeNot just does coupons basically, right?

Lewis: Yes, it's a coupon business. They run most of their revenue through affiliate relationships with retailers.

O'Reilly: Right, so I can go to Google, type in "Bed Bath & Beyond coupon" or something, and then ...

Lewis: 15% off.

O'Reilly: RetailMeNot will hook me up. Okay.

Lewis: Bed Bath & Beyond coupons never go bad.

O'Reilly: That's one of the reasons I brought that up; 20% off, baby. My wife loves it!

Lewis: Don't throw them out!

So, heavily reliant on search.

O'Reilly: Particularly Google, because it's 90-whatever percent.

Lewis: Yes, because it owns the Internet. Heavily reliant on search ...

O'Reilly: Google changed their algorithm, basically.

Lewis: Yes. They instituted this patch, or this update, called Panda. I think it affected like 7.5% of U.S. search.

O'Reilly: They could have at least called RetailMeNot. "Hey guys, heads up."

Lewis: "We're just going to drop this bomb on your business." Understandably, RetailMeNot's search went down dramatically. Their site traffic went down.

O'Reilly: I have to wonder if that was a risk, "We're dependent on Google," in the 10-Ks. That's something I'm going to check out later.

Lewis: It's funny you say that, Sean. RetailMeNot's filings have the risk note, "Major search engines frequently modify their search algorithms. Changes in these algorithms could cause our websites to receive less favorable placement, which could reduce the number of users who visit our websites."

O'Reilly: And that is exactly what happened.

Lewis: Yes. The good news for RetailMeNot was a subsequent Panda update in the following months affected about 3-5% of domestic search, and helped stabilize RetailMeNot's search position. It gave them some more favorable placement than they'd been receiving the month or two before that.

O'Reilly: This is what happens. It brings me back to the Ben Graham style investing, the margin of safety. You go for a margin of safety because you don't know what's going to happen. You need to have it work out at least OK, even if it totally screws up and Google messes you up. When you're paying 30 times revenues, it's kind of rosy.

Lewis: Yes. Like I mentioned earlier, you want to see a company that, maybe they start out reliant on another platform, but eventually they pivot to something that they can own and draw customers in on their own.

RetailMeNot, they do email subscription as well, so that's an avenue that they're looking to grow. Obviously their app, which they own, is another way that they can do that. These are the kinds of characteristics that you want to see businesses develop in order to get away from being so heavily reliant on the big platform.

O'Reilly: Yes. Not to bash RetailMeNot; they are profitable, which is more than we can say about a lot of the other companies we just mentioned earlier, so there's that.

Lewis: That's true. There's real money.

O'Reilly: Thank god!

Bring it back around. Do you think this is a bubble?

Mark Cuban; I watch him on "Shark Tank." He's hilarious. He pointed out a very interesting thing about this. The difference between what's going on now and 2000 -- this may or may not be good; it's probably good for the average investor -- is it's very isolated.

Anybody that invests in these companies, it's not liquid at all. You're not going to get your money back unless the thing goes public someday. You're just not. I don't know. It's probably good that mom & pop can't invest in Snapchat.

Lewis: Yes, thank god.

O'Reilly: But it's very weird, because all these people are very, very smart. I don't know what Peter Thiel's IQ is, but it's probably up there, and he's doing this stuff ...

Lewis: Yes. An interesting news piece I saw, if this is something you want to be tracking -- Sam Altman, tech investor, President of Y Combinator, he put up a $100,000 bounty on Bubble Talk.

O'Reilly: These guys are so rich, they're just throwing around ...

Lewis: Well, he made it clear that it would be a $100,000 charitable donation.

O'Reilly: Okay, that's at least better.

Lewis: A Boston-based venture capitalist, Michael de la Maza, took him up on the challenge. Altman has three statements, and he has to be wrong on one of the following statements to lose the bet.

These six unicorns, companies valued at over $1 billion -- so many of the companies we were talking about before -- Uber, Palantir which you mentioned, Airbnb, Dropbox, Pinterest, and SpaceX -- will be worth a combined $200 billion by January 1, 2020. That's double what they're worth today, according to Altman.

O'Reilly: Wow.

Lewis: Second condition, nine mid-level Y Combinator start-ups including payment start-up Stripe, and bitcoin exchange firm Coinbase, will be worth a combined $27 billion, up from less than $9 billion currently.

O'Reilly: He's losing that portion of the bet right now.

Lewis: Y Combinator's current batch of 114 start-ups, currently worth something that rounds down to $0, will be worth $3 billion by 2020.

O'Reilly: Wow.

Lewis: He's taking a big gamble there.

O'Reilly: That's fun! At least it's for a good cause.

Lewis: It's for a good cause, and I guess whatever he loses in that bet will pale in comparison to any losses he has in the VC money in those companies.

O'Reilly: Right. It might just add insult to injury.

Lewis: I think Y Combinator takes 6% equity in all the start-ups that they help seed.

O'Reilly: Yes. For our listeners, I wanted to point out an interesting thing. How many companies is he invested in? Over 100, right?

Lewis: Well, Y Combinator's current batch of 114 start-ups ...

O'Reilly: Yes, 114.

Lewis: And those are low-level start-ups. They break things out into mid-level, low-level, unicorns.

O'Reilly: When we started talking about this I was really excited for today's show because I couldn't help but be reminded of Zero to One, Peter Thiel's new book that just came out.

Our listeners really need to check it out if they just want to glimpse into this world and how one of its most successful investors looks at things. In Econ 101 they always tell us you're actually still supposed to focus on profits and stuff. Don't tell Jeff Bezos or anything ...

If he has $1 billion and he's going to invest in a start-up, it needs to have the chance, in his view, based upon potential market size in the future, to double the value of the fund on its own. If he puts $1 million into something, it needs to be able to go up 1,000-fold.

Lewis: Talk about moonshots!

O'Reilly: Yes. That's what he says. He sprinkles his bets across a ton of moonshots. How much did he make on Facebook? He put like $500,000 into it and he made, I don't know, $1 billion or something? Just something absurd.

Lewis: Nice to be connected to the tech scene, be able to throw $500,000 into something.

O'Reilly: Yes, just hang out in Silicon Valley! Why am I here in D.C.?

Lewis: One of our writers, Sam Mattera, did an interview with Peter Thiel. There are a couple articles on Fool.com.

O'Reilly: We should probably throw that up again.

Lewis: Yes, we should. We can link out to that.

O'Reilly: We'll do that. I just had to wonder if these crazy valuations are the result of, collectively, a couple thousand smart venture capital guys all sprinkling their bets across a bunch of moonshots.

Lewis: Yes.

O'Reilly: That's my assessment. I don't know.

Lewis: I think the cloud/app landscape ... it is the Internet frontier that existed in the late '90s, early 2000s. People are wrapping their heads around it and trying to figure out what can and can't be monetized. There's going to be a lot that's thrown at the wall, up until things start falling.

O'Reilly: Oh dear. Handle at your own risk!

Lewis: Yes.

O'Reilly: Very good. I think it's probably a bubble, but at least it's isolated. I don't know what you think, Dylan?

Lewis: I think the VCs like Thiel will probably wind up just fine. Sam Altman will probably wind up just fine. But there are going to be plenty of failures along the way.

O'Reilly: Fantastic. That is what creates progress.

Lewis: Yes!

O'Reilly: Very good. It is Friday, so why not ring in the weekend with a new deal?

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For Dylan Lewis, I am Sean O'Reilly. Thanks for listening, and Fool on!