You probably saw that Google is paying $3.2 billion in cash for Nest Labs, a maker of smart thermostats that has no profit and perhaps $300 million in revenue.
The search giant can obviously afford to pay a rich price, and scarily high valuations are nothing new in Silicon Valley. Yet, the Nest purchase also illustrates how cozy the Valley is â€" and how that coziness removes any check on more sober pricing. Higher prices are in everyone’s short-term interest.
Nest makes smart electronics for the home, starting with that thermostat and more recently an intelligent smoke detector. Nest makes sleek, highly functional products developed by a team led by Tony Fadell, who was formerly with Apple, and is sometimes known as the father of the iPod.
Sales are good, with some reports stating that Nest has sold more than one million thermostats. Profit may still be absent, but revenue is estimated by a Morgan Stanley analyst, Scott Devitt, to be $300 million a year.
Founded in 2010, Nest had three rounds of investment, according to Standard & Poor’s Capital IQ, a research service. It was looking to raise $150 million that would have valued the company at more than $2 billion when Google swooped in.
The Google deal is a party for Silicon Valley insiders. Not only is Mr. Fadell a prince of Silicon Valley with deep roots in Apple’s rise, but his initial investors included Google’s own venture capital arm, Google Ventures, as well as the top-tier venture capital firms Shasta Ventures and Kleiner Perkins Caufield & Byers. Shasta Ventures is a super winner â€" earning back the full amount it raised for its fund of $200 million, according to Tech Crunch. Tech Crunch and Dan Primack at Fortune both reported that Kleiner earned 20 times its money on an investment of roughly $20 million.
The $3.2 billion price tag significantly drives up valuations for other hardware companies. Now, the new thing in Silicon Valley will be looking for the next Nest (as opposed to the next Uber, which was last week’s search). This new interest will also benefit venture capital firms. Shasta Ventures, for example, has been deep in hardware, also investing in Ouya, a game console where users can try the games free. Venture capital firms will now be able to raise more money from the same Silicon Valley executives at higher valuations because the bigger exit is out there.
What about Google, you may ask? Surely, it has an incentive not to overpay.
Google may also benefit from higher valuations. Google Ventures will benefit from a rise in the value of its investments, and Google itself will get the same benefit from these rising valuations in its stock price.
Not only that, and perhaps more important, it will get the valuable publicity of being in on the next big thing and keep its reputation as a “hero†company. In Silicon Valley, no one wants to be known as a company that can’t keep up.
That’s really what is going on here. If there was skepticism in the coverage of the deal, it was limited. Mr. Fadell told the technology news and analysis site Recode that “the crux of this is that we thought a lot about what is it going to take to realize our vision and change the world.†Business Insider declared the deal a “great acquisition for both companies.â€
There was not a lot of coverage about the uncertainty behind this $3.2 billion play. First, Nest’s basic intellectual property for its thermostat is being challenged. Honeywell, the dominant maker of thermostats, has sued Nest, accusing it of violating its patents.
Nest may also have limits to its potential reach, as products to run the home are often sold through repair distribution channels. For example, the bulk of thermostats are sold through home furnace and air-conditioning repair services, which have had longstanding relationships with Honeywell and others. Thermostats are products that people feel are too complicated to install themselves, even though Nest has had great reviews for its ease of use and installation. So even if Nest continues to have success, it may be limited in how much market penetration it can achieve.
The $3.2 billion value can thus be justified only if Nest is the way to access the home, a company that will eventually bring out a variety of other products to change the way we live. Google is betting that the Nest team â€" which just made millions and millions of dollars â€" is willing to stick around to make that push and not move to another start-up. (Any arrangements with Nest employees to continue with the company were not disclosed, though Mr. Fadell said “nothing would change†and that he would remain, as would Matt Rogers, Nest’s co-founder and head of engineering.)
These are some sobering thoughts and perhaps a view heralding caution or perhaps a lower price.
But that is the problem generally with Silicon Valley these days. In recent years, we have seen Facebook’s purchase of Instagram at a relatively “cheap†$1 billion, which was purchased to keep users in the Facebook network, and Google’s purchase of Waze also at almost $1 billion, which was likely completed to keep the company out of the hands of Facebook. And Yahoo bought Tumblr for $1.1 billion in pursuit of reviving its own mojo.
The purchases are driven by a venture community that must feed the beast. Their friends at the few dominant players in technology â€" Google, Microsoft and Facebook â€" are all trying to find the next big thing and have core products that are money machines. The money is redirected into these acquisitions that are add-on products with great hype, but are undeveloped. It all builds the Silicon Valley prestige, driving valuations higher.
So everyone wins, at least until these great concepts don’t pan out and the bubble pumped up by these prices bursts.
Just ask Yahoo, which paid $5.7 billion for broadcast.com and $3.6 billion for GeoCities in the last Internet bubble more than a decade ago. It drove off a crazy round of overvalued acquisitions culminating in America Online’s $165 billion deal with Time Warner in which funny money bought an old-line media business. It was fun for a while, but when these businesses didn’t produce, it all fell apart. Mojo can’t sustain itself.
Let’s hope this is not what we are seeing again, but it’s hard not to be worried. Silicon Valley has no incentive to stop the valuation madness.
