Thoughts about bubbles and unicorns in the valley.
A bubble emerges when folks make investments that are risk free and have high yield. The appetite for mortgage backed securities was tied to the need for yield and the way in which the underlying asset was assumed to work. Basically the idea was that there was an upside risk but no real downside risk especially for the owners of the senior debt. And so people bought the asset figuring that in the worst case they made no money.
One of the interesting phenomenons in the current in funding bubble is the assumption that because of the scale of companies there is no risk to the investment. There may be marginal upside but the downside risk is marginal.
For example, one view of the SnapChat investment is that in the worst case the company is worth a couple of billion dollars. If you can structure your investment in such a way that you get your cash preferentially when the company gets sold, then as long as you get your millions your okay.
Because I don’t actually understand the details of the SnapChat investment, let’s talk about company X.
Suppose you invest 10 million in company X at 2 billion dollar valuation. Your upside only exists if the company is worth more than 2 billion – unlikely but still plausible. Your downside, on the other hand, may be significantly less risky. If you believe the company will get sold in the worst case for 10 million dollars and that you are first in line for the 10 million dollars, then this is a risk free investment. You simply can not lose your money so why not take the risk?
The beauty of this arrangement is that it works great for everyone. The founders get the cash they need without having to dilute their equity in the company. Presumably 10 million at 2 billion valuation means a lot less stock dilution than 10 million at 20 million valuation. The VC’s get to show growth in their portfolios – especially if they made an initial investment at 100 million. Just to make that point a little bit clearer – they invest 1 million at 10 million valuation, then 9 at 2 billion and their initial 1 million investment appears as a paper profit of 20 million dollars. And the employees get to feel that they are in a rocket ship that is going to outer space. And the LP’s in the fund get to see growth with no risk.
The downside, of course, is that the risk free nature of this investment may be a mirage. For example, the company may not get acquired for 10 million dollars, it might become vaporized. Or worse.
When everyone believes in the downside risk thesis we have bubbles. If everyone believes there is no risk and there is a lot of cash around – thank you QE – then we have a bubble because you become stupid to not invest in risk free investments with high potential yield.
Since I am fan of the black swan books, my belief is that when too many people believe in no risk, then risk gets magnified and disaster emerges.
We’re not there yet, we are in a boom – the danger is the boom turns to bubble before it becomes a bust.