Private Equity firms are about making money. They buy companies and then extract cash from them at the expense of everyone around them. Nothing wrong about that, it is what it is.

Venture Capital is about a shared risk between the entrepreneur and the venture capital firm. The firm puts the capital, the entrepreneur the sweat and the outcome is either great wealth or middling results or nada.

The emergence of Unicorns and their liquidation preferences and the ability of entrepreneurs to cash out during the investment has transformed the start-up scene considerably into something that feels a lot more like private equity.

Let’s walk you through the numbers.

In a private equity (PE) deal, the company is bought at some value X. Employees are then given signing bonuses to stick around for a period of time while the PE firm tries to extract either a better selling price or enough cash to make a significant return on the initial investment.

In a Unicorn billion dollar investment we have turned VC investment into a PE deal.

VC’s are not investing money they are buying companies with liquidation preferences guaranteeing their X. Why do I say that? Because if the company is sold for X, then the only group that makes any money is the VC firm. Consider a company that gets a 160 million dollar investment at 3 billion dollar valuation. That company, if it gets sold for 160 million dollars, then every cent will go to theVC’s. That’s what I call buying a company for 160 million dollars, not investing 160 million dollars in a company. There is no shared downside risk.

The founders meanwhile are given a one time signing bonus – basically they are allowed to cash out some amount of money and are allowed to keep a certain amount of equity. The bonus acts as a massive salary bump, and the equity should keep them somewhat motivated.

So what do we have:

A VC firm buys a company. Founders get paid to run the company. Sounds like a purchase not an investment.

This is not how VC investment has typically worked, I am told.

The real interesting insight is that because these are really just PE deals masquerading as VC investments is what makes these kind of deals so frigging attractive to investors. If you could buy some of these Unicorns for less than 300 million dollars, wouldn’t you? They are all good bets. The problem isn’t that the investors are making real money, or that the founders are making real money, the problem is that these deals are opaque and the market for them is illiquid and that this can create a serious problem when the market gets somewhat less frothy.

In the nightmare scenario where the market appetite for investments in illiquid early stage startups with excellent growth potential declines, the VC firms might find their customers looking to cash out. Essentially the guys investing in the VC firms may start wanting their money. And then we have this dichotomy between the VC firm that wants the money now and can get a decent return for a sale pre-IPO and the founders who have to sell to make real money. If the firm can IPO, then they will and if they can not then the company will get sold and then the employees will get nada. Because the company is structured in such a way where the VC firm owns the company, but employees owns an option to sell shares in a publicly traded company that is currently private (in other words, worthless stock) they do  not own a piece of the company they are currently working at.

Fun times… Love to learn I am wrong.

 

 

One of my friends who happens to be way more plugged into the start up scene than I am, has been telling me for months to ignore valuation, but focus on term sheets.

A public company’s valuation is based on a simple formula  # of shares * share price. Any owner of shares can get a return on his investment if the company pays a dividend or if the share value appreciates. Pretty simple. The price of the share is decided every day in the market based on public data. Price goes up, you make money, price goes down you lose money.

A privately held company’s valuation is determined as a result of the negotiation between the investors and the owners of the company.

Part of the negotiation is what happens when the company gets sold or gets liquidated.

And this is the important bit. Something I have been ignoring.

Consider a company X that recently got 116 million dollars at a 2.76 billion dollar valuation. If the company gets sold to another company for a 116 million dollars a naive engineer like myself would do the following math:

.116 / 2.76 = % of company owned = approximately 4%

investors get back 116 *.04 = 4 million dollars

Investors lose 112 million dollars.

Except they didn’t. They lost 0 dollars.

Because the Term Sheet basically said that the first 116 million dollars goes to the investors. And after that 116 million do other people get money.

This makes the investment feel risk free because folks are assuming that in the worst case the company will not be worth less than 116 million dollars. The upside may be limited because the company has to be worth more than 2.76 billion but the downside feels manageable.

The risk free nature of these investments may explain why investors are willing to pile onto a firm like Company X. With downside limited, and a possible massive upside who wouldn’t want to get into the action?

 

Earlier I wrote about early stage valuations being de-risked through schemes similar to how mortgage backed securities were derisked and how that was creating a bubble. The reason derisking creates a bubble is that  by artificially de-risking a high-risk investment, the amount of money that can be invested increases significantly.

To speak in math: if the total amount of money to invest is MONEY, and only 10% of MONEY can be invested in high risk investments, then only 0.1*MONEY is available to invest. Now suppose I can take an investment vehicle, like an early stage start-up, and de-risk the investment, then instead of only 10% of MONEY being available to invest, 30% or 40% of MONEY is available to invest. The net effect is to increase the total amount of money entering the market creating an asset bubble.

If the total amount of MONEY is also increasing (thank you QE), then you have two accelerators – the derisking making more money available and more money coming online…

As for how to derisk an investment … 

There are two ways to derisk an investment. The first it create a hedge. The second is to foist more risk on some people and less risk on others. So for example, in the mortgage backed securities market we had both. We had credit default swaps as a hedge, and senior debt as a way to derisk the investment for some. In the early start-up game, the hedge is to invest in many different start-ups in the same space, and the derisk strategy is to have warrants on any early liquidity the company may get.

Essentially the investor is pushing more risk on the employees and founders by being first in line to any money the company makes.

But there is another way to derisk … 

The other way to derisk is to believe that something is less risky. Essentially we take leave of our senses, and believe the hype that surrounds us. This second form of derisking is far more dangerous and far more explosive.

After I wrote my little note, this made the rounds: https://www.linkedin.com/pulse/investors-beware-todays-100m-late-stage-private-rounds-bill-gurley where he seems to be arguing that traditional risk analysis is being ignored in favor of a devil-may-care must-invest-at-all-mentality…

And it all leads to this: 

The author, Bill Gurley,  had this money quote:

All of this suggests that we are not in a valuation bubble, as the mainstream media seems to think. We are in a risk bubble. Companies are taking on huge burn rates to justify spending the capital they are raising in these enormous financings, putting their long-term viability in jeopardy. Late-stage investors, desperately afraid of missing out on acquiring shareholding positions in possible “unicorn” companies, have essentially abandoned their traditional risk analysis. Traditional early-stage investors, institutional public investors, and anyone with extra millions are rushing in to the high-stakes, late-stage game.

With the downside for the investors being derisked either through hedges or warrants, and the risk of poor outcome being pushed on the employees and founders, the companies are actually being forced to take bigger risks and by taking bigger risks …

But why?

Remember what I said earlier, with warrants when a company has a liquidity event the early investors make most of the money. Consider a hypothetical company that has it’s paper set up in such a way that any liquidity event up-to 500 million dollars the employees get to split less than 50 million dollars. The employees and CEO are now motivated to go after a billion dollar outcome.

And So?

The problem is that it’s a lot easier to hit 500 million dollar exits (historically speaking) than 1 billion dollars.

So the CEO decides to go for it because only if he goes for it does he make any real money thus he increases the risk

The problem is by going for it – he actually is increasing the risk of complete loss.

So ironically by derisking the investment the overall risk is actually increasing.

Somewhere Nassim Nicholas Taleb is smiling

 

 

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.