Nov 3, 2015 ยท 11 minutes

“The Internet is the largest legal creation of wealth in the history of the planet” -- John Doerr, during the last bubble telling us how much we didn’t get it. He apologized for the remark in 2001.

In my experience when an investor tells you there’s nothing wrong with a market and that you just don’t understand how to think about certain financial instruments, someone’s about to get screwed.

Last week, I noted that even many long time protesters of the notion that there is a tech bubble happening had, one by one, capitulated that some kind of correction is due and coming and welcome. (Including me, by the way.)

I’ve even mocked VCs for concern trolling the entire startup world--  begging them to slash burn rates-- as they participate in and encourage even more mega deals. Of course they do this for two clear reasons: They legitimately are worried that good times are turning but they aren’t driving the wildest part of the market anymore. And, they want to have something to point to when it does crash to make them not look quite as complicit in it.

I spoke too soon. Sam Altman – the current head of Y Combinator – has declared no bust is coming because we have actually spent 2015 in a tech bust.

Yep. A tech bust that has yielded the highest valued private company of all time. Uh-huh. A tech bust where startups raised more in the first nine months of 2015 than they did all of last year, with over 170 mega-rounds totalling near $20 billion. Sure. A tech bust that has seen 140 private companies valued at north of $1 billion and some 230 raise more than $40 million in capital, despite the fact that only 240 venture backed companies have gone public in the last ten years.

As Erin Griffith wrote in Fortune yesterday: For all 90 US unicorns to go public at anything like their current valuation, investors would have to buy a whopping $131 billion in new shares. This shouldn’t be a shock to anyone: Most investors and entrepreneurs expect an IPO to be the next step. That the basic math makes that look inconceivable isn’t…. a plus for the startup world.

Altman’s post is like that scene in Chicago where Richard Gere tap dances around the truth and the press just nods along. A market where all these unicorns can’t possibly go public? Not a sign that a shake-out is coming, it’s a sign we’ve already been living in one! VCs are investing in fewer early stage deals compared to last year? Not a sign that they are losing confidence because of several years of excess, it’s a sign that they’d already lost confidence! The worst is over!

Altman adds that if you owned YC’s portfolio, you’d be really happy. Well, I hope so given they invest in the very earliest stages of the market. And, also, that doesn’t rebut the concern that a correction is due. The exact argument made by those concerned is that exit markets can’t support current valuations. Most VCs probably have pretty sweet paper values of their portfolios right now, what with 140 unicorns floating around that haven’t yet been forced to see if public investors will pay those prices.

Altman argues it’s merely late stage private investing that’s the problem, and that’s because none of us really understand what those deals are. They aren’t equity. They are debt! And if we call it that, we’re fine. Because no massive economic correction has never come about because of new risky forms of debt. And, as a happy plus, calling it “debt” also conveniently absolves VCs from having creating any potential problem.

Sequoia Capital’s Mike Moritz made a similar argument when he coined the term “sub-prime” unicorns. Only, unlike Altman, he didn’t mean it as a sign of a rational, already corrected market.

In fact these things aren’t a sign the bust is over, and we can all relax. It’s a sign of the beginning of an unwinding.

Altman’s rhetorical trick would be brilliant if it weren’t so callous to entrepreneurs who are over their skis in price in a bad market, spending too much to acquire customers, and not sure what to do next. I guarantee most entrepreneurs who’ve raised these mega rounds over the last few years, being told that these prices were a reflection of larger markets and opportunities, thought they were raising equity.

From Altman’s piece:

This is hardly an equity instrument at all. The example here is an extreme case, but not wildly so.  Investors are buying debt but dressing it up close enough to equity to maintain their venture capital fund exemption status.  In a world of 0 percent interest rates, people become pretty focused on finding new sources for fixed income.

There is a massive disconnect in late-stage preferred stock, because if you’re using it to synthesize debt it doesn’t matter what the price is.  The closer the rounds get to common stock (a less-than-1x liquidation preference, for example), the more I think the valuation means something.  Unsurprisingly, the best companies usually have the most common-stock-like terms (and “the best companies” are never the ones that seem overpriced for long anyway).

Some of this debt is poorly underwritten.  Some unicorns will surely die (and those are the ones everyone will talk about).  That doesn’t make it a tech bubble.  It’d be more accurate to say it’s a tech bubble if no unicorns die in the next couple of years.

Throughout the piece Altman rebuts things that no one is saying-- the old straw man routine. We would all agree it’s a bubble if no companies died in the next few years. That’s why no one is predicting that. People are saying the correction has already started or is imminent and pointing to write downs of Dropbox, lower number of overall deals, a weak IPO market, and sudden explosions of companies like HomeJoy and Quirky as evidence of the beginning, not the end. We’re calling the period we just went through when none of that was happening the overheated time. You know, the time when 140 companies got a $1 billion-plus valuation, and…. almost none died. So by Altman’s own admission above, that period was the bubble? Sounds to me like we’re just quibbling about when the correction started, which is common. Typically you can’t tell the peak of these things until years later.

By the way: “Those are the ones everyone will talk about” is the VC equivalent of “Pay no attention to the man behind the curtain.”

Another example of the same straw-man trick:

But no matter what happens in the short- and medium-term, I continue to believe technology is the future, and I still can’t think of an asset I’d rather own and not think about for a decade or two than a basket of public or private tech stocks.

Once again, he rebuts something no one has said. I don’t know a single VC concerned about burn rates who’s saying they want to get out of tech altogether.  

Altman wraps up:

To summarize: there does not appear to be a tech bubble in the public markets.  There does not appear to be a bubble in early or mid stages of the private markets.  There does appear to be a bubble in the late-stage private companies, but that’s because people are misunderstanding these financial instruments as equity.  If you reclassify those rounds as debt, then it gets hard to say where exactly the bubble is.

This is essentially like going back in time to 1999 and arguing there’s no bubble unless you take into account, oh, the Nasdaq and all the companies that were going from formation to IPO in 18 months. And by the way, at the time we were also told it was just a new way of building companies we didn’t understand. A “new economy.”

It’s clever phrasing. And, again, breathtakingly disrespectful of entrepreneurs who are legitimately concerned when they hear every VC saying that money is about to dry up and they better cut their burn rates.

Here’s the most obnoxious part of Altman’s argument: It’s all based in rhetoric and tap dancing, not any actual empathy for what a collapse of high priced late stage rounds-- whatever you call them-- might actually mean for individual entrepreneurs and their employees. His view that these late stage rounds – with increasingly anti-founder terms – are just a new kind of funding we don’t understand.

Well, did entrepreneurs understand it when they were signing these terms? Because, I assure you, most founders I’ve spoken to certainly thought they were raising an equity round, and an IPO would be next. And if prices don’t keep going up, there can be serious consequences.

Don’t take it from me. Take it from an entrepreneur who’s lived it. From a Wall Street Journal article about Chegg’s IPO:

In a candid interview, an early investor in Chegg revealed how the company gunned for the highest possible valuation in several funding rounds ahead of its public offering. Chegg in exchange granted venture capitalists a favorable term called a “ratchet” that guaranteed the share price in the IPO would be higher than what they paid.

The move backfired. When Chegg went public, it was motivated to set an IPO price that met the terms of the covenant, or Chegg would have to pay the difference in shares to the early investors. The stock plummeted on the first day of trading and hasn’t recovered.

As a private company, Chegg “went through three years of suffering and struggling for no reason whatsoever,” Oren Zeev, the early investor in Chegg, said in an onstage interview at a tech conference earlier this year.

That’s an actual founder speaking – not an investor trying to cover his ass by excusing away excesses or renaming them. A founder who went public before things got too bad in the market. And this was a company “lucky” enough to get out. This was a company that had far less onerous terms than multiple liquidation preferences, which carry a huge risk that employees and founders never get shit even in the case of an exit.

What Altman doesn’t do in his clever tapdance is answer any of the very real questions that have been raised by us and so many others. For instance:

  • Why have the number of deals and the aggregate amount invested diverged so wildly in the last few quarters. Is that sustainable? Or are late stage deals just part of a “new asset class” that shouldn’t be grouped with classic venture capital?

  • What does he think actually happens when these companies try to go public. They are gonna have to at some point. Does he think it’s cool that this “debt” has left dozens of founders in a lurch as described above by Chegg’s founders?

  • Or maybe he’s unconcerned because he believes most of these companies will go public at these prices, because this was the bust we just lived through and a new good time is coming? That public investors have $130 billion burning a hole in their pockets?

  • The cost of these sky high burn rates and customer acquisition strategies that larger companies who can raise more cash at nearly any price have used to bleed out smaller competitors. Like-- yunno-- now deceased YC alum, HomeJoy.  

  • Most interestingly, he doesn’t once mention Dropbox – one of the biggest YC hits of all time, which is widely cited as one of the most troubled deca-corns, all but poised to take a hit in a coming correction. Or what about another YC star, Instacart, who Bill Gurley predicted could be one of the first unicorns to explode. Or what about YC’s Stripe, which sports a $5 billion valuation, refuses to divulge any volume numbers or stats to back it up, and is widely rumored to have onerous terms to support it. Was this post meant to defend these widespread concerns about the fate of some of YC’s biggest stars?
  • What happens when the hot money leaves? Or does he believe this is a permanent new way of investing on behalf of hedge funds and other “tourists” as VCs call them. Hedge funds are typically the hottest money of all. The money that sweeps in and out of opportunistic markets around the globe at will. No matter what you call it, if startups are relying on a certain financial instrument and it’s gone, what then?

YC -- as Altman says-- will be just fine. Just like early stage VCs who’ve invested in any period that’s ultimately become overheated. There’s no conceivable downround that makes Airbnb or Dropbox not a massive homerun for them. And because they are most involved with companies at the very earliest stages, they have more plausible deniability on the excesses than even standard VCs.

Yep, Altman is right about one thing. There’s no reason he needs to worry for the next few years. If only founders could have the same comfort.


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