So where is the problem? Late-stage private valuations. But perhaps the answer is that these “investments” aren’t really equity—they’re much more like debt. [1] I saw terms recently that had a 2x liquidation preference (i.e. the investors got the first 2x their money out of the company when it exited) and a 3x liquidation cap (i.e. after they made 3x their money, they didn’t get any more of the proceeds).
This is hardly an equity instrument at all. [2] 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.
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.
At some point, I expect LPs to realize that buying debt in late-stage tech companies is not what they signed up for, and then prices in late-stage private companies will appear to correct. And I think that the entire public market is likely to go down—perhaps substantially—when interest rates materially move up, though that may be a long time away. But I expect public tech companies are likely to trade with the rest of the market and not underperform.
The rest of the article is here. Very good read.
