Monday, June 29, 2015

The Pro-Rata Bubble

In 1999, New York cabbies were bragging about making money on dotcom IPOs.  Plumbers lamented getting into Yahoo too late. And a very smart friend whose internet startup had just gone public was excited to add to his substantial holdings of Cisco.  His argument was that this was a truly awesome company, you can’t go wrong selling shovels in the gold rush, swiss arms merchants, and all that jazz.  But what’s neat is that when I asked this very sophisticated investor what he thought the market cap was, he guessed $150B.  In fact at that time it had crossed $600B, making it briefly the highest valued company in the world, a full decade before any tech company would show the kind of revenues that could make a price like that remotely plausible.  But when I pointed out his minor mistake, it certainly didn’t cool his bullish fever, because what does the valuation really matter anyway, bargains are for bottom fishers, you just can’t go wrong buying an awesome stock like Cisco in ‘99!

It’s 2008, and I’m talking to an old real estate broker about house prices. He agrees that some seem a little steep and might come down, but claims that there are certain neighborhoods completely exempt from this risk.  “Take my professional word for it,” he says, “this is such a fantastic location that any house here will always go up in price. In a crash it would simply climb slower, but believe you me, a house in a place like this, next to this great university / hospital / tourist center will never ever get any cheaper, or I’ll eat my shoe.”  

You’d think that an experienced professional would know better than obligate himself to chew on shoe leather.  But what makes every bubble a bubble are two simple indicators:

  • Total amateurs who have no business buying an asset start to speculate in it actively, and seminars are advertised widely to help them learn how to get rich quick by doing it.
  • Actual experts begin to broadly communicate the belief that the top tier of the asset class is so amazingly attractive and safe that its price simply doesn’t matter at all; that mediocre investors look at prices, but the great investors simply buy the best product regardless of valuation.

It’s 2015, and a good dozen new accelerators and seed funds seem to open for business every month.  Mere mortal investors in places like Boston still negotiate valuations on occasion, but the Great Unicorn Hunters (frequently observed in their natural habitat around San Francisco) aren’t limited by such mundane details. Terms don’t matter much either in the early rounds, it’s all about catching a ride on the elusive horned beast, with one exception: from the tiniest first time angel to the savviest old time VC, every investor nowadays will insist on getting all their rightful God-given pro-rata rights in every deal.  After all, if your next investment does turn out to be The One, you wouldn’t want to get diluted, or to miss the opportunity of a lifetime to participate to the max!  How could you possibly allow an entrepreneur to take in more money from lucky late stage investors at high prices without including you, after all the work you did discovering them in the first place? And aren’t we little early stage guys every bit as worthy as the bigtime late stage whales? Pro-rata rights are actually human rights! Those later rounds will get expensive of course, but what does price matter when dealing with a True Unicorn like Uber?  In fact those pro-rata rights are so special, so precious, so critical to negotiate at all costs that when the late rounds do come in, it would be most embarassing to be caught complaining about price, or God forbid letting pro-rata rights go to waste unused after all that effort put into negotiating for them in the first place.  

Our collective pro-rata fetish pressures early stage investors into participating in overpriced late stage rounds that they have no business being anywhere near. And in an already overheated late stage market, it doesn’t take much extra capital from early stage investors to push the prices up and over the edge of the Late Stage Bubble of 2015.