How To Play VC Poker With Billions In The Pot

As the ranks of super unicorns continue to grow, such as with Pinterest’s shiny new $11 billion valuation, analysts are increasingly scrutinizing these prices and whether they signal a new tech bubble. Bill Gurley, the Uber investor and partner at Benchmark, argued at SXSW this week that there will be “dead unicorns” among some of these high-priced companies.

Another angle came from Sarah Frier and Eric Newcomer, who argued in Bloomberg that these high valuations rely on “fuzzy” numbers, since the terms of these late-stage deals often include strong downside protection provisions. Since these securities are safer, they command a higher price on the market, which may not be sustainable when a company attempts to go public.

I previously argued that there is logic in the craziness of the massive early-stage valuations seen with some startups, most notably Slack, which raised a $1 billion-valued round just a few months after its product was released. That math is more challenging at later-stages, where fundraising acceleration makes less sense and the capital being invested grows from a few million to hundreds of millions of dollars.

It is clear that VCs are playing a very public and high-stakes poker game, one that is increasingly becoming binary between riches and complete collapse. The bet is that there will still be a frothy exit market in technology for some years to come, making these super high valuations look cheap someday. But late-stage VCs are increasingly aware of the systemic risks in their investments and are trying to hedge them. It is only a matter of time until we know whether they are holding the right cards.

This Industry Is Equipped With Multiple Exits For Your Safety

There is a strong bull case for the super unicorn valuations we are seeing: the exit environment for startups has truly never been better. First, take a look at some of the valuations for America’s top technology companies. Among the top ten companies in the United States by market cap are Apple (#1), Microsoft (#3), and Google (#5). There are perhaps another two dozen companies with massive M&A budgets like Cisco and Oracle, and a whole slew of newly public tech companies ready to start their corporate development.

Perhaps most importantly, the NASDAQ has reached highs not seen since the dot-com bubble, and that means that companies have greater flexibility within their valuations to buy companies.

That has led to massive M&A activity last year that has continued into this year. In 2014, M&A deals were up almost 50% compared to 2013, driven by huge multi-billion dollar deals like Facebook’s $19 billion acquisition of WhatsApp.

To see an example of this, take a company like Twitch, which sold to Amazon for just shy of $1 billion. The company had raised a series B round in late 2012, and only two years later was playing several of the large tech behemoths off of each other, pushing its exit much higher.

While we tend to focus on those billion-dollar exits due to their size, the quality of this exit market is even more obvious when we look at smaller outcomes. Take a look at a company like Sunrise, which recently sold to Microsoft for more than $100 million. Here was a company founded in 2012, in an industry like personal productivity that is generally regarded as a tough exit market. Microsoft could have literally programmed this app themselves, but it elected to send the team a check instead.

This level of activity in mergers and acquisitions should only intensify as large Asian tech companies like Alibaba, Line, and Samsung potentially increase their corporate development efforts both globally and in the United States.

With more and deeper-pocketed buyers on the prowl for top-performing startups, the risks of exiting an investment have relatively declined, especially compared to five years ago. Fewer risks means that valuations are going to go up.

Those exit prices affect every stage of VC investment. They have a direct effect on late-stage investors, who are most aware of these final prices and are concerned with exiting their investments in a timely manner. But it also matters to earlier-stage investors.

While VCs always care about those final exit prices, they care far more about getting their portfolio companies to their next round of financing. VCs at each stage of the pipeline are deeply cognizant of the valuations that will be offered in the next stage. The high valuations being offered by late-stage investors leads to higher valuations from growth-stage investors, and then from early-stage investors all the way to seed funds.

With a massive pot, unicorn poker players are willing to put up equally massive bets.

In The Event Of A Hard Landing

Of course, that excellent exit market can suddenly turn south for any number of geopolitical and business cycle reasons. Unfortunately, late-stage investors are put in a tough place during changing market conditions due to the lack of liquidity offered by startup equity.

Public investments are elastic – any investor can buy one share or one million of them at will. As market conditions change, then so can the size of your stake in a company. Think that a typhoon hitting Thailand may affect the availability of Apple’s new watch? Sell the stock. Your timing doesn’t even have to be impeccable to make money, so long as your thinking is ahead of the rest of the market.

This is precisely the opposite of private company investments. Here, you have a window of opportunity to get your money into a company during its fundraise. Miss the window, and you may never get another opportunity to invest. Once in, you have little ability to change your ownership either up or down. It’s a one shot bet in private equity versus a continuous one in the public markets, greatly increasing the risk of these investments. If you close an investment on Thursday, your whole thesis could blow up by Monday. There is nothing you can do about that.

Late-stage investors are not venture capitalists. They are often public market investors who aren’t finding great opportunities in the stock market due to those high stock prices, and are thus looking for pre-IPO companies that are “assured bets” and trying to invest in them early. They need downside protection since their goal is not to get a 100x return on one of their investments, but to get a 20% return with high probability and little risk of capital loss.

And it is here that we see where the bets are being made. So long as the technology sector continues its fast-paced growth, all of those investments will continue to make sense at the valuations we have been seeing. But if something changes, then all of those investors are locked into assets with few places to offload them. That matters less with a $20 million early-stage round, but it can have serious repercussions with a $400 million late-stage investment.

Most investors are clearly betting that the market we are seeing is going to continue for some time. Every investment firm has the ability to fold and walk away, but the pot is so large right now. With unicorn poker though, that pot can suddenly vanish without a trace. Investment firms are taking calculated risks – let’s hope they are holding a flush and not a high card.