Weighing In On The Startup Debate: Two Warning Signs

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Photo Credit: Kevin Trotman startups

Photo Credit: Kevin Trotman

Before I write this evening, I have updated the blog’s theme so that it is more readable on mobile devices. I’ve tried to preserve most of the best of the former design. Let me know what you think. Also, I have tried to get commenting to work using Jetpack. For those that want to comment, if you can’t, drop me an email, and I will try to work it out. I prefer more interaction than less, even if I can’t always get around to responding.

On to the two warning signs: the first article is The Fuzzy, Insane Math That’s Creating So Many Billion-Dollar Tech Companies. This is about the terms that some private equity investors are getting that help to support current valuations of companies. Here are a few examples:

  • Guarantees that they’ll get their money back first if the company goes public or sells.
  • They can also negotiate to receive additional free shares if a subsequent round’s valuation is less favorable
  • Warrants to allow the purchase of shares at a cheap price if valuations fall.

Here’s my take. When companies try to offer protection on credit or market capitalization, the process usually works for a while and then fails. It works for a while, because companies look best immediately after they receive a dollop of cash, whether via debt or equity. Things may not look so good after the cash is used, and expectations give way to reality.

In the late ’90s and early 2000s a number of companies tried doing similar machinations because they had a hard time borrowing at reasonable rates, or, they wanted to avoid clear public disclosure of their debt terms. In the bear market of 2000-2002, most of these schemes blew up, some catastrophically, like Enron, and some doing minor damage, like Dominion Power with their fiber ventures subsidiary.

When you hear about a guarantee, think about how large it is relative to the total size of the company, and what would happen if the guarantee were ever tapped by everyone who could. If the guarantee is fueled by some type of dilution (issuing stock now or contingently in the future), maybe the total shares to issue would be so large that the price per share would collapse further.

There’s no magic here — there is no good way in the long run to guarantee a certain market cap or creditworthiness. That said, I agree with the article, this sort of behavior comes near the end of a cycle, as does the behavior in this article: Why Bankers Are Leaving Finance for No-Salary Tech Jobs.

We saw this behavior in the late ’90s — people jumping to work at startups. As I often say, the lure of free money brings out the worst in people. In this case, finance imitates baseball: those that swing for the long ball get a disproportionate amount of strikeouts. This also tends to happen later in a speculative cycle.

So be wary with private equity focused on tech, and any collateral damage that may come from deflation of speculative valuations in technology and other hot sectors.

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