Here's the dirty secret that's inflating the tech bubble

Sam AltmanBrian Ach/Getty Images for TechCrunchPresident of Y Combinator, Sam Altman speaks at TechCrunch Disrupt NY 2014 – Day 1 on May 5, 2014 in New York City.

The tech industry is in a weird spot right now.

There are over 100 private companies valued at $US1 billion or more.

This is leading a lot of people to say we’re in the middle of big tech bubble.

Yet, while those companies are richly valued, the public markets are being fairly rational — arguably even cruel — to technology companies.

Sam Altman leader of startup school Y Combinator points out, Apple trades at “a single-digit ex-cash forward P/E.”

And, you can ask Box, Twitter, King Digital, or just about any public ad tech company, if we’re in a tech bubble. When they stop laughing at you, they will say no.

At the same time that the big public companies are being (for the most part) rationally valued, Altman argues that early stage companies aren’t getting overvalued, and that mid-stage companies are having the hardest time in four years raising money.

Therefore, Altman thinks all of the bubble talk comes down to the late stage investments, where we’re seeing companies go above $US1 billion in valuation, and much higher.

And he says those valuations are being fuelled by debt.

Except — and here’s the secret — it’s not being called debt.

“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),” says Altman.

In case you don’t follow, that means that if I invest $US1 in Startupco, when it sells, I am guaranteed to get as much as $US2 back ahead of everyone else if it sells at a lower price than its valuation. But if it sells for a higher price, I can only get $US3 back.

“This is hardly an equity instrument at all,” says Altman. “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 per cent interest rates, people become pretty focused on finding new sources for fixed income.”

There are a lot of reasons startups are willing to take on deals like this. As valuations have soared, being able to say you’re worth a lot can be a good recruiting tool. If investors say your company is worth $US10 billion it’s a sign you’re pretty stable. It’s also nice for a founder’s ego.

Altman argues that because these fundings are more debt than equity, we’re not really in a tech bubble.

We’re not so sure we agree with that! If valuations are inflated, it doesn’t matter either way.

NOW WATCH: Donald Trump was one of the first to be ‘too big to fail’

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.