A bunch of venture capital firms invested a lot of money in a mobile company last week at a hefty valuation.
Specifically, IVP (which is also an investor in this site, Business Insider) and other VC firms pumped $60 million into photo-sharing startup Snapchat at a price that valued the company at a reported $800 million.
These firms also reportedly wrote $10 million checks to Snapchat’s two 20-something founders to buy some of their stock.
Predictably, this combination of news made even intelligent pundits explode in righteous ridicule.
An $800 million valuation and $10 million checks for 20-somethings for a 2-year old company with no revenue???
“Desperate lunacy!” the smart, plugged-in, and normally wise Dan Primack of Fortune cried, summing up the howls of ridicule emanating from the Silicon Valley techo-chamber.
In case you’re tempted to just parrot this view and denounce Snapchat’s investors as imbeciles, please consider the following.
First, this happens every time an investor makes a bold bet.
If you think armchair pundits are cackling with ridicule now, you should have heard them when Kleiner Perkins and Sequoia invested in “just another search engine” called Google, or when Kleiner invested in “an online bookstore” called Amazon. You should have heard them when Peter Thiel, Accel Partners, Microsoft, et al, invested in the obviously faddish and worthless Facebook. You should have heard them when Union Square and others paid a princely sum to buy into the no-business-model Twitter. And so on.
Every time someone makes a big bet that most observers don’t understand, the consensus conclusion is that these investors are obviously morons.
Frequently, however, these investors turn out not to have been stupid but early and bold.
The definition of “bold,” after all, is doing something that most other people regard as dangerous or stupid. If everyone regarded the action as safe and intelligent, it wouldn’t be bold. Yes, bold bets often fail. But sometimes they succeed. And when a truly bold bet succeeds, it often pays off well enough to cover any losses incurred in the failures.
In other words, they call it “venture capital” for a reason. If your objective as an investor is merely not to lose money, there are many other vehicles and strategies for that. (As one analyst I’ve always admired puts it, “If you can’t stand the heat, get out of the kitchen.”)
Second… before you snicker at any valuation made in a private investment, make sure you understand the difference between preferred stock and common stock.
If you buy stock in a public company, you are generally buying common stock. If the value of the company goes down after you buy it, you will lose money. Therefore, the price you pay is very important.
If you make an investment in a private company, however, you will generally be buying preferred stock.
Preferred stock is a different security than common stock, and it has a different risk/reward profile.
The most important difference between preferred and common stock is that it is much harder to lose money with preferred stock.
If the value of a company drops after you buy preferred stock, you will usually get all of your money back (if not more than all of it).
If the value of the company increases, meanwhile, you will get all of the upside.
Sometimes, depending on the terms of the preferred stock issued in a specific investment, you can even get a guaranteed return on your investment, regardless of what the value of the company does.
Knowing the specific terms of the security that a private investor buys, therefore, is critical to figuring out how much risk (if any) the investor is taking.
What does this mean in the case of the Snapchat investment?
At the very least, it likely means the following:
* Even if the value of Snapchat plummets, IVP and the other investors will still get all their money back under almost all scenarios. Only if the value of Snapchat drops below $80 million, the total amount of the investment, will IVP et al lose money.
In other words, for Snapchat’s new investors to lose money, the value of the company will have to drop by ~90%.
Could that happen?
Yes, of course it could happen. This is a speculative investment.
But based on Snapchat’s growth thus far, it seems very unlikely to happen.
So, right off the bat, even if the Snapchat investment is plain-vanilla preferred stock, the investors have very little potential downside and a lot of potential upside.
Also, it is possible that the preferred stock that Snapchat’s investors bought also contains something called a “liquidity preference” that will allow the Snapchat investors to generate a guaranteed return even if the value of Snapchat falls.
Often, in venture capital deals, preferred shareholders are entitled to exchange their preferred stock for a multiple of their invested capital before the company’s other investors get a penny. Sometimes, this term applies even if the company’s value drops.
In other words, a liquidity preference might entitle Snapchat’s new investors to get 1.5 times their total investment before Snapchat’s other investors get a dime. If this term applies even in the case of a loss of value, Snapchat’s value could crash from $800 million to, say, $150 million, and Snapchat’s investors might still be guaranteed at least a 50% return. (Under this scenario, if Snapchat sold for $150 million, the preferred investors would get $120 million–1.5x their initial investment–and the common shareholders would split up the remaining $30 million.)
If Snapchat’s value increases, meanwhile, the preferred investors will likely capture all of that upside. And if the liquidity preference is more than 1x, they’ll get a bigger share of the upside than the common shareholders.
The bottom line is that the risk/reward profile for preferred stock is entirely different than it is for common stock. It is much harder to lose money with preferred stock than it is with common, and depending on the security, preferred investors are often guaranteed a minimum return.
As a result, the valuation at which preferred stock is bought is much less meaningful than the value at which common stock is bought. Preferred shareholders have their downside protected and, often, their minimum upside guaranteed.
Based on these two factors alone, you should begin to appreciate why the knee-jerk ridicule of investments like Snapchat is usually misguided.
The investors who make these investments aren’t stupid. They know the risks they are taking, and then have a lot less downside than an uninformed observer might initially think.
Lastly, the logic that an investor uses to make an investment like Snapchat is often not apparent to those on the outside–because those on the outside are not privvy to the performance details and long-term vision of the company.
Like a lot of other people, I was curious what Snapchat’s investors were thinking when they invested $80 million in Snapchat.
So I talked to one of the investors.
I’ll save the specific logic about Snapchat’s upside for another article (check back soon!), but suffice it to say this:
The investors who just dumped $80 million into Snapchat have a very compelling case as to why they think the investment could turn out to be a great one.
The investors’ logic is not obvious to those who haven’t spent time analysing Snapchat. But it is still compelling.
Could the Snapchat investment fail?
Yes, of course the Snapchat investment could fail. All investments can fail.
But the Snapchat investment could also produce a very compelling return, one that ends up being many multiples of the price the investors paid.
The Bottom Line
So don’t get duped into parroting the simple, lazy logic of techo-chamber pundits when it comes to investments like this.
All of the best investments seem stupid and risky when they are made. If they were obviously safe and compelling, everyone would make them.
The people making these investments aren’t stupid. They also generally aren’t reckless. And they are very aware of both their downside, which is usually low, as well as their potential upside.
Venture capitalists also employ a portfolio strategy
They know that not all of their investments will work.
They even know that most of their investments won’t work.
But they also know that, if they make enough smart, bold bets, some of the investments will work. And as long as the handful of investments that work do well enough, all of the VC’s other investments can go to zero and the fund will still generate a compelling return.
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