What a tech bubble deflation and the recent financial crisis would have in common

With all this tech bubble talk, I’ve been thinking about the last financial crisis and whether there are any commonalities. There’s one big difference– a tech bubble deflation wouldn’t be the main event. Something else will be and that will be the catalyst for a sustained tech deflation.

For example, the Bernie Madoff scandal, which happened during the crisis, wasn’t the main event. It was the bigger financial crisis that hit Madoff’s inflows that uncovered his house of cards. Ponzi schemes break when inflows < outflows (I’m not insinuating that VC is a Ponzi scheme!).  For tech, something would have to impact the inflows into venture funds or exit opportunities significantly to cause a sustained deflation. Relevant questions should be “What would cause the Nasdaq to decline sharply?” or “What would make LPs stop investing in venture funds?”.

A tech deflation that happens in containment (no systemic risk/contagion) is a feature, not a bug, of the early stage tech industry. Startups are high risk/high reward. There’s alignment among parties involved that these investments are supposed to be risky. High variance is built into financial expectations. I’m not saying this won’t be a painful process, but it’s part of the process.

The SEC said the Bernie Madoff scandal was $64B theft. Most of that were fake markups that he created for his clients (sound familiar? i.e. unicorns). This event caused a lot of pain for high net worth investors but it feels mostly contained compared to the larger financial crisis.

On a related note: Lack of debt in tech makes a huge difference. We’re not playing with borrowed money. The reason why the recent financial crisis was so painful and hard to recover from is that it largely centered around debt. Debt is more tightly coupled and it’s expected to be a lot less risky. When these stable investment products become even a little unstable, it has huge impact because there’s not a lot of slack provided for variance.

 

 

 

Posted by John Ryu, Partner at Scout Ventures

What a tech bubble deflation and the recent financial crisis would have in common

A dead simple explanation of network effects

The concept of network effects and Metcalfe’s Law is really important in technology so it’s useful to understand how a network’s value grows with each new user that joins the network.  Here’s an attempt at making the power of network effects really easy to digest:

Step 1: Take a look at these three pictures

Two fax machines connecting to each other
Three fax machines connecting to each other
Four fax machines connecting to each other

Each of the lines represents a connection that adds value to the network.  Let’s say each line is worth a value of 1.  Below is a table that shows how the number of possible connections grow as you add another fax machine to the network:

The relationship between the number in column 1 and column 2 turns out to be:

This equation is “proportional to n ^2”. The easiest way to think about this is that as n gets bigger, there’s not much difference between [n x n] and [n x (n-1)].

And you can see how fast this grows if we show a chart going up to 100 fax machines:

Screenshot 2015-05-21 21.10.59

That’s it!

 

This post was written by John Ryu, Partner at Scout Ventures. Follow him on Twitter.

A dead simple explanation of network effects

IPOs are not liquidity events

The world is abuzz about liquidation preferences right now so it’s really important to understand that IPOs are not liquidity events.

In multiple articles, I’ve seen writers assume that liquidation preferences protect late stage investors and effectively lock in a minimum return in an IPO. The reality is that:

In an IPO, all the preferred shareholders convert to common and this process ends up wiping out the waterfalls created by liquidation preferences

The source of this conflation is in how we define a liquidity event.

An IPO is not a liquidity event.  It’s mergers, acquisitions, and/or changes in control, etc. that are considered liquidity events.

Liquidation preferences only matter during the kind of events listed above– BUT don’t relax just yet.

The waterfalls from prefs may go away in an IPO but there are ways investors can dam up and divert some water to themselves

For example, if you look at the Box IPO, it wasn’t the liquidation preferences that protected Coatue and TPG. It was the ratchet and poison pill. Check out this EquityZen post for detail.

Given this different point of view, go back and read this old Bill Gurley piece about the benefits of IPOs vs staying private longer:

It is obviously quite ironic that the very event that many of these entrepreneurs were hoping to avoid (the IPO) becomes their only saving grace. Yet, because they did not focus on the normal steps that lead up to an IPO, they are ill prepared for this singular redemptive path.

Now, on the flip side, let’s say you’re running Uber and you have strong conviction on an IPO path. The more de-risked the path to IPO becomes, the less you should be concerned about liquidation preferences.

This post was originally published on Medium by John Ryu, Partner at Scout Ventures.

IPOs are not liquidity events