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Pump and Dump: How To Rig the IPO Market with $20M (wolfstreet.com)
130 points by dualogy on Aug 29, 2014 | hide | past | favorite | 63 comments

One of the most depressing things I've heard in my life came from a VC type around 2007.

He basically told me straight up that working hard to build a real business with real value was a sucker's game. Every example he'd seen of people making real money was -- as he put it -- from "equity plays."

By equity plays he basically meant this kind of thing. I started calling it "hype, leverage, flip." If it were just a lot of harmless hot air that would be one thing, but what's really happening here is wealth transfer from honest and productive sectors of the economy and from the long-term savings of the population (e.g. pensions) into the chip stacks of high stakes gamblers.

Throughout history, gambling has always been one of the favored pastimes of decadent nobilities. Today's gambling is particularly clever, as it has the outward appearance of productive work. I cannot help but see today's financial elite in powdered wigs, and probably merkins too. Guillotines can't be far behind.

Luckily there are a few honest VCs and angels, as well as a new emerging financial system built around crowd funding and peer to peer finance. That's the future. When the guillotines fall -- literally or metaphorically -- the new distributed financial system will take over in the same way that mercantile and industrial financial systems took over after the fall of Medieval feudalism.

I'm not surprised to see this coming from KPCB. They have a reputation for using underhanded tactics and this is just the latest example.

I unfortunately learned about their reputation too late... they pressured my company into signing a Series A term sheet only to pull it 3 months later (at the end of the no-shop) after THEY messed up a partnership negotiation. Needless to say we were out of cash at that point, but luckily we had some great seed investors who re-upped and a month later we signed a term sheet with another VC. What a nightmare though.

Can you explain how they went about just pulling the term sheet even after you guys signed it? Sort of in a nebulous situation with our own investors right now and would appreciate chatting with someone with a similar experience.

You could also email me at me@dchuk.com if you'd prefer.

In general, the only "binding" part of the term sheet is the "no-shop clause", which doesn't let you solicit additional offers from investors, usually for 3 months. It otherwise represents a handshake on terms so that the VCs have time to perform diligence and produce the paperwork (which is substantial) while the founders find strategic investors to fill up the round.

Either party can still back out of the deal at any time, and this typically only happens when something bad emerges during the diligence process. It's important that startups can trust this fact because agreeing not to solicit investment for 3 months while (presumably) running low on cash is a pretty big risk. KPCB broke this trust in our case.

Feel free to email me at the address in my profile if you'd like to chat more.

Thank you for being out in the open about this.

The VC's have a lot of money to run their PR machine, but no one ever hears the negatives about them. It's important to a functioning market that the information is out there.

Nothing about a term sheet is realistically very binding. That goes both ways. If you break the terms, there's generally little recourse for the other side.

Wow! Yardstick Capital at work:

"37signals is now a $100 billion dollar company, according to a group of investors who have agreed to purchase 0.000000001% of the company in exchange for $1.

Founder Jason Fried informed his employees about the new deal at a recent company-wide meeting. The financing round was led by Yardstick Capital and Institutionalized Venture Partners."

(from https://signalvnoise.com/posts/1941-press-release-37signals-...)

And I thought it was fiction.

This shows a lack of understanding of the structure of late stage VC deals. These are convertible notes, not straight equity. Also, what is the liquidation preference on this round? My guess is that this $20M note is the most senior debt, so if there is a wind down, they get their $20M first. So, KPCB has hedged some of the downside. And this is the important bit: their hedge increases as the percent they take in the round decreases. In a bankruptcy, they could probably at least get $20M out of the company.

You seem to be missing the premise of the argument. You're right that they hedge the downside on this individual deal, but the point is that the upside for this individual deal is still small for KPCB. So why would they do it? Not because they're expecting an upside on that deal, but because inflating the valuation of a darling at a low cost will create a frothier overall valuation market for their portfolio.

You are completely missing the plot.

First, forget liquidation preferences. $20 million is a drop in the bucket to Kleiner. This funding is not concerned with downside; as the post clearly explains, it's designed to manufacture leverage to the upside. Note that leverage isn't exclusive to Snapchat; the name of the game is perpetuating and promoting the market dynamic of arguably insane valuations.

Second, if this was convertible debt, it wouldn't be pegged to a valuation. The use of late stage convertible debt is typical when the funding would be dilutive and the company needs a bridge to its next round of funding. You often see existing (and not new) investors do late stage convertible deals because they're less concerned with valuation and maximizing their stake. Kleiner, as far as I know, is a new investor in Snapchat, and having raised well over $100 million in the past year and a half, I doubt very much that Snapchat needs a bridge.

> This shows a lack of understanding of the structure of late stage VC deals. These are convertible notes, not straight equity.

Capital structure doesn't change the enterprise value of a company. Call it equity, venture debt, mezzanine, super-duper late series H, etc. Enterprise value is what is. The capital structure can be 100% equity, it can be 99% debt and 1% equity, but valuation, which is what the article talks about refers to a $2bn to $10bn change in value. I think you should check some corporate finance theory[0], it might help clarify things.

[0] https://en.wikipedia.org/wiki/Modigliani%E2%80%93Miller_theo...

The point was that an $8 billion valuation for a company with no revenue model is insane, and that this deal has been structured in such a way as to help inflate talked-about valuation numbers to those heights.

The structure of the deal is less central to that argument. If it's convertible debt, does that really matter if the point is lost on most people? If the point of inflating the valuation is hype, then who cares how it's structured.

I suspect a better measure of valuation would incorporate the investment amount. If a VC firm invests $X at a valuation of $Y, then it conveys a lot of information (on the beliefs of the VC firm) if X is close to Y, but decreasing information as X decreases.

> In numeric terms they have invested less than $30 million since last November, meaning that they have been able to leverage an $8 billion valuation gain at a ratio of 266:1.

Holy crap.

Reminds me of "Investment Grade Beanie Babies"

Your "Investment Grade Beanie Babies" are crucial to the Silicon Valley ecosystem right now.

When these carefully orchestrated valuation maneuvers meet liquidity (and in a lot of cases some liquidity comes pre-IPO), a lot of the money is invested back into the Valley. Those with it become angel investors and limited partners in venture funds, or start and fund their own companies, perpetuating the cycle.

This in and of itself isn't a bad thing, but anybody living and working in Silicon Valley should contemplate what will happen when the music stops. Even if you're just an average engineer with no real exposure on the equity side, less capital chasing opportunity will lead to fewer startups, and less heavily funded startups. Fewer startups competing for talent will mean fewer jobs and downward pressure on wages. Obviously, major companies like Google and Facebook aren't going anywhere any time soon, but the $1xx,000/year early-stage startup jobs are going to be harder to find, especially at the junior end of the market, and the days of being able to jump from six-figure job at unsustainable startup to six-figure job at unsustainable startup in a matter of a few days or weeks will be a thing of the past for most.

This could happen two months from now; it could happen two years from now. But it will happen. Given the valuations we're seeing and the increasing difficulty with which the Fed is maintaining the status quo, I think one has to be prepared for the possibility that we're closer to the end of the cycle than we are to the beginning.

No, most of the money doesn't go back into the Valley. It goes into the financial services industry and it stays there. Forever.

First, I never wrote that "most" of the money is reinvested in the Valley. I wrote that "a lot of the money is invested back into the Valley." Need evidence? Take a look at any of the increasingly common million-dollar seed stage party rounds and who the investors are. It's not cattle ranchers from Texas.

As for the financial services industry ("Wall Street"), this doesn't exist in a separate bubble. Who led Uber's recent $1.2 billion round? Fidelity. Who else participated? Blackrock and Wellington Management.

That's definitely fair, and its one of the main reasons I try explaining to non-tech friends why many (not all) of these valuations are complete and utter BS - they are options, not real equity purchases (note: some companies with $multi-B valuations are only selling common equity - those are closer to being real). Ironically, this is especially true of smaller startups that are raising at $100-$200M valuations - the fundementals don't uphold that valuation, and the "sell to Google / Yahoo / FB" approach only works for a few (and is a lot harder than the $10M acquihire.

Their expectations will probably lag reality, no question. A wise developer would be saving a decent percentage of their paycheck to let them ride out a future downturn. 2008 was not an isolated event - such things happen throughout history (Dutch tulip bulbs in the 17th century, for example), so being prepared is a good idea.

I get that investment money pretty much is the economy in SV presently. But I definitely have major concerns that so much money is being paid for so little.

> But I definitely have major concerns that so much money is being paid for so little.

Not enough people think about this. The ease with which multi-million dollar valuations are obtained in the Valley is incredible. Heck, Y Combinator, which offers a six figure valuation to entrepreneurs, many of whom have no real-world experience and nothing more than an idea, is considered a "bad deal" by many.

Outside of the Valley, the market is more like Shark Tank, where you'll struggle to get anywhere close to a million-dollar valuation without real traction (read: revenue and profit).

Silicon Valley's easy money supports a lot of high-paying jobs. If entrepreneurs in the Valley didn't have the ability to raise six and seven figures of capital so easily, and without giving up 100% of their businesses, there would be a lot fewer developers with a year or two of Ruby on Rails experience making $120,000/year.

6 figure valuation is in no way inflated.

When you get a job offer with a 4 year stock vest in Microsoft, that's a 6 figure valuation on your contribution to Microsoft.

So seed stage valuations should be based on the salary a founder could earn working at a large company over the course of half a decade? Show me an investor who invests on that basis and I'll show you somebody who is likely to lose his or her money.

Starting and growing a business is hard. If it was easy, everybody would do it. There are tons of people who are capable of thriving and creating value as an employee of a large company but who can't run a business. That's not a knock on them, it's just reality.

We're spoiled in the Valley, especially during boom times, and it's helpful to spend some time outside of the Valley. Like I said, Shark Tank is a lot closer to reality for most people in most places. Six and seven figure valuations aren't handed out like candy on Halloween. They are earned through meaningful traction.

If you own property in the SF Bay area that you purchased or mortgaged at current valuations, you're definitely exposed there.

Word on the street(in SF) is that bozo investment firms like K9 are potentially ruining the whole the market by significantly skewing valuations; basically, they don't know what they're doing.

These firms are like that scene in Jurassic Park when Jeff Goldblum's character tries to distract the T.Rex and ends up getting thrown into the outhouse by it. You have potentially valuable companies like AirBnb, Uber, etc. but the whole market is being skewed by completely outrageous valuations for products like Snapchat or Lyft.

I don't think it's intentionally malicious(by K9 and other firms) I think they think they know the value of these companies and that value is really high(in their minds) when it's really not. It's going to get worse and worse until pop. But the real ones will survive.

The problem is it's going to affect investment in potentially viable companies in the future.

Fool me once(2000), shame on you; fool me twice(2015), shame on me.

K9 isn't a firm being discussed here. Manu is an awesome guy who helps get companies off the ground.

This article seems to forget the 'horrible' Facebook IPO where the stock went nowhere. Or that companies like Box who were going to IPO and then pulled back (presumably from a lack of enthusiasm on the road show). Or Groupon, or Zynga. There are lots of wounds not fully healed out there keeping the IPO market fairly rational.

That said, the article says Snapchat has raised $160M. If you push them to take money at a high valuation, you can cut them off at the knees when they run out of money. No IPO required, just sell off the company to one of the existing players for your liquidation preference and maybe a small premium.

I will be quite surprised if Snapchat tries to IPO before any revenue, but if they do make that leap I'll be really interested in watching the market response. That would be a good data point for bubble/notbubble arguments.

I want to point out a few problematic components with this article:

1. For KPCB to exit, they need to find an investor that values the company more than they do. To find an investor who values an unprofitable picture sharing company at over 10B would be a difficult task. It will probably be possible to find retail investors to provide the exit strategy, but the big tech companies of the world (Google, Facebook, etc.) do not have incentives for buying out unprofitable poor performing companies with no future. They have an agenda, and their CEO's are looking for strong future revenues because they themselves are heavily vested in the companies which they work for. These are savvy people with a team dedicated to valuing M&A transactions. There is no good reason for a large tech company to acquire a snapchat unless it thinks it will contribute to the bottom line, the brand, the network, the IP, or the scale of the existing business.

2. There's this incorrect notion that VC firms are somehow not exposed to the risks of the market. Times are good right now, and if you're a VC firm, you should be making a profit right now. A typical pump and dump occurs because of timing effects, insider knowledge, and mass marketing. While you could argue that an IPO is a "mass marketing", I think that external financial institutions (hedge funds) are very much looking out for shorting opportunities. An overpriced IPO is a great opportunity for a hedge fund. Also, It's worth mentioning that the VC firms which will profit so nicely this year, are likely to lose 50-80% during a downturn. They are very much exposed.

3. If KPCB really wanted to profit, why only invest 20MM? This won't make them much money. The real reason they made this investment is because they're skeptical of snapchat, but still want the talking point if there is an upside. It will be a great story for investors, pretty much regardless of how snapchat exits.

I think you may have missed the point of the article. The whole thing about not really caring about this $20 million but using it to "signal" the wider market (and thus generate higher valuations on their other investments going IPO or being acquired) was the whole point.

As to points 1 and 3 I thought the article pointed out that the goal wasn't necessarily to make money on the $20mm invested in Snapchat, but to set the valuation bar higher for all their other VC deals.

The valuation raises as many questions, as the Whatsapp deal did and relates to the difference between price and value. To justify a 10 billion valuation on a company that makes no revenue makes nonsense, especially when looking at the fundamentals (earnings/cash flows, growth and risk). The simplistic attempt at making sense of the price is to look at the correlation between the market's assessment of corporate values and each of the measures and you will see that: 1) Number of users is the dominant driver. The key variable in explaining differences in value across these companies is the number of users. The pricing game is not about what you or I think makes sense, but what traders care about. 2) User engagement matters: The value per user increases with user engagement. Put different, social media companies that have users who stay on their sites longer is worth more than companies where users don't spend as much time. While making comparisons across companies is difficult, since each company often has its own "measure" of engagement, there is evidence that markets care about this statistic. 3) Making money is a secondary concern (at least for the moment): Markets (and investors) are not completely off kilter. There is a correlation between how much a company generates in revenues and its value, and even one between how much money it makes (EBITDA, net income) and value. However, they are less related to value than the number of users. Snapchat is said to have 100milion Monthly active users- Whatsapp-hit 600million monthly active users recently, but only had about 300million users at the time of the Facebook transaction.

Somehow I'm hoping that the most important phrase in this piece is: "The deal, which apparently hasn’t closed yet"...

A company does not always need to sell at higher valuation for an investor to earn profit. It may be very possible to invest in SnapChat at $10B valuation and still rip a benefit if they sell for $2B.

Can you explain how?

When someone invest 200M at a 1B valuation (for 10% ownership), remember that only the $200M are real at the moment. The rest, $800M, is "confidence in the team + hope in the market." This is especially true when the company makes no revenue.

So in the event the company sells for $300M, the investor get first get his $200M out. Then get 20% of the remainder. He won.

Liquidation preference.

Where's the "dump"?

Mom and pop investors who own facebook stock in their retirement accounts paid $2B to VCs for Oculus VR.

I don't second guess Mark Zuckerberg, as that is a consistently losing bet. That being said, there is no reason the price should have been $2B. The frothy prices, mean that a $100M company was priced at $2B and that dumped a lot of money from Mom and Pop to VCs.

They have also seen a 78% increase in stock price over the past year so maybe using Facebook shareholders as an example isn't the best way to make your point

Yeah but that's the funny thing about pension money going into equities. They have "seen" the 78% increase but not realized it unless they cashed out their accounts and retired right then. Wall St / US pension funds turned everyone into "investors" while mom & pop still think the funky numbers on their statements are their "savings". I mean I'm simplifying, I'm not a US subject, but that's what it seems like from afar.

Facebook has revenue, so it's sort of immaterial to the Snapchat discussion... at least in the short term.

Yet in the long term I'm not so sure. Facebook's revenue is built on doing things that cannibalize the value of their platform-- annoying ads, creepy surveillance, even creeper "experiments" on their users, etc. That's making them decidedly uncool. Network effects are holding their popularity high for now, but while network effects are powerful they are not unstoppable. Things can "tilt" at any time.

I think that's why Facebook is acquiring things like Oculus. If they're to become the next Yahoo they want to make sure they've invested in some other properties. That of course is why there's still a Yahoo-- the core Yahoo brand is almost worthless.

People said that Facebook overpaid for Instagram at 1B valuation. In hindsight that was extremely good deal that will pay many times over now that Instagram has 200M+ users and is still growing.

The bet is that Oculus will be used in many areas (not just gaming) and will become multi-billion business in the future. It a big bet and it could go wrong. Keep in mind that $2B is 1% of FB stock price - placing 1% bet on new promising technology is not unreasonable.

IG is making money now?

Instagram has ads - not sure if they are profitable. Service should not be too expensive to run - images are on smaller size so traffic and storage should be cheap.


Aren't many pension funds VC LPs? Seems they would also benefit from this phenomenon too.

The article speculates that SnapChat will offer an IPO.

Question: Why don't founders control valuation if it is exceeding what they believe to be the true value of their company?

They do. If they want to give investors a lower valuation, they can. But why would they ?

For fear of a down round - but most don't think that far.

Basically let's assume a company raised money on a $10B valuation, and needs money down the line for a variety of reasons. They will have to make sure that the future round is at $10B+ which may or may happen, especially if the company is not flying high at that time. And, if they can't raise at $10B+, they'll have to go for a down round which can look very bad.

I'm really interested to know this too. A few benefits I can think of:

- Their shares go farther if they buy another company with stock

- Helps recruiting and retention if their employees can sell their options on secondary markets

Levine has a much more responsible review of this deal. http://www.bloombergview.com/articles/2014-08-27/levine-on-w...

This existing post is extremely aggressive and over-the-top.

New VC model: ignore about that valuation number. Just get X preference (like 4x+).

Then higher valuation works even better for you. Oh Facebook you really need to pay at least 6 billions, b/c we valued them at 10. Such a great deal. VC enjoy your 300% ROI.

Most VC firms also get to value their investments at the value of the last round of funding, so this creates a paper win for them with LPs. The main reason why you'd want to do this is if you are raising another fund...

It's not "rigged" if no one can actually sell out at the inflated price.

EDIT: The link has now been updated, thanks HN mods!

------ My original post:

I was with this piece until it went off the rails, deep into the swamp of Federal Reserve conspiracy theories.

If you're interested in the title, I'd stop reading this article after about the 6th paragraph. After that, you're in the swamp.

Or just scoll to the bottom and read the real, original article. (Mods, I'd recommend switching the link to that article, which is actually about SnapChat):


Conspiracy nuts have a way of being right about the particulars and pretty astute at spotting trends while simultaneously being bat-dookie bozo about the overarching mechanisms behind it.

All the surveillance state stuff that the wacky Bill Cooper types were ranting and raving about in the 90s has all come to pass, often in weirder and more alarming ways than they predicted. Yet I'm still waiting for my 666 stamp, nor do I see very much Masonic influence in things.

A conspiracy theorist is kind of an investigative journalist with bad epistemology and a poor understanding of how the world really works. They see the smoke and correctly extrapolate the fire, but they think fire is phlogeston excreted by underpants gnomes.

The reason they're so often right probably boils down to the fact that as loony outsiders they've got no vested interest in towing the official party line. So they're able to say really contrarian things and not give a damn. According to Pravda, stocks always go up. Saying different is not a good way to advance your career in the Party.

Great comment, pretty much agreed on all points. One minor correction -- it's "toeing the line", not "towing":


>According to Pravda, stocks always go up.

I don't remember saying that.

I agree. Can an admin edit the link to point to the actual source, http://wolfstreet.com/2014/08/28/how-to-rig-the-entire-ipo-m...?

You should now edit this comment, since the link has been replaced. I was quite confused until I compared the links.

As OP, I agree. Posted slightly prematurely, should've used wolfstreet link in retrospect

Agreed. The current link is just some guy's opinion and it gets wacky. Certainly not the type of high level analysis I typically expect from a HN link.

Why do you say Fed conspiracy theories when all he's saying is that the Fed can't keep up the zero-interest charade forever?

give me a break

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