I was having dinner at Kleiner-Perkins some weeks ago. It was an event for female engineers, hosted out of the goodness of their hearts, nothing to do with mitigating bad press from the Ellen Pao lawsuit, and KPCB is totally not sexist.

I asked a senior partner whether he was worried about overpriced startup valuations, given KPCB’s later-stage investments. How much upside could possibly remain? Maybe the prices could even fall before exit?

We’re not worried, he said. We have downside protection due to liquidation preferences.

What’s that?

Box is a good example. Coatue and TPG bought $150M worth of Box shares at a $2.4B valuation. Box went on to IPO at only $1.7B valuation. Coatue and TPG should have taken a loss, but no. Their term sheet included a ratchet, which gave the investors as many additional shares of common stock as needed to guarantee they would not lose money.

Coatue and TPG could have agreed to a valuation of a trillion. Who cares? The investment was upside-only*!

This isn’t venture capital, this is a variable annuity. Allowing venture capital firms to self-value their investments is like inviting a bank to rate its own credit instruments.

Who makes up for the deficit if a company doesn’t actually exit at the magical made-up valuation?

We work through the cap table until all preferred shareholders are paid out. These are the people who put money into the company. The common-stock employees pick over whatever remains. Unfortunately, many startup employees end up with underwater stock options.

Employees aren’t even complaining about a tech bubble because they have catered lunches and on-site masseuses. Paper billionaires Evan Spiegel, Travis Kalanick, and Elizabeth Holmes are certainly not complaining about a bubble.

The ones bitching loudest about the bubble are the ones close enough to see the action, but not close enough to get invited to the party.

Sorry we didn’t invite you to the Sand Hill Exchange party round, Mark Cuban.

See Also:
How Preferred Stock Makes Employee Stock Less Valuable –StockOptionCounsel
Box Investors Make a Killing –BloombergView

*Okay fine, sometimes a billion-dollar company can completely implode, like Fab. And then nobody gets anything.