Liquidity Causes Bubbles


A shitty app called Meerkat is raising money at a $50M valuation. Perhaps the only thing keeping it from being priced at a billion is the fact that the herd can’t come charging in. Restricted demand.

A market bubble needs a propagating mechanism, a process by which new investors are attracted into the market to keep the price momentum going (on the way up) and existing investors are induced to flee (on the way down). [1]

Liquidity also results in burst bubbles. As long as no one can sell anything, the price will never go down. In an illiquid market, Meerkat will sit on its last-traded price forever. I’m not sure if that’s a good thing, but in theory that means the bubble doesn’t pop.

Aswath Damodaran is a little late to the Hate-on-Mark-Cuban game, but he makes a very important point: Mark Cuban became a billionaire by creating a crappy internet company in the 90s. was a negative-profit company that put local radio stations on the internet, and Yahoo bought it for $5.7B at the height of the dot-com bubble.

Mark Cuban thinks this tech bubble is worse than the last one only because he’s not profiting off the excesses this time.

If Cuban is serious about staying out of bubbles, he should look at the largest investment in his portfolio, which is in a market where prices have soared, good sense has been abandoned and there is very little liquidity. In a market where the Los Angeles Clippers are priced at $2 billion and the Atlanta Hawks could fetch a billion, the Dallas Mavericks should go for more, right?

This bubble is even better than the dot-com bubble.
This bubble is even better than the dot-com bubble.

1. Illiquidity and Bubbles in Private Share Markets: Testing Mark Cuban’s thesis! –Aswath Damodaran

2. Caginalp, Gunduz and Porter, David and Smith, Vernon L., Overreaction, Momentum, Liquidity, and Price Bubbles in Laboratory and Field Asset Markets. Journal of Psychology and Financial Markets, No. 1, pp. 24-48, 2000. –SSRN

Rich People Bitching about Bubbles

kpcb has women

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*!

box ipo

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.