If I put a hundred million dollars into Snapchat today at a 3 billion dollar valuation, three things can happen:Scenario A – BIG WIN
At some point in the future, Snapchat IPOs or gets purchased for more than 3 billion dollars. I reap the rewards through an appreciation of my stock price. That’s what happened to everyone who invested during Facebook’s long run up.Scenario B – SMALL WIN
Snapchat gets bought or IPOs for less than 3 billion dollars, but more than I invested in the company. I’d actually do just fine. It’s not the result I was hoping for, but it’s actually not bad. I get a hundred percent of my money back (assuming I’m the most senior investor) plus I also earned interest on my money every year. While the interest rates vary, often they are as high as 8%. So basically, my investment in Snapchat looks more like an interest bearing bond than anything else.Scenario C – LOSS
It goes bankrupt or sells for less than the amount I invested in the company. I lose my money along with everyone else.
And now things start to look a lot more sane from an investment perspective. With acquisition offers already rumored around 3 billion dollars from Facebook, it’s hard to imagine a world in which Snapchat dies so dramatically such that that the acquisition value dropped below a hundred million dollars. I won’t say it can’t happen – but that’s effectively the bet I’m making as a late stage investor.
So now you can see why these valuations get so high. It’s because the risk profile of the last money in is actually pretty low. They can afford to get into these bidding wars because they have the confidence that they are likely to at least get their money back, and yet they still get upside exposure if things go extremely well.
Good explanation of liquidation preferences and how they influence technology investors' tolerance for high valuations. Generally, if you can play any financial game where your downside is getting your money back and your upside is many times your investment, that's a good game to play. Your average retail investor is shut out of that game, however.