Liquidation preference

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.

Taking stock

My piece on Amazon last weekend elicited a lot of email and comments, many of which were about Amazon's stock price. People who are bullish on Amazon were reassured by my piece, but many more comments and emails were from Amazon bears who thought I was deluded. It's worth reiterating for new readers: nothing I ever write here should be read as investment advice on Amazon, whether pro or con. 

Amazon's stock price (or company stock prices in general) is a topic that doesn't really interest me, and I'm going to disappoint those hoping for me to come up with some long-term valuation model for Amazon. I believe Amazon's business model is often misunderstood, but as to whether it's current stock price is fair or not, I can't claim any more insight than the average armchair analyst. Honestly, I don't even know what Amazon's share price is right now. I could find out without moving my mouse cursor more than a few inches, but I decided long ago that I didn't find stock picking very fulfilling.

This might seem disingenuous coming from someone who still owns some Amazon stock, but I'm sure I'm not the only former employee of a company who kept a small equity stake. It's difficult to be more familiar with the people, processes,  and business of a company than the one you worked at for so many years, and there is not some small amount of sentimental value in my Amazon stake.

If you want my serious investment advice, though, buying individual stocks, especially those as volatile as technology stocks, is not a game the average investor should be playing. When people ask me for advice in playing individual stocks, I tell them to only invest with money they're comfortable losing entirely, the same advice I give to people wondering how much to take to the blackjack table in Vegas.

For most everyone I know, I recommend diversifying your portfolio across a set of low-cost index funds, rebalancing occasionally, and spending the time you save stressing about the stock market on doing something more enjoyable and productive. That's how I manage my own finances, with a small play fund set aside for a few individual stocks including Amazon.

I'm far more interested in the strategic questions surrounding Amazon, Apple, and other technology companies than what their stock prices are. For entrepreneurs, investors, or other people working in technology, there's more to learn from how those companies create value and defend their businesses than the vagaries of the stock market. In only a few cases does a company's stock price hold interest for me: when it impacts their ability to retain employees, when they can use stock to purchase other companies, or if I'm thinking of working there and I'm negotiating my compensation.

While my last two pieces on Amazon, spread across a year, highlight some strengths of their business model, I certainly don't think Amazon is perfect. I view companies as networks, and you can tell a lot about a company's strengths and weaknesses purely from their outputs. From the Amazon bears, I'd love to hear more analyses as to why Amazon's business might fail and fewer discussions of what the proper P/E ratio is. GAAP earnings may have a strict definition, but within that definition companies can willfully manipulate their earnings up or down, moving them in or out, depending on their strategic goals.