A bubble? No way, we're in a bust, says rich VC living in alternate reality

Silicon Valley has lost its mind. Episode 22: Marc Andreessen

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The reality: huge sums of money are being spend on small biz

Why do people say we are in a tech bubble? Very simply because huge sums of money are being spent on companies that have yet to make any of it.

During the dotcom boom, it was the realization that with the internet you could reach anyone on the planet that caused people to lose their minds. Companies conflated possibility with reality.

Before the internet, if you managed to get ten million customers in under a year you were a megastar corporation. But those were different customers. They were bought in, less likely to leave, and more likely to hand over money. Not so online. Online, people could join one day and leave the next. And they did.

This 2015 bubble is built on much the same kind of foolish optimism, but this time it is driven by the combination of the internet and smartphones. Not only can you get to billions of people, the optimists excitedly tells themselves, but you can get to them all the time on a device they carry around with them.

Except of course, the money is still not there. Money going in does not equal money coming out. Sure, everyone could theoretically order an Uber every time they want to go from A to B, but the truth is that they won't. It's a fantastic app, but the service is expensive and people only have so much money to spend.

A big part of the VC mindset is built around the exciting world-changing possibilities, so it should come as no surprise that when left to their own devices – and with thousands of programmers buying into the dream of cashing out their employee shares – that the system massively over-values itself.

Hype versus profit

But that doesn't explain why Andreessen and Altman would push their fantasies of living in a tech bust if it is against their own financial interests.

To which the answer is, of course, that it isn't. If the tech bubble burst this afternoon, they would still make a tidy profit. How come? Because in the contracts being signed with these tech companies – none of which are made public – the VCs are using a range of tools to ensure that they get most of the real value created.

Key among these tools is "participating preferred stock." It's well known that VCs will often award themselves "preferred stock" in a company they invest in. That means that when the company does sell or go public, they see their money first before anyone else.

When you add "participating" to the mix, things get even better. Not only do you get paid for your shares first but you also get a second payout based on the value of those shares. In other words, if you own 25 per cent of a company's shares, you get the value of those shares plus 25 per cent of the cash left over when all those high priority shares are paid off.

Which means that even if these "unicorns" are no more than Shetland Ponies with plastic horns held on by elastic, the VCs will still make a profit. And the more everyone else buys into that valuation, the more profit they are likely to make.

So long as the companies are worth more than the amount they invested, they don't have to be worth anywhere near as much as they are valued at. And that real value will be built through really good technology, which will be built by really good engineers.

Uber is worth nowhere near its $40 billion current valuation, but its technology is undeniably brilliant – and getting better thanks to the engineers working tirelessly on it.

Unfortunately for those engineers, many of whom will have bought into the "value" of their shares, when the bubble does burst and the company is valued more realistically, they will be last in line to get the money.

And by the time the Andreessens and Altmans have taken their share, there's likely to be very little left. ®

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