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Are Some Tech Startups ‘Subprime’?

If venture capitalists were as imaginative about what could go wrong in their industry as they are about what could go right, maybe we wouldn’t be in this situation.

“A lot of VCs might think about this privately, but they don’t talk about it publicly, because you’re sort of shooting yourself in the foot if you do,” says Rui Ma, an investor at 500 Startups, a global early-stage investment fund.

“This” is the state of the mega-startups, the privately held tech “unicorns” worth more than a billion dollars, and the terms under which they are financed. From the outside, everything looks great—at least 124 unicorns are, according to their backers, glowing with health, growing their revenue aggressively, if not their profits.

The pressure to join the “unicorn club” is enormous, in part because having a billion-dollar-plus valuation is a signal to potential new hires that yours is a company that is going somewhere. PHOTO: AGENCE FRANCE-PRESSE/GETTY IMAGES

But with ever greater frequency and urgency, a chorus of the very same venture capitalists who are investing in these companies are sounding the alarm, declaring that many of them aren’t only worth less than their paper valuations, but some may cease to exist altogether. And while this tech “bubble” may be different than the one that popped in 2000 when many startups went public too early, what is at stake is much more than just billions of dollars in private equity.

That is because, while the unraveling of these privately held companies may not directly affect the stock market, I think we have so far underestimated the potential impact of an implosion of relatively large, extremely visible companies that are supposed to be the vanguard of our brave new tech economy.

Investors are herd animals, after all, and the same forces that are currently leading to what investors including Bill Gurley of Benchmark,  Michael Moritz of Sequoia Capital and Fred Wilson of Union Square Ventures are calling irrational exuberance will lead to just as much flight to less risky investments when markets inevitably turn—and not just in tech.

So far most people—including me—have thought that the damage from a correction in pre-IPO tech companies would be fairly contained. But the complex financial machinations propping up some of these companies now have the potential to lead to a chain reaction of failures and pullbacks. The direct consequence would be the loss of thousands of highly compensated jobs, but the indirect consequences could include everything from trouble for commercial real-estate markets to problems even for publicly traded companies that are still in high growth mode and need a steady supply of investors willing to part with cash in order to follow through on their ambitions.

I used to think that it would take some kind of global economic shock to crash tech’s current valuation mania, but the more I talk to VCs, the more convinced I am that some of today’s largest startups will simply collapse on their own. One reason for this is simply that many of them are losing money on every transaction, writes Mr. Wilson, in hopes of building a “natural” monopoly in markets in which there may be no such thing.

The pressure to join the “unicorn club” is enormous, in part because having a billion-dollar-plus valuation is a signal to potential new hires that yours is a company that is going somewhere, says Ms. Ma. The problem with this logic is that raising more money is often, paradoxically, a bad thing.

As venture capitalist and Stanford Professor Heidi Roizen wrote in May of 2015, “Venture capital is not free money. It’s debt.” And owing to conditions put on that debt, we’re now at a point where, writes Ms. Roizen, for many startups the headline valuation of that company matters less than the terms put on that investment.

Those terms, or “liquidation preferences,” are written so as to guarantee that investors get their money back, and then some, even if the company doesn’t perform as promised. It is these terms that led Mr. Moritz to call many unicorns “subprime”—an analogy that works perfectly if you look at these investments as debt with usurious interest rates, as in the subprime housing crisis, rather than investments that happen to have fine print attached.

You might ask why startup founders and their boards aren’t warier of these terms. I think the answer is that the tech industry is currently in the grip of a powerful cultural phenomenon: the cult of the unicorn.

It manifests in a hundred ways large and small—over-the-top compensation, exploding prices for office space, startup founders prioritizing valuation above deal terms, and most disturbingly, an increasingly complicated menagerie of means by which financiers can convince startups to take on more debt.

What I worry about most in this climate isn’t the individual deals signed at questionable valuations and under potentially onerous terms, but the sum of all of these deals, and the unpredictable way they could all quickly unravel at once if companies are unable to go public, be acquired or continue through endless rounds of private financing.

Despite their fondness for playing them on Twitter, venture capitalists aren’t macroeconomists. And to those who seem to believe that the current state of affairs is sustainable, I would ask this: When in history has ever-increasing financial complexity, lack of transparency, perverse incentives and new ways to extend credit and increase leverage not eventually led to disaster?