Who To Blame For Failed IPOs

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Editor’s Note: Alexander Haislip is a marketing executive with cloud-based server automation startup ScaleXtreme and the author of Essentials of Venture Capital and The Modern Business Guide to Panel Discussions. Follow him on Twitter @ahaislip.

Praise be to Box, the cloud storage company that recently waggled $125 million from private investors to continue its growth trajectory, expand internationally and continue ratcheting up its valuation into the billion-dollar range.

There’s a lot to like in this story, starting with Box’s service. I pulled Box into our company and we use it religiously to version control internal documents. It’s awesome and Aaron Levie and his team deserve to get rich from their hard work.

And 15 years ago, you could have gotten rich from his work too. Levie would have brought his company to the public markets, seeking growth capital, and you could have invested and watched Box grow from a $600 million valuation last year to a $1.2 billion valuation today. Box would have been open to average investors, folks aiming to see capital appreciation in the public markets and a modest return on their small savings. The high tide of Silicon Valley could have raised even the smallest boats.

But today, Box remains private. When it does go public, it will no longer be in its high-growth phase. Chances are it will look a lot like the companies that have gone public in recent years, ballyhooed and heaped with expectations that have failed to produce.

The beneficiaries of Box’s remarkable growth aren’t you and me. We can’t save our money and invest it in good, growing companies with an expectation of capital gain. No, the beneficiaries are the venture capitalists, private equity investors and company insiders. The rich will use Box’s growth, and the growth of dozens of other similarly impressive private companies, to get richer and retail investors won’t have access to the investment.

The concentration of wealth into the hands of an ever shrinking few leads to a bifurcated society of have and have-nots that few of us want to see. And the avarice that underwrites this shift is bleeding Silicon Valley of its best talent and the type of people who made it such a remarkable and productive place.

AN ALARMING TREND

Consider how a similar situation played out for Facebook investors. The company had a $550 million valuation when Greylock Partners, Meritech and others invested $27.5 million in 2006. The company went on to be worth 100X that over the next six years. I wish I could have locked in a return like that in the public market!

Instead, Facebook did half a dozen large private investment rounds while it was in its high-growth phase, benefiting a slew of private investors such as Elevation Partners, Digital Sky Technologies (DST), Li Ka-Shing and TriplePoint Capital, among others. All the investors that came in before shares started trading on the secondary market have seen a capital gain.

Just to be clear, this isn’t an issue of over-pricing the stock, first day bumps, or the investment banks propping up price. It’s shameful that Facebook has lost more than three-quarters of a billion dollars worth of market capitalization each day since it went public. And it’s doubtful that money is coming back. There’s no perfect apples to Apple comparison, but Steve Jobs took his company from a $48 billion market capitalization in October 2005 to a $104 billion market cap in May 2007. All he had to do was create the iPhone.

But even today, after the stock has dropped and dropped, the private investment firms that bought into Facebook before it went public at the minimum doubled their money. (That of course excludes Goldman Sachs and its clients, which are likely regretting they had no financials to consider when they bought Facebook shares at a $50 billion valuation.) The simple fact is that venture capital and private equity investors captured Facebook’s era of explosive growth and left nothing for public investors.

You can say Facebook is an outlier, a once-in-a-decade aberration, but we’re seeing this kind of post-IPO performance more and more from tech companies. Quick, name a tech IPO that’s done well recently. Did you say LinkedIn? It’s been up 36% since its May 2011 IPO. That sounds pretty good, until you consider that for the three years before it went public it jumped 7X. The private investors that footed a massive investment round then captured the capital gain that could have been in your pocket.

Venture capitalists and private equity firms are killing the IPO. When they make large investments in fast-growing growing companies at more than $1 billion valuations, they’re effectively doing what the IPO market once did. And in so doing, they’re harvesting explosive growth that used to accrue to public market investors.

THE GOOD, THE BAD & THE INEQUITY

Companies today wait longer to go public. That could be construed as a positive thing. There are fewer garbage companies going out, fewer instances of Webvan or Pets.com. We should be glad for that, I suppose.

And maybe the ability to stay out of the public markets helps startups focus on long-term goals instead of short-term earnings. Operating in the public market imposes costs on a company including listing fees, legal fees and accounting audit fees. Moreover, there’s the threat of activist shareholder intervention, stock manipulation from hedge funds and the possibility of hostile takeover. There are lots of reasons executives choose to keep their companies private and take growth equity from investment firms instead of individuals. As Box’s Levie told TechCrunchthere are elements of the company’s strategy, like investing heavily in international growth and “deep technology”, that Box has “more latitude” to do as a private company.

But what’s good for the individual isn’t necessarily good for the ecosystem. We the people have decided that big companies are more responsible when they report to a broad base of shareholders, that they are more accountable when we can all scrutinize their financials and that our economy works better when major companies act as public entities. That’s why congress established the SEC, that’s why we require transparency, that’s why we support an ecosystem of service providers that create nothing save more efficient markets. It’s for the greater good.

I’m certain the people who bought Facebook shares on the secondary markets when it was still private are starting to appreciate the value of transparency and financial disclosure.

But there’s a more pernicious product of the shift away from public market IPOs to massive pre-public rounds. It’s that late-stage venture capitalists and private equity investors will take 20% of the valuation increase that Box experiences between now and the time it eventually goes public in carried interest. The partnerships, run by people who already make an average of between $750,000 to $1 million each year already, will collect a huge payout.

I’m not talking about skilled venture capitalists who handhold naïve entrepreneurs and facilitate the creation of great companies. I’m talking about leaches that offer little beyond an extended cash runway.

To be sure, university endowments, public pension funds and other large pools of capital benefit too and many small investors have exposure to the value created in Silicon Valley through these intermediaries. But they too would benefit better from promising and proven startups entering the public market. After all, venture capitalists and private equity investors might well be the world’s most expensive money managers.

We’re witnessing a technology boom in Silicon Valley, where real companies are creating valuable products. They’re also creating wealth. There was a time when that wealth would be spread around, accessible to anyone with savings and a stockbroker. But now massive pre-public investment rounds are taking that wealth out of the reach of regular investors and putting it into the pockets of a select few.