Sheeroy Desai
When Amazon went public in 1997, its stock opened 62.5 percent above the target price and the company ended its day $54 million richer than it had started it. In the three years or so leading up to the IPO, Jeff Bezos had finally begun to prove that the company had a viable business model, real revenues and a proven approach. Investor confidence was high.
But how would things have played out if Bezos had chosen to take late-stage private financing (which is common practice in Silicon Valley today) instead of taking Amazon public? In that scenario, it’s not inconceivable that when the NASDAQ crashed in 2000, the market for private financing would have come to a screeching halt, leaving Amazon without any access to capital — and possibly dead.
It used to be that every young company dreamed about going public one day. But more recently in Silicon Valley, the standard wisdom has been somewhat reversed. Dozens of “experts” have weighed in with advice to hold off on an IPO for as long as possible, stay private and retain control. I believe this will not end well for most companies, their entrepreneurs and, most importantly their employees.
Why The Valley Loves Staying Private
The key arguments people point to for remaining private are maintaining control and protection from investor scrutiny. Marc Andreessen has spoken extensively about these risks, saying, “The compliance and reporting requirements are extremely burdensome for a small company…It’s biased enormously toward companies that are big enough to hire fleets of lawyers and accountants, biased against companies that are very young and for whom there’s still a lot of variability.”
As someone who was part of the leadership team when a company (Sapient) went public (NASDAQ IPO in 1996 under the ticker SAPE) and was later chief operating officer of said public company, I can empathize with these concerns…but I disagree with the conclusion.
If you run a venture-financed company, you eventually have to either sell the business or IPO — it’s the only way to provide a liquid exit for your investors and your employees. I hear from many private company CEOs that they don’t want to run a public company and be beholden to quarterly earnings cycles and the pressures of a constantly changing stock price.
Here’s the rub — private companies who have taken private financing from public investors are already experiencing those same problems. Fidelity just released a list of private investments in which they adjusted their valuations down, something they are required to do by law every quarter — and now these companies are going to see their valuations altered on a quarterly basis.
Private funding comes with other latent dangers, too — the SEC just launched a deep investigation into mutual funds amidst controversy about whether investor fees were properly disclosed.
In addition, the popular idea that going public negates or even just severely limits a company’s ability to pursue its long-term mission is often unjustified. Moving to a public model doesn’t have to compromise a company’s vision. For the best high-profile example of that, look at Facebook.
Facebook went public in 2012. At the time, shares fell far short of what the company had anticipated. In the years since, the value of those shares have skyrocketed — and you don’t see Mark Zuckerberg simpering to shareholders during their quarterly reviews.
Since its IPO in 2012, Facebook has launched an international initiative called Internet.org to bring web service to some of the most underserved areas of the world. It has branched into content and media. It has made bold acquisitions, lead the charge in the migration to mobile and revolutionized analytics and AI. Facebook has not compromised its vision or long-term strategy since going public. If anything, doing so has prompted it to even greater innovation.
The Secret Dangers Of Private Financing
First of all, it’s important to understand that the decline of the IPO has been made possible in recent years because of two factors: 1) the signing of the JOBS Act in 2012, and 2) the emergence of non-traditional late-stage investors (hedge funds, mutual funds, etc.). The JOBS Act is a key factor here; before it passed, any company that exceeded 500 investors had to start filing public financial statements with the SEC.
Hence, any company with more than 500 employees (who had stock options) faced the reality of having to make their financials public whether or not they went public. The JOBS Act raised the limit of 500 investors and excluded employees from the requirement.
So, with essentially no obligation to publish their financials and with the free flow of hedge fund and mutual fund money, we have seen the dangerous emergence of the “unicorn culture” — a culture where entrepreneurs lose focus on building a great business with strong fundamentals and instead worry about raising large sums of private capital at ever-increasing valuations. And these new investors have been all too willing to participate and write big checks, at lofty valuations — but only with very favorable terms for themselves.
And that’s where these late-stage financings look less like equity financings and more like a debt instrument (such as a mortgage). Taking on second and third mortgages is great when the market keeps going up. But when they come down, they can result in massive pain, and even foreclosure (i.e., bankruptcy).
There is an ongoing debate in the valley about whether or not there is a tech bubble that will burst, but I believe that’s the wrong debate. There’s no doubt that the late-stage private financing market is far ahead of public market valuations. In almost 30 years in the industry, I’ve never seen anything like it. In fact, private companies have always traded at a discount to public companies for the simple reason that they are illiquid investments.
So, the question is really when will we see a correction in private valuations and how dramatic will it be? Fidelity has already written down some major unicorns (like Zenefits) by almost 50 percent — a massive correction — which I think is the tip of the iceberg. And just as we saw with the real estate market, corrections of that scale will wipe out a lot of equity. But unlike the mortgage market, the common shareholders (i.e., entrepreneurs and employees, not the VCs) are the ones who will lose the most.
Some of these companies will grow into their valuations. Others will be fortunate enough to somehow make it to an IPO, even if it’s a down round or a “forced IPO” that puts your business in a terrible light — a misfortune that Square has recently lived through. In another era, a six-year-old company going public at a $3 billion valuation would be a huge success story. But in the unicorn era, the focus was on how the IPO was a down round. But Square was one of the lucky ones — others will be forced into a fire sale, and still others will simply run out of money.
For whatever reason, going public has been painted as the enemy for enterprising young startups, but that attitude belies an unfounded paranoia. Think about the benefits of going public. You have a liquid currency with which you can make acquisitions and aggressively pursue your strategy. You get access to much larger pools of capital for future financings. And, most importantly, you owe it to your investors and employees.
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