by Investing in companies such as Facebook before they went public has proven very lucrative for many well-connected investors – and Facebook’s decision to stay private for eight years before going public certainly worked out well for the social media giant. Bill Gurley, a general partner at venture capital firm Benchmark Capital, believes that early success stories such as Facebook and many other high-flying technology companies have made it fashionable for CEOs to resist public offerings. Investors who get in early certainly have no complaints. And without the pressure of quarterly earnings announcements, CEOs claim they’re able to focus on long-term growth. Everybody wins. Or do they? From investors’ perspective, the fear of missing out on the next big thing and a low interest-rate environment that makes other investments challenging is enough to keep their money flowing into private companies even when they know an exit could be a long way off, if it comes at all. That’s what’s led us into the age of unicorns – private companies valued at billion or more. While Microsoft was valued at 8 million and Cisco at 4 million when they went public in 1986 and 1990, Google waited until it was worth .2 billion to IPO in 2004, and Facebook was worth 0 billion at its 2012 stock market debut. In February 2015, Fortune magazine identified 80 unicorns.
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Investing in companies such as Facebook before they went public has proven very lucrative for many well-connected investors – and Facebook’s decision to stay private for eight years before going public certainly worked out well for the social media giant. Bill Gurley, a general partner at venture capital firm Benchmark Capital, believes that early success stories such as Facebook and many other high-flying technology companies have made it fashionable for CEOs to resist public offerings. Investors who get in early certainly have no complaints. And without the pressure of quarterly earnings announcements, CEOs claim they’re able to focus on long-term growth. Everybody wins. Or do they?
From investors’ perspective, the fear of missing out on the next big thing and a low interest-rate environment that makes other investments challenging is enough to keep their money flowing into private companies even when they know an exit could be a long way off, if it comes at all. That’s what’s led us into the age of unicorns – private companies valued at $1 billion or more. While Microsoft was valued at $778 million and Cisco at $224 million when they went public in 1986 and 1990, Google waited until it was worth $27.2 billion to IPO in 2004, and Facebook was worth $100 billion at its 2012 stock market debut. In February 2015, Fortune magazine identified 80 unicorns. By January 2016, VentureBeat counted 229.
What’s wrong with well-funded private companies staying private for as long as they can? Nothing, if they ultimately prove to be worth their sky-high valuations. But that’s the crux of the matter. At Credit Suisse’s 2016 Thought Leader Forum, Gurley suggested that the market for investing in private tech companies has turned dangerously frothy. He described an atmosphere in which tech firms solicit each new round of funding at a valuation larger than the last, with everyone involved motivated to accept the new valuation without an undue amount of scrutiny. Founders naturally want their company to attract as much funding as possible, while venture capitalists are happy to see valuations in companies they own stakes in grow in the relatively less brutal realm of private market valuations, as it keeps their own investors happy.
By staying private, unicorns forfeit the intense—but also arguably helpful—financial scrutiny from lawyers, bankers, auditors, and regulators that precedes an IPO. Unicorn investors are funding companies that often lack information public investors take for granted, such as timely audited financial statements.
But Gurley says that the lack of scrutiny is starting to show, and gave several examples of high-flying tech companies that have recently crashed back to earth to prove his point.
The steady flood of cash has other consequences, too. First, sky-high valuations obscure the issue of just how liquid investments in private tech firms really are. In the absence of IPOs, high valuations reduce the potential for an exit through M&A. Second, Gurley believes that for technology companies in particular, a never-ending supply of funding inevitably results in excessive operating costs. “These companies don’t have capital expenditures—they don’t build stores, they don’t build factories,” he noted at the Thought Leader Forum. “If you give them more money, they hire more people, they increase burn rates, and they get further away from their core unit economics.” This also creates the need to raise even more capital in the future, perpetuating the cycle.
Major investors such as Fidelity, T. Rowe Price, and BlackRock have recently marked down the value of their startup investments, and Gurley believes that there could be more such markdowns to come. “I call this the great experiment,” Gurley said. “We’ve never crammed this much private capital into immature private companies…and there will be consequences.” Rather than a catastrophic crash, as in the dot-com crisis, Gurley fears the proliferation of firms that stay in business long after their business models aren’t working.”
The funding environment, on the other hand, is already starting to shift. In a blog post, Gurley anticipates the arrival of opportunistic investors carrying structured term sheets that would make it difficult for companies to raise money in the future. One example of what Gurley calls a “dirty” term is a guaranteed payout for the investor when the firm goes public. Any investor coming in after that investor would have to think long and hard about a commitment. As unicorns raise money in the future, they may find themselves in a position where they have to either accept terms that endanger their ability to raise further private capital, lower their valuations, change their strategy to one that prizes profits over growth, or go public.
The potential for lower valuations would obviously pose a problem for venture capital firms who have tied up money in private tech companies, as well as their investors – the foundations, mutual funds, and endowments that have been banking big paper gains on the strength of their venture capital investments. More companies going public and taking steps to become profitable, on the other hand, might be a healthy shift for investors and tech firms alike.
Photo by Richard Drew courtesy of AP Photo.