More and more startups are valued at over $1 billion, even if they have dysfunctional corporate structures and hazardous business models. For tech companies, going public might prove much more difficult than before.
Remember the Wicked Witch of the West in The Wizard of Oz? Spoiler alert if you haven’t seen the movie: She gets doused with water and melts in the end. That happens to venture capital-backed tech unicorns too.
The term “unicorn” was first applied to tech companies valued at more than $1 billion in 2013 by Aileen Lee, a venture capitalist from Cowboy Ventures. At the time, there were only 39 unicorns. Today, according to a recent report from PitchBook, more than 187 tech unicorns exist in the US. Their combined value is just over $600 billion.
The We Company (the parent company of WeWork) is a nine-year-old startup company based in New York City that leases offices and desks to customers who “co-work.” It has an international footprint. We Co. has met a lot of resistance from potential public investors for many reasons. It’s now delaying a planned initial public offering (IPO).
Like the Wicked Witch of the West, the valuation of We Company is melting.
The first indication that this was about to happen was the company’s desire for an IPO valuation of $47 billion or more. The headline number on its last private financing was $47 billion. However, it received resistance from potential investors and dropped the valuation to between $10 billion and $12 billion. Prior investors pledged to put more money into the company, but that didn’t dissuade other potential new investors from balking at the price, or the terms.
One reason for the pause has to do with the generosity of the board toward CEO/founder Adam Neumann. Another reason has to do with the proposed shareholder voting structure of the company. Without a one-time accounting change, We Co. would have had $1.535 billion in revenue with $1.175 billion in losses in the first half of 2019. Analysts expect We Co. will need another $8-$9 billion in investments to get cash flow break even.
We Co. has stepped back and is reworking its business structure. According to Reuters, Neumann’s “superior voting shares will decrease to 10 votes per share from 20, though he will retain majority control of the company.” In addition, “no member of Neumann’s family will be on the company’s board and any successor will be selected by the board.” Any profit he receives from real estate deals he entered into with We will be returned to We. Neumann will also “limit his ability to sell shares in the second and third years after the IPO to no more than 10 percent of his stock.” He will continue to have a lot of skin in the game, with less power to determine the outcome.
This is the first sort of pushback investors have given unicorns like We Company. Facebook, Snapchat, and other venture-backed companies all had non-conventional corporate structures that gave dictatorial advantages to CEOs. Their actions were unchecked by boards of directors and shareholders.
The rate in which new unicorns are forming is accelerating. According to Axios’ Pro Rata, the past year saw 71 firms reach unicorn status, compared with 55 that did in the three years before. Both the average time and median time it takes private US firms to cross that threshold is a little over seven years. Even with the cheaper cost of capital, it’s becoming more expensive to enter the coveted $1 billion club: The median amount of VC funding raised prior to a company’s joining the unicorn club has been on a steady climb, hitting about $126 million in mid-2019.
This is partly because dollars don’t go as far as they used to in places like Silicon Valley and New York City, where commercial real estate costs and tech salaries have climbed. The other part of it is that valuations have soared, and investors need to invest more dollars to own enough of the company at exit for their limited partners to get paid.
Since 2001 and the enactment of new rules for public companies, such as Sarbanes-Oxley (SarBox), more companies are choosing to stay private. As a matter of fact, the number of public companies has decreased by 50 percent over the last 20 years. SarBox was enacted due to deliberately fraudulent companies like Enron and Worldcom, but also because of the tech bust of 1999-2002, as evidenced by this chart of the QQQ.
The historically cheap cost of capital gives another economic incentive for companies to stay private. According to a 2018 McKinsey study, private market fundraising grew by 3.9 percent to a record $748 billion globally. Valuations are up: “The average deal size grew from $126 million in 2016 to $157 million in 2017, a 25 percent increase.” The ability to raise capital is much better than it was 20 years ago. “Private markets’ assets under management (AUM), which include committed capital, dry powder, and asset appreciation, surpassed $5 trillion in 2017, up 8 percent year on year.” The continuous quantitative easing (QE) strategy of the Federal Reserve between 2009-2018 has altered how investors assess risk. More money is being allocated to riskier assets.
Maybe I am wrong, but I believe the public market is telling the private market that We Company’s valuation got a bit ahead of itself. My guess is that because of continued cheap capital and the changes in risk preferences, we should see more and more unicorns in the private market.
The figure below shows data on IPOs of hotshot startups this year. It only goes back a couple of months because some companies IPO’ed then:
Maybe the private market isn’t as efficient as the public market? As shown by the data in the chart above, the common person didn’t get rich if they bought the initial public offering of recent private market unicorns.
Back in the early days of internet companies going public, valuations were much cheaper than they are today. Microsoft, for example, went public in March 1986 at $21 per share, giving the company a valuation of $772 million at the end of the first day of trading. With stock splits, if you would have bought 100 shares for $2,100 on the open that day it was worth $750,000 in 2011 25 years later. Sure, private investors made money, but the big money was made by pension funds and the public after the IPO.
The story of venture-backed blogging platform Tumblr ought to be a good guide as to the difference between private and public valuations. Founded in 2007, the company raised a total of $125.3 million in venture capital. The company was bought by Yahoo for $1.1 billion in 2013 and just sold for $3 million. I bet their first seed round was done at a higher valuation than that. Yahoo made a bad assumption that Tumblr’s user base was sticky and that it could make it grow, earning a lot of ad revenue off the platform.
I am reminded of what a private equity investor told a CEO who had just taken his company from the public stock market to private. Here are his instructions to that CEO:
- Make more money for shareholders.
- Make more money for shareholders.
- See rules one and two.
Concentrating on top-line revenue growth generally increases bottom-line revenue growth, which pays shareholders. The recent pronouncement by the CEOs of the Business Roundtable flies in the face of that advice.
If shareholders are compromised by the public market, the economic incentives to stay private will be even stronger than they are today. There can be several problems when companies stay private:
1. The valuations are lumpy. Public markets price in all publicly available information, all speculative information and instantaneously incorporate it into a stock price. Often in venture capital, they are purely speculative.
2. It’s harder to do deals with stock since the valuation is not market-driven but driven by one single analyst’s 409A valuation. This is when one private analyst is asked to look at the financial statements of a private company and assess what the valuation should be.
3. Sometimes, board governance is not professional and there can be less accountability for management.
4. Sometimes, financial statements are not based on Generally Accepted Accounting Principles (GAAP), so it is hard to compare and contrast the economic reports of private companies.
5. Public markets drive discipline that doesn’t exist in the private market.
The other facet that most policymakers don’t consider about private versus public markets is that only accredited investors get to play in private markets. Even if you are accredited, you might not want to allocate to private companies because of the time it takes to do research and the costs to invest in them. You might be better off putting money in a public index fund with low fees.
Jeffrey Carter is a general partner at West Loop Ventures and a co-founder of Hyde Park Angels. He blogs at Points and Figures. You can find him on Twitter @pointsnfigures.
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