A Blog by Jonathan Low


Oct 25, 2016

Silicon Valley Faces Renewed Pressure For Public Offerings

There is a need to put the risk back in risk capital. Raising money privately worked as long as there was sufficient opportunity to realize gains over the longer term.

But with growing consolidation, the demand for monetization by competitively critical employees and the need for more capital in order to grow, the cycle is swinging back to initial public offerings.

The question is how long entrepreneurs, venture capitalists and investors have before the usual excesses in floating suboptimal companies leads to a correction. JL

Tom Braithwaite reports in the Financial Times:

The hollowing out of the public markets has reduced US listed companies from more than 8,000 in 1996 to 4,300 today. There have been 14 tech initial public offerings this year compared with 371 in 1999 and an average of 49 since 1980. Unicorns valued at more than $1bn — have elected to stay private. (But) pressure from investors and employees to cash in is mounting; the need for a higher profile or more liquid stock to fund acquisitions is becoming acute; it is harder to raise money privately; and there is pent-up demand from investors
Walter Price cannot get enough technology stocks. “I was looking at the Bloomberg terminal and all the public tech companies that have disappeared,” says Mr Price, who manages $4bn of equities for Allianz Global Investors. “It would be nice to have some more of them,” he adds longingly.
The hollowing out of the public markets has reduced US listed companies from more than 8,000 in 1996 to about 4,300 today. In tech, private buyouts, including Dell in 2013, and acquisitions, such as Microsoft’s takeover of LinkedIn this year, are shrinking the pool.
Most glaring, though, is the lack of new entrants. There have been only 14 tech initial public offerings this year compared with 371 in 1999 at the height of the bubble, and an annual average of 49 since 1980. The reason is simple: world changers like Uber and Airbnb — so-called unicorns valued at more than $1bn — have elected to stay private.
Several years into this tech boom, however, the IPO drought shows signs of breaking. The pressure from investors and employees to cash in is mounting; the need for a higher profile or more liquid stock to fund acquisitions is becoming more acute; it is harder to raise money privately; and there is pent-up demand from public market investors like Mr Price. The unicorns are finally trotting towards IPOs.
Jim Goodnight thinks they must be mad. In 1999, the founder of Sas Institute, a North Carolina-based data analytics company, almost succumbed to dotcom fever.
“There was a lot of pressure internally from some of the senior management that we ought to go public,” says Mr Goodnight. But the bursting of the bubble intervened and Sas prospered in private hands: it now has annual revenues of more than $3bn. As he watches his public peers getting bogged down in regulation and facing pressure from their outside investors, Mr Goodnight concludes: “Why would you want to go public and ruin your life?”
Jack Dangermond agrees. Over nearly 50 years he has built Esri into a mapping software company with $1bn in revenues. “You don’t have to go public to succeed and that story is not told to young entrepreneurs,” he says. “You don’t have to buy shoes with tassels on them and go into debt and use a template in PowerPoint on how to do a start-up.”
Even some who make a living from equity offerings appreciate the sentiment. John Kolz, in charge of tech IPOs at Credit Suisse, says he asks company founders a similar question to that of Mr Goodnight: “‘Why the hell would you ever want to go public?’ I go on to say there are a lot of good reasons but unless you can name them I will be the first to tell you to stay private.”

‘Only so many investors’

Raising capital used to be the obvious reason: the company sells new shares to the public to expand the business at a time when it is producing relatively little cash flow. But the flood of money into private companies — $261bn since 2010, according to PwC MoneyTree — has alleviated that pressure.
Before Google went public in 2004, it had raised just $36m privately. Uber has raised almost 100 times that amount in one funding round from a single investor — the sovereign wealth fund of Saudi Arabia — and overall, the ride-hailing company has raised $15bn in debt and equity, an unimaginable amount for previous generations of entrepreneurs.
This year, however, private fundraising in the tech sector has slowed, with 355 late-stage deals in the third quarter, according to the National Venture Capital Association, the lowest number in any quarter for six years. Smaller unicorns are viewed more sceptically, while even the biggest and best have fewer options.
“There’s only so many investors to go to see,” says one banker covering the tech sector. “The number of people who have no exposure to Uber and are large and [invest in] privates is a dwindling universe.”
For some companies, the chance to raise money at an IPO still looks attractive. Evernote, the productivity app, has not raised money privately for two years and, though it now generates cash, has limited resources.
An IPO, says chief executive Chris O’Neill, might allow funds to be directed at new projects. “I would love to invest a pretty significant amount of money in China,” he says. But in the current state: “It’s hard for that [China-specific proposal] to compete with things that have [more of] a global impact.”
Mr O’Neill is not certain if Evernote will launch an IPO — ultimately his investors and their thirst for liquidity will determine that.
But for tech companies that enjoy the private life, there may come a point when investors expect to be able to cash in on their investments. Venture capital firms such as Andreessen Horowitz, Benchmark and Sequoia Capital have 10-year funds and can afford to wait. Shorter-term investors are becoming impatient. A VC fund expects to earn a big multiple on its invested cash; private equity firms might care more for the internal rate of return, which is boosted by a swifter exit.
“I do think there is a class of investor who invests more on an IRR basis, who does not have a decade-long horizon and is looking for an exit,” says Bryan Schreier, a partner at Sequoia.
One banker who works with private investors says: “Family offices and wealthy individuals may not have appreciated the risks they were taking and they are getting itchy.”

Release valve

The patience of even venture capital funds is being tested when companies like Dropbox and Spotify celebrate their 10th birthdays and remain private.
“Nobody’s going to cry for the venture capital community,” says Scott Kupor, managing partner at Andreessen Horowitz. “But at some point VCs will need to be able to provide liquidity to their limited partners to continue investing in new companies.”
An obvious fix is for investors to buy and sell each others’ stakes — in the same way that private equity firms, such as Blackstone and KKR, have become comfortable buying mature companies from each other — but that is frowned upon in Silicon Valley. An early angel investor might be permitted to sell their stake but for VC funds it would be seen as a terrible lack of confidence to follow suit.
Something has to give, says Mr Kupor. “Either companies start to go public on a reasonable timeframe or people do start to say, ‘Look, let’s create a fully formed secondary market.’”.
If long-term institutional investors could do with cash, so too could lower-level employees who chafe at living in the San Francisco Bay Area, one of the most expensive housing markets in the world. They might have significant paper wealth in shares but modest salaries. Secondary share markets have developed and act as a release valve.
Companies typically allow staff to sell a portion of their vested stock periodically — typically 10-20 per cent — during a funding round. Institutional investors, however, bridle at senior executives wanting to take out large amounts. Says one venture capitalist: “I’m OK with you taking $1m, $2m, because it’s got bloody awful to live here and you need that to go buy a house. When you take $10m, even though you have 90 per cent of your shares, I worry that it gets to a ‘you win, I lose’ scenario.”
For rank-and-file employees, as the gaps between funding rounds lengthen, the secondary sales become less common and the pressure for an IPO, which would allow employees to finally get some cash for their stock at a market price, is building.

Public pressures

After the last major tech boom in 2000 the main driver of IPOs had nothing to do with money. A rule from the Securities and Exchange Commission required private companies with more than 500 shareholders to publish accounts, at which point a number of companies, including Google, decided they may as well go public. Its 2004 IPO filing said: “Our growth has reduced some of the advantages of private ownership.” It also pushed Facebook towards its IPO in 2012, but that same year Congress passed the Jumpstart Our Business Startups or JOBS Act, which raised the bar from 500 to 2,000 shareholders and excluded employees from the tally.
Another non-financial impetus has weakened too: the razzmatazz guaranteed by an IPO often raised a company’s profile, but the likes of Airbnb and Uber have created strong brands without going public. It is questionable that they will generate much new business on the back of IPO marketing or change the opinions of those investors deterred by their multiple legal battles.
However, for groups whose business is selling to the government, or other companies, the imprimatur of being public and having regularly audited accounts still matters.
“Silicon Valley is a black box,” says Aaron Levie, chief executive of Box, the cloud storage company that went public in January 2015. He says going public ends that secrecy and reassures prospective partners. “Customers want to make sure you’re building a durable, viable company.”
A final reason has stayed fairly constant: acquisitions. As initial products mature, tech companies need to find new growth, which is sometimes easier to buy. Even the flushest unicorn, however, lacks billions of dollars for big purchases. It could attempt to use its own private stock but battle-scarred investors say that is difficult.
“It’s just much harder,” says Mr Kupor of Andreessen Horowitz. “Because 90 per cent of the negotiation is not just ‘I have to figure out what you’re worth’, but ‘you have to figure out if I’m worth what I say I’m worth’.”
It is much easier when there is a publicly traded currency to use, as Facebook did, buying Instagram for $1bn on the cusp of its IPO in 2012 and then WhatsApp for more than $19bn in 2014.

Waiting game

It is possible to keep extending the private lives of US tech companies, but the betting is that the biggest names are approaching a tipping point. Snap — parent of messaging app Snapchat — has hired bankers in preparation for a $25bn IPO next year. Jockeying between bankers is well under way for the Uber IPO that will dwarf the rest amid a growing expectation that in 2017 and 2018 a number of the big companies will list.
The wait might not be all bad. Mr Levie of Box notes that five years ago lower quality companies used to opt for an IPO, poisoning sentiment about the broader venture-backed ecosystem. “The counter is you get more Zyngas and Groupons [whose stocks boomed and busted as business model weaknesses became apparent]. Because when you are not ready to go public, taking that decision is far more corrosive for the Valley.”
Colin Stewart, head of technology capital markets at Morgan Stanley, says by the time the likes of Uber come to market: “The concentration of quality will be among the highest — companies will be bigger, more scaled and either close to profitability or profitable.”
At the same time, the idea that the public markets are a hostile place is overdone. Tesla Motors, Netflix and Amazon boast sky-high valuations despite meagre profits. Most popular tech companies can command premium voting rights for their founders, which shield them against unwanted takeovers or activist attention.
Some will shy away from an IPO because they are not offering the sort of growth story that public market investors demand and opt for other transactions like a private sale.
A Palo Alto-based managing director at one of the biggest global private equity groups claims to have been approached about acquiring three separate unicorns.
There also remains a handful of implacable holdouts. Asked whether he still gets investment bankers knocking on his door, Mr Goodnight of Sas Institute thinks for a moment. “We get a stray letter once in a while, saying: ‘I have a client who wants to invest in you’,” he says in his Carolinian drawl. “We have a special file for that. It’s called the trash can.”

The operator of messaging app Snapchat has hired banks led by Morgan Stanley and Goldman Sachs in preparation for an IPO that could take place as early as the first half of next year, with an estimated valuation of more than $25bn. Last private valuation: $18bn
The ride-hailing app has said it wants to stay private as long as possible but concedes that an IPO will occur in the next few years. Banks are trying to cozy up to the company by providing debt financing and employee stock plans. Last private valuation: $68bn
The Swedish streaming music service is expected to go public in 2017. A debt financing deal this year included a provision giving lenders a bigger cut of equity the longer an IPO was delayed. Last private valuation: $8.5bn
The online file storage service has struggled to develop new products. Growth will be needed to attract investors at an IPO. Last private valuation: $10bn
Established 12 years ago, the data mining company is old by the standards of today’s unicorns. A need for secrecy given its relationship with the CIA is said to have impeded an IPO, but restless employees and investors might make it more likely. Last private valuation: $20bn
The room sharing site is one of the last to raise a big funding round, allowing it to defer an IPO until probably 2018 at the earliest. It also needs more certainty over legal threats. Last private valuation: $30bn


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