Startup Funding

May 16, 2019

There’s been lots of talk recently about the coming influx of millionaires in the Bay Area. Of course, new millionaires are being minted as a result of large privately held tech companies going public. The biggest story out of Silicon Valley this year so far has been the Uber IPO. One of the biggest privately held companies of all time when it went public, Uber has long dominated the talk of “unicorns” in the tech sphere. Since Uber was founded in 2009, it seems like every new startup uses the phrase “the Uber of blank” in their investor pitch. The wave of IPOs this year include Lyft, Pinterest, Slack, Zoom, and PagerDuty. Rumors have been circulating about We Co. (WeWork), Palantir, and AirBnB going public this year, too.

So far, these IPOs haven’t been doing great - Uber dropped 17% in the two days following IPO, after pricing on the lower side of their range. Lyft has lost around a third of its value since IPO. Clearly public markets haven’t been taking to the cash burning unicorns as much as private markets have.

One attractive feature of being a venture capitalist, or an employee at an early-stage startup, is that you have considerable upside on the equity you own in the company, especially in the event of an IPO. Unfortunately, for many longtime Uber employees, the equity that they owned in the company has not appreciated in value since they joined the company. IPOs this year have not done a good job of convincing the venture capitalist or startup employee (such as myself) that the value of their investment will increase significantly with the initial public offering. I’m concerned that the appeal of investing in private companies for venture capitalists will significantly decrease with the wave of IPOs this year. Especially if IPOs continue to go as poorly as they have.

Perhaps the public markets aren’t fooled by the sparkle of buzzwords like “cloud”, “AI”, and “machine learning”. One indicator of this is the fact that one of the most successful high-profile IPO this year was Beyond Meat, a company that makes (delicious) vegan meat through a combination of plant-based materials and chemicals. They’re currently at 4x their IPO valuation, but they are definitely not tech.

Perhaps investors in the public markets don’t have 100 billion dollars to burn (most don’t). Public investors are inherently more sensitive to a billion dollars of cash burn every year. It’s pretty hard for a sales and trading intern to make a compelling pitch on a company that may never make a profit. In the private markets (or as some may call it, the “magical forest”), there’s a tendency to sell a “mission” or a “vision” rather than future cash flows. You could have a hotshot CEO that gives inspiring albeit poorly delivered speeches. There’s a way to manufacture non-GAAP metrics that make you look good (ie, adjusted EBITDA) and make you look like you’re growing. Executives out here in the Bay Area have this magical ability to hook you on an idea. CEOs are particularly good at pitching to private investors, but when the shares go public, you don’t get as much facetime with the execs. All private investors get to meet the CEO on a mission; public investors don’t. That’s one of the reasons why Lyft and Uber’s S1 filings are so filled with stories about the company vision, mission and values. There’s no financial value in that, but they’ve been selling the value to private investors for years, and it’s worked. Once these companies are public, they don’t get the benefit of the doubt. Subject to scrutiny and metrics galore, these companies don’t generate discounted cash flow models to the public markets’ liking.

Matt Levine from Bloomberg loves talking about how private markets are the new public markets, how companies like Forge are making pre-IPO shares more liquid, and how companies (in particular, big, high growth tech companies) are able to make most of the money they need in private funding rounds. This is very much thanks to huge venture capital funds, like Sequoia and Benchmark. Not to mention the questionable-at-best hand of the Saudi sovereign wealth fund and SoftBank’s Vision Fund.

There are several reasons companies choose to go public. (1) Historically, the primary reason has been to get funding from a broad investor base. (2) Going public provides liquidity to early shareholders (employees and VCs). (3) The publicity around a successful IPO can often positively impact a brand. For many private tech companies these days, the first and third reasons are not as relevant anymore, given that funding has been easy to come by in the private sphere and most of these companies are household names. Going public these days is more a rite of passage than a source of funding. Slack is going public through a direct listing over a typical IPO, because it doesn’t need publicity, cash, or dilution. At the same time, Slack’s executives must be wary of the additional scrutiny that going public brings.

So why is Slack still choosing to go public? I can imagine that large investors in Slack (Accel and Andreessen Horowitz) were pushing for the liquidity that the public markets provide, potentially in an effort to exit their positions. Completion of the rite of passage gives employees an ego boost, and a way to cash out. They better hope that it’ll go better than Uber’s, or they’ll be sending a warning sign to other companies trying to go public.

Things are looking bright in the private space, though. SoftBank’s Vision Fund somehow managed to allocate the hundred billion dollars worth of capital in just over two years, out of the expected four. This is a testament to either (a) the strength and growth opportunities available in their tech-heavy portfolio, or (b) a gross overestimation of the value of the companies they are investing in. As an engineer in the Bay Area, I am crossing my fingers that it’s the former. Their investors seem to think so too, and for good reason. The fund has already returned 45% net of fees to partners. The Vision fund is itself seeking to go public, which would provide some liquidity to its generally illiquid parts. After jumping through some legal and regulatory hoops, a public Vision Fund would look like Berkshire Hathaway, except with a growth-focused rather than a value-focused mindset. It’d provide proxy access to investment in private companies for the individual investor.

The Vision Fund is supposedly going for a round 2 of over a hundred billion dollars in capital allocation, after tapping out the first hundred billion too quickly. This’ll be a great driver for continued over-inflated startup valuations. This new Vision Fund is one (large) counterargument to the point that private investors could abandon their large-scale bets on startups in the future.

Only time (and more IPOs) will tell whether IPOs have a negative impact on private market funding. For now, things don’t seem to be slowing down. But given market volatility and trade uncertainty, I wouldn’t be surprised if venture capitalists are a little less enchanted by startup investor slide decks.

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