Valuation, not regulation, is what held Silicon Valley IPOs back
April 22, 2017
For years, Silicon Valley venture capitalists have said that onerous regulations are holding back companies from going public. If the recent market is any indication, those complaints are alternative facts — if not fake news.
Tim Draper, the tech investor who backed the likes of Hotmail and Skype, once told me he no longer even wants his startups to file for IPOs. That makes sense, since he made a tidy bundle selling those companies to Microsoft and eBay, respectively, instead of to the public markets.
And that’s the crux of the issue: It’s not over-regulation that’s been holding companies back. It’s overvaluation.
Until recently, selling companies has often been more lucrative and less arduous than prepping them to go public. Think of Google buying Nest for $3.2 billion, or Facebook shelling out $19 billion for WhatsApp. Venture investors made out handsomely in those deals, without the uncertainty of guessing what finicky shareholders might pay.
As it turns out, they had good reason to worry. Last week, Cloudera set an estimated IPO price of $12 to $14 per share; in 2014, it valued itself at more than $30 per share. Square’s $2.9 billion IPO valuation was far below its highest private valuation; only recently has its market capitalization climbed above that $6 billion mark. Snap, the parent of Snapchat, has struggled to stay above $20 per share, down 23 percent from its IPO price.
“What you see are these artificially inflated unicorns having to take huge haircuts with an IPO,” said Laura Huang, an assistant professor of management at the University of Pennsylvania’s Wharton School.
This year, about 45 companies have gone public or were acquired at prices significantly below their private valuations, according to research firm CB Insights. Nine of those companies were unicorns — startups valued at $1 billion or more on paper. Zirra, an Israeli data firm, estimates that the 20 most valuable unicorns, including Uber, Airbnb, Stripe and WeWork, are overvalued by an average of nearly 27 percent.
It’s typically the employees who get hurt in those circumstances, since investors protect themselves with terms that compensate them with more shares if a company fails to live up to its IPO price. (Founders and employees typically hold common stock and lack such protections.) Even though Square went public at a lower valuation, its investors managed to make money in the deal, thanks to such protections.
Regulation is often the favorite bogeyman for business. If only the feds would allow the free market to do its thing, the economy would thrive, goes the argument. But regulation doesn’t seem to have much to do with whether companies go public.
This year there have been 36 IPOs, a 177 percent jump from the same point last year, according to Renaissance Capital. Last year was slow for IPOs, especially in Bay Area tech. But not much has changed on the regulatory front. So what gives?
“Companies with high private valuations were waiting for revenues to catch up to allow them to avoid” taking a cut in price, said Matthew Kennedy, an analyst with Renaissance Capital.
In fact, IPO regulations were eased five years ago, when President Barack Obama signed the Jobs Act, designed to help companies raise capital and go public more easily.
The law made it easier for companies to go public, said Michael Zuppone, who chairs the securities and capital markets practice for the Paul Hastings law firm in New York.
But instead of encouraging startups to go public sooner, it had the opposite effect. Companies used to have to start filing financial disclosures when they reached 500 investors, whether or not they were publicly traded. That prompted many companies to go public, reasoning that they might as well raise money in an IPO if they had the same disclosure burdens anyway. By raising the limit to 2,000 investors, Congress removed that incentive.
The Jobs Act also allows companies to stay private for longer by letting them raise money from a larger range of private investors, like corporations, private equity, mutual funds, endowments and pension funds, Zuppone said.
So the law meant to get companies to file IPOs actually allowed them to avoid going public, while getting happy and fat on private cash and concentrating returns among private investors.
Hence the proliferation of unicorns. Huang said companies started seeking that label, along with the sky-high valuation it implied, to market themselves and attract the best talent.
“Your success is dependent on your intake of resources,” said Scott Sonenshein, a professor of management at Rice University. “When you are surrounded by all of these signals that measure success, you start to play these games.”
“You are not a real business unless you have a big office,” said Sonenshein, author of “Stretch: Unlock the Power of Less.” “That building isn’t good enough because (you) look at the guy down the street and his building is bigger. It never ends until no one is at the door with a lot of cash.”
And that’s the problem. Staying private works until it doesn’t. Some highly valued companies, once touted as IPO candidates, have seen their billion-dollar valuations vaporize. Remember One Kings Lane, which raised more than $225 million to build a home-goods empire? Investors like Kleiner Perkins would probably rather forget that it was sold to Bed Bath & Beyond for a pittance. An earlier, smaller IPO might have done better.
It’s easy for Silicon Valley to blame government bureaucrats instead of its own hubris. But the reality is that an IPO is just another business deal, with someone buying and someone selling. The price is what determines whether a Wall Street debut is a day of celebration … or of reckoning.