I thought to share this email response I sent to a journalist asking me if I am worried as a VC about the current private IPO phenomenon. I am not.
Her email to me is included in bold and my response is in normal font.
OK, Victoria, here are my thoughts with your email highlighted in bold.
Hi Andrew, I also was wondering if you could share with me some of your thoughts as I am working on my next Huffington Post article.
As you might know, there are now more than 100 VC-backed companies with valuations that exceed $1 billion that are still private. There was a report on CNBC this morning that VC-backed private market valuations now exceed public market valuations by 100% to 200% in many cases, making it more difficult, if not impossible, for these companies to have an IPO in the current environment. Further, many of these companies are now requiring cash, but without a public market, are having a cash crisis. It appears that many unicorns are no longer non-public by choice.
I do not agree with this. These unicorns are successfully raising amounts of cash equal to or greater than the amount one might expect them to raise in an IPO. Because they offer a senior liquidation preference to the new investors the new investors can support unusually high valuations, because the newest investor knows that she will get 100% of her capital out of the deal prior to any other investor getting their money back. At this point the new investor practically does not care what the valuation is, because they have a nearly zero risk investment that is likely to double in 1 to 3 years and they are moving a large amount of capital. In some cases the new investor could believe that they might make up to a 4x return, but the key is that the down side is very low and they may view it as zero risk of losing any capital based on how these deals are structured. In some cases to get a higher valuation the issuer (management and existing syndicate of VCs) offer the new investors a “guaranteed return” where they get a 1.2x liquidation pref before any other investors or founders / employees can liquidate anything. So they get all their capital back plus a 20% return before anyone else can liquidate giving them more confidence to up the valuation further. The twisted reality is that the founders, early employees and investors often sell some of their position into these new rounds. So when you see Uber raise $1.2bn, at a $50bn+ pre-money valuation you can believe that many insiders are selling some of their position. A VC who invested at a $40m or $250m pre-money valuation, might want to sell 20% of her position at this new $50bn+ valuation and bring her investment to a zero cost investment and possibly return her entire fund while still keeping 80% of her position in Uber for the next uptick in valuation or the definitive liquidity event for the company. I think it may make sense for some founders, early employees and early investors to consider selling 20% of their position with each major uptick in financing. You might be smart to just sell 20% every 6 to 12 months in this environment.
You mentioned that some unicorns are in a cash crunch. I’m not connected to any of those, but I wrote a blog post about not overpricing your current financing so that your next financing fails – Considerations on valuations for angel and VC financings – how to price for success. This same thinking should apply to unicorns just as it does to early stage angel and VC financings.
Andrew, Is this your sense as well? As a VC, are you concerned? Also, in retrospect, do you feel that the recent trend of D+ and higher rounds has been a mistake since many good companies did not conduct an IPO when the environment on Wall Street was more favorable and their valuations were not as difficult to support?
No this is not my sense. I do not agree with what you are suggesting and I am not concerned. IPOs are expensive, time consuming, a huge distraction from growing the business and ongoing compliance is a drag for a high growth technology startup. Sarbanes-Oxley and a downturn in the economy were the initial cause for startups to stop going for IPOs. M&A became the only path to liquidity for founders and their investors. Then the private IPO phenomenon arrived. Capital that used to go into an IPO started to go into later stage pre-IPO financings. We witnessed Fidelity and Carl Icahn investing in financing rounds of $100m+ or in the case of Lyft $630m. That is enough money to achieve many of the core objectives of an IPO without the unattractive burden of an IPO and ongoing compliance. These huge financing rounds provide founders, employees, angel and VC investors with liquidity. The company gets the capital it needs to become global dominating world beating companies and expand their business. The new investor gets security via the “structured” nature of the liquidation preference. The company does not need to comply with the painful regulations our incompetent government officials have put in place. What you will see is that most of these unicorns will “grow into their valuations” over time.
Another driver for all of this mega-financing of private companies is the entry of many new players now investing in growth stage financings. Essentially the class of investor that used to invest at and after an IPO has entered the private market. We have seen an increase in the supply of capital for this sort of financing. I sometimes get the sense that for some of these investors newly arriving on the scene that the amount of capital they are investing into any one of these financings is a drop in the ocean small percentage of the pool of capital out of which they are investing. So they view the risk to be lower as the investment is a small percentage of their fund and they are in some cases “buying” their way into unicorns. I’m not impressed by someone just willing to overpay to get a list of successful startup logos on their portfolio page, but that is happening for sure. Later stage growth has become a crowded segment of the market and the supply / demand dynamic favors the issuer not the investor. I would also argue that this growth segment is at far greater risk of an economic downturn than early stage venture capital, which might benefit from lower investing valuations and a recovered economy by the time their portfolio companies crystalize liquidity events.
A final point I will make is that 70% of the dollars that are perceived to be going into the venture capital system are actually going into the pre-IPO phenomenon. This means that there are 70% fewer dollars in the system and that we are not right-sized with correct amount of VC dollars chasing deals to invest in. There are more good deals and not enough actual VC dollars to fund the good ones. So now is a great time to be a VC, invest in a VC fund or found a startup. My fund Rubicon Venture Capital is very well positioned to benefit from this private IPO phenomenon and supply / demand dynamic of VC dollars to high quality deals seeking funding. VCs in this context do well in the current boom economy where we can liquify / sell into financings at super high valuations and we also benefit when a market correction / downturn arrives.