Tucked away in southern San Francisco is a place that thousands of technology startup companies call home. Silicon Valley, a global hub of innovation and entrepreneurship, has been built on the foundations of venture capital firms and tech startups adhering to a conventional roadmap to success. The roadmap for a tech startup used to begin with an infusion of “seed capital” from specialist venture capital firms. As the startup grew and matured, it would receive more infusions of capital at the discretion of those firms. The end goal was to eventually IPO to grant the company access to larger pools of public capital and lend itself credibility. Yet winds of change are blowing in Silicon Valley, as capital floods the private market, also known as the pre-IPO market, a market that facilitates investments into startups beyond traditional venture capital. Today tech startups are finding it more attractive to delay the IPO for up to a decade, and instead raise money in the private market.
Rise of the Private Market
The overall tech investment from venture capital firms reached US$66.5bn last year, double that in 2013. This current tech boom is not unlike the dotcom bubble at the turn of the millennium, with torrents of hot money flowing into new tech startups. However, this time round the money is flowing in the form of private money through “late-stage financing rounds,” as opposed to public money through a stock exchange. It appears investors no longer care about the detailed financials of the companies they are investing in – and in some cases, those companies haven’t even generated any revenues yet – but are so caught up in the frenzy of potential sky-high returns that they can’t help but get their foot in the door early. And it’s no longer exclusive to venture capital firms; traditional asset managers like Fidelity and Blackrock are keen to jump in the game by investing in companies like Pinterest, Dropbox and Uber.
Mind the Valuation Gap
This has led to a phenomenon where there are too many monks for too little porridge, as a glut of private capital from venture capital firms, mutual funds and hedge funds looks for opportunities that are few and far between. As a result, private valuations of tech startups have skyrocketed to soaring levels, in some cases surpassing their public valuations. For example, big data company Hortonworks was valued at US$1bn in its final private financing round last March, but eventually priced its shares at US$538m in its December IPO. Another cloud storage company Box recently floated at US$14/share, valuing the company at US$1.7bn, compared to its last private valuation of US$2.4bn. A case could be made that that the public valuation will eventually rise to meet the private valuation, as public markets need time to familiarize themselves with newly listed startups, and understand the true potential of these companies. This certainly appears to be the case for Hortonworks, as its share price has risen wildly over the past two months to over US$20/share, valuing it at over US$950m, close to its final private valuation of US$1bn. However, it could also be argued that having spent so much time in the private markets, these companies have reached their valuation limit and are already mature by the time they float. They are thus no longer ideal for the public investor seeking sky-high returns, like the rise of Google stock from US$85/share in its 2004 IPO to over US$550/share today.
The major issue with private finance is the lack of transparency in disclosure regulations of company financials. Private companies don’t have to go through the arduous due diligence process in an IPO, which can often drag on for months as investment bankers, lawyers and auditors analyse every single digit and word in company filings. This translates to a massive leap of faith for investors into private companies, as they could be investing into companies that generate no revenues or even operate at a loss, which is often the case for tech startups. Furthermore, the lack of transparency allows the startups to abuse the funds they receive without the investors knowing. On the other hand, individuals have no access to the private markets and are thus shielded from the effect of any startup bubble burst, unlike the dotcom bubble where retail investors felt the pain directly. However, with the arrival of fund managers to the private market scene, when the burst of the tech startup bubble comes, the effects will be felt by pension funds and subsequently: the average household.
Eager to secure a slice of the pre-IPO market pie, Nasdaq set up Nasdaq Private Markets (NPM) in March last year, while NYSE entered a strategic relationship with information provider VC Experts and transaction management platform ACE Portal last July. Tech startups that use the private market services of these exchanges are also likely to stay with them when they eventually go public. The new tendency of tech startups to stay private for prolonged periods appears to be a regression from the transparency and efficient capital allocation of the public markets to complacent opacity and private fanfare; it is easy to build an outlandish valuation based on opaque financials and assumptions on growth and operating margins. Will the tech startup private finance bubble burst? Maybe, maybe not. But when all the sheep are scrambling to get somewhere, wisdom says to think twice instead of blindly following the herd.
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