We saw in the second part of this series that, when casting around for new frontiers, today’s generation of start-ups benefited from significant support from central banks and governments to fund ambitious and visionary strategies. This article shows that easy access to cheap capital has led financiers and entrepreneurs to adopt very distinct behaviors from those witnessed twenty years ago.
Q4 2019 hedge fund letters, conferences and more
In the dotcom era, one way VC backers engineered artificially inflated valuations was by introducing their portfolio companies to the public markets and creating first-day pops with the cooperation of bankers sponsoring IPOs. The practice saw many equity analysts grant a Strong Buy or Market Outperform rating to stocks they privately described as “a powder keg” or “a piece of junk.”
Because of regulation introduced post-dotcom crash, today’s stock markets are not so easy to manipulate. Although when the veil is lifted on today’s bubble, perhaps will we get to read the subpoenaed email exchanges of research staff at JP Morgan, Goldman Sachs and Morgan Stanley - all sponsors to WeWork’s IPO - and find out what they really thought of it.
Public Markets Can Wait
Between 1994 and 2000, over 3,000 IPOs took place. The intriguing fact is that the average first-day stock return went from +8.6% in 1994 to +70.9% in 1999 and +57.3% in 2000. The first-day pop record was held by open source developer VA Linux, which saw its stock rise 733% on December 9, 1999.
The thinking behind many a dotcom listing was to keep funding growth. At the time, late-stage VC firms managed smaller funds and could not invest sufficiently large tickets to scale up portfolio companies. Today, Sequoia’s flagship fund has $8 billion of commitments. In 1999-2000, the firm had raised three funds, each with a size comprised between $350 million and $700 million.
Public markets were necessary to inflate start-up valuations. Between 1995 and 2000, the Nasdaq Composite index rose 400%. It posted an 85% gain in 1999. Some individual stocks lost touch with reality - chip maker Qualcomm’shares rose 2,619% that year.
The Big Long
Nowadays, first-day price increases are very tame. The way VC firms fill in their pockets is by inflating valuations in the years leading up to an exit, keeping the largest extent of the value expansion under wrap by holding onto their investees a lot longer. It is much harder to register a 50% or 100% pop when a company lists with a multibillion-dollar price tag, as Facebook, Snap and Uber did.
Yet recently floated start-ups are not of better financial standing. Over 80% of Internet start-ups going public in the late 1990s were loss-making in the year preceding their float. The same proportion applies to the current generation of tech IPOs.
But transaction volumes are also much smaller. In 2019, there were 159 flotations in the United States, one third as many as there were twenty years earlier. It is not for lack of appetite from public investors. It is because venture capitalists realized that, in the past, they left too much money on the table by selling too early.
Apple listed in 1980, four years after its inception, at a $1.5 billion valuation. Amazon’s 1997 IPO gave it a headline value of $438 million less than three years after launching. These market capitalizations are laughably puny when you consider what these two tech behemoths have become.
Under the supervision of venture capitalists, unicorn founders have pushed valuations while still in private hands. WeWork’s price tag went from $5 billion in December 2014 to $47 billion four years later - a very respectable 840% increase over the period.
Investors are playing the long game. They hold onto assets for a decade or longer. Facebook was VC-backed for nine years until its $100 billion IPO. Uber listed at an $80 billion valuation ten years after being set up. Airbnb, due to float this year as a decacorn, was started 12 years ago.
Thus, for the most part, the bubble has been privatized. The danger for VCs is that, if they fail to convince public markets eventually to take full custody, they might be caught holding hot potatoes when the cycle ends.
The Costa Concordia Syndrome
Partly due to the emergence of unicorns, today’s entrepreneurs have learned to bag in part of their gains. They know that the party will not last forever.
Adam Neumann pocketed $700 million in the months leading up to WeWork’s failed IPO last September. He could make even more following his defenestration. Secondary sales of founders’ stakes are becoming widespread. That was not the case in the dotcom days, when many start-up entrepreneurs and employees held onto their stock until the bitter end.
The growing trend of seeing founders of overhyped businesses partially exit is the equivalent of a captain fleeing a sinking ship prematurely. Let’s call this the 'Costa Concordia syndrome', after a ship that ran aground off the coast of Tuscany in 2012. Her captain shamelessly departed, leaving hundreds of passengers on board. Resulting in 32 deaths, the incident led the captain to prison.
Entrepreneurs behaving in a cowardly manner by selling part of their holdings before VC investors have monetized their gains do not risk any jail term, but the practice raises similar concerns around negligence, dereliction of duty and, maybe, corporate manslaughter if their boats eventually overturn.
One of the arguments brought forward is that these individuals need to diversify their risk. But as Warren Buffett rightly explained: “diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.”
In principle, now that the time to liquidity has stretched out considerably, there is some justification in allowing unicorn builders to cash in a small stake to finance personal projects. But if they amount to hundreds of millions of dollars, when combined with indulged visions of global domination, these vast sums can encourage inexperienced - at times immature - entrepreneurs to browbeat or ignore investors.
Control Freaks
Indeed, recent case stories demonstrate that some unicorns have adopted shabby governance.
Opening up the shareholders’ register to the public upon an IPO does not mean that founders relinquish control. They are not willing to follow the example set by Bill Gates and Jeff Bezos, who lost significant voting power at the same time that they were cashing in. The new maestros of powerplay want the best of both worlds - becoming wealthy while still yielding unrestrained influence on their firms’ destiny.
Critics partly assigned WeWork’s Neumann’s sacking to his insistence on holding super voting stock, yet a multiclass voting structure is common for tech firms. Upon IPO in 2017, Snap famously issued stock to public investors that granted the latter no voting rights whatsoever. Facebook and Google among others have issued classes of shares with limited voting rights. This practice was rare twenty years ago. It is the default setting of the unicorn going public.
In the next part of this series, we will draw the lessons learned from the dotcom and unicorn eras
