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Felix Salmon, the king of financial bloggers, has a big story in Wired this month about tech IPOs. We were excited because Felix is a very smart guy and company financing is one of the things we think a lot about and have written about.
(Update: Felix responds here.)
Felix points out that the tech IPO market is broken (he’s right) but instead of trying to come up with ideas to fix it, he says we should do away with it altogether. This is because financial markets demand quarterly performance and are full of algorithmic traders. And entrepreneurs only want to go public because they raised VC money, and VCs are greedy bastards who pump companies up to the moon until they go IPO and then let them crash and burn.
There are many things wrong with Felix’s story, but they boil down to two problems:
- Felix doesn’t understand breakthrough technology entrepreneurship.
- Felix does understand the role financial markets play in financing technology entrepreneurship, but bizarrely draws the opposite conclusion from where his correct premises lead.
Let’s get into it.
First, Felix notes that Mark Zuckerberg isn’t thrilled about taking Facebook public, and is only doing it so his investors can get a payoff.
Then he does a good panorama of how important the financial markets have been to financing innovation in the US, and how that system was broken by the dotcom crash and regulations:
For roughly 65 years—say, from 1933 to 1998—the initial public offering was the engine of American capitalism. Entrepreneurs sold shares to investors and used the proceeds to build their young companies or invest in the future. After their IPOs, for instance, Apple and Microsoft had the necessary funds to develop the Macintosh and Windows. The stock market has been the most efficient and effective method of allocating capital that the world has ever seen.
That was a useful function, but it’s one that IPOs no longer serve. Going public is more difficult than it used to be—Sarbanes-Oxley regulations have made filing much more difficult, and today’s investors tend to shy away from Internet companies that don’t have a proven track record of steady profitability. That has created a catch-22: By the time a company can go public, it no longer needs the cash.
Felix also notes that the goal of an IPO now isn’t so much to finance a new company as it is allowing an already existing company (and its shareholders) to get liquidity.
But Felix strangely says that this is a problem not because companies have fewer financing options available, but because VCs are evil. If you’re a VC, “your profits don’t accrue to the company itself, which could implode after your exit for all you care.” And this is why VCs “invariably force the companies they invest in to take outsize risks.”
And this is where Felix gets completely off-track, citing Groupon as an example:
Look, for instance, at Groupon. In the first quarter of 2010, it made a profit of $8 million on revenue of $44 million. That’s a healthy profit margin for a young company, and it’s easy to see how it could have grown steadily from that point onward.
But in the first quarter of 2011, Groupon’s revenue skyrocketed to $645 million—an increase of 1,357 per cent in one year. Meanwhile, the once-profitable company was suddenly faced with a loss of $146 million. In one quarter. The reason for the reversal? Groupon, with the full support of its VC backers, juiced revenue by spending gobs of money on marketing, sacrificing profits for growth. That’s an enormous bet: If the company grows fast enough, everyone gets extremely wealthy—but if it stumbles, it can quickly wither.
Oh boy. So many things are wrong with this.
First of all, historically, it’s the company’s founders, especially Eric Lefkofsky, who bet all on growth and then found VCs to give them the cash to execute on that plan. (Many of whom turned them down for taking too much risk.) Felix sort-of acknowledges this, saying that Groupon did this “with the full support” of its VCs, instead of being “invariably force[d]”. (In Felix’s telling, VCs “invariably” do something except in the example he cites to buttress his case that they “invariably” do something.) (If you want to know more about Groupon’s founding, you can’t do better than our Nicholas Carlson’s groundbreaking reporting on the company’s history.)
But the Groupon example isn’t just wrong because of these historical details, it’s wrong because it shows that Felix doesn’t understand the nature of breakthrough technology startups.
Breakthrough technology startups are different from other kinds of businesses in that they either create a new market or violently disrupt an existing one. This means that they almost invariably require to spend lots of capital in order to stake out a defensible market position against their numerous competitors. In particular, many technology markets have winner-take-most or winner-take-all dynamics, either because of network effects or economies of scale.
Tech startups very often have Glengarry Economics: first prize is a Cadillac, second prize is a set of steak knives, third prize is you’re fired.
What does this mean about Groupon?
Felix writes that Groupon had a profitable Q1 2010 and “it’s easy to see how it could have grown steadily from that point onward.” Except that given the characteristics of the daily deal business, particularly the need for scale, what would have happened if Groupon had tried to “grow steadily” and profitably, is that the company wouldn’t be around anymore.
It’s LivingSocial that would have raised over a billion dollars and be worth $10 billion today, Groupon would have been sold for scrap like BuyWithMe and plenty of other daily deals also-rans, and Andrew Mason would be back to doing yoga on YouTube. Groupon would be a footnote.
This is why VCs exist. Not to fund some type of Ponzi scheme (these types of VCs don’t make money anyway, as the industry’s crisis shows), but because some types of market opportunities, and therefore some types of companies that go after these markets, are of the “go big or go bust” variety.
Did you know Amazon wasn’t the first online book retailer? It was a small company called Wordsworth. They tried to take the “steady” road to profitable growth Felix describes. Wordsworth isn’t around anymore. Amazon is around, and it’s one of the biggest companies in the world. And it was unprofitable for its first eight years of operation. Why? Because e-commerce was a gigantic new opportunity that required spending tons of money to achieve a market leadership position in a “land grab” era and enough scale to run profitably. Many people called Amazon a fraud, and we don’t hear too much about those guys anymore.
Felix then notes that plenty of VC-backed companies fail. That’s true. Then again, plenty of companies fail. That’s how capitalism works. Maybe VC-backed companies fail more than regular companies, because they take more risk. Felix doesn’t try to argue that, and I don’t know if it’s true. Maybe it’s true. But even if it were, Felix gets the causal relationship backwards. If VC-backed companies fail more, it’s not because VCs push their portfolio companies to take more risk, it’s because the kinds of companies that come with more risk (and more reward) are the kinds of companies that will need VC backing.
If one criticism (which Felix doesn’t make) could be leveled at the VC system, it’s that VCs back too many companies that shouldn’t raise VC, and too many “me-too” companies that go after the same opportunity. Many people think the VC industry has gotten too big. But of course, this problem is solving itself, as the VC industry is in a secular fundraising decline.
Felix also notes that according to a study, most of the fastest-growing (in revenue) companies in the US aren’t venture-backed. Here’s the thing, though: you haven’t heard of most of those companies. Not to diss any of them, which we’re sure are great businesses founded by great entrepreneurs, but when you take the world-changing companies, the ones that come up with radically new products and create new markets or disrupt existing ones, almost all are venture-backed. Those are the breakthrough technology companies. There’s nothing wrong with other kinds of companies. But breakthrough technology companies operate in a specific way which means they will have a huge appetite for capital, which means they’ll need VC and IPOs.
Photo: LinkedIn via Flickr
As we saw earlier, Felix realises that financial markets have played a tremendous role in funding innovation in the US, and that this system is now broken. But instead of wanting to fix it, Felix wants to do away with it altogether. He encourages companies to grow slowly and profitably. (For the most innovative businesses, as we’ve seen, that’s not possible.)
And if they really, absolutely must have access to capital, they should go through the private markets:
But if private markets currently serve as a way station on the road to an IPO, in theory they could end up replacing the IPO altogether. That would be a boon for most companies. Because these markets restrict the number of times a company’s stock can be traded, they avoid the problem of overtrading. In public markets, high-frequency algorithms can trade in and out of a stock hundreds or thousands of times a day, making tiny profits and losses on each transaction. They neither know nor care what the company does; they just trade the flows. At the same time, billions of dollars flow in and out of passive instruments like index funds, which buy and sell a set group of stocks. The result is that we’ve recently seen record highs in market correlation—stock prices driven by broad market movements rather than by any unique qualities of the companies themselves. The private markets remove those factors, meaning that share prices rise and fall based on a company’s unique prospects, not just on global trends over which it has no control.
This is all misguided or irrelevant.
High-frequency trading may or may not be a good thing from a financial markets perspective, but how is it relevant to how a CEO runs his business? There’s no obvious impact of HFT to stock volatility or stock returns.
As for saying that private markets could allow stock to trade regardless of global trends—please. By definition, any market which would be deep and broad enough to allow large tech companies to finance themselves would be made up of investors who would sell Facebook and Twitter and Zynga on news of a financial crisis in Europe or unrest in the Middle East. That’s how investors are. If the euro breaks up, you don’t think there’s going to be less demand for private internet company stock? (And justifiably so, by the way, because it will impact their future earnings potential and therefore the net present value of their future cashflows.)
And actually, this shows why Felix’s argument for the private markets breaks down: if private markets were big enough, liquid enough, deep enough to replace the financial markets, then they would just be…the financial markets.
Felix’s argument boils down to: “The IPO is bad for tech companies, therefore we need to replace it with something that’s exactly like the IPO, but let’s just not call it the IPO.”
Don’t get us wrong, we have nothing against private markets, but they’re an answer to the problem which is the broken public markets.
Photo: LinkedIn via Flickr
The broken public markets aren’t just a problem for tech companies, they’re a problem for everyone else. They’re a problem for the world because they make it harder at the margin to start and run tech companies, and therefore we enjoy less or more expensive products and services. They’re also a problem for the world in a more specific way, which is (and we seem to remember Felix worrying about this, though he doesn’t anymore) that most of the returns of the growth of innovative technology companies used to accrue to the investing public, instead of VCs and other late-stage investors who are rich people or invest on behalf of other rich people like endowments. It may be no coincidence that the stock market has been broken since the 00s and that it’s been anemic since. And this isn’t bad just for bankers, but for all of us since our pensions are directly or indirectly linked to it.
To figure out how to fix it, let’s look at the Good Old Days. Here’s VC godfather Alan Patricof, who we’ll quote at length because it’s such a great quote:
On October 13, 1971, Intel Corp, a manufacturer of semi-conductor memory circuits went public with a common stock underwriting of 350,000 shares at $23.50 per share for a total of $8.225M and for a post money value of $58M.
In the previous six months the company had revenues of $3,978,000 and profit before extraordinary items of $93,000. This offering included 42,000 shares for selling shareholders.
There were 64 underwriters in the group of which only 5 remain today as an independent entity with the original name […]
On April 18, 1972, CE Unterberg Towbin also took Datascope Corporate public, “a company engaged in the design and development of medical instrumentation” with an offering of 105,000 shares at $19 per share raising $2,011,000 of which $977,000 went to selling shareholders.
The company post offering value was $9M. There were no other underwriters. In the previous six months Datascope had revenues of $973,000 and a profit after full taxes of $130,000.
In 2009, Datascope was sold to a Swedish company for $865M and had reported annual revenues at the time of $230M. Intel recently reported revenues for their third quarter ended September 30th of $11B.
To add further to the flavour of what the public markets and IPOs were like: In 1972 Storage Technology went public with an offer of $13M; In 1976 Four Phase Systems raised $15M and Cray Research raised $10M; In 1977 Tandem Computers went public raising $9.4M and in 1980 Sci-Tex raised $6.8M.
As recently as 1986 Adobe had an IPO raising $6M. None of these companies could have gone public in today’s environment even adjusting for inflation. [Emphasis ours.]
There are many reasons why this couldn’t happen. Sarbanes-Oxley and other regulation is obviously one factor. Skittish investors, still scarred by the dotcom bust, are another. The lack of boutiques to underwrite and sell small IPOs is another.
The point is that this is what we should be going back to. Small, quick, easy IPOs relatively early on in a company’s life, where it can then tap the financial markets to keep funding its growth and have access to all the perks of going public. VCs can and should be along for the ride even as the company goes public, holding preferred shares and board seats. (Well-intentioned insider-trading rules make it more difficult for public companies to have these sorts of “anchor investors”, as Reihan Salam convincingly argued in The Daily, but that’s the point: those are the problems we should focus on.)
Entrepreneurs say they don’t want to go public because of the demands of the quarterly reports and Wall Street analysts. To which we say: oh please, grow a pair. Steve Jobs wasn’t scared by quarterly reports. Neither is Jeff Bezos. Bezos recently decided that Amazon needed to go back into “investment mode” to go after huge opportunities like cloud computing and the kindle content/devices ecosystem, crushing the company’s profits and sending the stock into a tailspin. What happened then? Nothing. He’s still doing what he wants. (Or not: we have nothing against remaining private forever. It’s what Michael Bloomberg did. But we do believe it would be better for entrepreneurs, companies and society if the early IPO were the route for most tech companies.)
It’s worth noting that the VCs Felix bashes in his piece actually love the new status quo. As companies stay private longer, they can capture more of the value they create (as opposed to the public) and can get early liquidity through the secondary markets. A world where the early IPO was the norm would be a world where VCs might generate much better returns (because they’d get more exits) but would have to be smaller (because they’d be smaller). For more on this phenomenon, read this post of ours on “superangels.”
In terms of capital flexibility, nothing beats being public. It’s much easier to raise equity and debt capital. You can use your stock for acquisitions. And in other countries, it happens a lot. Xero, a software-as-a-service accounting firm in New Zealand, uses its early IPO as a weapon. Here in Paris there are plenty of public tech companies with 7 and 8 figure revenues.
Allowing tech companies to go public more early and more often is going to be hard. We have to do more than simply slash a bunch of dumb regulations (though we should certainly do that). But that’s the direction we should go, and it’s the opposite where Felix wants to go.