Posts from Initial public offering

There is a lot of sturm und drang out there in the worlds of social media, finacial media, and just plain media about all the lockups coming off and all the insider selling going on in some big internet stocks. As someone who has played this game a few times, I tought I'd post some thoughts about this.

First and foremost, this post has nothing to do with what USV has done, might do, or is thinking about doing with specific stocks we might own or not. That's a disclaimer for those who aren't familiar with one.

When a venture backed company goes public and is worth billions (or even hundreds of millions), the investors who provided the early capital to that company are going to be sitting on a lot of stock. They can easily own 15-20% or more of these companies. But even if they own less than 10% (as Accel Partners does in Facebook), they can be looking at billions of dollars of value.

It is an investors job to return capital. I will say that again. It is an investors job to return capital. That is how we are measured. Paper gains are fine. But at the end of the day, an investor will be measured by the amount of cash or liquid stock they return divided by the amount of cash that was invested in their fund. A multiple of three is good for a venture capital fund. A multiple of five is great. A multiple of ten is once a decade.

When an investor is looking at a single holding being worth three, five, or possibly ten times their entire fund, you can be sure they are looking to lock in that gain. That's a recipe for fantastic performance and the downside of not locking that in is a lot bigger than the upside of another one or two times their fund size.

And then there's the question of whether venture capital firms are good public market investors and whether they should be managing/holding public stocks. I don't have any hard data here, but my anecdotal data says that we are terrible public market investors. That is why many VC firms have a policy of moving the public stocks out of their portfolios as quickly as they can.

I think that is a good policy. Venture capital is about capturing the value between the startup phase and the public company phase. Others should be focused on capturing the value post the public offering.

So let's go back to the expiration of lockups and the waves of insider selling that result. This is to be expected and in fact is expected by the public markets. Look at all of the short positions that get built up in the locked up newly minted public companies in the weeks before the lockups come off. Investors know that a ton of stock is going to hit the markets and they make bets that it will impact the stock price and in most cases it does impact the stock price. As JLM likes to say "this generation did not invent sex." This has been going on since I got into the venture capital business in the mid 80s and I expect its been going on for a lot longer than that.

So to all the folks out there who are shocked and outraged at all the insider selling going on, I would suggest they park their outrage at the door of capitalism. Those who took the risk of losing all the capital they bet on 20 year old Mark Zuckerberg are entitled to their return. And they will get it. And anyone who thinks otherwise has their head in the sand.

Jeff Bussgang asks an interesting question on his blog.

He suggests that the lack of NYC tech IPOs compared to Boston is a result of:

• The IPO culture hasn’t fully permeated NYC?  There are only very few public technology companies based in NYC:  I count AOL as the only one with > $1 billion market capitalization, whereas Boston has 30-35 innovation economy companies with greater than > $1 billion market capitalization.  Perhaps Boston CEOs, CFOs and boards feel more pressure to go public sooner and/or are comfortable with the IPO process because they community has done it so many times.  Honestly, this theory doesn’t totally resonate with me as NYC is the heart of Wall Street – all the relevant bankers, accountants and advisors are there.  If any technology hub can build a strong middle market public company ecosystem, it should be NYC.
• NYC’s tech sectors are out of favor with public markets?  This theory suggests that the sectors that NY is particularly strong in – consumer, advertising technology, media – are out of favor for some reason.  Perhaps the poor performance of the Facebook IPO soured Wall Street on the consumer sector and advertising-based business models?  But then why have consumer plays like Boston-based Kayak, TripAdvisor and Zipcar done so well?  As for the adtech sector, why did DC-based Millenial Media, a mobile advertising network, have such a strong public offering if the sector is out of favor?  Again, I’m not sure this theory holds water.
• NYC companies are more sizzle than steak?  This theory is that because NYC companies are so heavily covered in the mainstream media, they are perceived to be ahead of where they really are in terms of actual business progress.  E-commerce companies like Etsy, Gilt Group and Rent the Runway get a lot of ink compared to, say, Boston-based Wayfair and RueLaLa.  But if you objectively examined their financials in terms of actual revenue scale and profitability, who is really closer to being ready to file their S-1?  This theory resonates somewhat with me.  For example, there is no TechCrunch reporter in Boston, but a number in New York and Business Insider is a strong local publication that does a nice job cheerleading for the local sector.

I would agree with all of that. Plus as Shai Goldman points out in the comments, time is also a factor:

Hi Jeff, you are missing another reason why NYC hasn't had many IPOs as compared to Boston. Many of the NYC companies that are doing well were started in 2007 or later, so it will take a few more years before they are IPO ready. The Boston IPOs that were stated in this post were started before 2007 I believe. You also forgot to mention Admeld (NYC company) which was a $400M acquisition by Google in June 2011.

I responded in the comments with this:

i think it's all of the above (including Shaig's comment about time)

NYC is a trader town. people like to trade stocks not hold stocks. so what Buddy did is more in line with how NYC folks think. Boston seems to have a long standing culture of building large public companies, like Silicon Valley.

that said, i think we have a couple NYC based companies that will choose the IPO route in the next few years. we are not in a hurry nor are they.

To me this is all about the decades it takes to build a lasting startup community. Boston has been at it since the end of World War II. Silicon Valley has been at it since the 1960s. NYC has been at it since the mid 90s. We will get there. I see it in our portfolio and all around NYC these days.

And while we are talking about Jeff's blog, let's all encourage him to get Disqus on there. He writes good stuff and I am sure he'd get more discussion with a modern comment system.

This past thursday, the Senate voted 73-26 to approve its version of the JOBS bill. The House had previsiously approved a similar bill and the process will now go back to the House to come up with a modified bill that can be approved by both the House and Senate. I hope they make quick work of that and present the bill for signature to Obama who has committed to sign it.

I suspect most readers of this blog know a bit about this bill. The three provisions that are most meaningful are the crowdfunding provision, the increase in shareholder ceiling for private companies from 500 to 2,000, and the "sub $1bn revenue IPO" provision that we discussed previously here at AVC.

I had held off blogging about the crowdfunding provision because frankly I had some reservations that I had privately discussed with friends, colleagues, and elected officials. I did not want to publicly throw cold water on this provision, but I privately hoped that the provision would be modified to help insure that equity crowdfunding of startups doesn't become a fraud infested sector of the capital markets.

The Senate added a number of measure to address the fraud concerns. This is how the NY Times described these modifications:

Under the Senate amendments, any company using crowd-funding methods must still file some basic information with the S.E.C., including the names of directors, officers and holders of more than 20 percent of the company’s shares, plus a description of the business and its financial condition.

Companies seeking to raise $100,000 or less must also provide tax returns and a financial statement certified by a company principal; those raising up to $500,000 must provide financial statements that are reviewed by an independent public accountant. Companies raising more than that must provide audited financial statements.

The Senate also inserted requirements that intermediaries seeking to help companies raise money through crowd-funding must register with the S.E.C., make sure investors are advised of the risks they are taking, and take measures to prevent fraud.

I am a huge fan of allowing every person, not the just super wealthy and institutions, to participate in the funding of startups. Frankly its a shame that the average Facebook user has not been able to own shares in Facebook during its increase in value from zero to $100bn. The same kind of thing can be said about Twitter and many other of our portfolio companies. The changes to securities regulations in the JOBS bill are fundamental and important and very much needed.

But it is also true that investors are due some basic disclosure when parting with their capital. If they choose to ignore the disclosures, then that's fine. But the disclosures should be there for them when they want it and/or need it. The Senate was wise to add some basic disclosure requirements to the crowdfunding bill. I suspect the disclosure requirements might get toned down a bit in the final bill and that is probably a good thing. Requiring an audit for a $500k seed round seems a bit nuts to me.

As for the changes to the shareholder number rule (increase from 500 to 2,000) and the regulatory relief for "sub $1bn revenue IPOs", I am ecstatic about these new rules. Our portfolio companies have spent countless hours handwringing about the existing rules. They have made important decisions based on the current rules which are unnecessarily stringent and have hampered their access to capital. These new rules are much needed regulatory relief for startup companies.

Finally, I'd like to thank our elected officials for coming together in a non-partisan way to address an important set of issues and deal with them sensibly and corrrectly. This doesn't happen enough in Washington and we need more of this. I know that the majority leadership in the Senate, particularly Harry Reid and Chuck Schumer, fought back a mini revolt among the left wing of its party to get this bill passed. I applaud them for doing that and standing up for something that was not popular in their caucus. That is leadership and I appreciate it and I am sure the readers of this blog do too.

There's a bill in Congress to reduce the regulatory burdens for public companies that have less than $1bn in revenues and/or have been public for less than five years.  The name is too long so I call it the "sub $1bn IPO bill."

This is a good bill. This undoes some of the bad stuff done to smaller public companies in Sarbox.

It should become law. I hope it will.

Here are some blog posts on this topic.

I met with a group of very experienced and sophisticated investors yesterday who make up the investment committee of a large charitable foundation that is an investor in USV. I gave them a two minute brief on our macro investment thesis (large networks of engaged users that can disrupt big markets) and then took them on a tour of some of these large networks (Lending Club, Kickstarter, Etsy, Twitter, and Codecademy).  Then I took questions.

This group doesn't spend a ton of time on AVC, Techmeme, Hacker News, or the tech industry in general. And yet the questions they asked me were as good as I ever get. I guess four decades of investing teaches you a lot.

One of the best questions I got was "when do you decide to sell?". Such a great question and such a hard one to answer. I've got scars from this one.

I explained that first and foremost, we generally don't make that call. The entrepreneur and her management team generally makes that call and the board is asked to ratify it.

But when and if we get to weigh in on the timing of the exit, my view is that you look to exit your weakest investments as soon as you can and you let your winners run as long as you can.

USV 2004 is instructive. Between 2004 and 2008, we made investments in 21 companies. So the youngest portfolio company in that portfolio is four years old now. Most are five to six years old. And a few, like Meetup and Return Path, are ten years old or more. We've exited six of the 21 investments, you can see them here, under past investments at the bottom.

We still have fifteen investments active in that portfolio including Zynga and Twitter and we own large blocks of stock in both of those companies. We own stakes in thirteen other portfolio companies most of which we believe are super strong companies that are building large and sustainable businesses. We will likely exit a few weaker investments in that portfolio over this year and next. But there are at least ten companies in the USV 2004 portfolio that we would be happy to own for the rest of this decade.

This does create a bit of an issue in that we raise ten year venture capital funds. So we are supposed to wind things up in the 2004 fund in another two years. But I am fairly sure that my partners and I and our limited partners will be happy to let this fund play itself out over a longer period of time.

I've made the mistake of exiting investments too quickly. Back in the middle of 2007, my previous firm Flatiron exited our investment in Mercado Libre at the IPO selling our entire position for about a 10x gain. In the almost five years that MELI has been public, it has gone up 5x. So had we held our position for another five years, we'd have made 50x instead of 10x. That stings. Lesson learned.

When you have portfolio companies that are category creators, category leaders, who are well managed, and growing 50% per year or more and delivering 20-30% pre-tax margins (or more), and who have no existential threats to their market leadership, you might want to hang on to them for a bit. They may be just getting going on the valuation creation thing.

We have an IPO market for web companies again. I don't have all the names in front of me, but this year has brought IPOs for Pandora, LinkedIn, Groupon, Zynga, and TripAdvisor. These five companies are all trading for north of $1bn market cap. Pandora is at ~$1.5bn. LinkedIn is at ~$6bn. Groupon is at ~$15bn, Zynga is at ~$7bn, and TripAdvisor is at ~$3.5bn.

We can (and surely will in the comments) argue about these valuations. Some will say they are too high. Some will say they are too low. That's what makes a market. But in the aggregate, these valuations do not seem ridiculous to me. The public market investors are valuing these companies at prices that have some rationality to them.

What is possibly more interesting is that the public markets are valuing these companies at less than the late stage private market might value them at. Again, I don't have the data in front of me (I'm on vacation), but I believe that some of these companies had private financings at our above these current market caps.

The past decade (post Internet bubble, post Sarbox) brought a new normal to the late stage venture capital market. Companies are staying private longer. They are doing multiple rounds of growth financing privately. And they are doing multiple rounds of secondary liquidity for the founders, angels, and early investors. Mike Moritz calls these financings the "new IPOs".

This "new normal" is allowing these companies to stay private and develop into real businesses. With a lot of revenue. The five companies I mentioned at the top of this post will have close to $5bn in revenue this year. The company with the least amount of revenue is Pandora which, as of its last quarterly report, is operating at a $300mm annual revenue run rate.

These companies also have built sophisticated management teams that are highly capable of managing a business to meet the expectations of public market investors. They have strong operating executives, strong financial executives, and strong product and engineering leadership. They should be well run public companies.

The five companies I mentioned at the top of this post are carrying a combined market cap of $33bn. So they trade at an average of 6.6x revenues. And that is not including the cash they have on their balance sheets. I am not going to do the math, but I would bet if you back out the excess cash, you might see revenue multiples of less than 6x for this cohort. These are full valuations in a historical context, but these are not crazy valuations. If these companies can continue to grow at the rates they are currently growing, and if they can generate significant cash flow from their businesses (some of these companies already are doing that), then they should be more valuable in the next couple years, generating gains for the public market investors who hold the stock.

When Zynga was pricing its offering last week and getting ready to start trading its stock, I got a note from a friend who said "let's hope for a '99 style first day pop." I responded that was the last thing I wanted to see. And thankfully we did not get that.

It is not healthy for companies to trade at prices well beyond what they are worth. It puts incredible pressure on the team to deliver results that can't be delivered. And when the stock inevitably comes back to reality, the team feels like they somehow failed. Morale is impacted. The whole things is madness. And who benefits from that first day pop? Only the best customers of the banks who led the offerings. Why should they get a windfall when they did nothing to build the company and when they will be out of the stock so fast it will make your head spin?

The IPO market for web companies we have right now is rationale. We can argue whether it is pricing thse offerings correctly. But it feels about right to me. I believe we will see a bunch of IPOs next year, led by Facebook, which is the poster child of this whole "stay private longer" movement. If we as an industry can be patient, keep our companies private longer until they are truly IPO ready, then we should have a sustainable IPO market. That's where we seem to be headed. Let's not get greedy and screw it up.

Disclosure: USV has a significant holding in Zynga therefore I am long that stock through my interest in USV.

As a follow up to yesterday's post on this topic, here's another chart from Mark Suster:

So using the math I laid out yesterday (roughly 1,000 startups funded each year by VCs), this means that on average between 1% and 3% of venture funded startups get to an IPO.

To recap, 1-3% get to an IPO and 5-10% get to an M&A exit over $100mm. So 85-95% of all venture backed startups will either fail or exit below $100mm.

I am certain the VC industry is not using this probability of outcome in setting valuations right now.

I had breakfast with Alan Patricof last week. Alan is the dean of NYC VCs, he's been at this game longer than any of us. He was in the business when Intel and Apple went public.

The breakfast came about when Alan wrote this blog post in Business Insider about the problems with the IPO market. I read the post and emailed him with some feedback on the parts I agreed with and the parts I disagreed with.

We decided to have breakfast and chat about it.

My going into breakfast position was that the IPO market isn't all that it is cracked up to be. That the emerging secondary market is allowing companies to stay private longer (maybe forever) while allowing founders, angels, and early stage VCs to get liquidity. I believe that the IPO market should only be for the very best companies that can sustain value creation for long periods of time for their shareholders post the public offering. I think that is a very high threshold that most VC-backed companies cannot meet.

Alan's going into breakfast position is that we have lost our way (read his BI post for details). Back in the days of the IPOs of Apple and Intel, great tech companies would go public at low valuations, there were dozens of small market makers who would do research on the stocks, and most of the investors in these deals were individuals. Now we have markets that are largely closed to the individual investor. VC investing is largely instititional and limited to "qualified investors" (ie rich people). The secondary markets are also largely limited to qualified investors. And the IPOs these days are sold to a dozen or so large hedge funds who are also dominated by institutional investors and rich people.

Like all good discussions, we both came away with an appreciation for each other's point of view. I agree with Alan that we need a way to allow the individual investor to participate in the value creation that large tech companies can provide. And I recognize the the vast majority of people who have participated in the value creation from Facebook, Zynga, Twitter, and Groupon have been institutions and the very wealthy. That doesn't seem right or fair.

I think the SEC needs to rethink the capital market regulations and structure we have in our country. The secondary private market is a good thing and does allow great companies to stay private longer while providing liquidity for founders, angels, and early VCs. But there are issues with the secondary markets as they exist today. There are no disclosure requirements. There is little or no way for individual investors to participate. The 500 shareholder rule is creating all kinds of problems for companies. And we don't have a public market system that allows companies to be public at lower valuations with less capital raised. Alan believes we need a "new nasdaq" where companies can list for $250mm or less and have liquid markets in their stocks that individuals can participate in.

The US has a vibrant tech economy, a VC industry that is the envy of the world, and public markets that are highly liquid. We can and should stimulate the development of some additional layers of capital markets between the VC market and the current IPO market. A vibrant and fair secondary market that provides individuals some access and a new "low cap public market" are the natural additional layers to our current system. I'd also like to see more access for individuals into the VC market.

I hope the SEC is thinking about all of this. I hope they read Alan's post and this post. It is important stuff.

Most of what I've been saying recently about valuations here at AVC has been negative. I think we are in a "focus on the upside" phase in the web investing sector and I've been pretty liberal with my thoughts on that.

But when friends have privately asked me whether they should take some of the Facebook shares their Goldman representative has offered them, I mostly tell them I think they should. I don't think anyone should bet their net worth on Facebook at $50bn, but I think it is a pretty good bet that Facebook will one day be worth more than $50bn. Is it today? Hard to say. I don't have access to Facebook's P&L, cash flows, and balance sheet. But from what I have heard Facebook should do between $1bn and $2bn of EBITDA in 2011 and possibly more. 25x to 50x EBITDA for one of, if not the premier Internet company in the world is not crazy. And if you just think how much market power (i'm talking driving traffic, audience, brand, attention, value) Facebook has relative to the other Internet services which are valued well north of $50bn, I think it is pretty obvious that there is more value to be created in Facebook stock.

My friend John Battelle has similar thoughts on his blog in a post everyone interested in the second coming of the Internet IPO should read.

How do I reconcile these conflicting thoughts, that the web sector has gotten overheated and that the coming Internet IPOs might in fact be good buys? Well, to be honest, I haven't completely reconciled those thoughts. First of all, we don't know how these deals will be priced. Will Facebook shares be offered to the public at $75bn, $100bn, even higher? We just don't know. And how will Groupon, Demand Media, LinkedIn, Skype, and other offerings be priced? Don't know yet.

But it is very possible that some or all of these deals will be good buys even in the face of an overheated valuation environment. The public Internet names, most of which went public eight to ten years ago (or more), are mostly carrying full but not crazy valuations. If this new crop is priced off of those comps, then they could be worth buying and owning. And, as John points out in his post, if these companies contiue to grow rapidly and throw off ever larger amounts of cash, then they could easily be worth well north of what they are worth today.

In the spirit of complete transparency, I do not plan to purchase any of these offerings. I have plenty of personal exposure to the web sector right now and am adding to it every day via our firm and other private deals and funds I am part of. I don't particuarly like to buy and own public stocks unless we are in a really down market and I see unbelievable values. So I am not going to be calling the banks and asking for allocations. But that doesn't mean you shouldn't. But whatever you do, make sure to do your work and understand what the price is and that it makes sense. Blindly buying something just because it is "hot" is never a good idea.