The Silicon Valley Standoff in Three Charts
Throughout this year’s first quarter, the unthinkable has happened: Not a single tech company went public.
Granted, this isn’t completely unprecedented.
Silicon Valley put up a goose egg quarter for IPOs three other times in history – the third quarter of 2002, the first quarter of 2003, and the first quarter of 2009.
But each time, the dearth of IPO activity made sense. All of them occurred during periods of crisis, when stock markets were plumbing record lows.
This time around? Not so much – the markets rest near nominal record highs. And there’s certainly no shortage of IPO-eligible companies, either.
There are currently 163 venture-backed companies valued at $1 billion or more, according to CB Insights’ real-time tracker. That’s the traditional size at which private companies look to go public, making the situation all the more perplexing.
“That total lack of activity, I’m surprised by it,” says Jay R. Ritter, a professor at the University of Florida and “go-to” IPO market historian.
So what’s going on and what does it mean for everyday investors like us?
The answers can be found in three simple charts.
Venture Capitalists Channel Their Inner Scrooge
Cash is oxygen to fast-growing tech companies, particularly technology ones. And for years, there’s been an endless supply of it coming from venture capitalists around the world – almost $130 billion in 2015, $91 billion in 2014, and $50 billion in 2013, according to CB Insights data.
Not since the dot-com days have we witnessed such a robust environment for raising capital.
At first blush, the latest data suggests the trend should continue unabated, too. At least in the United States. After all, U.S. venture capitalists raised money at the highest rate in more than a decade during the first quarter.
Lots of cash coming in doesn’t automatically means lots of cash going out, though. As it turns out, venture capitalists suddenly got stingy.
As you can see in the chart, while U.S. venture funds raised near-record amounts of cash in the first quarter, they doled it out to the fewest number of companies (1,035) in nearly three years. Total deployments in dollar terms likewise dropped precipitously.
So what’s behind the seemingly overnight Daddy Warbucks to Ebenezer Scrooge transformation?
Blame on it on mounting concerns over sky-high valuations, the poor performance of tech IPOs in recent years, and the beatings public tech companies have endured this year.
Speaking of which…
Nothing but Busts
Normally, when venture capitalists cut off the oxygen supply, it’s no big deal. Tech companies find fresh air and financing via the IPO market.
This time around, they’re reluctant to rush to the public markets because it’s going to hurt.
Only one-third of the tech companies that went public last year were in the green, as of April 1, according to Dealbook.
Meanwhile, the performance of the mega-exits – companies with $1 billion-plus valuations – is even bloodier.
If you’re a private tech CEO, do you want to bet you’ll be the next exception? Not a chance! And that’s led many private founders to believe staying private as long as possible is the solution. Even if it’s more difficult to raise money from venture capitalists than it was previously.
Unfortunately, the data quickly dispels the wisdom of such thinking. It’s nothing but a lie!
The Goldilocks Principle
“What we discovered blew us away,” writes Harvard Business Review about its study on how technology companies produce enduring value.
“There is a material correlation between company age and post-IPO value creation.”
Or more simply, they found that the longer a company stays private, the less value it creates in the public markets.
The value creation “sweet spot” exists between 6.5 and 10.5 years.
Per the study:
- Companies in the sweet spot create 113% of all market cap created post-IPO.
- Companies that go public early are “94% sure of losing value post-IPO.”
- Meanwhile, companies that go public late create negligible value (just over 1% of all post-IPO market cap).
In other words, time it just right, or your stock is doomed.
Here’s the thing – since 2013, the average age of venture-backed companies at the time of an IPO was approximately 11 years. So it’s no surprise many of them have been a bust. They went public too late.
On the other hand, companies like Uber, which was founded in 2009, are right in the sweet spot. Yet they’re tempting fate by delaying an IPO as long as possible, thereby lowering their odds of outperformance.
Add it all up and it’s time to…
Discount or Die
In a recent essay, venture capitalist Bill Gurley summed up the situation perfectly.
In short, unicorns now have limited options. They’re getting cut off from private market capital, yet their business fundamentals aren’t strong enough to justify the current valuations in the public markets.
At this point, the only option is to fold up shop or accept a severe discount and go public to get more cash.
Obviously, the latter is most likely.
If you doubt a discounting spree is headed our way, consider it’s already happening in the private markets.
The number of venture capital-backed downrounds and down exits recently hit a five-quarter high. Meanwhile, the creation of new unicorns each quarter plummeted 80% between the third quarter of 2015 and the first quarter of 2016, according to CB Insights.
It’s only natural for this trend to migrate to the public markets next. Ironically, as I wrote back in November 2015, that’s good news for everyday investors.
Once tech companies accept the inevitably of valuation resets on an IPO, it should provide us with some compelling opportunities at, dare I say it, potentially bargain prices.
Ahead of the tape,