Some in the venture community see the fact that there have been only a handful of tech IPO’s in the last six months as the harbinger of doom. If there are no public exits, they can’t harvest gains from their “winners” and return capital to their investors. They acknowledge the best growth companies are staying private much longer, but are not sure exactly why.
To understand what’s happening, you have to first ask what a growth company needs from its capital market. Most CEO’s would tell you they want ample capital, patient investors, a liquid secondary market, low trading costs, and a minimal regulatory burden. Though each of these qualities are present to a greater or lesser extent in both the private and public capital markets, there has been a sea change among entrepreneurs in their view of which market is best for tech growth companies.
Where entrepreneurs used to push to get their companies public as quickly as possible, the leaders of Uber, SpaceX, AirBnB, Palantir, Pinterest and many others – companies that could opt for an IPO at anytime if they wished to – are now electing to stay in the private market. Though that shift has enormous consequences for company builders, venture capitalists and the innovation economy generally, its causes are still not generally well understood.
A Tale of Two Markets
To understand how entrepreneurs are evaluating the public vs. private markets, it’s useful to understand their relative strengths and weaknesses.
The public markets have historically been a great place for companies raising a significant amount of capital and that value a liquid secondary market for their stock. Since the decimalization of equities sales commissions, the cost to trade stock on public exchanges has dropped to a fraction of a penny per share. There’s another major advantage of going public: The credibility and prestige of being a publicly listed company. A public company is typically viewed as more stable and seasoned than its private competitors.
By contrast, entrepreneurs value the private market’s long-term orientation. Because private companies have a significant degree of control over who can buy or sell their shares and when, the private market is not a place for day traders, short sellers or program traders. Investors therefore are investing based on what a company will do to create value over the next couple of years instead of the next couple of quarters.
Private companies are also able to keep their financial performance and other sensitive information confidential. This gives them an enormous competitive advantage over public companies that must show their hand to the world every quarter. The private market’s relatively low regulatory burden also eliminates the need for costly time consuming audits and reporting to the SEC. It also insulates them from expensive, time-consuming shareholder lawsuits.
The Transition Point Has Changed
Companies start in the private market and then, if they grow large enough and market conditions are right, can opt for an IPO and transition into the public market. Entrepreneurs and their boards naturally pick that transition point when they perceive the benefits of being public outweigh those of staying private. Typically, that happened when companies began to value capital raising and secondary liquidity over privacy and control of their investor base.
So what all of a sudden is driving companies to stay private so much longer? Two things. First, the public market has become much worse in terms of its investors’ short-term orientation and its regulatory burden. Second, the private market has become much better in terms of capital raising and secondary liquidity. That in turn has meant the logical transition point from private to public has been pushed much further out in the life of a company. And the result of that is that the private market has been growing massively in recent years.
There are multiple reasons the public markets have gotten much worse for growth companies. High frequency and algorithmic trading programs now dominate the public markets, generating unprecedented levels of volatility. These traders focus primarily on small changes in quarterly earnings. LinkedIn, for example, recently lost approximately 40% of its value, about $7 billion in enterprise value, in a single day because it missed its earnings forecast. This high-speed trading mentality of the public markets is disconnected from – perhaps even indifferent to – the long-term plans of the company to build shareholder value. Lastly, the regulatory requirements on public companies are enormously expensive in legal and accounting fees and management time.
Just as the public market is becoming an increasingly dangerous, difficult home for growth companies, the private market has been evolving into a very supportive one. Increasingly, there is a deep capital market for private companies. Institutional investors, including large mutual funds and other long-term patient investors, have been migrating to the private market. In pursuit of growth equity returns they can’t get anymore in the public markets, Fidelity Investments, T. Rowe Price, Wellington are now routinely investing in private companies. For the first time, many late-stage growth companies are able to raise more capital and at better valuations in the private market than they can in the public one.
The other major advantage of public markets, efficient secondary liquidity, has also been eroding rapidly as a thriving secondary market for private company shares has evolved. At SharesPost alone, we’ve executed more than $2 billion worth of secondary transactions for roughly 130 companies since 2011. And it’s a self-reinforcing phenomenon. As more secondary transactions happen, more information becomes available, more service providers open up shop and shareholders and issuers get increasingly comfortable with secondary liquidity. It becomes the “new normal.” The result of all that? Transactions and the market generally get more efficient, reliable and safe – and the private market grows.
No Going Back and That’s a Good Thing
Some are worried about the larger role that the private market is playing in the innovation economy. They argue that laws should be passed to make the public market more hospitable to growth companies and/or impose greater burdens on private companies. In our view, that is impractical. Regulators can’t now realistically legislate away the public market’s program traders, trading algorithms and short-term orientation. Similarly, imposing public company audit and reporting burdens on start-up companies and exposing them to shareholder derivative suits would severely impede their ability to grow.
The much more important insight, however, is the growth of the private market is actually a very good thing. We should recognize that a single capital market cannot effectively serve both growth and mature companies. Their needs are too different. What we are seeing now in the capital markets is a reflection of that. It’s a very rational, healthy divergence between two types of investors and two types of companies. Long-term investors are being matched with growth companies in the private market and short-term investors are being matched with large, mature companies in the public one. Driven primarily by market forces, the public and private worlds are optimizing around the needs of their participants.
The U.S. has long been the leader in market and financial services innovation. The recent emergence of the private market is just the latest example. The private market is adjacent and complementary to the public market; it does not undermine it. A robust and growing private market nurtures growth companies and innovation and therefore American economic competitiveness. Everyone in the innovation economy should embrace the new private market to make it bigger and better – to be part of what’s happening right in front of us and no longer lamenting the way things used to be.
Image Credit: CC by mollybob