Private for longer? — Go public early!

Since the dotcom boom, there have not been so many high-profile tech IPOs in such a short time corridor. Lyft, Uber and Slack have already taken the plunge to the stock market, and start-ups such as Palantir and WeWork are, according to rumors, in the final stages of preparation. This year, start-ups have already been able to raise a total of around EUR 17bn in capital through IPOs, but also have experienced some disappointments in terms of value depreciation such as Uber, Pinterest or Lyft.

However, more and more start-ups decide to stay private for longer. In 1999, the average tech-company in the US went public only four years after its founding. Amazon, the online retailer, for example decided to file for IPO only three years after its founding. When it entered the trading floor at the end of the 90s, the company had a market capitalization of less than $500m. For today’s start-ups, which would classify themselves in the same weight class as Amazon and Co., such a valuation would be a catastrophe to say the least. Today, the average stock market valuation of a venture capital-funded technology company is $9.6 billion.

Most companies stay private due to abundance of private capital and an increasing tendency to avoid public scrutiny

But why do companies choose to stay in the private market for longer? Reasons are manifold, but two reasons seem to be at the center stage:

• Influx of capital in private markets
• Avoidance of public scrutiny and corporate governance

In times of ultra-low interest rates, central banks seem to be the “only game in town”, which leads to sizable shifts in return expectations of investors. Traditional asset classes like government bonds or cash fail to deliver returns that large investors, like insurers and pension funds, are required to achieve. The German ten-year government bond trades in negative territory and the expected real return of the traditional US 60% Equity and 40% Bonds portfolio is 2.9%, compared to a long-term average of 5%.

Consequently, investors are required to look elsewhere on their hunt for yield. Unsurprisingly, investors turn to illiquid asset classes like venture capital, which is growing 13% year-on-year, and by 18% p.a. since 2015. New mega-funds initiated by Softbank or Sequoia profit from this trend, but questions arise whether such large funds can still be characterized as venture capital or whether they are already private equity funds.

Anyhow, investors are required to put their cash piles to work and often find in young technology company willing recipients. If companies choose to stay private for longer, because the influx of capital in private markets allows them do so, valuations of those companies reach unseen heights. WeWork’s latest funding round valued the company, which recently markets itself as a tech company instead of an real estate firm, at roughly $82billion.

To be fair, valuations have increased in recent years, but today’s IPO candidates are also more established than their counterparts during the dotcom boom. By deploying $8.4 billion, which WeWork was able to raise since its founding, WeWork achieved $1.8 billion in revenue in 2018. The increased runway gave start-ups the opportunity generate billions in revenue, which was unthinkable for start-ups from the dotcom era. For example Pets.com, the dotcom-upstart that sold supplies for pets, generated only ca. $750k in revenue when it went public.

Inflated valuations bring later-stage investors in difficulties and lack of public scrutiny encourages questionable corporate behavior

Such valuations, in turn, can ultimately lead to companies, which, when they finally go public, will trade at a price below where they did their last round of financing in the private market. It remains to be seen if companies like Uber or Lyft will be able justify their valuations achieved private markets in the upcoming months.

That mechanism basically undermines the business model of later-stage investors, which make a living on strong IPO performance.

Beside of the influx of private capital, many start-ups avoid public markets due to public scrutiny and corporate governance. When going public, companies need to be prepared to publish ad-hoc news, send out financial reports and face the (unpleasant) questions of shareholders. Even though such monitoring tasks are expensive in private markets — in public markets thousands of analysts and newspaper cover specific stocks, whereas in private markets asset managers need to manage that task on their own, which makes it expensive — venture capitalists or private equity managers obviously do not really care.

Uber, the ride-hailing company, was famous for its former boss, Travis Kalanick, who was known for erratic behavior and eventually stepped down due to sexual harassment allegations, which were known by his employer. Another case in point is Theranos, a health-care start-up, was shut down after reports were published which claimed that the company’s blood-testing device was not working properly. If private companies continue to avoid the public eye, those corporate governance issues might only get worse.

One possible solution: file earlier for IPO

If young tech companies file earlier for IPO, multiple problems could be solved or least mitigated.

First, better corporate governance.
Monitoring large start-ups properly is expensive as they don’t need to stick to certain accounting and disclosure rules. Venture capital funds, where partners are meeting start-ups’ executives only on a couple of board meetings during the year, are definitely not sufficient to diligently check governance issues.

One of public markets main jobs is to make industries and companies more transparent. Financial institutions and NGOs employ thousands of analysts, whose “only” job is to monitor corporations, and markets, most of the time, listen to their words. Thereby, listed corporations have an incentive to act like good corporate citizen, which in turn can limit excesses at companies like Theranos, Uber & co.

Second, when start-ups avoid public markets it can contribute to the trend of rising inequality in society. There primary reason why staying private for longer gives rise to inequality is that most individual investors are excluded from private markets.

Most startups that plan to go public these days often show a lower growth momentum than start-ups during the last decade and raise the question if much of young start-ups’ growth may lie behind them. If that is indeed the case, most of the investor’s profit is generated in private markets, which typically exclude the majority of individual investors. Only very wealthy investors have access to private market funds, which then are the only ones who profit from start-ups. Earlier IPOs would enable “ordinary” people to participate too.

I guess that only time will prove if the current trend toward “staying private for longer” will remain active, but if “digital” is really there for the greater good, it might be worth to rethink the current development.