Valuations of privately held companies have been on the up for the last few years. Multi billion dollar valuations for companies such as Urber, Airbnb and Dropbox are making investors wonder how much these companies will IPO at and whether there will be any meat left for the public markets. Put to things in perspective Microsoft’s market cap grew 500x after its IPO, for Facebook to do the same its valuation would need to supersede the combined global equity market today.
Companies choosing to stay private for longer is attributed as the main reason for this trend. The reasons for this trend seem twofold. Firstly the nature of global business has changed. Successful startups, particularly VC backed ones are expected to scale fast and require quick fire rounds of fund raising coupled with centralized, quick decision making. Such flexibility is unlikely to be granted to a public company. The second and perhaps the more practical reason for staying private longer would be the easy availability of funding for high performing companies. VC funding for late stage private companies is almost at an all-time high, close to the 1999 dot com bubble levels.
So can this be attributed to a bubble in VC markets? Or is this trend underpinned by a tangible shift in value creation to private markets, due to the advantages offered in terms of lower corporate disclosure requirements and faster decision making and funding mechanisms available? The current exuberant valuations are party driven by the arrival of large institutional funds such as Google Ventures. The structure of the VC industry and the way incentives are aligned also support the bubble theory.
Examining some recent late stage funding rounds (from series C onwards) done at a valuation higher than 1 billion USD reveal that the actual money kicked in is a fraction of the total valuation. At the same time these VCs secured the highest liquidation preference after creditors. Liquidation preferences determine who gets paid when a company goes bust, thus meaning that late stage investors in the above investments will get their money back with the attached profits, before common stock holders and original owners. This downside insurance is likely to make VCs bolder given that a company like Urber – valued at 44 billion USD in the last funding round – will still sell for well more than the 1.2 billion USD that investors actually kicked in that By Mudith Uswatta round, even in a fire sale. The vast majority of VC backed companies fail. In order to make back the losses and also some profit VCs need to eke out every last dollar from the winners. Thus, there is natural tendency to hold on to the high performers during their rapid growth phase and think about exit mechanisms such as IPOs when the growth trends down. Even with slowing growth companies with promise, particularly tech companies that promise to create a worldwide monopoly in a sector, such as Facebook or Airbnb can go public at very high valuation.
For the investors in public markets who jump into such IPOs all this means that actual action happens well before they arrive on the scene. Is this the inevitable result of public markets in the developed world maturing, driving more investors into private markets in search of higher returns? To an extent it does seem that way. As private markets become more competitive, they are also becoming more liquid. Restrictions on private equity investment are being lifted in many countries such as the US which formerly only allowed individuals with incomes and asset levels that qualified them as accredited investors, to dabble in private equity. Crowdfunding private equity and global market places for non-public securities such as Second Market are creating liquidity for private stock, reducing traditional illiquidity – a key contributor to the high risk of PE investments.
While investor interest and value creation in private markets is on the up, the total funds in play are still a fraction of what’s invested in public equities. Here at home the private equity investment and the startup eco-system are still nascent. But some of the largest companies in the country remain family held and are unlikely to be listed. Thus, a majority of value created in the country is not reflected by the market cap of public stock. These firms dipping into the private equity markets or venture backed startups – by the likes of the Lankan Angel Network – going for public listing could see the global trend repeating locally.