Originally published on Equities.com
It used to be the case that an initial public offering was the preeminent financing opportunity for startups, leading most companies to go public earlier in their life cycle. But the proliferation of private equity dollars over the past 30 years means that one of the best investment strategies is to influence founders to keep their companies privately held for considerably longer.
The grocery delivery company Postmates is just the latest example of a unicorn tech company — a privately held business that’s valued at more than $1 billion — that seems to be in no hurry to initiate an IPO. It was expected to go public in 2019, along with around a dozen other buzzworthy tech companies. However, after surveying market conditions and seeing harsher criticism directed at Silicon Valley, Postmates opted to back out of its IPO, according to Recode.
That’s understandable — even advisable — considering how some other startups have faltered since going public. Vox reports that Lyft has lost half its valuation since its debut on the stock market. Rival Uber isn’t doing much better, and upstarts like Slack and Pinterest are down, too. The spectacular failure of WeWork on the eve of its IPO is still fresh on everyone’s mind as well. There simply aren’t a lot of positive examples that suggest now is the right time for private tech companies to go public.
The interests of private equity investors have been increasingly represented in these market headwinds — by ushering fewer companies toward IPO. Private investors’ earnings grow much faster when a company is private because they have more say over the strategy (including when and how it raises funds) and face less pricing uncertainty. Private investors are incentivized to encourage their portfolio companies to sell or go public only when that decision maximizes their investment.
To give this issue some context, Postmates is more than 8 years old, and it’s still raising hundreds of millions from private investors. In contrast, according to Crunchbase, Netscape went public in 1994 — the same year it was founded. Amazon took two years, Netflix took four, and Google took five. As companies wait longer to go public, outsize returns will continue to accrue to private investors and founders. Unfortunately, it likely will hurt everyone else.
Squeezing Out the Average Investor
More than 90% of investors aren’t accredited and don’t have access to private equity markets. Instead, these investors must wait for the best and brightest new companies to go public before they can get involved — by which time a lot of the opportunity has already been realized.
For example, a few hundred dollars invested in any one of the top five network companies while it was still private would be worth millions now. By contrast, the same investment in the S&P 500 would have delivered a modest annualized return of around 5% to 7%. Successful private investors are also writing even bigger checks to ensure the continued success of a handful of popular private companies, leading to even higher valuations at the time of IPO.
Unfortunately, there’s no indication this trend is slowing down. Consider that in 2010, there was only one privately held tech unicorn. Now there are more than 430 of them, many with no clear plans for going public. That means that a lot of investors have been left on the sidelines, watching prosperous companies concentrate all their gains in the hands of a few early stage venture capital investors. It’s easy to feel bitter, but there’s also reason to believe the pendulum of power could swing back in the other direction.
The Future of Public Companies
When Postmates decided to forgo its IPO, it was responding to some clear and troubling IPO trends in the market. The landscape may have looked different if the ride-sharing companies hadn’t stumbled immediately after going public and Slack was hovering a little closer to its initial value. The outlook might have been bleak in early 2019, but if and when it improves — buoyed by some successful IPOs — private equity investors may start to encourage their portfolio companies to go public sooner.
They may also start to opt for different listing options. Slack, for example, pursued a direct listing instead of a traditional IPO, and though it’s stumbled since then, it has inspired others to consider the same strategy. Applications for improving the direct-listing route have been submitted to the U.S. Securities and Exchange Commission recently.
Companies are also contemplating initial coin offerings as an alternative to taking the whole company public. Investing in tokens, rather than shares, may offer investors the opportunity to speculate in the growth of a network rather than the valuation of its equity.
As always, the best investment strategy is to be vigilant and adaptable. Be aware of the risks along with the rewards. To capture outsize returns, investors should try to get involved early while the stakes are still high. Investors, foundations, and endowments alike are increasing their allocations to venture capital, knowing that the right early investment can lead to a massive windfall. It could also lead to disaster, though, given that only 10% of early stage fund managers actually generate outsize returns.