[An edited version of the following blog post originally appeared in a modified form in the pages of the weekend edition of the Financial Times last Saturday.]
Every successful technology company raises money throughout its lifecycle, perhaps starting with a seed investment and progressing through Series A, B, C, late-stage investments, and, for the most successful companies, an IPO. Historically, different financial institutions specialized in different stages, because the assessment of risk and opportunity was considered unique at each stage — for example, a seed investor was unlikely to do late-stage financing, and vice versa.
Over the last few years, the late-stage (pre-IPO) market has become the most competitive, the most crowded, and the frothiest of these financing stages. Investors from all walks of life have decided that “late stage private” is where they want to play. As a result, a “late-stage” financing is no longer reserved for high-revenue, pre-profitability companies getting ready for an IPO; it is simply any large round of financing done at a high price. An unprecedented 80 private companies have raised financings at valuations over $1B in the last few years. These large, high-priced private financings are the defining characteristic of this particular technology cycle.
Some have argued that each of these companies would already be public in a prior era. Buying into such a notion is dangerous – dangerous for the entrepreneur and dangerous for the investor. Actually, very few of these companies are at a point where they could or should consider being public. Lost in this conversation are the dramatic differences between a high priced private round and an IPO. Understanding these differences is crucial to understanding the true risks in this large private-round phenomenon.
Ironically, 2014 was a record year for IPOs, so the suggestion that these “extra” companies were supposed to be public does not really make sense – the companies that were supposed to go public went public. The size of these companies’ private valuations may be similar to a traditional public company valuation, but that is where the similarities begin and end.
The first critical difference is that these late-stage private companies have not endured the immense scrutiny that is a part of every IPO process. IPOs are remarkably intense, and represent the most thorough inspection that a company will endure in its lifetime. This is why companies and their board of directors agonize over whether or not they are “ready” to go public. Auditors, bankers, three different sets of lawyers, and let us not forget the S.E.C., spend months and months making sure that every single number is correct, important risks are identified, the accounting is all buttoned up, and the proper controls are in place. Conversely, these late stage private have no such pageantry or process. There is typically just a single PowerPoint deck presentation.
In the absence of this auditor deep-dive, investors are assuming that the numbers they see in the fund-raising deck are the same as those they might see in an S-1. However, many of these private companies will wait up to twelve months after the end of a fiscal year to complete their audit. And even then, the auditors do not roll up their sleeves in nearly the same way they do during an IPO process, where they know the SEC will review their work in excruciating detail. As a simple example, many investors and entrepreneurs do not realize that coupon or discount use is a contra-revenue event when it comes to revenue recognition. You must subtract it from your top-line revenue. Yet, for many “promising” private consumer companies this marketing tactic is widespread, and many improperly account for this in their financial presentations.
Without the guidance of a banker, companies may also mischaracterize their financial positioning relative to industry standard or norm. As another example, consider that most public marketplace companies, such as ebay or GrubHub, report revenues on a “net” basis rather than gross (approximately 80-90% of revenues go to supplier partners, so this is the proper conservative representation). Despite this, startups commonly highlight “gross revenue” even when 80+% goes out the door for every single transaction. A good banker in a normal IPO process would get this straightened out. You should not pay a net revenue multiple for a gross revenue disclosure.
The very act of dumping hundreds of millions of dollars into an immature private company can also have perverse effects on a company’s operating discipline. The only way to use the proceeds of such a large round is to take on massive operating losses. Historically, as a company neared an IPO level of revenues (say $50-$100mm), investors would expect convergence toward profitability. As these late-stage private companies digest these large fund raises, they are pushing profitability further and further into the future, as well as the proof that their business model actually works.
Consider the case of Fab.com. In a February 6th article in Business Insider, Allyson Shontell discovered that a mere four months after adding $150 million to a total of $330 million in invested capital, the founder and CEO disclosed to its employees that “we have spent $200 million and we have not proven out our business model.” Investors must realize that it is materially easier to take a company to substantial revenue if you generously relax the constraint of profitability. Customers will love you for giving away more value than you charge, and therefore, focusing exclusively on revenue success is a sure-fire path to risk exposure.
In order to overcome such risks, the onus is on the investor to dive deep and unpack the actual unit economics in the underlying business. This requires analyzing the “true” contribution margin of the business; not simply looking at gross or net revenue and the proper contra-revenue treatment, and not even looking just at gross margin as defined by the company. Many companies embed costs that are truly variable (for instance customer support, marketing, credit card processing) below the gross margin line. If you want to know if the business model truly hunts, you must pay careful attention. Otherwise, you may have simply found a company that is simply selling dollars for $0.85.
Lastly, there are structural issues in private company investing that are simply absent when you invest in public companies. Most private company financings involve the use of preferred stock with liquidation preferences. These liquidation preferences give the investor a debt-like downside protection. When you have many of these preferred rounds on top of one another, the future payouts at different valuations can be wildly divergent depending on whether the company clears certain preference hurdles. As these preferences pile up, the new incremental investor begins to worry that the “percentage” of the company they are buying may not actually equate to their eventual payout. In some cases, these incremental investors require special terms to protect their interest, but ironically that makes this cap chart even more complicated and unfriendly to new investors.
Eventually, the only way to escape this capitalization chart calcification is to actually go public. In going public, all preferred shares are converted to common shares, and the pile of liquidation preferences goes away. This was the recent case with the Box.com IPO. It is obviously quite ironic that the very event that many of these entrepreneurs were hoping to avoid (the IPO) becomes their only saving grace. Yet, because they did not focus on the normal steps that lead up to an IPO, they are ill prepared for this singular redemptive path.
All of this suggests that we are not in a valuation bubble, as the mainstream media seems to think. We are in a risk bubble. Companies are taking on huge burn rates to justify spending the capital they are raising in these enormous financings, putting their long-term viability in jeopardy. Late-stage investors, desperately afraid of missing out on acquiring shareholding positions in possible “unicorn” companies, have essentially abandoned their traditional risk analysis. Traditional early-stage investors, institutional public investors, and anyone with extra millions are rushing in to the high-stakes, late-stage game.
We might all do well to heed the advice of Warren Buffet who said, “there is a fool in every market and if you don’t know who it is, it is probably you.”