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Why Private Valuations Are Muddying The Waters For IPO Hopefuls

Vineet Jain is the CEO and co-founder of Egnyte. Vineet has over 20 years of experience building capital-efficient organizations, and he has worked with Trinity Ventures, Kleiner Perkins, Google Ventures, Floodgate, and others.

There are many reasons that a company decides to go public. One main reason is to raise money for the company to expand its business and move to a bigger stage. Another is to create liquidity for investors, founders, and employees. From a public perspective. it’s easy to see why the IPO is often considered the “Holy Grail” in terms of exits for a startup.

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With roughly a quarter and a half left to go in 2017, we have still yet to see IPO filings from some of the biggest names in tech—Airbnb, Dropbox, Pinterest, Palantir, SpaceX, Uber, and more—despite the rumors. By all accounts, these are seemingly successful companies with hundreds of millions, if not billions, in revenue. With all the potential positives, why is everyone hesitating to take their company public?

There is only one place to look: venture capital.

The Venture Gamble

Venture capital firms have minimized the financial pressure on private companies to go public. This is mostly thanks to oversized late-stage funding rounds accompanied by inflated valuations.

While many won’t admit it, investors are hanging themselves by their own rope. As many of portfolio companies mature in this non-GAAP era we are currently living in, late-stage companies struggle to hit important GAAP metrics for a successful public market debut – things like growing net revenue, and an improving net income result. Therefore, instead of facing a potential slaughter on the public market, startups go back to VCs for more funding.

For a VC, this is a tough spot to be in. Investors don’t want to lose their initial investment if the company falters; however, for these late-stage funding rounds to be worthwhile for the VCs, the investment needs to be much larger. In turn, the late-stage startup must accept a higher valuation. The side effect of this late-stage funding is that it typically provides a much longer runway for startups to stay private and not have to deal with the pressures of answering to the public in the form of earnings reports and stock price performance.

The Valuation Trap

When I make this argument, this is where many people get very confused about private valuations, thinking that a high valuation completely dooms a company.

However, that is not necessarily the case and I will give an example:

Think about a private company that currently has $100 million in annual revenue, with a post-money (most recent round of funding) valuation of $750 million. They are getting a little low on operating cash because they are still spending roughly $150-160 million a year. The CEO wants to wait until they are cash flow positive before he or she takes them public so they have no choice but to take another round. At this point, the term sheets they get from VCs want to offer them $100 million in funding at a $1.2 billion valuation, but it also offer protections so that if the company doesn’t reach $1.2 billion then the investors will get their $100 million back. With no other options, the company takes the money at a valuation that is well overpriced, knowing that worst-case scenario is they just have to give back the initial investment.

As you can see, the company’s sensitivity to the valuation is very low since they needed the money and there are protections built in for the investor anyways. As a result, the company has plenty of cash on hand and they can take their sweet time in terms of securing an exit. The only downside is that they’ve now made a hot seat for themselves when it comes to public perception. These late-stage startups will be constantly poked and prodded with questions concerning an IPO announcement, fulfilling the now-higher valuation, and raising enough money on the public market.

Looking at the numbers today, the Crunchbase Unicorn Leaderboard reports that there are currently 263 private companies that are part of the worldwide unicorn club, a cohort of companies with valuations of $1 billion or more. Those 263 companies have a combined valuation of over $900 billion and have raised over $168.8 billion in funding.There are a number of companies in this group who have an inflated valuation that is a direct result of taking a late-stage funding round.

Look at a company like Airbnb, for example, which just raised $1 billion in funding in March. From what we know, they have a very solid growth story and strong financials, so what does that tell us?

  1. They received a $31 billion private valuation that they may or may not fill. But as we have learned, there are likely protections built in for the investors.
  2. Airbnb bought themselves a longer runway to make sure their books are as strong as possible when they do decide to make their debut.

So while all signs point to Airbnb continuing on a successful path as a private company, the public’s thirst for yield will now put a significant amount of pressure on them to file for an IPO as soon as possible. With that kind of contrast in sentiment, it’s no wonder that everyone is having a hard time putting a read on tech companies these days.

I understand the need for VCs to diversify and make late-stage investments that are relatively safe or protected. I also understand the need for companies to take money in the late-stage to sustain growth and push for profitability at scale. However, I believe the unnecessarily large rounds that are soaring past the nine-figure mark are where this has gone wrong.

Most companies do not need two, three, four hundred million in funding in order to get them to an IPO and, thus, should not be offered that kind of capital at that stage. While it doesn’t inherently hurt the company to take the large investment (as explained in the Airbnb example), it creates detrimental exuberance and unrealistic expectations from the public. For those who are not well-versed in the dynamics of venture capital investment that I’ve explained here, what they end up hearing and seeing on the news only makes matters worse—especially given the lack of credible, publicly available information about private companies.

Pair that with the recent missteps by Blue Apron and Snap Inc., and you now have some very muddy waters when it comes to the tech IPO market.

With all of that being said, I do believe there is a light at the end of the tunnel.

With companies getting larger injections of capital it is creating longer runways for startups than ever before. As a result, VCs are experiencing longer wait times to see a return on their investments and thus capital will start to dry up. Once the available capital starts to dry up, VCs will have less money to throw around for these large late-stage investments and they will put more pressure on their portfolio companies to make an exit in order to create ROI.

This chain of events will put focus back on fiscal responsibility and create a more unified view of what a successful company looks like. From there, all it will take to spark momentum is for one IPO hopeful with a strong balance sheet to debut and maintain—for two-to-three months—a strong price. I believe that such an IPO will happen by the end of the year. This will open up the doors to a resurgence of the tech IPO market in 2018.

Illustration: Li-Anne Dias

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