Mark my words: Aggregate returns are going to get worse for VCs over the next few years, not better.
The rash of acqui-hires may be stemming some of the abject losses, but the industry only functions with big, gaudy home runs. Those come from IPOs. And after a brief flirtation with the thrill of ringing the opening bell, we’re back to a time when the best entrepreneurs hate, loathe, detest, and can’t imagine anything worse than going public.
Witness what Phil Libin of Evernote said last week. “It is terrible,” he said of going public. “Everyone I know who is running a public company is not having a good time. We just want to delay.” Compare this to a year ago, when Libin was optimistically prepping his company to go public, talking it up as the best way for his company to accomplish his lofty goal of staying in business for 100 years.
It’s not that Libin has decided not to go public. He doesn’t really have a choice, having raised hundreds of millions of dollars at a $1 billion valuation. But he’s dreading it. He’ll drag his feet. He’ll do whatever he has to to put it off as long as possible, because good God look at Groupon, Zynga, and Facebook.
You might be able to convince yourself that you’re a better CEO than the flippant and inexperienced Andrew Mason. After all Groupon deviated from this generation’s playbook by rushing to go public — despite a lot of advice to the contrary. But the public stumbles of well respected entrepreneurs like Facebook’s Mark Zuckerberg and Zynga’s Mark Pincus have been humbling for everyone in the Valley to witness.
Who the hell wants to opt into that?
In fact, a confluence of factors may have made the allure of the IPO even worse today than it’s ever been. And that’s saying something, compared to the post-2000 market hangover.
That’s bad news for the Nasdaq and traders that are always frothing at the mouth over new, high-growth stocks. It’s bad news for VCs — for obvious reasons. It’s bad news for the bankers and lawyers who make money off these mega-issues.
In fact, it’s only good news for a handful of people. Facebook, LinkedIn, and Google benefit — at least in the markets. As the reigning crop of still high-growth, large cap tech stocks there are few other places for large mutual funds and institutions to put their money.
It’s also great news for companies like SecondMarket and SharesPost. They like to say they can get all sorts of “below the fold” companies who can’t go public liquidity, but really their businesses were built on highly-desirable companies pushing out IPOs as long as possible. Much of their market — the stocks that people care about anyway — was in danger of evaporating if IPOs became too sexy.
But mostly, this is bad news for the startup ecosystem and another sign of what organizations like the Kauffman Foundation, the National Venture Capital Association, and PriceWaterhouse Coopers have been saying for years. We weren’t dealing with a IPO slump for much of the 2000s — we were dealing with a fundamentally broken system for getting early stage companies to liquidity. This isn’t an economic cycle thing. This is a cultural thing combined with systemic changes in how the public markets work.
Even that’s an old story. My 2006 book on the rise of Web 2.0 centered around the idea of companies not wanting to go public. It’s long-been a culturally defining aspect of this era of companies.
But here’s what makes it so bad this time: Fundamental “hacks” made over the last decade that were supposed to make this better just haven’t worked so far in practice.
Why people started hating IPOs
ICYMI, 20-somethings: When the Valley was riding high in the late 1990s, there was nothing sexier, nothing more exciting, nothing that said success more than going public.
Those three little letters — IPO — seeped into popular culture in ways they never had before. I remember back before I even moved here watching an episode of “The Simpsons” where Bart had a roll of pre-IPO stock options like paper towels in his Internet company, and an episode of “The X-Files” where paranormal activity was threatening to scuttle the IPO of an 18-month old startup. Naturally, the “Lone Gunmen” — three geeks who helped Mulder and Scully out from time to time — all had options in the company and were particularly worried at the prospects of a weaker than expected first day pop.
By the time the next generation of Web companies were being created, no one wanted to come close to going public for a few reasons. The biggest was that in the past you had to hire a “grown up” CEO to lead a public company — yep, even Google did. And there were too many examples of “grown up CEOs” either screwing over founders or just plain not understanding the company. (We saw yet another stark reminder of the latter recently with ShoeDazzle.)
The second was you had to actually run a public company, and that meant spending a disproportionate amount of time pleasing shareholders, not users or employees. For salesmen CEOs, that’s in their DNA. But to hacker-entrepreneurs shareholders are a means to an end, not the north star you run your company by.
Add to that cultural change, a grab-bag of changes that made it worse. Reg FD meant you couldn’t rebut rumors hedge funds might spread. The amount of time a stock is held has plummeted as activist shareholders and quick-trade hedge funds have taken over the markets. Sarbanes Oxley makes it more costly and annoying to be public. Changes in the separation between analysts and banking mean only the largest cap stocks get covered. (For more on all of this, watch our PandoMonthly with Ben Horowitz. He breaks down every reason running LoudCloud was so awful.)
None of these things mean you can’t successfully run a public company. But good lord, did they make a shitty job shittier. The bulk of successful recent IPOs have been mid-cap issues, which have floated a small number of shares at a time. They’ve essentially changed the IPO from a liquidity event to a next round of funding.
Along with hacking the nature of the Web, many of the leaders of the Web 2.0 movement tried to hack the very nature of going public, including why you had to do it, when you had to do it and how you could do it better.
There were a few big shifts, that solved some problems, but also had catches:
- Partial liquidations and secondary stock. Allowing entrepreneurs and investors and employees the freedom to cash out shares before an IPO helped convince some founders to go long, and focus on building a company that would be — in theory — as bullet proof on Wall Street as Google was in 2005. In practice, that didn’t work for Facebook — the company that invested the most efforts in it. And because the private markets were lousy at valuing these things, it set high expectations the IPOs couldn’t live up to.
- Founders staying the CEO — bring in an adult COO instead. This was the big gamble of Facebook: Could it be the first mega-cap consumer Web IPO where a young founder retained control? They did it, but the after market performance hasn’t yet proven it’s a good idea. He makes an easy target for unhappy Wall Street, even though the pot shots are unfair, given the job Mark Zuckerberg has done building the company over the last eight years.
- Dual class shares for that worst case scenario. Unlike the late 1990s, no one in recent times has blithely assumed they’d do well as a public company. Everyone who can has forced the public markets to swallow terms that give CEOs a fortress against activist shareholders. The catch is that the CEO has to be good, and that takes time to see. My sense is this will serve Zynga and Facebook well at the end of the day. Groupon? Maybe not. People who adopted these provisions may have underestimated how hard the emotional toll of a slumping stock can be, even if you can’t be fired by activist shareholders.
Add them up and these protections, ability to take money off the table, and push off going public until you were ready helped push the pendulum back in favor of IPOs. They seemed safer.
And as a result, you saw more entrepreneurs turning down acquisitions. Sure entrepreneurs were able to make more money from an acquisition than in past cycles, thanks to the lower costs of starting a company and the ability to hold onto more equity. In the past you had to sell a company for $1.5 billion to make $30 million. Open source software, commodity hardware, and other shifts made it possible to sell a company for $30 million, and make about $30 million.
But for people who want to build something lasting, it was an unsettling outcome. The memories of the dot com crash were lost on a younger generation of entrepreneurs and more recent transplants. And, it seemed, things were different this time.
Except, they weren’t. Not for Zynga, Pandora, Groupon, and Facebook. Sure, we have Workday and some smaller issues whose stocks have held up pretty well. But Workday in particular is a total anomaly. Everyone is suddenly pushing investments in enterprise now, but most of those companies take years to mature. Even Box.com quickly cooled the pre-IPO rhetoric it was whipping up pre-Facebook. Ditto, AngryBirds. And Twitter’s Dick Costolo has never signaled he’s in a hurry.
In the short term, this is a good thing. If Facebook had irrationally soared, companies that weren’t ready to go public would have been tempted, pushed, or cajoled into it. Groupon was an attempt to prove a company could go public after two years and was roundly smashed as a result.
But we settle in for another winter. The best companies — Airbnb, Dropbox, Evernote, Spotify, and of course Twitter — are trapped with $1 billion-plus valuations. In some cases, the valuations are for multiple billions. What yielded a bragging press release at the time is now looking like a gilded trap: They have to go public, do a down round, or sell for a smaller price and largely be viewed as a failure. And that means — as Libin hinted last week — it may be in for another eight years before we see some mega-cap consumer Web exits.