BDCs: Earlier access, better value for retail investors burnt by tech IPOs
Despite the popular perception of technology IPOs – explosive growth potential and lucrative investment opportunities – many recent tech IPOs have destroyed value for the majority of retail IPO investors. In the period from January 2011 to July 2012, we witnessed an easing of IPO conditions, enabling 71 technology companies to access the public markets. This article focuses on ten of the most prominent IPOs, generally with $1 billion-plus valuations and based in the social Web.
There is huge disparity between the returns for the first investors and those of the IPO investor. Anyone who invested in the first round of preferred equity financing received, on average, a return of approximately 288 times. This is skewed by a monster 1,000 times return for the first Facebook investors, so this article predicates a median return of 160 times for the Series A investors.
On the other hand, those who invested at the stock’s first publicly traded price have lost approximately 40 percent. Cautious retail investors who avoided the wild first trading day and invested at the end of trading day two have fared only marginally better with a 35 percent loss on their investment. This disparity has caused many to ask whether the IPO game is rigged to benefit the Silicon Valley insiders and Wall Street bankers.
Inequality between institutional and retail investors is hardly uncharted territory. Rather than rehash populist sentiment, we should explore the underlying reasons for the disparity. Such research indicates that three factors drive recent IPO under performance: (a) Companies are staying private longer and coming to market as more mature businesses; (b) founders are less motivated to cash out early and are seeking better deals; and (c) secondary marketplaces are providing transparency and liquidity, driving up the valuations of private companies in advance of their IPO. My view is that these factors are likely to persist and that the expectations of IPO investors need to be substantially moderated.
Problem 1 -- Staying private longer
The window between first venture capital investment and IPO ("time to liquidity") has expanded. Thus there is more time for the company to grow revenue, scale costs, and ultimately build value before accessing public capital. The median "time to liquidity" of the recent batch of tech IPOs is approximately six years compared to 3.5 in the 1999-2002 IPO bull market. With 70 percent more time to grow user bases, revenue and margins, these companies are more mature upon IPO and don't exhibit the same growth trajectory.
Problem 2 -- De-risking the founders
Buttressing this "time to liquidity" expansion is the recent trend toward founder de-risking. Other than outright sale, the IPO has been the only means for founders to reap the benefits of tireless work. Founders were thus highly motivated to go public to pay bills, diversify their holdings, and take money off the table. Desire for liquidity may have led to companies going public or selling themselves too early, sometimes at sub-optimal valuations.
This created opportunity for venture capitalists and dealmakers. If they could satiate the founders’ liquidity desire, wring out additional revenue and operational growth from the company, and block retail investors from participating for 6-12 months, they could maximize the IPO valuation of the company. The three highest-profile examples of this are Facebook, Zynga and Groupon. Facebook took $1.5 billion four months before its IPO at an approximate valuation of $50 billion; its stock is down approximately 40 percent from its IPO price. Zynga received $490 million 10 months before its $6 billion IPO; its stock is subsequently down approximately 77 percent from its IPO price. Groupon took $950 million 10 months before its IPO at an approximate valuation of $6 billion and has seen its stock decline over 78 percent since its IPO.
Problem 3 -- Maturing secondary market
Another development contributing to robust IPO valuations is the emergence of a semi-liquid secondary market for pre-IPO stock. Marketplaces like SecondMarket and SharesPost offer qualified, accredited investors an avenue to purchase stock of pre-IPO companies from employees and early investors. These markets not only provide more transparency into the current market valuation of a company’s shares, thus improving the company’s negotiating leverage as it raises additional capital, they also create more hype and upward pressure on the valuation. Additionally, they provide liquidity for those investors that want to sell, further reducing the pressure to go public.
Problem 4 -- Investor expectations are too high
It is simplistic to argue that, given the dismal results and the seemingly rigged game of IPO investing, retail investors should ignore bleeding-edge technology and invest in blue chips and indexed funds. Instead, they need to re-calibrate their expectations and explore alternative securities to gain exposure to early-stage technology.
The recent batch of tech IPOs shows that much of these companies’ valuation growth had occurred before the IPO. Emerging technology offers retail investors huge potential for value creation – but not at the moment of the IPO. The purchase of IPO stock of tech companies may be a winning investment in the long term and incremental value may be created after the IPO, but the expectation of exploding post-IPO stock results in poor investment decisions by retail investors.
The solution -- Early-stage tech portfolio access offered by BDCs
Various avenues exist for investors to gain exposure to private technology companies, however most require the investor to be accredited, have significant net worth, excess cash, and a long investment horizon. Two such avenues include traditional venture capital funds and technology accelerators, both of which carry minimum investment requirements and multi-year lockups, and are generally closed to retail investors.
Business Development Companies (BDCs), focused on making investments in privately-held technology companies, have emerged to address this opportunity and create an investment option for the retail investor. Tech-focused BDCs are akin to closed-end mutual funds and essentially serve as publicly-traded venture capital funds. These BDCs provide retail investors with a professionally-managed portfolio of technology companies and can be traded like any other public stock. When compared to traditional venture capital funds, BDCs offer investors the same asset selection and active management of a portfolio of private technology companies without the minimum investment thresholds and lockup periods.
There are two subcategories of BDCs focused on making equity investments in privately-held technology companies: (a) later-stage investors like GSV Capital (GSVC), Keating Capital (KIPO) and Firsthand Technology Value Fund (SVVC); and (b) early/seed-stage-focused INVENT Ventures (IDEA).
It is too early to judge the relative success of the early-stage focused versus the late-stage focused BDCs, however as one can imagine, those that made late-stage investments at near-IPO valuations in SecondMarket or SharesPost have suffered as the public markets punished companies like Facebook, Zynga, Groupon, and others.
Given the tremendous value creation potential of technology companies, private and retail investors alike will continue to seek exposure to early-stage technology. As VC-backed exit valuations trend lower, with 97 percent of exits below $100 million, is it becoming increasingly difficult for investors whose entry valuation point is greater than $10 million to generate appropriate risk-adjusted returns. For retail investors gun-shy from recent post-IPO returns, the most attractive opportunities may lie with the BDCs making early-stage investments at sub-$10 million valuations. These vehicles offer unparalleled access to the retail investor, tax-sheltered dividends and potential capital appreciation in the public markets, and reduce the risk profile of early-stage technology investing – all without requiring astronomical exit valuations to generate strong returns.
[Image courtesy Tax Credits]