I’ve written before about the curse of the megaround which can happen, for example, when a startup raises $100M at a unicorn valuation and I’ve described before what typically happens next:
- The company is under great pressure to invest the money to drive strong growth. Late-stage investors don’t give you money to put in the bank at 0.2% interest. They want you to invest it, typically over the next 2-3 years, implying something like an insane $15 to $20M/quarter burn rate.
- As a result of this spending pressure the company gets inverted — instead of making a plan and finding money to finance it, the company gets a pile of money and then needs to figure out how to spend it. This is backwards.
- The company over-expands and over-invests. You end up in 10 countries not 3. You double your employee base in 9 months. You sign up not just for projects 1-3, but for 4-9 as well. It sounds great until you realize that half your countries are executing the wrong strategy, half the new employees can’t articulate the company message, and that projects 4-9 were down-the-list for a reason: they were dubious ideas that shouldn’t have been funded in the first place.
- The soon-to-be-former CEO develops a sudden interest in spending more time with his/her family. A new CEO is hired to “bring focus” to the situation. He/she ceases operations in 5 of the countries, lays off 35% of the employees, and shuts down projects 4-9.
If you were paying attention, you probably just noticed that $50M went up in smoke in the process. Fortunately, in Woodside, no one can hear a venture capitalist scream.
The Math Behind the Problem: Expectations and Power
In this post on the Silicon Valley hype machine, I argued that unicorns were the product of three trends:
- The cost and hassle of being a public company. Why go public if you don’t have to?
- The ability to raise formerly IPO-sized rounds in the private markets.
- A generally frothy environment in late-stage financing .
This got me thinking about what really differentiates a $100M IPO from a $100M late-stage private financing. Benchmark Capital’s Bill Gurley recently did a great post on this precise subject where he points out several major differences:
- The private round has far less scrutiny due to lack of an IPO process. The numbers in a financing deck may not be the same numbers that would have been in the S-1.
- In the private financing, the money is much more likely to have perverse effects on operating discipline (as I detailed above).
- In an IPO the company usually ends up with a single class of (common) stock, putting everyone on an equal footing. The $100M private round will be preferred stock, with strings attached in the form of liquidation preferences. This creates a difference between a common stockholder’s nominal and effective ownership positions and — if the business subsequently gets in any trouble — can literally wipe out the value of the common stock in an M&A exit scenario. This can be devastating for employees who typically are unaware of the terms (e.g., multiple and/or participating preferences) that create the gap between nominal and effective ownership.
While I think Bill’s post his excellent, I think he missed two factors that are particularly important from the CEO’s perspective: expectations and power. Specifically, what are the go-forward expectations for the stock and what is the power of the people who have them?
In the IPO scenario, there is a short-term expectation of an immediate pop in the stock price, which is conveniently handled by the endemic under-pricing of IPOs. So, assuming that takes care of itself through the usual process, what are the general expectations of an IPO stock after that, say during the next three years?
I spent some time researching this, looking at several studies and reviewing the capital asset pricing model. Since I didn’t find any authoritative source (and since many IPOs actually under-perform), I will somewhat arbitrarily suggest that an public-market investor would be happy with a 20 to 25% annual return on an IPO stock purchased a few days after the offering. I would be.
What does our late-stage private investor want? Everybody knows that: the rule of threes. They want a 3x return over 3 years. That’s a 44% annual return. And, in today’s markets, that will often be atop a considerably higher initial valuation.
So the first big difference is about expectations. Our private buyer expects roughly double the return of our public buyers.
The second big difference is about power: who, exactly, wants that return?
- In the IPO scenario, it’s a series of portfolio managers at institutions like Fidelity who each own positions worth single-digit millions. If they get mad at you, they can sell their shares or their sell-side analysts can downgrade the stock.
- In the private scenario, it’s a board member from a VC/PE firm that owns maybe $75M worth of stock. If they get mad at you, they can try to fire the CEO at the next board meeting.
So other than getting an investor with infinitely more power seeking double the return, in an environment with far less scrutiny over the numbers, in a situation more likely to cause a loss of operational discipline, and the use of structure / preferences that create potentially large gaps between nominal and effective ownership, there’s no real difference between doing a $100M private round and an IPO.
Well, at least the CEO can sometimes sell into the late-stage round. He or she may well need to.