This article is written by Josh Burwick, managing partner at Sand Hill East Ventures.
If I told you the leading Internet streaming music company with 80% share was raising a private venture capital round, what questions would you ask to determine the pricing of the round?
– The company has 88 million listeners of whom roughly 90% are monthly active listeners
– The company is more prolific in streaming music than YouTube is with video
– The company is close to penetrating the $15 billion broadcast radio market
– The last round was down a year ago at an $8 billion post money valuation
– Listener hours increased 20% for the year
– Annual revenue increased 40% year over year
– EBITDA increased 158% year over year
– Its closest competitor doubled the valuation of its round over roughly the same timeframe
If you are a private market investor you might guess the round should be priced up 20-25% from the last one. Potentially more depending upon what other brand name VC funds/investors were involved.
If you are a public market investor your answer is down 60%! How do I know? Because the stock is Pandora and the stock has corrected 60% to reach a low of $15 from $40+ a year ago.
Reality Distortion Field
Steve Jobs was famously credited for creating the ‘Reality Distortion Field’ where he could orchestrate the seemingly impossible through a masterful combination of force, bravado and focus. Jobs’ use of the reality distortion field allowed Apple engineers to see beyond the herculean task ahead, to see that it was possible to create a new device (e.g. iPod, iPhone, iPad) in a timeframe many considered impossible. Steve Jobs believed that reality is malleable.
The private venture capital frenzy has created a similar reality distortion but not quite one that has produced anything as important. Rather the result has been sky high burn rates, unrealistic expectations, and crazy valuations. Just because a bunch of smart investors say a company is worth a certain valuation and invest money with that underlying assumption, does not make it a reality. No one on Wall Street pitches a stock saying you need to buy Cisco because Fidelity is buying it and paying these market prices. As silly as that sounds, that’s exactly what many in the venture capital community use as an excuse to invest/participate in a round and pay a certain valuation- i.e. “Andreessen Horowitz is leading this round”.
Roots in the Technology Bubble
Historically, the way to achieve massive outperformance for a hedge fund or mutual fund was by picking the next secular winner. If a portfolio manager was early spotting Microsoft, Starbucks or Amazon, he/she could buy the IPO and achieve the vast majority of the stock performance. Microsoft IPO’ed March 13, 1986 at $21 per share and since then the stock has split 9 times and generated 34,186% reflecting today’s price.
Unfortunately, today if you spot the next Microsoft, whether you think its Facebook, Alibaba, or Twitter, you have virtually no chance of gaining 1/10, 1/100, or even 1/1000 of those returns because of the private market’s later rounds bidding the valuation up pre-IPO. Google is looking increasingly like the modern day Microsoft, EU investigation included. Google IPO’ed at $85 in August 2004 ($85 billion market cap) and seen its stock rise 527% since then. More recently, Facebook IPO’ed May 18, 2012 at $38 per share for a market cap of $104 billion. Since its IPO, Facebook has been wildly successful at making the transition to mobile but the stock has appreciated “only” 115%, an impressive gain, but not in the same ballpark as Microsoft, Amazon and others post IPO.
The private markets are taking the vast majority of the public market performance as seen by the successively higher market caps of technology bellwethers’ at IPO and their smaller public market gains.
Hedge funds and asset managers need to play in the private market to gain returns like they used to garner with IPOs like Microsoft. Thus we are seeing hedge funds like Tiger along with asset managers like Blackrock and Fidelity dedicate billions of dollars to venture investing. In order for funds like Tiger to make a return worth mattering to the firm’s bottom line they need to deploy hundreds of millions to later stage private companies in order to reap a 2-5x return at exit.
As a result of the typical public market participants playing in the VC sandbox, companies are pushing off IPOs until much later in life and doing $50-300 million deals in the private market. (Note Jawbone just raised $300 million as I write this). While the availability of credit is a good thing for private companies, the valuations they are raising money at are in the “reality distortion field” realm.
It’s a game of musical chairs where the later stage investors are investing assuming that there will be someone to pay a higher price at the next round within a year or so. But if the “final” buyer, i.e. the public market buyer, moves away the reverberations will be felt throughout the value chain.
If these later stage billion dollar companies (sorry I hate the term unicorn so can’t use it with a straight face) were in the public markets their valuations would not endure because of increased disclosure bound to reveal unflattering areas of any company. Hedge funds provide a much needed “devil’s advocate” market equalizer by their ability to short stocks they feel are overvalued and not priced for the inherent risks. I know quite a few hedge fund portfolio managers who are eagerly waiting for the day when Uber goes public so they can short the stock.
How Will This End?
Just like in the late ‘90s it was obvious to most that we were living in our version of the Tulip bubble but money was too easy to not participate. I expect the roots of the end will involve the large, later stage raises for companies like Uber, Airbnb and Pinterest who are raising massive pre-IPO like rounds. Investors like Tiger and Blackrock are investing hundreds of millions of dollars in rounds like Jawbone (http://on.recode.net/1CN5a3a) and Spotify (http://wrd.cm/1EGFI4e) as they believe the next round will be even higher. The “next round” has to be an IPO. But what if the IPO window closes? If the IPO window closes as it always does, (2017 is my best guess), then it will reverberate down the line to earlier rounds. Until then the reality distortion field remains.
Advice to Private Investors
If you are a VC I would focus on the earlier stages where there is much less competition for deals and as a result valuations have not gotten unruly. While investors complain that seed round valuations have migrated toward the high single digit million vs. the previous low-mid single digit range, in the end it really doesn’t make the difference between an investment being a winner or a loser. If we invest in a great company at a $7 million valuation vs. $4 million and the company gets acquired or IPO’s at $500 million, it will still more than make up for the others in the portfolio. The risk reward at the earlier stages is much more appealing than hoping to get in at a high valuation later stage with hopes to sell it higher to someone else.