On different wavelengths

Venture capital tech valuations continue to rise. Public markets have hit a wobble. If IPO exits are to stay strong, something has to give, writes Paul Bryant for the BVCA Journal.

Despite the shift to ‘private-for-longer’, IPOs remain important both for venture capitalists and entrepreneurs. This is especially the case in Europe. Between 2014 and 2017, IPOs accounted for 50% of total European venture capital exits by value. In the first nine months of 2018, this number jumped to 85%, boosted by the IPOs of two large ‘unicorns’, Farfetch and Funding Circle. According to Chris Smith, partner at London-based Playfair Capital, a seedstage investor: “For many of the entrepreneurs that I talk to, an IPO is still an aspiration that they would love to achieve. I don’t think the public scrutiny is considered so much of a downside that they would rather stay private.”

But public markets might be cooling to new tech IPOs. Judith MacKenzie, partner and head of public equity at Downing, says that her firm has been nervous about valuations in the tech space for about a year now: “Valuations are pretty much at their 10-year peak, so we started to step back from new investments in quoted tech companies in early 2018, especially if the company was venture capital-backed. Buying at a relatively heady valuation from someone that knows more than you do isn’t an attractive proposition.”

This tension could be indicative of a looming slowdown in tech IPOs.

Frothy private valuations

For most of the past five years, venture capital valuations have roughly matched the increase in public market indices. But over the last few months, they have diverged.

Public markets have stumbled, with the Nasdaq Composite index down approximately 13% from its August 2018 peak. Meanwhile, private markets have continued to run. In the US, late-stage venture capital median valuations jumped 50% in the first nine months of 2018, and early-stage valuations jumped 27%.

Although no median venture capital valuation data is available for Europe, there’s no reason to believe the situation is any different, particularly in late-stage venture capital. Twenty-four European companies reached a US$1 billion valuation for the first time in the first six months of 2018 (18 were unicorns), compared to 20 that reached this milestone in the whole of 2017.

James Clark, Head of Tech and Lifesciences — Equity Primary Markets at London Stock Exchange Group (and previously policy manager at the BVCA), says that this run in private valuations has largely been driven by an abundance of venture capital. He says: “Since 2011, there has been a marked increase in venture capital fund-raising, and this had to be invested. As a consequence, valuations took a large jump. VCs had to take bigger bets and as a consequence pushed more money into companies to fuel growth. For good quality companies, it’s definitely become a seller’s market — entrepreneurs have more power than they used to, and firms have had to pay more for the same equity stake.”

While venture capital firms have ratcheted up investment activity as they have raised more capital, it hasn’t been fast enough to deplete stocks of ‘dry powder’ (capital raised but not yet deployed), which has stayed at around US$100 billion for the US and Europe combined. So the abundance of capital and upward pressure on valuations has remained. According to the Pitchbook PE & VC Fundraising Mid-Year Update, 2018: “This capital may be sitting idle due to the frothy valuations in the venture capital market, which is forcing investors to revisit their investment strategies or wait for air to let out.”

Public markets balk

In the same report, Pitchbook presented an analysis showing a significantly less lucrative tech IPO environment in 2018. It compared the 90-day post-IPO valuation increases of venture capitalbacked, non-biotech IPOs. In 2016 and 2017, the median step-ups were in the mid-high 20% range. In 2018, step-ups had fallen to 10%. The fall was found to be heavily correlated to broad market price movements.

Pitchbook explained the significance of this metric: “As venture capital-backed IPO activity accounts for significant proportions of total exit value over the past two years, the health of public markets and investor demand are crucial to providing liquidity to private backers… Importantly, however, the IPO rarely represents a full exit for existing backers since the main function of the transaction is to raise funds by selling newly-issued shares. This means the performance of the newly-listed companies in the first few months — a factor frequently overlooked in discussions of venture capital exits — often plays a meaningful role in determining the actual valuation at which investors exit. The 90-day timeframe is also a common end to the IPO-lockup period for insiders, representing the point at which liquidity can be achieved fully.”

In addition to the general state of public markets impacting tech IPOs, there seems to be a growing unease with the venture capital-backed tech sector specifically.

MacKenzie says that in the last few years, it’s not just valuations, but also the way many deals have been structured that have made tech investments less attractive in public markets. She reckons some of the ‘financial engineering’ in private markets — mechanisms like liquidation preferences that allow private investors to receive a disproportionate share of IPO proceeds — are meeting more opposition: “It’s always been a factor in the tech sector, but things like liquidation preferences have become more common and aggressive. Two or three years ago, because there was so much demand for these types of stocks, it didn’t make much difference, but now it does. It’s a turn-off for new (public market) investors who have become more militant about it. We have certainly turned away from situations where we like the business but there has been a whacking great redemption premium in terms of money going out the door.”

What next?

Chris Smith doesn’t see any looming changes at seed stage. His take is that seed valuations are impacted mainly by the amount of capital firms have to deploy (which is a lot), and the quality of the individual company, not what the state of potential exit markets might be in five to seven years.

But for later-stage venture capital investors, and entrepreneurs in more mature companies, exit transactions might be more imminent, so the state of public markets is much more important. Clark says there is definitely a potential glut in the supply of companies wanting to go public, especially in the US: “There are still an awful lot of tech companies of unicorn valuation, sitting on the side-lines, waiting for valuations on public markets to catch up. We have seen some storied companies file to IPO in 2019. It will be interesting to see if their public market valuations hold up, especially in what seems to be an uncertain market. It will also be interesting to see how that plays out with less well-known companies.”

With public markets now moving in the opposite direction, not playing catch-up, this dilemma doesn’t look like it will be resolved soon. These companies are faced with potentially large valuation haircuts if they float, so they might decide to stay private for even longer.

From an entrepreneur’s perspective, Christian Faes, CEO of LendInvest, which is currently considering an IPO, thinks that the current valuation situation is unsustainable, but won’t speculate on whether any changes are imminent in the short term. He says: “Much of the problem with overvaluations has to do with the opaque way that venture capital transactions are now being structured. In the last three or four years we have met with many firms and have been quite shocked at some of the practices around things like liquidation preferences. There’s clearly a game that many startups are playing to try and stretch the ‘headline’ valuation, but when you scratch beneath the surface, there’s a massive liquidation preference for venture capital. So you might have a headline valuation of a billion and claim to be a unicorn, but with the liquidation preferences, the business is definitely not worth a billion to other investors. It’s not a particularly healthy culture for start-ups and founders to be aspiring to.”

Without doubt, private and public tech valuations are on different wavelengths. And with so much capital still needing to be deployed, private valuations show no sign of pulling back. It’s hard to see the momentum in tech IPOs continuing without one side blinking.