Technology Investing: Private vs. Public and the Role of Unicorns
One of the most frequently asked questions is where is the best place to invest. Sifting through all the data the answer that consistently comes up is technology. Here is one reason why. Big name American technology companies like Facebook, Apple, Netflix and Google represent almost half the market weighted value of the Nasdaq Composite.
Today the value of the so called FANG stocks is nearly $2.25 trillion. Investing $10,000 in Netflix as recently as 2014 translates into $34,823 today. Twenty years ago, three of FANG companies either did not exist or were early stage startups.
Consider this point also. Over the past five years, the tech heavy Nasdaq Composite has risen a healthy 76.6% or 15%+ annually. The broader S&P 500 did well but managed a more modest 50.8% or 10% annually. So this is one of those investment questions with an easy answer: tech stocks are the undisputed winners.
The legendary investor Warren Buffett, avoided technology for many years. He is now practically a tech disciple. Through Berkshire Hathaway, Buffett now owns a 4.8% stake in Apple. Before Apple, Buffett was a big player in IBM.
Now the question of where to invest becomes more challenging. What is the best approach; buying well established companies like those that comprise the publicly traded stocks of the Nasdaq or getting involved at a far earlier stage while these startups are privately owned.
Google And Facebook: Private Versus Public Investing
The history of Google and Facebook are good places to start. Together these two account for more than 10% of the Nasdaq and are good examples of “unicorns”.
In 2004 Google’s IPO raised $1.67 billion, for 19.6 million shares. At the time there were 271.2 million shares outstanding. That is 7% of the total company. Google’s IPO priced at $85 per share has appreciated 1928% over the past 14+ years.
Now consider Google immediately prior to its 2004 IPO. The tangible book value was $3.55 per share. Instead of paying the $85 public offering price, your cost as a private investor is just $3.55. So investing in Google as a private company and owning shares pre IPO your 1928% investment return would have multiplied to a mind boggling 46,272%!
And then there is the saga of Facebook who held its initial public offering on May 18, 2012. The $16.0 billion offering was the largest in history. On the day before its IPO at $38, Facebook’s value was $2.85 per share. An investor buying the IPO and holding during the last six plus years, has enjoyed a hefty 20 fold gain. A private investor, on the other hand would have a 58 fold gain.
There is absolutely no doubt that both companies have treated public shareholders very kindly. They have changed the way people communicate, delivered ever higher revenues and earnings and have judiciously diversified their business. But some private investors scored the type of gains that legends are made of.
In Search Of Unicorns
Facebook and Google are examples of unicorns. Our thanks to Aileen Lee who back in 2013 coined the name of this mythical animal to describe privately held startup companies valued at over $1 billion.
With this information in hand, the challenge is to find the next unicorn. The news here is bright. Since 2013, an increasing number of technology companies have achieved “unicorn” status. As of the end of last year, 146 private tech companies were valued at that level, according to CB Insights — more than twice the number a year earlier. In addition, 14 private companies were held valuations exceeding $10 billion earning the designation “decacorns”.
There are several reasons for this explosion. The US Jumpstart our Business Startups (JOBS) Act, which passed into law in 2012, increased fourfold the maximum number of shareholders a company can have before it must disclose financial statements. And it’s no secret that the private capital available to certain start-ups has rocketed in recent years, possibly to unsustainable levels.
This acceleration in the amount of capital invested in private companies — an increase that originated with an influx of later-stage capital from nontraditional sources chasing venture like returns — eventually trickled down to earlier stages. In just the past two years, the capital invested in private companies almost tripled, to about $85 billion as recently as 2017, from around $26 billion in 2013
Recent IPOs Have Had Mixed Results
Finding a unicorn and holding on to capitalize on the big IPO markup is the prize. Lately, however, that bonanza has proven harder to come by. Data from the last five years shows that public tech markets haven’t performed nearly as well as Facebook and Google. In fact, many tech companies that undertook IPOs in the past three to four years have performed poorly.
More than 40 percent of the unicorns that went public since 2011 are flat or below their final private-market valuations, according to a November 2015 study by Battery Ventures. (For more on the disconnect between private- and public-market valuations.)
And for late-stage investments, there are even signs of a cooling in private markets as some asset managers mark down their stakes in unicorns by anywhere from 10 to 50 percent.
It’s Not Deja Vu All Over Again
The widespread concerns over high pre-IPO valuations today recall debates over the technology bubble of the early 2000’s. Until nine years ago, no venture capital–backed company had ever achieved a unicorn valuation before going public, let alone the $10 billion valuation of 14 current decacorns.
The exploding number of unicorns could be a warning sign. However, most analysts believe the risks are nowhere as severe and the consequence of the current situation will produce a far better outcome.
The explosion of unicorns could be caused by aggressive pre IPO pricing. In the final analysis determining the fair value of a young private company is always subject to arbitrary calculations. However, there is another important force affecting the data.
Companies Are Staying Private Longer
Back in 1999, the average US technology company had at just four years of Pre IPO operations of under its belt. According to a study at the University of Florida: Of the more than 35 public tech (software) that reached valuations of as much as $10 billion between 2004 and 2015 only six achieved that level pre IPO. The other 29 needed more than eight years to reach that level.
The tendency of staying private longer has other tangible examples: Dropbox, AirBnB, Palantir Technologies and Uber. Except for Dropbox (IPO March 2018) each of these well recognized companies is private. The average company in this group was founded just over 8 years ago.
Thus logic suggests that by staying private for longer periods, private investors are taking greater risks in monetizing their investment and thus are entitled to greater returns.
Another factor needs to be considered, given the significant uptick in the number of high-valuation private software companies, combined with down rounds — new funding that values these businesses at lower levels than previous rounds did — and post-IPO losses. Research, drawing on 35 years of financial data covering around 3,400 software companies across the globe, leads to several conclusions:
- Software companies especially are staying private longer.
- This new dynamic calls for different investment models for early- and late-stage investors, as well as different funding approaches for companies.
- IPOs can and should be used as a strategic lever to accelerate growth.
Public company results seem to confirm the benefits of staying private longer. Research published by Jeremy Abelson and Ben Narasin looked at technology businesses with close to eight years of operational history that went public from 2012 to 2015. They found that public markets assign the larger ones a higher multiple at the time of their IPOs and afterward. The stocks of these companies also perform better.
In the interest of accuracy it is important to point out one of the indigenous flaws in the date. It needs to be remember that many unicorns fit into the software space. The characteristics of that business includes ultra-high profit margins that require comparatively little fixed investment. This offers the luxury of flexibility in IPO planning.
Time For Conclusions
What does all of this data point to? With the continuing flow of capital into the venture capital space, private investors are having to anti-up more to get into the game. The odds of finding another Google or Facebook (always a long shot) are probably a bit lower.
Who Are The Home Run Hitters
It would also be unfair to discuss the subject of private capital without including things like batting averages. In the public stock market, if a hedge fund manager picks the right stocks 51% of the time, in the long run, that person will be deemed a legend. Private venture capitalists come nowhere near this level of success.
A simple rule of thumb is that 95% of all new businesses fail within the first two years. There is little reason the believe that the batting average of even the best venture investment firms are any different. So success is achieved by choosing the right candidates and constantly supplying enough capital to maximize growth. Executing this simple formula with consistency is what separates the home run hitters.
Not long ago, Microsoft founder and present day venture capitalist, Bill Gates acknowledge the raw fact. “For every massive success like Sequoia Capital’s investment in WhatsApp, there are many deals that go nowhere”. A study by the Kauffman Foundation covering 20 years was published back in 2012. It showed that firms returned 1.31 times what was invested.
But averages are nearly always deceptive. Of the approximate 798 venture capital firms who are the exceptional ones? In July 2018 Forbes Magazine published their list of the top US venture capital firms.
- Tencent Holdings.
- New Enterprise Associates.
- Sequoia Capital China.
- Sequoia Capital.
- Higher Ground Labs.
- Quake Capital Partners.
- Goldman Sachs.
The rankings don’t always tell the whole story. As already noted, valuations and the investment returns based on those assumptions can be arbitrary. It is only well after a company has gone public and been seasoned by several quarters of trading can a realistic value be determined.
Nevertheless there is one firm that appears to have hit more homeruns than any other.
Sequoia Capital has invested in over 250 companies since 1972, including Apple, Google, Oracle, PayPal, Stripe, YouTube, Instagram, Yahoo! and WhatsApp. The combined current public market value for these companies is over $1.4 trillion, equivalent to 22 percent of Nasdaq. Its portfolio is mainly in financial services, healthcare, outsourcing, and technology. As of 2017, they have exited in 68 initial public offerings and 203 acquisitions.
Yahoo founders, Jerry Yang and David Filo sought out the advice of Sequoia Capital provided Yahoo! with two rounds of venture capital, raising approximately $3 million. By the time Yahoo was acquired by Verizon in 2016, it was worth $4.8 billion.
The team at Kleiner Perkins is distinguished by their June 1996, investment of $8 million in Amazon. This was its only VC investment before Amazon went public in May of 1997.
When Amazon went public in May 1997, the only one of those three early investors whose name was on the S1 was Tom Alberg, who is still director of the company, as well as managing director of VC firm Madrona Ventures. He owned 195,000 shares at the time. Amazon has split its shares three times, all in 1999, so those shares today would be worth about $1.9 billion.
In the summer of 2004, venture capitalist Peter Thiel made a $500,000 investment in Facebook through one of his VC firms. In return, Thiel received 10.2% of the company and joined Facebook’s board. Thiel’s record which includes early stage investing in PayPal, pretty much speaks for itself.
Technology: What Business Leaders Are Closely Watching
At the World Economic Forum in Davos, Switzerland in January, business and political leaders debated what technologies would be the future disrupters of business, politics and government policy. One of the hottest topics was the power of the Internet of Things. Of all the topics at Davos, it was agreed, IoT had the greatest chance of having its impact felt in the immediate future.
Here is just one example. Google recently shared that its Google Assistant can be found on one billion devices (mostly Android phones). Meanwhile Amazon has sold 100+ million Alexa devices. This is just the beginning.
According to data presented at the World Economic Forum, IoT devices are expected to generate $3.7 trillion in revenue annually be 2018. Illustrating the immediacy of its impact, almost 20 million American homes became IoT networks buying more than 40 million smart home devices.
The technology behind the Internet of Things started with the mobile phone but is rapidly moving throughout the home, into the car and even entire cities. This very technology has been termed the core that will power the “Fourth Industrial Revolution”
Whenever the future of technology is debated terms like big date, artificial intelligence and robotics are included. IoT is where it all comes together. According to WEF founder and conference speaker Klaus Schwab, big data and artificial intelligence can dramatically improve the efficiency of organizations and even manage assets.
IoT transforms mundane objects into applications that have additional functionality. IoT data provides important insights and can be used to train artificial intelligence algorithms. Suddenly mundane objects act like applications that you can interact with and learn from.
IoT is not without its dangers, though, and there are cases of glitches have raised red flags about how they can expose consumers to hackers. In spite of these important privacy issues, IoT is changing the way we all function.
5G The Next Big Thing In Mobile Communications
The latest generation of cellular mobile communications is 5G. This technology targets high data rate, reduced latency, energy saving, cost reduction, and massive device connectivity. The first phase of will be ready by April 2019 and will accommodate early commercial deployment. The second phase is due by April next year.
The November 2018 edition of Ericsson Mobility Report projected that by 2024, 5G coverage will reach more than 40 percent of the world population, making it the fastest generation ever to be rolled out on a global scale.
In parallel, cellular IoT is making great strides — connections are set to pass the 4 billion mark by 2024. Technology experts consider 5G critical to the broad acceptance of driverless applications.
Behind these life changing technology themes are many more evolving technologies to support or service each of the major players. One thing has been obvious since the commercialization of the first personal computer 40+ years ago, technology is consuming a bigger share of life as we know it. That also means a greater share of our investment dollars.
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