Technically Private

Wall Street and Silicon Valley: A Ballad

“It’s called continuous polling,” he explained, “instead of sampling metrics every second, our system provides complete & continuous collection and aggregation of applications and operations data! It delivers true full-stack visibility in a single pane of glass!” Our marketing executive at his finest.

It was the summer before my freshman year of college. I was working at AppFirst, a software company (a probably painfully obvious fact by now), developing python code designed to alert system administrators that their components had reached supposedly dangerous thresholds (a job I was questionably, at best, qualified for). The marketing executive, Mark (not his real name), was gleefully detailing why our technology was superior to our closest competitor, AppDynamics, with about as much enthusiasm as one can possibly have when discussing B2B software. He was rather good at his job.

“If our technology really is better,” I questioned, “why haven’t we captured the market?” Pop. His almost palpable enthusiasm began to rush out out of his face, quickly replaced by an air of sobriety. I hit him where it hurt. “They’re a much larger firm — much more established,” he justified, “They’re probably going to go public soon.”

“Oh,” I thought, accepting this as a perfectly reasonable explanation. “Going public,” I determined, must be important. Two years later, at time when tech “unicorns” are seemingly more common than technology IPOs, the gravity of Mark’s answer still weighs on me.

199(IP)0s: How Netscape Changed the Valley

They broke every rule of Wall Street. Their revenues required six figures; their costs — seven. If they were a child, their age would be expressed not in years, but rather months (16). Reliable valuation metrics for the new internet economy had yet to be developed, and arguably still haven’t. So on August 9th, 1995 when Netscape Communications helped its Initial Public Offering (IPO), investors bought into the next-big-thing with seemingly unprecedented appetite given the company’s age and financial health. After being priced at $28, Netscape’s equity valuation more than doubled by day’s end, closing at $58 a share. Marc Andreessen, the company’s co-founder, became a millionaire overnight. Silicon Valley had gone on its first date with Wall Street, and the well-dressed bankers of Southern Manhattan pulled out all the stops. After Netscape, the second and third dates were a foregone conclusion. Silicon Valley liked what she was seeing. New York was getting laid.

They say you can’t put a price on hope, but that’s in essence what Netscape did. And at $28 a share, who wouldn’t want to dream? But soon, hope wasn’t all that difficult to come by in the Valley. Following Netscape’s success, firm after firm, after an initial fling with Venture Capital infested Sand Hill Road and “staying just friends” afterward, moved up to the public markets. In 1996, Yahoo — backed by one of the most powerful VCs on Sand Hill Road, Sequoia Capital — held its IPO with only $3 million trailing revenue. $3 million. To put that in perspective, when Facebook had its IPO in 2012, it had revenue of over $3 billion. The ’90s honeymoon phrase between the two coasts was certainly lucrative if not gluttonous.

*Like* the Private Market: The Legacy of Facebook’s IPO

After 2001, Silicon Valley and Wall Street decided that they were going to see other people. After the .com bubble, the public markets were hesitant to indulge in another next-big-thing company. Tech companies were forced to settle for their old, yet reliable ex: The Venture Capital firms of Sand Hill Road.

If the public markets were the Valley’s yuppie boyfriend from the East Village, investors from Sand Hill Road are the slightly nerdy, sweater-wearing conservatives from Westchester. Sweater-wearing conservatives with a trust fund. That’s because the pooled capital that VC funds use to invest comes from what are known as accredited investors. The SEC has decided that for the majority of the public, investing in private markets is just too risky. But for the select few that have an annual income of over $200,000 or a net worth of at least $1 million and therefore qualify as accredited investors, buying into the future is a legitimate, and often lucrative, investing opportunity.

By now, you may have seen The Social Network, and if have, you probably noticed how much the founders argued about about money. But nowhere in the 121-minute film do they mention how the Facebook, as they were calling it then, was going to make money. Facebook, however, was the darling of Sand Hill Road. In 2008, the company hired Sheryl Sandberg to figure out how the company was going to turn a profit, but by then the company was already worth 11 figures. As it turned out, you didn’t need to show more profits to deserve a higher valuation, you just had to convince investors that income was hiding somewhere in the future.

The SEC section 12(g) requires companies to register with the regulatory industry when it “has total assets exceeding $1,000,000 and a class of equity security … held of record by five hundred or more … persons…” By 2011, Facebook had exceeded both of these thresholds, and was therefore obligated to begin reporting financial statements within “120 days of the last day of its fiscal year.” This meant that Facebook was compelled to publish quarterly earnings and submit to an annual auditing. The darling of Sand Hill Road was essentially forced to IPO.

It turns out that Silicon Valley didn’t mind settling with it’s sweater-wearing boyfriend from the suburbs. In California, engineers were interested in making real advances in technology; they were concerned with the 1’s and 0’s that powered computers, and not — as they were on the East Coast — with a 1 followed by zero 0’s. The Venture Capital investors were content to defer seeing profits, just as long as Silicon Valley stayed close to home and allowed them to show unrealized returns to their accredited invests. Firms would raise money from VC firms, and upon seeing their previous valuation and impressive technology, other VC firms would invest at a higher valuation in the next round. In large measure, on the West Coast the phase “Show me the money,” was reserved for reruns of Jerry Maguire.

The Facebook precedent was the beginning of a long-term relationship between Sand Hill Road and its neighbors in the Valley. I heard they met on tinder.

Not-So-Private Companies: Why a16z is (Probably) Wrong

Following Facebook, staying private became in vogue. By now Marc Andreessen (remember him) and fellow Netscape alum Ben Horowitz teamed up to form the new cool (well, relatively — how cool can IT guys be really) firm on Sand Hill Road. Andreessen Horowitz — or a16z if you’re cool (again, relatively) — began to advise firms to mature in the private sector. Yes, the two overnight internet millionaires, who made their money in Netscape’s first public issuance, were now advising firms to remain private as long as possible. Rather convenient.

The entrepreneurs turned investors, weren’t alone, however. Many firms successfully grew in the private sector and only later entered the public markets when they were more mature (e.g. LinkedIn). Uber, following the trend, recently topped Facebook when its over $60 billion valuation became the largest private technology appraisal in history. Their CEO, Travis Kalanick, seems to almost fear the public markets and openly brags that the firm will remain private until at least 2018.

Changes from the Jumpstart Our Business Startups Act (commonly referred to as the JOBS Act), changed the requirements of section 12(g) and quadrupled the maximum number of equity holders from 500 to 2,000. Suddenly remaining private wasn’t just more attractive from and an equity financing perspective, it was now a whole lot easier to do legally.

Rumor has it Kalanick was spotted last week wearing a wool, crew-neck sweater. Westchester is supposed to have great schools.

Silicon Valley was as hot as ever and soon Wall Street grew jealous. If he couldn’t have tech’s IPO’s, he wanted their explosive growth. Mutual funds like BlackRock, Fidelity, T. Rowe Price, and Wellington began purchasing shares in late stage, pre-IPO technology companies. In doing so, private markets became even more attractive. At one point in 2015, Shopify, who rather successfully transitioned into the public, raised roughly $150 million in its IPO. A week later, investor Carl Icahn invested $100 million in Lyft through his personal investment vehicle: Icahn Enterprises. Think about that. One guy essentially provided IPO-level equity capital in the private market. 20 years ago, when we still used the Netscape browser, that would have been unheard of. Then again so would Lyft.

In the past, public offerings yielded two distinct advantages: they allowed firms to raise equity capital and they provided investors with liquidity. With private markets as attractive as they are, the former advantage is moot and therefore firms’ only real incentive to enter the public markets is to allow their investors to realize their returns. According to the Wall Street Journal’s Billionaire Startup Club, 146 private technology companies have been valued at over $1 billion and have therefore achieved unicorn status.

Valuations have been booming and some, justifiably, have been wondering if we are in another bubble. In July of 2015, a16z gave a presentation entitled US Tech Funding — What’s Going On with the intention of calming some of their skeptics. The slides from the presentation are publicly available and provide rather convincing evidence that this time is, in fact, different. They correctly pointed out that most of the growth in valuations in the tech sector have come from late stage firms that are generating real profits — not moonshot companies like pets.com that were going public in the late ’90s — and that these valuations are happening in the private markets — in no doubt partially attributable to mutual funds’ willingness to invest in these companies before their IPO. They also point out in 1999 — the year when pets.com held its Initial Public Offering — 371 technology companies entered the public markets. In 2014, only 53 such firms hired an investment bank to underwrite their IPO.

TL;DR: Tech firms can get money in the private markets both from VCs and mutual funds and are therefore delaying their IPO. I could have told you that, but somehow when the guy that “invented the internet” says it, it’s just so much more reassuring.

Mutual funds are a publicly traded asset class. So when mutual funds invested in Californian unicorns, the distinction between private and public began to grey. Because firms like Fidelity and Wellington are shareholders in these “private” companies, and because retail investors are shareholders in their mutual funds, the public suddenly had exposure to an asset class that was previously reserved exclusively for elite accredited investors. Retail investors are now indirectly shareholders in companies like Uber, Snapchat, and Pinterest. Even though private technology companies don’t have to submit yearly audits or report quarterly earnings, they are now scrutinized by the public and the luxury of growing in the private sector is now slightly less attractive.

It’s important to remember, however, that mutual funds aren’t just for accredited investors; they’re long term investment vehicles intended for retail investors like you and me (maybe you, definitely me). And because retail investors can’t afford to be in the dark about their investments, the SEC requires that mutual funds publicly disclose their valuations every quarter. When tech firms received capital from mutual funds, they implicitly subjected themselves to the quarterly-capitalism inherent to Wall Street. And Wall Street, the Valley would learn, is a fickle bitch.

In March 2016, the Wall Street Journal reported that of the 40 unicorn firms that mutual funds BlackRock, Fidelity, T. Rowe Price, and Wellington have invested in, 13 have been written down by an average of 26%. These companies written down by New York investment firms include some of the Valley’s most beloved: Zenefits, Evernote, and Snapchat amongst others.

What does this mean for private technology companies? Since technology companies don’t follow the rules of value investing and are perhaps overly reliant on relative valuation, write downs can have powerful ripple effects. When analyzing technology companies, it’s not uncommon to use relative valuation multiples such as enterprise value/registered users or EV/page views rather than a more traditional metrics such as EV/EBIT or Price/Free Cash Flow. So if Wall Street decides that Snapchat isn’t worth $16 billion, similar-but-smaller, less-established companies will also see a significant dip in their implied valuations.

If private markets continue to be less attractive, you may postulate that private companies will rush to the public markets as an alternative source of equity financing. Doing so, however, could negatively affect valuation as the public markets have been unforgiving. Unlike Silicon Valley where potential is an almost tangible asset, Wall Street is more demanding.

When Jack Dorsey’s Square hired Goldman Sachs, Morgan Stanley, and J.P. Morgan as their lead book runners for their IPO in November 2015, they originally hoped to price their shares between $12 and $14 per share. This is well below the $15.46 per share valuation it received in its last equity financing round in the private market. It ended up pricing at $9.

Wall Street is not a rebound relationship.

As a rule of thumb, valuation typically increases during an IPO, and this fact can be used to justify late-stage investments in unicorn firms. But if public markets continue to be be unrelenting, this could have disastrous consequences on private markets. Investment firms will have to think twice about valuation before they buy into the next-big-thing.

In 2016, we have yet to see a technology company brave the public markets. The Valley keeps texting him, but rumor has it, Wall Street’s been flirting with industrials.

Conclusion: Databases and Valuations in the Cloud

In HBO’s popular show Silicon Valley, the Mark Cuban-esque, self proclaimed 3-comma investor (thousands, millions, billions — OH!) advises one of his startups that they shouldn’t try to earn revenue. He shrewdly explains, “If you show revenue, people will ask how much and it will never be enough.” In the Valley, he explains, it doesn’t matter what you make — it matters what you’re worth. And what companies are worth the most? “Companies that lose money.” You can’t build a DCF when there’s no CF to D, and in those cases our natural curiosity in the future and technology seemingly creates a higher valuation than a normal excel model would.

The reason that Facebook can trade at a multiple that resembles my likes/comments ratio on my profile picture (160/9) is because Silicon Valley allows us to attach a dollar figure to hope. When Netscape had its roadshow, investors didn’t understand the nuances of network engineering that powered its browsers, but they didn’t care. $28 was a bargain, investors reasoned, when you’re buying into the future. It’s much easier to have demanding valuation requirements when you aren’t putting a price on your dreams.

In July 2014 when Mark was telling me, “Now, organizations can see every interaction between the OS and every application component, down to the microsecond,” what he was really saying is that he’s long hope. How could you blame him?

Mark was born to a Jewish family in Maryland. His father is an accountant. His mother is an accountant. When he went to college at the University of Maryland, he decided to follow his dream and pursue a degree in — accountancy. But going to college in the ’90s, it was impossible to not to be roped into the innovation out West. Mark finished with a double major in marketing and began his career at theladders.com. He has since left AppFirst to head up marketing at another B2B software company with, I’m sure, as much an enthusiasm as ever.

If I were to talk to Mark now, he would be bullish as ever on the next-big-thing. “ITaaS [Information Technology as a Service — sexy, I know] is going to change the way cloud-based, technology companies do business!” Mark would tell me. He’s rather good at his job. He would point out that there are still so many things that still need fixing. When was the last time you were satisfied with your trip to the airport? Your healthcare provider still uses a paper filing system? Mark would make it seem like it’s the ’90s and we are on the precipice of the next great wave of innovation. Then again, he is a marketing executive.