Performance Concentration and Power Laws

Google created over 90% of its value since it IPOed in August 2004. The same goes for Apple. According to data from FundersClub, Steve Jobs, Steve Wozniak, and Mike Markkula Jr. earned a combined $436 million when Apple went public at $1.78 billion valuation in 1980. Four years earlier, Apple began with $1,750. Jobs and Wozniak sold their most prized possessions — for Jobs, his VW bus and for Wozniak, his programmable calculator — to buy the initial hardware to get the company off the ground. While still private in 1978, Apple took $250,000 in venture funding from Sequoia Capital. 18 months later, Sequoia sold all its stock in Apple.

Consider Apple’s market capitalization now: $650.28B. Let’s compare the rate of value creation during its life as a private company versus that as a public company:

  • 1976–1980 (Private): 819.55% on $1.77 billion of value creation.
  • 1980–Present (Public): 17.25% on $648.28 billion of value creation.

There is a story I recently heard about a private company going public. At the stock exchange open bell, the NYSE president approached the founder/CEO and said 90% of value for companies is created after the IPO. Here lies the long held consensus about company value creation. Is that a truism today? I do not know. A September 2016 discussion in the Journal of Applied Corporate Finance moderated by University of Texas professor Ken Wiles disagrees,

Whereas 20 years ago 90% or more of the value appreciation came after the IPO of a highly successful company (think about Micro-Soft or, a much larger share of the overall value creation now appears to be taking place before the IPO.

Can the public capture as much value?

“Twenty years ago, 90% of the accretion in tech company value came after the IPO, and not during the time it was privately held.” How do we measure value accretion? One way would be to measure value created for consumers. However, that presents the dilemma of measuring the utility created, say, by Domino’s Pizza versus the utility created by Alphabet. A medium Domino’s BBQ chicken pizza has 2,080 calories. So while I may be shaving seconds off my life there, a Google search for “pizza” returns results in 0.84 seconds. It’s comparing apples and oranges.

Instead I choose to measure the delta (change) in market capitalization. It may be the best way to gauge value captured by the public. Despite the fact that we all do not eat Domino’s pizza or use Google’s search engine, we all have a stake in the public equity market. 52% of American households have money invested in the stock market. Perhaps you fall in the other 48%. Do you know someone with a 401k? Maybe someone you love has a pension plan invested in mutual funds or index funds.

We all are tangentially involved in the stock market. Do you remember the Great Recession of 2008? Emotionally or financially, we all were affected.

Glenn Schiffman is a former Senior Managing Director at Guggenheim Partners, and he recently became CFO of IAC. Congrats, Glenn. He highlights four cases illustrating the effects of companies staying private for longer,

  1. March 1986: “Microsoft was worth less than $500 million when it IPO’ed.”
  2. May 1997: “When Amazon went public its market capitalization was less than a billion dollars.”
  3. January 2004: “I was one of the lead managers of the Google IPO, and I think the company was valued at $85 billion when it went public.”
  4. May 2012: “Facebook went public with a market cap of over $100 billion.”

What are these companies worth today? Microsoft (MSFT): $508.32B. Amazon (AMZN): $397.13B. Alphabet (GOOG): $569.15B. Facebook (FB): $380.96B.

Schiffman’s conclusion may prove prophetic of what’s to come, “The mutual funds have been shut out of more recent tech success stories but they still have, in aggregate, about $300 billion to invest. They have to put that somewhere.”

These few anecdotes serve to represent a snapshot of a bigger picture. My article earlier this week was about Cisco’s $3.7 billion purchase of AppDynamics. It is a fair to say that the management at AppDynamics did not want to management the constant lens of being public. Is it easier running a company with or without Mr. Market determining your business’s value each weekday from 9:30 a.m. to 4:00 p.m EST? In an October 2015 HBR article, Peter Drucker framed the pressures of being public better than I could,

Everyone who has worked with American management can testify that the need to satisfy the pension fund manager’s quest for higher earnings next quarter, together with the panicky fear of the raider, constantly pushes top managements toward decisions they know to be costly, if not suicidal, mistakes.

Does Schiffman agree with Drucker’s sentiment? 100%. “I think if you have a valuation of under a billion dollars, and given the headaches of being public, I don’t think you should go public unless an exogenous factor forces you to.” The advantages of being public are quickly diminishing:

  • The plentiful sources to invest capital give private companies many opportunities to raise money.
  • The US interest rate is 0.75%. Qualified private companies have ample access to debt markets.
  • Cash on corporate balance sheets is higher than ever. Opportunities in mergers and acquisitions (M&A) abound. In 2016, U.S. and European M&A totaled over $1.7 trillion. With or without President Trump’s cash repatriation plan, acquisition hungry corporate buyers have the ability to fund M&A.
  • Being public is more expensive than ever. Sarbanes Oxley compliance and new banking regulation put downward pressure on margins. These costs apply to business ranging from prescription drug manufacturers to small and medium sized banks.

What are the incentives for companies today? Stay private or join the umbrella of a corporation. Alphabet has made over 200 acquisitions since 2001, and Salesforce has made 44 since 2006.

I am not postulating about what is to come. Instead I have articulated a set of incentives to present possible reasons for the pervasive trend of companies staying private for longer. The trend is widespread. First, according to the Wall Street Journal, “The number of publicly traded companies peaked in 1997 at 9,113 but now stands at 5,734. This drop of almost 40 percent puts the total of public companies at about the level it was in 1982.” Second, the number of IPO’s in 2016 fell to 105 from 170 in 2015. As Maureen Farrell writes in the previously mentioned WSJ article, “The U.S. is becoming ‘de-equitized,’ putting some of the best investing prospects out of the reach of ordinary Americans.

My original intent for this article was to measure corporate growth. I wanted to answer the question of whether companies create more value pre or post IPO. Unfortunately, survivorship bias is powerful. The winners, the survivors such as Valeant, Google, and Tesla exhibit exponential returns on invested capital for founding employees and early investors. Companies like Spyker in automobiles or Nasty Gal in online retailing created value until their demises. We have no way to measure the temporary value created by the non-rocket ships.

In writing this article, I accidentally stumbled onto a different topic. As companies stay private for longer, the value captured by early risk takers (founders, early employees, and investors) increases. In this zero-sum game, the ordinary public is in jeopardy.

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