Already, IPO investors have been getting burned. Prominent IPOs from recent years such asTwitter (TWTR), Lending Club (LC), and Box (BOX) are all down over 35% since they made their debut on the public market. The Renaissance IPO ETF (IPO) is down 7.5% so far this year, while the S&P 500 has been flat.
Most investors are unaware of how VCs use public markets to rake in huge pay days while also shifting risk out of their portfolios onto unsuspecting IPO investors.
Late-stage VCs increasingly build onerous provisions into funding deals that guarantee them big returns in an IPO. In the most recent funding round for mobile payments company Square, investors were guaranteed at least a 20% return in an IPO. If the price comes in below that, these VCs will get extra shares, diluting all the other investors.
These structured deals help fuel the bubble in private tech companies. Startups get cash so they can keep marketing like crazy, VCs get guaranteed payouts, and everyone gets the prestige and attention of being a “unicorn”. So who suffers? IPO investors that are tricked into believing these massive valuations have any basis in reality.
Bad IPO Pipeline Is Swelling
It’s getting harder and harder to find people that disagree with the notion that a startup bubble is forming. Even influential venture capitalists are warning of inflated valuations.
“Our late-stage, privately held technology market is clearly in a bubble,” wrote Upfront Ventures general partner Mark Suster on his blog last month.
The list of startup “unicorns”, privately held companies valued at $1 billion or more, has grown rapidly and now stands at 143.
“When we start throwing around the billion dollar valuation number in such a casual way, then it is a sign we are losing some perspective,” said Joe Horowitz, managing partner at Jafco Ventures. “Building a company that is truly worth a billion dollars or more takes a lot of work and lot of smart people.”
Instead, we have companies like Jet.com, the Amazon competitor that achieved a nine-figure valuation before it even launched and promised to undercut the ecommerce giant by 10-15%. Its plan was to not make any money on transactions and rely totally on member fees for its profits. Only now, the company has done away with membership fees as well.
So where are profits going to come from? Venture capitalists don’t seem to care. Jet.com just joined the unicorn ranks and raised $500 million at a valuation of $1 billion. With money being thrown around in such large quantities at ideas like Jet, we wonder if companies have any incentive to build profitable and sustainable business models.
As long as VCs can bet on selling these companies to unsuspecting IPO investors, why slow the gravy train?
Who Cares About Profits When You Have Unsuspecting IPO Investors
We’ve warned IPO investors about being extra careful because of special IPO accounting loopholes.
Now, we are warning you about VCs that are not only pushing valuations to unsupported levels, they’re doing so in a way that rewards companies with unsustainable business models. Companies chasing “unicorn” status are pushed towards spending excessively on customer acquisition rather than focusing on their core product, leading to companies with massive revenue growth and no profits. This helps them attract big funding rounds, which they then spend on more marketing.
“Companies are taking on huge burn rates to justify spending the capital they are raising in these enormous financings, putting their long-term viability in jeopardy,” writes Benchmark general partner Bill Gurley.
This short-term view helps the company achieve a higher IPO valuation while damaging its long-term prospects. Venture capitalists make a big profit, but the company itself earns a poor return on invested capital (ROIC). This short-term view helps the company achieve a higher IPO valuation while damaging its long-term prospects. It’s the same reason why companies hide their true stock compensation costs in the lead up to the IPO, leaving average investors with a nasty surprise once the VCs have gotten out.
This model has become so common that it is genuinely surprising when a tech IPO comes around that is actually profitable.
Not only has the VC funding model pushed companies away from sustainable growth models, it hasn’t done much to encourage new business formation. Figure 1 shows that while VCs have been chasing unicorns, the actual startup rate in the country has been in decline for decades.
Figure 1: Venture Capital Has Not Helped New Businesses
Sources: U.S. Census Bureau