Two months ago, the IPO market for venture-backed companies looked full of promise. Even VCJ felt the excitement, publishing a story in its May issue entitled The Return of the IPO.
What a difference 60 days make.
Uncertainty from a chaotic European debt crisis now roils an unsteady financial marketplace as growth slows worldwide. The prospects for successful new offerings also took a blow from an unexpected source: Facebook’s highly anticipated IPO. The dud of the decade, from a Wall Street trading perspective, threatens to put a damper on IPO activity, impact late stage valuations and make staying private seem a welcome alternative.
“It seems like the company and its bankers pushed too hard,” says Christopher Girgenti, managing partner at New World Ventures, echoing a widely held view. “Obviously there was a fair amount of push back. … It had a negative affect on other companies in the pipeline.”
With a lot on the line for the venture community, VCJ asked a variety of experts for their opinions on the Facebook effect and whether the lackluster IPO jeopardizes liquidity options for hot social Internet and other startups.
What’s clear so far is company boards face new questions, even as many push ahead with new offerings, and general partners wrestle to understand an event many hoped would validate their investment calculations of the past several years.
The most immediate impact of the Facebook IPO was to pressure the stocks of social peers, such as Zynga, Groupon and LinkedIn. All three traded lower in unison. The question now is whether future IPO pricing and private company valuations will sink as well.
A Dysfunctional IPO Market
Someone who says yes is Jay Ritter, professor of finance at the University of Florida, who expects the lower valuations to extend to related companies in the IPO pipeline.
“Individual investors tend to over weight personal experience,” Ritter says. “Those who lost money on Facebook will be skeptical about investing in other IPOs.”
Ritter says the Facebook IPO exposes problems with the traditional way offerings are sold. The difficulties lie in the process of “book building, where underwriters are allowed to allocate shares to their most profitable customers rather than favoring buy-and-hold investors,” he says. This led Morgan Stanley and the offer’s other underwriters to misestimate the split in demand between long-term investors and short-term buyers interested in flipping the stock.
He suggests auctions would create different economic incentives for underwriters, aligning their interests with issuing companies instead of asking them to please both the supply and sell sides. This may benefit young venture-backed companies seeking to be noticed in a market where underwriters favor large deals and high valuations.
William Hambrecht, founder of the investment bank WR Hambrecht + Co., is another supporter of auctions, including for Facebook—perhaps no surprise given his company’s focus on the auction business. To argue his case, he points to Google, which used one for its 2004 debut. At the time, the company cut the size and price of its stock in the face of soft demand.
“Facebook wouldn’t have gotten as high a price because the market price wasn’t where they thought it was,” Hambrecht says.
He hopes the impact of Facebook’s super-sized offering will be to encourage venture-backed companies to go public with smaller offerings over the next year or two, perhaps of $20 million to $30 million, instead of waiting until they can launch a $100 million IPO. This will put them in public hands earlier, and in the position to deliver value to their shareholder base for five years or longer as their growth takes off, a stark contrast to Facebook’s strategy of waiting for growth to take place.
“There is a huge backlog of companies that were financed by venture and are really in very good shape,” he says. “They are just not big enough or frothy enough to attract these billion-dollar valuations.”
In Facebook’s case, the company raised a lot of money at a very high valuation and can claim success from a short-term perspective. From a longer term perspective “having this kind of aftermarket and so many of these retail investors feel disappointed and in some case almost cheated by selective disclosure, could be a real problem,” he says.
Despite its scars, Facebook’s reputation could swiftly repair if it performs well financially and wins over public market investors unsure of how to price emerging consumer Internet companies. Many of these money managers struggled with the question of where Facebook stock would trade two years from now, suppressing their appetite for the IPO.
A poor financial performance, however, could see this same uncertainty nip at the private company valuations. “People will be rethinking, ’Wow, should I really have invested in Dropbox at a $4 billion valuation?’” says George Zachary at Charles River Ventures. “There will be some compression of crazy prices for companies in the later rounds.”
This may not happen right away, concedes Zachary. But come September, if Facebook’s shares are largely unchanged or lower, and its business is not sparkling, a valuation haircut could take place.
It most likely will hit the late stage rounds of companies with valuations of $500 million and above, and particularly technology companies sporting high price-to-sales ratios. These valuations might fall by 25% to 50%, Zachary says.
The Bubble Deflates
The Internet bubble hasn’t necessarily burst, concurs Robert Ackerman, founder and managing director of Allegis Capital, but “we just let a little air out of it.”
Ackerman says the consequence is that investors will likely dig deeper into the metrics of future offerings and become more skeptical.
“The IPO is really the beginning of a recapitalization process where you trade one group of shareholders for a new group of shareholders.” he says. “In that context, there certainly are some caution lights flashing in my mind about the Facebook IPO.”
“There certainly are some caution lights flashing in my mind about the Facebook IPO.”
Founder and Managing Director
However, Ackerman sees a constructive side to the fallout. In the early phases of a technology shift, such as the development of the social Web, expectations can run ahead of reality, he says. Eventually the growth of revenue streams, such as advertising, comes to depend on rational metrics, such as the financial payback, rather than experimentation.
“There’s going to be a second wave of social media that’s going to be driven by ROI,” he says. “That’s going to be interesting.”
Entrepreneurs Look for Lessons
Entrepreneurs, nevertheless, are looking more cautiously at plans for future public offerings. “If I were ever in that situation, I would want to study what Facebook did,” says Jon Dahl, co-founder of the video encoding service Zencoder. The San Francisco startup is still years away from an IPO and backed by Y Combinator, Ron Conway’s SV Angel and Andreessen Horowitz. “I imagine every tech IPO over the next several years will want to look at it and see if there are mistakes that could be avoided.”
Staying Private Longer
One entrepreneur convinced startups might step on the brakes is Gene Hoffman Jr., CEO of the Silicon Valley online billing and marketing service Vindicia. He suggests companies may stay private longer.
“In some ways, the Facebook IPO is the closing of a chapter,” he explains. It took place prior to the JOBS Act, which lifted the permissible number of private company shareholders to 2,000 from the 500 threshold Facebook faced before being forced to go public.
“There’s been and will continue to be a rash of sophisticated entrepreneurs who have a very direct and unique vision and would prefer not to be focused on the quarterly results,” says Hoffman.
Hardening their resolve are new tools unavailable several years ago. Late-stage and private equity capital is plentiful and so far comfortable with high valuations and delayed liquidity. An active secondary market also has evolved to provide some liquidity to early investors and employees.
A Higher Bar
A new hurdle to IPO-seeking companies will be greater investor reluctance to award multi-billion-dollar pre-offering valuations, like the ones that led buyers of Zynga and Facebook shares in the secondary market to loose money.
“There seems to be a disconnect between what the private market thinks these companies are worth and what the public market thinks they are worth. What you’ll see is just like what you see in the IPO market: You’re going to see the bar get raised.”
“There seems to be a disconnect between what the private market thinks these companies are worth and what the public market thinks they are worth,” says Jeff Richards, a partner at GGV Capital. “What you’ll see is just like what you see in the IPO market: You’re going to see the bar get raised.”
But, according to Richards, it is important to keep things in context. Facebook’s valuation at $75 billion still makes it “one of the greatest venture investments of all time. Early investors are going to make a fortune on their investments.”
So as tempting as it is to draw quick conclusions and claim Facebook waited too long to go public with dire consequences, it may be smart to defer judgment … at least for the moment.
Mark Boslet can be reached at email@example.com. He tweets at @mgboz.