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Private Matters and Public Markets

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8/28/97

Private Matters and Public Markets
The Rise of the Internet and Public Venture Capital
Andre de Baubigny, Vice President
Robert Heath, Vice President
Robertson, Stephens & Company

Private Equity Investor: “… Okay, so Release 2 of the software is shipping and revenue this quarter is
going to be a million dollars plus or minus. So what are your valuation expecta-
tions?”

Entrepreneur: “Well... Yahoo! has a billion dollar valuation, and Microsoft paid $425 million for
WebTV... And we’ve been told by some investment bankers that we could be
worth $200 million in an IPO, but what’s important for us is to get the right part-
ners in quickly, so we’re looking to raise ten to fifteen million at a $100 to $120
million valuation. That’s only a double from our last round, and we think it’s con-
servative since we’ve hit our milestones. What do you think?”

Private Equity Investor: “Well, as a general rule, we don’t make investments above $100 million...At
those valuations, all we bring to the table is money. But good luck, the story
sounds great...”

Genentech and Netscape
In the late 1970’s, the development of recombinant DNA technology led to the formation of
Genentech and eventually to its highly successful 1980 IPO. Genentech’s technical and com-
mercial successes in turn spawned a “public venture capital” market willing to fund biotech com-
panies years before they achieved meaningful revenue, let alone profits. Many of these biotech
IPOs involved companies so young that investment bankers joked about their “market capitaliza-
tion to Ph.D ratios” for comparative valuation purposes. But they were only half joking; these
companies generally lacked any meaningful operating and financial data on which to base a
valuation. And they were outstandingly risky investments by public market standards; many of
these companies would require multiple infusions of equity before they could hope to become
profitable. The existence of the public biotech market may seem unremarkable today, but its de-
velopment demanded a dramatic shift in attitudes towards risk on the part of the investors who
bought the shares as well as the bankers who underwrote them.

While the public market for biotech issues was developing in the 1980’s, information technology
startups were generally held to different standards. Until recently, a software company going
public would typically sport a $25 to $30 million sales rate and five consecutive profitable quar-
ters. There were exceptions, but for the most part, an information technology company was ex-
pected to be profitable and possessed of a relatively mature operating model before most Wall
Street firms would consider underwriting its shares.

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Netscape Communication’s 1995 IPO was a watershed event for information technology inves-
tors. Like Genentech 15 years earlier, Netscape was largely conceived, assembled and quickly
launched into the public markets by Kleiner Perkins Caufield & Byers, one of Silicon Valley’s lead-
ing venture firms. And just as Genentech’s success legitimized the idea of a public market for
biotech startups, Netscape’s success has paved the way for IPOs by many early stage Internet
companies. Since then, scores of Internet-related offerings have been completed well before the
issuers achieved profitability. Many of these offerings have been spectacularly successful and
others have been equally disappointing. Not surprisingly, the investing public has demonstrated
the same “hot and cold” attitude towards these stocks that has characterized the biotech market
for most of its existence.

Investment trends come and go, and it’s tempting to dismiss the recent flood of Internet-related
offerings as a passing fad in a hot IPO market. In contrast, we believe the market’s appetite for
Internet-related stocks is likely to persist for years. The emergence of the Internet as a social and
commercial phenomenon presents the potential to radically transform the entertainment and
communications industries, much as advances in biochemistry transformed the pharmaceutical
industry fifteen years ago. And, unlike more arcane areas of technology (especially biotech); the
Internet is particularly accessible to the public investor who wants to evaluate a company’s prod-
ucts or services personally. Consequently, we expect that even very young startups will continue
to find willing investors in the public equity markets if they possess the potential to build leading
businesses based on the Internet.

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Public Venture Capital for Internet Navigation Companies
Perhaps the most notable examples of public venture capital were the 1996 IPOs of four search
engine or Internet navigation companies. During the second quarter of 1996, Excite, Yahoo!, Ly-
cos and InfoSeek all completed initial public offerings. Table 1 summarizes these companies at
the time of their IPOs.

Table 1. Internet Navigation Companies
IPO Market
Company IPO Date Capitalization Founded Filed for Incubation Employees Revenue
($ million) IPO Period Total / R&D Run Rate

Lycos 4/2/96 $219 Jun 95 Mar 96 9 months 28 / 15 $3.3
Excite 4/4/96 $183 Jun 94 Feb 96 20 months 38 / 14 $0.6
Yahoo! 4/12/96 $334 Mar 95 Mar 96 12 months 43 / 7 $4.3
InfoSeek 6/11/96 $299 Aug 93 May 96 27 months 71 / 26 $6.9

Average $259 17 months 45 / 16 $3.7

Note: All information is derived from the IPO prospectuses of the respective companies. IPO Market Capitalization is equal to initial public
offering price times total shares outstanding and excludes over-allotment shares and options. “Incubation Period” is calculated as the time
from the company’s incorporation to the IPO filing date. Revenue Run Rate is equal to 4x revenue for the most recent quarter reported in the
preliminary IPO prospectus.

On average, these companies were less than two years old, employed fewer than fifty employ-
ees, and booked sales of less than $1.0 million in the quarters leading up to their IPOs. Withhold
the company names, and most venture capitalists would recognize the profile as a typical sec-
ond- or third-round venture investment. Instead, these four companies went public at an aggre-
gate market capitalization in excess of a billion dollars, giving the public investor the opportunity
to play venture capitalist. So how has the public fared?

We considered the performance of a portfolio consisting of $10,000 divided equally among the
IPOs of these four companies. As of this writing (August 28), an investor’s original $10,000 would
be worth $20,222 for an annual return of 67.5%. For comparison, $10,000 similarly invested in
the Standard & Poors 500 index (“S&P”) would have grown to $13,962, or an annual return of
1
27.7%, excluding dividends. In this instance, the public venture capitalist would have made out
quite well. (Given the recent volatility in the markets, by the time of publication, the comparative
returns could be substantially different.)

1
For students of the Capital Asset Pricing Model, we also considered risk-adjusted returns. Over this relatively short
observation period, our portfolio of Internet Navigation stocks had a negative beta. This raises the intriguing possibility
that our portfolio represents the Holy Grail for efficient market theorists, namely, positive expected returns and a negative
correlation with the market. We suspect the negative correlation will abate over longer observation periods, although it
seems logical that the valuations of early-stage companies will fluctuate mostly due to company specific events and less
significantly due to overall macro-economic or market factors. Consequently, returns to investors in these companies may
appear to be un-correlated with market returns for extended periods.

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While our Internet Navigation portfolio has outperformed the S&P, it has experienced stomach-
churning volatility. Chart 1 plots the value of the portfolio vs. the S&P from the date of the first IPO
to the present. (Note that the $10,000 was not fully invested until the completion of the InfoSeek
IPO in June 1996). A couple of points stand out. First, the Internet Navigation stocks typically
rose quickly following their IPOs but declined sharply during 1996’s summer swoon in technology
stocks. Thus, while the portfolio has outperformed the S&P overall, until the summer of 1997, the
portfolio generally lagged the S&P, often quite significantly. The portfolio actually trailed the S&P
over two-thirds of the observation period. Second, the volatility of the Internet Navigation portfolio
2
has been 58% over the holding period compared to 14% for the S&P. The Internet Navigation
portfolio has been riskier in an everyday sense as well; for almost half (47%) of the trading days
graphed below, the value of the portfolio was less than the original $10,000 investment.

Chart 1. Internet Navigation Portfolio vs. S&P 500

$25,000

$20,000

$15,000
S&P 500

$10,000

Internet Navigation Companies
$5,000

$0
4/2/96 7/2/96 10/1/96 12/31/96 4/2/97 7/1/97

One cautionary note for public investors hoping to play venture capitalist: the foregoing analysis
assumes that our public venture capitalist was able to purchase stock at the initial offering price.
The shares of all four IPOs were heavily oversubscribed and were unavailable to many investors,
so we also calculated returns to investors who purchased these stocks on the first trade following
the offering. This produces a dramatically different result. An investor buying each of these
stocks on the first trade would have earned an annual return of only 13.8% (through August 28),

2
Volatility is calculated as the standard deviation of the logarithmic daily returns times an annualization factor of 260.
Logarithmic daily return is the natural log of one day’s price divided by the prior day’s price. The volatility calculations in
the text were based on 307 trading days after each of our portfolios was fully invested.

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and the value of his $10,000 portfolio would never have exceeded the value of the comparable
S&P investment. These results are summarized in Table 2.

Table 2.
Value of $10,000 on
Investment Portfolio August 28, 1997 Total Return Annualized Return

Internet Navigation at IPO Price $ 20,222 102.2% 67.5%
Internet Navigation at First Trade Price $11,666 19.3% 13.8%
Standard & Poors 500 (w/o divs) $13,962 39.4% 27.7%

Note: Each portfolio consists of $2,500 invested on each of April 2, April 4, April 12 and June 11, 1996 for
a total investment of $10,000. Return calculations do not include dividends on the S&P 500.

We believe venture investors in companies at this stage in their development seek investment
returns closer to 67.5% than to 13.8%. If so, then these deals appear to have been fairly priced
at their offering prices, but they may have traded too high in the immediate aftermarket. This
small sample suggests that, contrary to popular convention, it is not the issuer who “leaves
money on the table” in a hot IPO. Rather, it is the investor who gets caught up in the after-market
bidding frenzy and ends up with a below-market return. The simple advice to individuals looking
to play venture capitalist in the public markets would seem to be “Don’t overpay.”

Notwithstanding the volatility, a 67.5% annual return should not be lightly dismissed. And invest-
ment theory tells us that company-specific and industry-specific volatility can be diversified away.
For the investor who avoided the first-day bidding war for these stocks and had the stomach to
ride out the 1996 summer swoon, holding this portfolio has been rewarding. At least for this small
sample of companies and short holding period, the public’s foray into venture investing must be
deemed successful.

The availability of public capital to venture-stage companies is a boon not just to the direct recipi-
ents of that capital, but to emerging industries and the economy as a whole. Most entrepreneurs
would agree that the most difficult obstacle to building a company is the limited sources of risk
capital available to them. A flourishing public market for later-stage venture companies dramati-
cally increases available capital, and by providing liquidity for early stage investors, it allows rela-
tively scarce seed-capital to recycle more quickly.

Moreover, the existence of public market valuations for young companies improves the price dis-
covery mechanisms of the overall venture marketplace, both public and private. From the entre-
preneur’s standpoint, the availability of a public market “price check” helps keep venture capital-
ists and other investors honest during valuation discussions.

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Finally, there is a certain inevitability to an increase in the availability of public venture capital.
High market valuations, the growth of assets under professional management and portfolio diver-
sification strategies should all work to increase demand for alternative asset classes such as ven-
ture capital. History suggests that financial innovations that create new funding sources for prom-
ising companies and new investment opportunities for investors eventually become permanent
fixtures in the financial landscape.

Implications for Venture Capitalists and Entrepreneurs
Venture capitalists have traditionally been considered a breed apart. Unlike public shareholders,
traditional venture investors almost always take board seats, usually serve as informal advisors
and sometimes step into management roles during times of crisis. In fact, as the amount of
money flowing into venture capital funds has increased during the mid-1990s, venture capitalists
increasingly tout the benefits (other than money) that they can offer a hot new startup in order to
avoid price competition (i.e., investing at a higher valuations). Clearly, the public investor or fund
manager cannot provide these services, and so poses little threat to the venture capitalist in
seed-level and very early stage investments.

But the development of a public venture capital market undoubtedly increases competition for
later-stage venture and private equity investors. If the public markets continue to purchase the
IPOs of young Internet companies, later-stage venture investors may find themselves frozen out.
The $1.6 billion invested by venture capital firms in Internet companies in 1996 is dwarfed by the
$50 billion contributed to aggressive growth mutual funds over the same period. Moreover, the
IPO has always held a certain seductive appeal. It strengthens the company financially, helps
publicize the company’s success, and validates the millionaire status of the founders. For these
reasons, we believe the receptiveness of the public markets will force later-stage venture and
private equity investors to somehow differentiate their services. As a mere source of capital, the
public market will frequently outbid them.

This doesn’t mean that every young company should go public simply because it can. The glare
of publicity and the volatility of the stock market can amplify problems when a young company’s
growth unexpectedly slows for a quarter, or when it must change strategic direction, restructure
operations or replace senior managers. And for many young companies the need to meet Wall
Street’s quarterly earnings targets can actually interfere with the normal course of their business.
For example, many enterprise software companies find that customers won’t sign a purchase
order until the last week of the vendor’s fiscal quarter knowing that the pressure to meet earnings

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estimates will induce the vendor to offer the most generous terms. But setting aside the possibil-
ity of a startup’s going public “too soon” there would seem to be no downside to the existence of a
liquid and receptive public market for venture-stage investments.

While we agree, we believe the emergence of an active public venture capital market may force a
change in the customs of the venture capital community. In our capacity as bankers, we fre-
quently meet private companies looking to raise second or third rounds of equity in the private
markets. When the subject of valuation comes up, these companies often point to the eye-
popping multiples enjoyed by public companies that are arguably comparable. (Of course, when
public markets are weak, the valuation argument is based on an appropriate step-up from the last
financing round in light of the company’s substantial progress since then.) While the availability
of public comparables helps inform the valuation discussion for private companies, the volatility of
public market valuations is inconsistent with some of the fundamental premises of venture invest-
ing.

Traditionally, valuation of early-stage companies has been somewhat uncoupled from the public
markets. And this is probably as it should be – note that the value of our Internet Navigation port-
folio appeared to be completely un-correlated with changes in the broad market. Of course, in-
vestors and entrepreneurs look to an IPO as the most likely liquidity event so fluctuations in the
public markets do affect private market values, but only at a distance and discounted by several
quarters at a high cost of capital. For the most part, the valuation trajectory for young high-tech
companies is driven more by the company’s meeting conventional milestones: business plan,
proof of concept, prototype, shipping product, booking sales, and eventually making money. Un-
der the traditional model, if a company continues to make progress on its business plan and
reaches its milestones, valuation steadily increases, and often impressively. On the other hand,
when a startup does a down round, it’s generally assumed that something‘s wrong; the product’s
behind schedule or competition is forcing the company to re-think its business plan. Morale may
suffer, and the company becomes a poaching ground for competitors who prey on its employees
who find their stock options suddenly underwater.

If private market valuations become more tightly coupled with the more volatile public market, one
should expect the valuations of startups to trade up and down just as public companies do.
There is no stigma when Microsoft trades down 15% from its high (“The stock just got ahead of
itself”). So, in theory, there should be no stigma attached to a private company doing a financing
at the same or a lower value than its last round (“I guess the VC’s just paid too much last time.”)
Somehow, we don’t think entrepreneurs and venture capitalists are quite ready to accept this
state of affairs.

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In Figure 2 we have plotted the value of a successful but hypothetical startup (“Software Startup
Corp”) over time. The value of the company grows at a steady rate as the company meets its
operational and technical goals and moves closer to profitability. There are also discontinuous
jumps in the valuation as the company hits significant milestones and when it raises new equity.
This is a fairly traditional model of how entrepreneurs and venture capitalists approach valuation
for early stage companies. To compare this model of valuation to our “public venture market” we
have selected beginning and ending valuations which correspond to the beginning and ending
portfolio values of our Internet Navigation portfolio, and we have re-plotted the daily values of our
Internet Navigation portfolio in the same figure.

Figure 2.

$25,000

$20,000

"Software Startup Corp"
$15,000

$10,000
Internet Navigation Portfolio

$5,000

$0
6/11/96 9/10/96 12/9/96 3/11/97 6/10/97

Arguably, the entrepreneurs who founded Software Startup Corp should be indifferent between
the traditional private valuation path or the “mark to market” public valuation. After all, they start
and end in the same place.

But we suspect the founders of our hypothetical startup would be a little disappointed to have the
value of their company marked to market against the portfolio even if the beginning and ending
values are the same. This is especially true if the business plan required a financing during those
periods when the company was meeting its milestones but the comparable public companies had
traded down by 30%. But even if a startup doesn’t explicitly raise funds at a time when public
market values are temporarily depressed, it typically issues stock every week to new employees
in the form of options. How would founding employees feel, if having met all the company’s mile-

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stones for the first year, employees who joined later were granted options at substantially lower
exercise prices because a basket of publicly traded comparable companies were trading lower?

While this may all seem somewhat hypothetical, our recent experience suggests that the institu-
tionalization of public venture capital will force changes to private market traditions as the volatility
of public markets clashes with the traditional model of value creation for startups.

As mentioned above, in late 1995 and early 1996, many Internet-related companies went public
and traded up significantly. Since then, many have not only traded down from their 1996 highs,
but have traded steadily below their IPO prices. No surprises there, it happens all the time. Dur-
ing that same period, however, many other companies were raising venture capital privately but
at valuations that reflected the exuberance of the public market. Now many of these companies
are in the process of raising additional funds in the private equity market. As many of companies
seek later-stage private investors, they’re looking for a significant step-up in value because
they’ve hit many of their milestones since the last funding round.

On the other side of the table, private investors see the picture a little differently. They may ac-
knowledge that valuations got a little excessive back in the spring of 1996, and for the most part
they’re glad to see more down-to-earth levels. (They are understandably ambivalent on this issue
because at any given moment they act as buyers of new companies and sellers of their existing
portfolio.) As of this writing, venture capitalists and other private investors appear to be enforcing
some valuation discipline. As a consequence, many companies approaching their second- and
third-round financings are finding that new money is available to them at only modest step-ups, or
in some cases, flat with or down from the preceding round’s valuation. Given the traditional mo-
res of Silicon Valley, entrepreneurs are understandably horrified by the possibility of the dreaded
“down round” and its connotation of stagnation.

What’s worse, traditional venture capitalists and private equity investors often look to take signifi-
cant ownership stakes, say 10% or more, but rarely commit more than $10 million by themselves.
If these constraints hold, it implies that even when valuations of comparable companies in the
public markets are quite high there may be minimal demand for private equity investments at
valuations much higher than $100 million. We have seen this phenomenon replayed many times
over the past year or so. Ironically, the appearance of a liquid public market for venture-stage
investments appears to have created a liquidity trap for the many companies who choose to re-
main private, but rely too heavily on the public markets to form their valuation expectations.

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