Bridging Private and Public Markets

Being precious of your time, I'll just say the idea upfront: the reason IPOs are historically poor investments is because the valuation is already at a peak prior to the IPO. The subject of this post is why that is the case.

Before we reason this logic out together, let me be clear that this point holds only for VC-backed companies. There are plenty of great companies that never take VC money, IPO on their own terms, and do just fine, but that's not the subject of our post. And if you would allow me, a caveat: what I write below is from my personal experience watching private and public markets unfold. I did not have the time to compile a data-heavy analysis, but my gut tells me it would resemble something like what I came up with below. 

If you follow investing and finance circles closely, you know that the common wisdom is to avoid investing in IPOs at all costs (I assure you, the pun is unintended). Historically, returns of such newly public companies can be poor. We like to think of newly public companies as disruptors, and they very well are, but being a disruptor does not mean you will succeed. The reverse, however, is often true. Successful companies are disruptors, but disruptors are not necessarily successful companies. 

So let's say you are a disrupting company (a Black Swan) on the verge of going public, and you raised a few hundred million from venture. At that very point in your company's history, valuation is at an all time peak. If there were checkboxes to check on how to reach the highest valuation you can, you'd have checked them all. To better illustrate this point, I made a chart (see below):

As a seed or angel investor, your job is to invest from time period 2001 - maybe 2005 while the company is in its extremely early and risky stages. As a later stage VC, you will be investing from 2006 and until the liquidity event, which is when the company goes public in 2016. You will notice there is a premium attached to going public, which I originally dub the "IPO Premium" (also goes by "IPO Pop"). There are many different explanations for why this premium often occurs, very few of which actually have anything to do with the fundamental health and prospects of the company. For the intellectually curious, the premium can be due to phenomenons like investors and employees getting liquidity for their stock and a growth momentum that occurs when a company goes public (I'm not saying it's rational, I'm just saying it exists). 

Going back to the original bolded premise of this post - why is it that VC backed companies tend to perform so poorly post-IPO? You might think the answer is due to a highly complex financial explanation, but the answer(s) can be explained with relative ease:

Venture capital valuations are usually not a function of the fundamental value of a company. Unlike, say, a blue chip stock, startups do not have a reliable track record of, well, frankly anything. You cannot discount the cash flows of a startup since they are often unprofitable; you might as well run a DCF on your toddler as a predictor of their future success (please don't). Instead, venture valuations are a function of the marginal backing of the last investor. In plain terms, this means the valuation is dictated by the willingness of the last VC to invest in your company. Unlike public markets, which are distributed value carriers, valuations in private markets are often driven by very few investors. This is not a bad thing, it's simply the way in which markets operate (mind you, public markets can be just as irrational).

Another reason why VC backed companies often underperform ex-post is due to the difference in the way public investors view success versus a private investor (a VC). A VC is looking for visionary founders who create products that have the potential to be huge businesses. Once that potential is agreed upon by other VCs and people in the private climate, valuations tend to increase. Meanwhile, a public investor judges a company based on totally different metrics. Public investors care about the business model and all of the things that come with it; revenues, expenses, and profits. The potential of the company on which private investors have agreed upon should now be coming to fruition. If it doesn't, and soon, public investors start to get antsy and eventually sell the stock, dropping the valuation considerably. Again, there is nothing inherently wrong with that (and if there is, I urge you to design a better system). 

This last point is a bit harder to articulate but that won't stop me from trying. If you take a look at the chart above once more, you will notice that the liquidity event for private investors occurs are the highest valuation the company has had up to that time. This makes sense - a company grows and is at its healthiest right at the point it goes public. But this private valuation, which remains private as the investment bankers attempt to take it public - does not translate well into a public valuation, which can only be calculated after the stock is publicly traded for a period of time. This discrepancy occurs at the point at which valuation turns from an art form to a science. I exaggerate slightly, as even public company valuations are still often guesstimates (read: art), but as a general rule, private valuations are gut-feeling based while public ones are more data heavy (after all, there is finally data to analyze). The gap between what a company is actually worth, called intrinsic value (it is the amount which public valuations tend to approach after a certain period of time), and what is it worth on the private market, gives rise to this pricing irrationality.


You might say, but Larry, what about companies like Apple, Google, and Facebook, all of which took venture money and were outrageously successful in public markets? Survivorship bias is a very real threat here. While it's true that those companies (and many more) started as private darlings and became public darlings, what about the hundreds of companies that went out of business or were acquired for a discount? Don't forget about those.

There is one rule in venture capital and that is there are no rules in venture capital. That said, there are general theories, which often hold. This post was an attempt to bridge the rules of private markets and public markets. Similar to the discrepancy between quantum mechanics and general relativity (which is a much more interesting debate than the one we're having), the same rules do not govern private and public markets. For that reason, it's important to understand both sets of rules and know when each applies.