Are technology startup valuations in the middle of another bubble? The New York Times stoked the debate last month when it quoted famed venture capitalists John Doerr and Fred Wilson, who were seemingly agreeing that it is.
One area of tech investing that seems especially “bubble-icious” is the secondary market where investors trade shares of private companies. Last week, Bloomberg reported on a study by Nyppex LLC, a broker for secondary transactions, which found that valuations of private, VC-backed tech companies on the secondary market have risen a whopping 54 percent since June. Retail investors are so eager to get a piece of the action that they’re paying a 31-percent premium over the valuations paid by institutional investors when they first put money into the startups, up from 12 percent in June.
Light volume is part of the reason for the run-up in prices; the market simply isn’t liquid. Nyppex estimates that secondary market transaction volume will be just under $5 billion this year. That’s a small amount of churn compared to the total capitalization of the companies in question. To put it in perspective, $5 billion is roughly equal to the value of Groupon and only 1/10th the most recent valuation of Facebook as reported by SharesPost, so any surge in demand would drive prices up significantly.
I’m quoted in the Bloomberg article noting that the likes of Yelp, Zynga, and LinkedIn are great companies, so it’s natural there would be strong demand on the secondary market for their shares. But why are these companies trading on a secondary market in the first place? A few years ago, many of them would have been publicly traded by this point. Facebook’s revenue run rate is around $2 billion, and Twitter’s is said to be around $300 million, which is more than enough revenue to merit a market cap (and the corresponding liquidity) sufficient for a publicly traded company.
There are some obvious reasons why many tech companies are choosing to remain private instead of having an initial public offering:
- The weak stock market remains a challenge. While markets have rebounded from their early-2009 lows, it’s still a tough environment.
- Financing terms have gotten more pro-founder in recent years, and VCs and angels are increasingly willing to let entrepreneurs take some money off the table along the way. This decreases insiders’ needs for a liquidity event.
- The venture capital bubble is only recently beginning to truly deflate. For many years, private capital has been plentiful and cheap for high-growth tech firms, rendering IPO proceeds as less important.
These factors are well-known, and no doubt they’re all contributing to the IPO drought, but the federal government’s role in the process can’t be ignored. In the wake of stock market scandals in the early part of the decade, Washington sought a political solution in the form of legislation called Sarbanes-Oxley.
Known as “Sarbox,” the legislation mandated sweeping new internal controls over the bookkeeping of publicly traded companies. The new mandates came with a cost: A 2008 study by the U.S. Securities and Exchange Commission found the average cost of Sarbox compliance is $2.3 million per year. A whopping 70 percent of all smaller public companies said compliance costs have prompted them to consider going private, and 77 percent of smaller foreign firms reported considering abandoning their American listings.
The feds made the moribund IPO market even worse by providing additional disincentive against going public, and the end result has been to make it harder for the little guy to get in on the action at all. Or, if he wants to take a small stake in a high-growth tech company like Facebook, he’s got to pay a 31 percent premium to buy it on the secondary market.
Defenders of Sarbox may counter that fewer IPOs are a good thing, and it’s true that during the late-90s dot-com bubble (fueled by the easy money policies of the Federal Reserve) there were companies going public that shouldn’t have. The pendulum has swung in the opposite direction. Ten years ago, the IPO market was too hot. Today it’s so cold that Facebook, Zynga, and their peers won’t come out to dance. Retail investors must feel like Goldilocks, wondering if it will ever be “just right.”
Retail investors are increasingly looking down-market by investing in earlier-stage startups, something we’re seeing on our platform at CapLinked. This doesn’t diminish the fact that soaring prices on the illiquid secondary market are a symptom of a larger problem. While personal responsibility on the part of retail investors shouldn’t be overlooked in inflating this apparent bubble, the federal government shares in the blame. When prices can’t adjust, the government needs to find ways to increase efficiency so the market can work. Driving up costs through red tape like Sarbox restricts supply, and we can see the effect of this in the overheating secondary market.
Eric M. Jackson is the CEO/co-founder of CapLinked, an online platform for private companies to share deals and communicate with investors. He is also the author of the book The PayPal Wars and was part of PayPal’s marketing team from 1999-2003, where he served as interim VP following eBay’s acquisition of the company.
For more research on Venture financing check out GigaOM Pro (subscription required):