An Initial Public Offering (or IPO) is for most early-stage Venture Capital investors, who have been allowed to arbitrate innovation with the deployment of part of a Limited Partner’s monetary reserves, the most crucial and last stop on their path to producing a healthy multiple in return for the early support of the vision of a single company. Serious money can be made and it is therefore not surprising how the media and the public wildly speculate on the proposed value of the company in question.
In a perfect world
An IPO (and a Merger or Acquisition), and sale of company stock to the public provides VC investors with a return equal to a multiple of the amount of money they have put in (money-in) at the early stage of the then private company. After the IPO (generally after an SEC defined holding period) most early investors liquidate their interest and stock in order to pay back (money-out) their LP investors. Such repayment of returns generated by all investments in a VC’s portfolio - minus management fees and carry - will then provide LPs with higher risk and returns on investment than other, to LPs more generally available investment strategies and classes.
In a perfect world where everybody has a holistic view of the world, the IPO mechanism makes total sense. And forty-some years ago when Venture Capital as a high-yield sub-sector of Private Equity was born, some great companies were created that provided lasting social economic value in addition to great public investment returns.
In the real world
But the world has changed and our financial system is showing its age. Not in the least because it offers a safe haven for too many who also want to take it for a prosperous ride.
The bulging complexity of a financial system eleven times the size of production (in the U.S.) has given preference to those who gamble on innovation over those who invent it. The number of investors with the merit to spot groundbreaking innovation in Venture (some thirty-five, according to a prominent money manager to LPs) is heavily diluted with those who cannot (seven-hundred and fifty-five others), with risk avoidance and investment uniformity becoming all too prevalent in a sector that requires the opposite.
Years of unadapted financial and economic constructs has turned the IPO process into a very unreliable proxy of value and thus a very volatile investment strategy for the public. No wonder gold is now seen as a more reliable investment than the public stock market. Not because no company can be trusted, but because the economic constructs feeding the public market processes are economically not-free, but a free-for-all that violates public freedom.
Here is why today’s IPO value regardless of company can hardly be trusted:
-The pre-IPO value cannot be trusted. We all remember what happened in the late 1990s, when the public lost trust in the promise of value attached to many newly minted companies, quickly followed by the unexpected fear spread by 9/11. Many lost trust in shaky technology stocks, since investing in a hyped-up brand-new public company of which the public has had no prior insight (or transparency) in its turbulent past, is like adopting a 17-year old child without knowing anything about its upbringing. And with many subprime VCs trying to prove they are not, the upbringing of many startups and their tangible social economic value to the public is in serious doubt by the public.
-The stock exchange is not a free-market (as we explain in this blog). While uncontrolled on the buy-side (and thus not-free by economic principle), the sell side is forced to trade in a singular fashion regardless of a company’s age or desire, and therefor also economically not-free. It applies different freedoms to sellers of stock than it applies to the buyers of stock. In addition it manipulates stock indices in any way its governing body, not the collective of marketplace participants deems appropriate.
-The post-IPO value cannot be trusted. The stock market gives preference to companies who do well in using a fixed (and thus not sell-side free) quarterly earnings granularity that a bevy of short sellers use to outperform their less attentive and less informed peers and worse, the public. Worsened by trading systems able to make buy-or-sell decisions at over a thousand times per second and simply faster than any human being ever could, have turned public investing into the unpredictable Las Vegas slot machine it is today. Post-IPO stock performance therefore is a terrible prognosticator of future IPO success.
Rigorous financial reform can rebuild trust
At this point only rigorous financial reform can solve the mistrust inherent to the process leading up to an IPO and re-instill confidence in our most precious underlying asset, innovation.
Private companies should be made transparent before they hit public markets, which will give the public insight into its past way before it has the opportunity to invest. That newfound transparency will also make private investing more competitive and erodes the demi-cartel VCs, chock-full of collusion and responsible for subprime investing enjoy today. The stock market can be turned into a real free-market so seller and buyer have equal freedom of trade. And as a result, post-IPO values can become much more reliable indicators of the real value of an emerging company.
Proceed with caution
Much of the current IPO storm and its artificial inflation is because the public has no way to discern between the prospective value of Facebook and the companies that follow in the slipstream of Facebook’s success. And none of the financial constructs leading up to an IPO gives the public more clarity in accurately pricing and investing in either wannabe.
And thus until rigorous financial reform happens, IPOs on the stock market are just bubbles that live within another giant bubble. And investing in public stock - if one must - should be done with extreme caution and with money one can afford to lose. Because within a market mechanism that is by economic principle not free, only the very few who know more have a chance of extracting money from the many who know less.
Georges is an entrepreneur, serial CEO, Venture Catalyst, Private Investor, (part-time) Venture Capitalist turned Venture Economist (by fate). www.venturecompany.com