Facebook went public this year, and traded below its offering price for most of the year afterward. There are lessons in this for our portfolio about what public markets actually reward, and we have been pressing those lessons on every founder we work with.
On the Year of the Disappointing IPO
Facebook's May IPO was priced at thirty-eight dollars. By August it traded near eighteen. The headline narrative attributed the underperformance to mobile-monetization concerns; the substantive narrative, which we believe to be more accurate, is that the company had been valued in late private rounds at a level that priced in execution which had not yet been demonstrated. Public markets refused to extend the credit.
This is a healthy refusal. The premium private markets had been paying for narrative was, in retrospect, larger than the underlying businesses justified. We have been saying so in private conversations with peer firms since 2010; the year's mark-to-market has provided unambiguous evidence for an argument that had previously been a matter of judgment. We expect, in consequence, late-stage private valuations to compress over the next eighteen months across the venture industry. Several of our portfolio companies will be affected by this compression. We have already had the relevant conversations with their boards.
The Facebook outcome is, in our reading, more significant for what it tells us about the boundary between private and public valuation than for what it tells us about Facebook itself. Facebook has, in the months since its IPO, demonstrated meaningful progress on mobile monetization; we expect the stock to recover within eighteen months. The company is not the lesson; the markup is.
On What Public Markets Care About That Private Markets Do Not
The list is short and the items are stable across cycles. Public markets care about: the unit economics of the marginal customer, the durability of the moat against the next competitor, and the operator's track record of meeting their own forecasts. Private markets, in late-stage rounds, will accept narrative as a substitute for any of the three. Public markets will not.
The bridge between the two valuation regimes is exactly as wide as the credibility of the operator. We have been telling our founders this for fifteen years. We are telling them again, more loudly, this year. The most useful conversation we have had this year was with a portfolio CEO in October, who had been preparing for a 2013 IPO and was reconsidering after the year's events; we walked through, line by line, the disclosures she would have to make in her S-1 and the questions she should expect on her road show, and concluded together that the company was eighteen months from being ready. She has paused the process. We expect the company to be a stronger 2014 IPO than it would have been a 2013 IPO.
On the Founders We Are Not Pushing Toward an IPO
Three of our portfolio companies, this year, told us they were ready to file. We disagreed with two of them and the disagreements were sharp. The shorter the road show, the more public-market discipline a company can absorb without being broken by it. We do not consider an IPO a goal. We consider it a financing event with downstream implications most founders have not modeled adequately.
The downstream implications include, most consequentially, the erosion of operational flexibility. A public company has different shareholder bases at different times in its life; the shareholder base it inherits at IPO is rarely the shareholder base that will support it through its eventual operational difficulties. Founders who go public early, in our experience, find themselves in their first crisis with shareholders who entered at the IPO price and demand stability above all else. Founders who go public later, with more developed businesses, attract long-term holders by disposition. The difference compounds across decades.
On the Sectors That Are Re-Pricing
Daily-deals, group-buying, and several adjacent consumer-internet categories — repriced sharply this year, in some cases by an order of magnitude. We had limited exposure to any of these. The lesson we draw is not about category selection but about temporal discipline: any category in which capital is flowing faster than business models can be tested will, eventually, be repriced by someone less patient than the funder.
The sectors that we expect to underperform over the next eighteen months are, in roughly this order: consumer-internet companies whose business models depend on user-acquisition costs that have been falling but are about to rise; certain enterprise-software categories whose late-stage prices priced in pricing power that the underlying products do not yet possess; and consumer-hardware companies whose competitive positions assume continued component-cost compression at rates that are unlikely to persist. We are not short any of these; we are simply not initiating new positions in them, and we are reducing weights in existing positions where we have the option to do so.
A Closing Note
The most generous thing public markets do for our industry is refuse to ratify our worst pricing decisions. We should be grateful for the refusal. Several of our peer firms appear to view the year's IPO performance as a setback for venture capital. We view it as a course correction whose consequences will compound through the next vintage.
The Partners
Winzheng Family Investment Fund · December 2012