Farhad Manjoo has a thought-provoking piece on tech companies staying private. This is a dynamic that Benedict Anderson recently highlighted in an Andreessen Horowitz presentation on the state of U.S. Venture Capital / Tech Funding that deservedly generated a lot of buzz (see: US Tech Funding).  Both are worth reading if you’re into these sorts of things.

In a rare hour of silence I took to the blog to jot down some thoughts / questions that occurred to me while reading the article.

Disclaimers: I’m not a Valley VC and I’m jotting this down in a fleeting moment while my two month-old son is sleeping; so have a grain of salt handy.

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But something strange has happened in the last couple of years: The initial public offering of stock has become déclassé. For start-up entrepreneurs and their employees across Silicon Valley, an initial public offering is no longer a main goal.

There does seem to have been a shift in U.S. capital markets.  It seems the stock market is seldom used as a source of capital formation anymore.  Anecdotally, I’ve heard from some investment bankers that institutional investors rarely have a time horizon longer than six months, and they balk at the willingness to face near-term dilution while a company builds up its capital base.

I believe the world needs more long-term investment.  Are public capital markets the appropriate vehicle to intermediate long-term savings for long-term investment?

“If you can get $200 million from private sources, then yeah, I don’t want my company under the scrutiny of the unwashed masses who don’t understand my business,” said Danielle Morrill, the chief executive of Mattermark, a start-up that organizes and sells information about the start-up market. “That’s actually terrifying to me.”

It’s easy to raise capital in the private markets now.  “Unwashed masses”?!

“These companies are going public, just in the private market,” Dan Levitan, the managing partner of the venture capital firm Maveron, told me recently. He means that in many cases, hedge funds and other global investors that would have bought shares in these firms after an I.P.O. are deciding to go into late-stage private rounds.

This is a phenomenon that seems to be happening globally; traditional growth equity and even buyout firms are participating in late-stage rounds for new-economy companies.  I don’t know to what degree these deals are structured to provide founders / early investors with liquidity events on par with an IPO.

Regardless, the scale some of these new-economy companies are achieving — and the pace at which they are doing so — is absolutely extraordinary.  Just never happened before.  So why wouldn’t non-VC funds try to participate?  Asset allocation buckets can be somewhat rigid and constraining.  If a hedge fund has a side pocket for illiquid opportunities, these rounds may very well provide the most favorable prospective risk-adjusted returns — particularly if the company has been able to use VC funding to scale up and capture market share.  Of course, they could lose their shirts — and more importantly, their investors’ capital — too.

But there is also a downside to the new aversion to initial offerings. When the unicorns do eventually go public and begin to soar — or whatever it is that fantastical horned beasts tend to do when they’re healthy — the biggest winners will be the private investors that are now bearing most of the risk … It used to be that public investors who got in on the ground floor of an initial offering could earn historic gains … By the time tech companies come to the market, the biggest gains have already been extracted by private backers.

The equity risk VCs’ limited partners take in building out unicorns is quite substantial.  And in addition to capital, the good VCs bring expertise, governance and networks to the table to help these companies grow.  If and when these unicorns list, all things equal the public investors will face a lower equity risk premium, so it’s not surprising that prospective returns — theoretically — will be lower.¹

Is the issue that it’s not fair for public market / non-accredited investors to be presented with lower returns than once existed?

Should retail investors be able to allocate a portion of their IRAs / 401ks to private equity / venture capital funds?

Should there be more ways for folks who aren’t accredited investors to provide equity capital for entrepreneurial ventures?  Crowdfunding is an interesting manifestation of this, but I’d be very interested to see some form of intermediation whereby retail investors could invest directly in private companies, acknowledging that there are enormous challenges to this, and it would not be for everyone.

Initial public offerings were also ways to compensate employees and founders who owned lots of stock, but there are now novel mechanisms — such as selling shares on a secondary market — for insiders to cash in on some of their shares in private companies.

Who will be the next Musks / Omidyars / Thiels?

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Oh dear.  The image on the baby monitor is beginning to squirm.

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Note:

¹ Nobody knows the future.