Technology investment: US tech start-ups get dose of reality

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Private/public valuations diverge; investors becoming ‘more rational’.

by Ben Edwards

Following a raft of giddy private market valuations, some of the world’s biggest mutual funds are sharply marking down the worth of some high-profile tech start-ups. BlackRock recently slashed its valuation of file sharing service Dropbox by 24%, according to a regulatory filing. Fidelity cut its valuation of instant messaging app Snapchat by 25%.

Mobile payments provider Square, which went public in November, was forced to offer its shares at a price that valued the company at $4 billion, a third lower than the valuation in its final private funding round just a year earlier.

That could be a sign of things to come.

"There are a handful of companies whose valuations are vulnerable to a correction in the public markets should they pursue a public exit and they pursue that exit soon," says Rob Tompkins, a senior director at SVB Analytics.

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Brad Slingerlend, Janus
"It’s just become a little bit more rational," says Brad Slingerlend, manager of Janus Capital’s global technology fund. "The correction that needed to take place was probably bigger than a speed bump but smaller than a mountain, and although we’ll still see some fallout in the coming year, it’s largely behind us now."

David Peinsipp, a partner at Silicon Valley law firm Cooley, says many of these tech start-ups have been commanding such high valuations because they are transformative businesses.

"These are visionary, life-altering companies," he says. "You didn’t see that in 1998 or 1999 when we saw a lot of tech companies go with high valuations, there really wasn’t so many that were changing the way our daily life is structured."

Fear of missing out

Public funds, fearful of missing out on investing in these companies as valuations surged higher, began piling into private financing rounds alongside traditional venture capital funds, driving up valuations even further, says SVB’s Tompkins.

"These are [public] funds who would have gone into an initial public offering had the IPO happened sooner, but they felt the company was going to wait a while and they wanted to get into the deal now, so they’ve come into a valuation that was already perceived to be pretty high," he says.

The trend for tech start-ups to remain private for longer has torpedoed the IPO market. In 2015, by the end of November, there had been 27 tech IPOs in the US, roughly half the number of flotations over the same period in 2014, and the lowest number of deals since 2009, according to Dealogic.

Cully Davis, co-head of equity capital market solutions for the Americas at Credit Suisse, says this reluctance to go public is largely because private companies can get access to capital comparatively easily.

"If you feel like you can raise money privately at valuations in excess of where you could raise it publicly, the decision to stay on the sidelines is logical," he says.

Growing concerns that a company’s IPO price might be lower than its private valuation, as happened with Square, is also deterring some start-ups from taking the plunge now in the hope that public valuations will later catch up.

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Rob Tompkins, SVB
"Some of those companies might actually be able to stay privately-held for long enough to where they’ll be able to exit by IPO without that downward correction, because they’ve ripened on the vine to the point where they can command a higher valuation in public markets," said SVB’s Tompkins.

Furthermore, an unpredictable IPO market has made that exit route less appealing. Of the 10 largest US tech IPOs in 2015, half were trading below their offer price in December. For instance, peer-to-peer e-commerce platform Etsy’s share price almost halved to $9 from $16 in the first eight months after going public.

Emotional factors

Emotional factors may also be at play.

"There has been a little bit of bravado in Silicon Valley in staying private for longer," says Janus Capital’s Slingerlend.

Yet that attitude might be changing as some sky-high private valuations start drifting back to Earth.

"The pace of private round investing for technology companies has definitely slowed," says Credit Suisse’s Davis. "Deals are getting done at more modest valuations, so the ability to stay private with huge valuations relative to going public is diminished."

Companies that continue to push for high private valuations are also being slapped with more onerous terms that protect late-stage investors, he says. Features such as ratchets – which grant certain investors additional shares if an IPO is priced below an agreed value, diluting existing shareholders such as employees – have become more common.

But Janus Capital’s Slingerlend says that any increase in IPO activity will hinge on the success of previous offerings.

"There are a lot of private companies now that should have already come public, but we need to see some healthy deals for the market to really open up," he says. "If we don’t see that we might stay in limbo for a little longer."