Why Facebook Clearly Belongs in the 10X Revenue Club

Posted on February 1, 2012. Filed under: Facebook, Internet, IPO, Uncategorized, Venture Capital, Web/Tech | Tags: , |

Attached are my thoughts on the Facebook S-1 along with some quick stabs at valuation.  Brief disclosure, Benchmark Capital has a minority position in Facebook as a result of the acquisition of FriendFeed, a company that was incubated in our offices.

I thought it would be useful to look at Facebook using the scorecard from our May 24 blog post, “All Revenue is Not Created Equal, the Keys to the 10X Revenue Club.” For those that want to save time, the key point of this piece is that there is a broad disparity of Price/Revenue multiples for global Internet stocks, and that only a very small fraction of these companies achieve a multiple over 10X. We also created a list of 10 factors that public investors consider when trying to qualify if a company is deserved of such a prestigious and lofty valuation.

On a roll, these factors are:

1. Sustainable Competitive Advantage – how big is the competitive Moat?
2. Presence of Network Effects – does the model tip to a single vendor?
3. Visibility/Predictability – is the revenue consistent
4. Customer Lock-in / High Switching Costs – is it expensive to leave?
5. Gross margin levels – How much leverage exists is the business?
6. Marginal Profitability Calculation – is the leverage still expanding?
7. Customer Concentration – are there key dependencies?
8. Major Partner Dependencies – are there key dependencies here as well?
9. Organic Demand vs. Marketing Spend – is customer acquisition expensive?
10. Growth – how big will the future be?

So how does Facebook score on these metrics? As you would expect, pretty well.

Metric: Comments: Grade:
Sustainable Competitive Advantage It would be extremely hard to launch a direct-on competitor to Facebook.  Look at what has happened to Friendster, MySpace, Bebo, and is happening to Orkut in Brazil.  Google+ as a FB competitor is a tough slog. A+
Presence of Network Effects These are about as strong as you could design. All current non-US Facebook users have immediate connections if they log-in. A+
Visibility/Predictability This is fairly strong as well, simply because there is no lumpiness.  There is a small dependency on Zynga that could cause variability. Also, a premium product would offer more consistency than pure ads.  That said, this is not an issue. A
Customer Lock-In / Switching Costs Leaving Facebook is possible, but finding an alternative with all your friends on it is not really possible.  Obviously, the inclusion of Timeline works to increase this even more by creating a permanent dependence on past content. Also, Facebook’s DAU number is staggering. Over half of all users check-in daily. That is uber lock-in. A+
Gross Margin Levels Gross margin has hovered between 75-80% for the last several quarters.  This is a fantastic overall gross margin. It would be great to think they have more leverage here, but as the largest Internet site in the world, this probably represents peak margins. A
Marginal Profitability Calculation On this one Facebook doesn’t score so well.  Peak profitability (on a margin % basis) was in Q4 of 2010, and since then spending has kept pace with revenue growth. It is likley that the team would argue they are “investing for the long-term,” but if the long term is forever, than EPS growth is permanently tied to revenue growth. B-
Customer Concentration Zynga is 12% of revenues, but this is fairly low and they are the only company over 10%. Plus, if Zynga stopped competing for these ad purchases, there are many, many Zynga look-alikes that would rush to fill that void. So even if they left tomorrow (which they won’t) the number would not go away completely. A
Partner Dependency Facebook has grown to be the largest site in the world with the help of no one. No partners. No dependency. A+
Organic Demand All of Facebook’s customers are organic. This is as good as it gets.  The pure stuff. A+
Growth Facebook grew the top line 88% in 2011. That’s quite amazing. Q4 of 2011, however, was only 55%.  People will definitely be watching this number in Q1. If growth rate hurts the company, then it’s a direct result of waiting too long to go public – past peak growth. B

The bottom line is that these scores are fantastic. Facebook is a shoe-in for the 10X+ revenue club. Perhaps the only question is which years’ revenue you consider. If the company grows 50-60% in 2012, you end up with roughly $5.5-6B in revenue. With all the hype, assume a 12x multiple on the $6, and you end up right at $72B. You can double-check this with earnings. As operating margin is stable, 60% growth would result in $1.6B in after-tax earnings. At $72B, this is a 45 PE ratio for a company growing at 60%. At a 60 PE, you would have a $96B market capitalization. The bottom line is that the banker range looks right to me. Of course, overt and ecstatic demand for the hottest IPO of the past 10 years could easily lead to much higher speculative valuations. But it’s hard to argue that the $70-100B range is wrong. Feels quite right to me.

Here are a few other interesting things from the S-1:

  1. Tax Rate. Warren Buffet’s secretary would be happy. Facebook’s tax rate is already north of 40%. Other multi-national companies typically have found a way to reduce this. Facebook is paying full-boat.
  2. Model appears set. With gross margin relatively fixed, and peak operating margins over 5 quarter ago, investors should get comfortable that bottom-line growth is limited by top line growth. Management could change their attitude later, but experience suggests that founders like Zuckenburg want to invest for the long term. As a result, one shouldn’t expect these super healthy margins to go any higher.
  3. Sales > R&D. It is somewhat surprising that sales expense is greater than R&D expense. The ad units clearly are not self-serve. Interestingly, this ratio is very similar for Google.
  4. Seasonality. The company has more seasonality than I would have expected (geared towards Q4). The prospectus says this is tied to traditional advertising seasonality.
  5. Facebook’s unique RSU program. In an effort to avoid the restrictions of 409A, Facebook long ago created an RSU structure whose shares vest on a liquidity event.  As a result, a large amount of stock (close to $1B in value) will all “vest” on the IPO. This will result in an enormous one-time, non-cash charge. What I still can’t figure out, is how this will effect the overall share count. If you know let me know, and I will append the post. If auditors and the SEC are happy with this RSU structure, I would expect to see other startups adopt it, as it avoids the restrictions of 409A.
  6. Cash. Over $3.9B in cash already. And they will raise $5B more. That’s a lot of cash.

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On IPOs: If You Are Going To File, Make Sure You Price

Posted on September 14, 2011. Filed under: Internet, IPO, Uncategorized | Tags: |

As you likely know, I am a big believer that the IPO can play a key role in the development of a company’s life. Moreover, I have argued that many in our ecosystem have an unhealthy anxiety regarding the dangers and consequences of being public. Lastly, I have argued that the IPO window is wide open for great companies – something I still believe today. All that said, I have been quite surprised by the recent trend in companies that file and then chose to delay. If you are going to file the S-1, it is imperative that you are prepared to follow through. Standing too long in the middle of the financial equivalent of the river Styx can have severe consequences.

Why is this a bad thing? The longer a company remains on file without pricing, the more questions arise about “why” the company may be struggling to move forward. Did they miss their numbers already? Are they having cold-feet? Are they not ready?  Do investors not like the company? Have the bankers lost their belief on the company? Employees may begin to wonder the same thing. As you are in a quiet period, it may be difficult for you to respond to concerns through the press. If you then take the added step and “pull” your IPO, you now risk being considered a “broken” deal and potentially a “broken” company. Potential acquirers will certainly see it that way. These problems can be especially acute in Silicon Valley, where competition for talent is intense. Lastly, to file and not price is to give up all the benefits of being private with none of the gains of being public. You have been exposed, but you have nothing to show for it.

There are many things that can cause delays in filed IPOs. The most common factor is unexpected questions from the SEC that cause iteration and re-filing. This is especially true of the SEC questions that require the auditors to revisit their original assumptions. Shaky investor sentiment as a result of a weak broader stock market can cause both investors and bankers to have “cold feet.” There may also be concerns with valuation and dilution. If your company looks like it is going to price at a 30% discount to what your bankers conveyed on filing date, you may not want to suffer unexpected dilution. Lastly, there may simply not be enough demand for your IPO – which is an amazingly tough position for your company.

 

The attached table shows the # of days from pricing to filing for some recent IPOs as well as the days on file for Zynga, GroupOn, and Kayak. These five companies had an average pricing-filing span of just under 100 days. Two of the IPOs in which Benchmark was lucky enough to be an investor (Zillow and ServiceSource) had particularly good showing on this “pricing-to-filing” metric with 93 and 94 days respectively. (*Just added Bankrate, which had an error-free 62 day filing to pricing window). GroupOn is starting to move outside this ban, but recent news suggests they may be back “on track” with a target date of late October (this would equate to 150 days on file). Zynga’s IPO is listed as “delayed” on Yahoo Finance while standing at 75 days. Kayak, a leader in the travel search space, had been on file for 301 days – a precarious position for any company.

While many of these potential causes of delay appear external and “out of your control,” there are in fact many things you can do to minimize the number of days between filing and pricing.

  1. Don’t start the process until you are ready. This certainly includes knowing your business is performing well, but also includes having the auditors ready, having your financials in order, having a strong CFO and general counsel, having your BOD ready to go, and generally being prepared for what is about to happen. Talk to other CEOs who have kept the process on time, and find out how they prepared.
  2. Pick a banker who understands that you are sensitive to filing-pricing timing. Some bankers will tell you this metric is not critical. You own the problem if you are stuck in a filed but un-priced company. You should tell the service provider what is important to you, not the other way around. Great investment bankers have a strong understanding of SEC process, SEC rules, and may even have an ex-SEC representative on staff. These things matter, and you should be able to tell whether or not they matter to your banker. Also, find out before you file if your banker believes in you and your business. If you are defending your business to your banker “after” filing the S-1, you had a clear sequencing problem.
  3. Watch out for “wedding planners.” IPO are expensive and as such, they tend to attract “service providers” encouraging you to purchase the “royal package” at every turn. The argument, just as with a wedding, is that you only do this once, and therefore; expense should be of little concern. There are two problems with this logic. First, companies about to be public should not be carelessly wasting money. Second, the “royal” package takes more time and slows things down, and will inherently contribute to extending the pricing-filing window.
  4. Pick experienced professionals in every slot.  There are many constituencies that are involved in your IPO process – auditors, valuation firms, compensation firms, external counsel, underwriter’s counsel, bankers, analysts, even these whacky constituents known as “printers.” You want professionals who know how to get things done, which is very different from the “wedding planners.” Think Harvey Keitel as Winston Wolf from Pulp Fiction. “I solve problems.” Facilitation is key.
  5. Intentionally target a smaller offering. Many investment banks will encourage larger offerings (see point 3). While this serves them well, it may be at odds with maximizing the probability of a successful pricing. Less supply means less demand is required to pull off a successful offering. A smaller offering also will make all shareholders less sensitive to dilution and therefore pricing. Once again, do not file if you do not plan to price, and this includes all prices in the planned offering range.
  6. Don’t disrespect the precious nature of an open window. The four companies above were on file during a very strong IPO window, and as a result had seemingly error-free processes. Being prepared to go when things are good means avoiding the situation where you file, and the global market melts down in your face. If (1) your company has the numbers to be public, (2) your company is ready and prepared to be public, and (3) the IPO market is healthy and the window is clearly open and you still chose to wait to go public than you are accepting the timing risk of the future.  As Geddy Lee of Rush says, “If you choose not to decide, you still have made a choice.” Growth can slow, markets can turn, new competitors can show up. Going public too early clearly has risks – but so does waiting too long and missing your opportunity.

IPO markets will always have “pulled” and “delayed” IPOs. This is simply the nature of the beast. An open IPO window attracts two types of companies – those that should go public, and those that “need” to go public for capital reasons. Portions of the “need” group will always fail to find supporters, and therefore you should not view delays and withdrawals as signs of a weak IPO market. That said, certain delays can and should be avoided. If you are stepping up to the plate for an IPO, be ready, be prepared, and be committed to seeing it through. Don’t submit an S-1 if you don’t plan to price. Waiting on file for extended periods of time can be catastrophic.

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Silicon Valley’s IPO Anxiety

Posted on November 15, 2010. Filed under: Internet, Uncategorized, Venture Capital, Web/Tech | Tags: , , , |

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“Living in the limelight
The universal dream
For those who wish to seem.
Those who wish to be
Must put aside the alienation,
Get on with the fascination…”
— Limelight from Moving Pictures, Rush

If you could travel back in time to the early 1990’s and ask Silicon Valley’s top entrepreneurs and private company executives about their long-term career ambitions, you would hear a constant theme – they all wanted to be part of an Initial Public Offering (IPO). Back then, taking a company public, either as a CEO, CFO, or founder, held an allure similar to that of a young athlete dreaming of making it in the major leagues. Clearly, not everyone was able to go public, but that of course added to appeal. Everyone still wanted to go public. They all dreamed of playing on the business world’s biggest business stage.

A great deal has changed since then. First, we lived through the peculiar time now known as the Dot-com bubble, where the elite requirements for going public were greatly reduced. This was followed by a period of heavy regulation where many aspiring startups felt as if they were absorbing the burden of sins committed by the likes of Enron and WorldCom, two companies that are far away from Silicon Valley. If you believe what you read, we now live in a world where young entrepreneurs have a more cynical view of the IPO and being public in general. It is common today to read a phrase like “You don’t have to go public early to provide liquidity to early investors or employees.” It is critical to consider just how far away “don’t have to” is from “want to” or “dream of”.

How Did It Get This Bad?

There are many potential causes of this widespread pessimism. First and foremost, going public and being public are not nearly as much fun as they once were. The combination of a rise of ambulance-chaser shareholder lawsuits, Sarbanes-Oxley, the requirement for CEO and CFO signatures on financial filings, and limited personal trading flexibility has unquestionably made being public less enjoyable for executives. Increased bureaucracy and red-tape almost never lead to increased enthusiasm.

We may also have a perturbed notion of what a “healthy” IPO market looks like. For many, the go-go days of the late 1990’s stick in their mind as the definition of a strong IPO market. Unfortunately, the IPO market of 1999 was a myth, a façade, a once-in-a-lifetime mirage that you will never see again. While that period was economically fruitful, it was clearly manic and a long, long way from being healthy. Moreover, it was completely and utterly unsustainable. It also may have “cheapened” our view of the IPO. If anyone and everyone can go, it is no longer a heroic accomplishment.

One recent argument knocking the IPO is as follows: Wall Street is too short-term focused, and that if you want to run your company for the long-term you should remain private. There are three great reasons that this “can’t focus on the long term” argument falls short — Jeff Bezos, Marc Benioff, and Reed Hastings. All three of these amazing entrepreneurs turned CEOs took their company public on a standard IPO time frame. They also all three conveyed to Wall Street that they would postpone short-term earnings results in order to chase a greater long-term objectives and ambitions. The intelligent mutual fund investors that were swayed by their convincing arguments (there were many) were handsomely rewarded. Furthermore, Bezos, Benioff, and Hastings all three used “being public” as a bully-pulpit to tell their version of their industry’s story, thereby aiding their advantage. If you are unconvinced go ask Steve Riggio, Tom Siebel, or Blockbuster CEO Jim Keyes.

Certainly one contributor to the negativity surrounding the Silicon Valley view of the IPO market is the negative perception of the local press echoing off the hillsides of the Santa Cruz mountain peaks. Over the past several years, it has become quite common to read Silicon Valley articles and blog-post offering near-eulogies of the high-tech IPO. TechCrunch refers not to simply the “IPO” but to the “dreaded IPO,” or the “Poor, Pilloried, Tech IPO.” Famed early stage investor and typically glass-half-full blogger Fred Wilson recently penned “IPOs Just Aren’t What They Used To Be.” The San Francisco Chronicle stated that the “market for initial public offerings remains badly broken,” and the ecosystem “..has been destroyed.” And despite the numerous successful IPOs in the last two years that have supposedly put an “end to the IPO drought,” the only thing that doesn’t seem to go away is the use of the phrase “IPO drought.” If that were not enough, the NVCA (National Venture Capital Association) argues the situation is so dire that we need a Four Pillar Plan To Restore Liquidity. The pessimism is consistent and deafening. The glass isn’t simply half-empty; everyone seems to think there is a hole in the bottom of it.

How Bad Is It Really?

A more optimistic eye can see that the IPO data is actually improving. This quote from the NVCA’s second quarter update is rather straightforward:

Venture-backed company exit activity showed continued momentum during the second quarter of 2010, with the best quarterly total for venture-backed Initial Public Offerings (IPOs) since the fourth quarter of 2007, according to the Exit Poll report by Thomson Reuters and the National Venture Capital Association (NVCA). The quarter ended with 17 venture-backed IPOs, marking the third consecutive quarter for increased offerings, by number and by dollar amount.

Looking at the Q3-2010 NVCA data included above, you can see that 2010 is markedly improved over 2009. We have already tripled all of last year in the first three quarters of this year. Moreover, with a healthy Q4, we could meet or beat the annual numbers from 2005 and 2006. If you limit the data to VC backed companies in the U.S. in high technology (leaving out Pharma and bio med; which is different from the above), there were five in 2008, twelve in 2009, and 25 year-to-date in 2010. These data points are clearly up and to the right. And while they may not hit the bar we are looking from for a cyclical market high point, it surely makes it hard to say the IPO market is fatally flawed. And it unquestionably not “closed.”

The Majority of Recent IPOs Are Outside of Silicon Valley

U.S. High Technology / VC Backed IPOs Since the Beginning of 2008 (XLS)

The Excel spreadsheet embedded above contains a detailed look at all of the high-tech VC backed U.S. IPOs since the beginning of 2008. There is some very surprising data in this table. First, these IPOs have performed relatively well since their initial offering. On average, these IPOs have averaged 55.9% in price appreciation since their IPO date. This represents almost $14B of post IPO value creation as a group. Moreover, 19 of the 42 companies are worth over $1B. A full nineteen VC-backed companies with recent IPOs are now worth over $1b!  The press that keeps yearning for the next “big” IPO in Silicon Valley and complaining about the health of the IPO market, doesn’t spend much time talking about RackSpace ($3.3B market cap), RealPage ($1.8B market cap), GreenDot ($2.2B), or Ancestry ($1.1B) – all recent IPOs that have traded up quite nicely since they went public. Maybe there is a reason for this.

Is there any chance that the negative IPO sentiment that is reverberating through Silicon Valley is actually having an impact on the local IPO volume? One might expect, that as the epicenter of innovation, Silicon Valley would warrant more than its fair share of IPOs. But the data shows the exact opposite (see table below). In this same spreadsheet of recent IPOs, we have highlighted whether each company has its headquarters here in Silicon Valley or elsewhere in the United States. The shocking reality is that only 11 of the 42 high-tech, venture backed IPOs since 2008 reside in Silicon Valley. In other words, 74% of these IPOs hail from outside of the SV echo chamber.  If you look at the data in terms of initial IPO value, 78% of the overall value is from outside SV. In terms of value today its 73.5% (SV IPOS have outperformed those outside SV).  Perhaps these out-of-market IPOs aren’t well covered within Silicon Valley, and perhaps the negative IPO sentiment isn’t well heard outside of it. Our pessimism may have led to a self-fulfilling prophecy.

Demand or Supply Problem?

There is an interesting commentary at the end of the San Francisco Chronicle article that we previously discussed. “Brent Gledhill, with William Blair & Co., a small investment bank in Chicago, said he has buyers for small IPOs, but can’t get sellers.”  This argument, which was also supported by Paul Deninger of Jefferies, suggests that we have a “supply” problem, not a demand problem. He has BUYERS but not SELLERS. The problem is not that Wall Street doesn’t want product, it is the opposite; that we are not offering them enough of it. While it is clearly a chicken-egg argument, you simply cannot have a healthy IPO market if the leading high-quality companies are unwilling to file. The problem may be attitudinal, not structural.

To this point, and perhaps ironically to some, most of the people I know that work in high tech mutual funds and hedge funds would like to see more IPOs not less. They are tired of trading the same large technology names that are showing limited equity returns over the past 10 years, and have very low growth opportunities/ambitions. If you look at the the forward revenue growth estimates for technology bellwether stocks you may be surprised: Intel (3.5%), HP (5.6%), Microsoft (6.8%), Cisco (11.1%),Ebay (11.4%), and Yahoo (3.3%). And many of these stocks are flat to down for the past decade! Even Google, the youngest of the large cap tech plays has a go forward growth estimate of below 20%. As you can imagine, these traditional “must have” technology names are not contributing to mutual fund outperformance the way they once did. Fund managers desperately need more exposure to growth. They also crave exposure to new trends like social networking and mobile computing, but with limited IPOs they have limited ways to invest in these new innovative trends. They simply need more “quality” product.

Valuations Are “Higher” in the Public Market

As a result of this scarcity of growth across the broader set of public companies, strong category leaders like OpenTable, GreenDot, Realpage and Ancestry.com are seeing healthy valuations in the public market. These high growth Internet leaders trade at PE multiples (30-50x) that are roughly twice that of Internet leaders Microsoft, Yahoo, Ebay, and even Google. The IPO market is currently paying a substantial premium over the M&A market (the exact opposite of what you read). The same large companies that are struggling to find growth have reduced valuation multiples (P/E, P/S). This in turn makes it hard for them to pay strategically high prices in an acquisition. Therefore, entrepreneurs that follow the advice from the San Francisco Chronicle, and are “looking to be acquired” may be leaving ample money on the table.

As an example, drill down on RealPage, a Dallas based leader in SAAS solutions for property management companies. It is currently trading at $1.86B after a successful August IPO. They currently trade at about 8.7X annualized Q2 revenue. Which potential acquirer would pay this valuation for a private vertical industry specific SAAS play? Do you think Salesforce, who has never done a large acquisition, would? Do you think Oracle (who trades at 3.5x sales would)? What about SAP (3.8X sales)? IBM (1.7x sales)? Or consider GreenDot which went public in July and currently trades at a $2.2B market capitalization. This valuation equates to roughly 6 times 2010 revenues. Do you think American Express (currently trades at 2X revenues) would have offered that in a private transaction?  What about Ancestry.com?  This recent Internet IPO is currently trading at a market capitalization of $1.17B. Which large Internet company would have paid close to $1B for Ancestry? None is my answer.

We should also consider DataDomain, 3Par, and Arcsight, all companies with remarkable sell-side M&A transactions who went public BEFORE engaging in an M&A transaction. Being public is a wonderful way to establish a baseline valuation in an eventual corporate sale. There is no chance someone would make an offer at or below the current market price, as the expectation is to pay a market premium. And because the BOD has a very high duty in terms of maximizing shareholder value, these deals are often seen by multiple bidders and therefore more likely to be competitive than a private transaction. Lastly, and not to be ignored, public company sales have zero escrow provisions. These escrows typically put at risk 10-15% of the transaction value when a private company is acquired. Being public before you get acquired can be extremely valuable.

Your Company Is Not Facebook

A large contributor to the negative IPO press is Facebook’s definitive view that it prefers to postpone its IPO well into the future. Recent comments suggest an IPO may be put off until 2012. As a top three worldwide Internet site, the press is obviously interested in what Facebook wants to do. Also, because of its huge impact, and the emerging trend of social networking, the buy-side is quite interested in owning Facebook. The demand for an IPO, were one to happen, would be enormous. And that is probably an understatement. However, it is critical to put this in perspective relative to everyone else.

Facebook is the exception not the rule. They can do what they want when they want. They can raise money privately at any time if they feel the need to do a cash acquisition. There are literally firms willing to wait in line to give them money. They can hold a press events and everyone comes, so they certainly do not need to be public to broadcast their message. However, they are also a miserable proxy for the average private company CEO and BOD to consider. Your company is not like Facebook, and it should not build its IPO plans based on what Facebook does or does not do.

Things Are Looking Up

This entire problem may be self-correcting. The BOD and executives from the companies that have not gone public have certainly noticed the successful offerings, post-market performance, and valuations of the IPOs mentioned herein. As such many of these executives are now marshalling the forces for their own IPO. As an example, Betfair, a long awaited IPO in the UK (congrats @jdh) just went public and had strong results. Skype and ZipCar have filed, and all indications are that LinkedIn is working on its own filing. There is also a good chance that companies like AutoTrader and eHarmony will come public soon, and there have been multiple rumors of IPOs at companies such as Hulu and Pandora.

In addition, the very recent press seems to also be singing a different tune than the dire press from this summer.  Check out the following headlines from the last few weeks:

I recently had the opportunity to hear the story of how Tim Sullivan, the former leader of Match.com, went into Ancestry.com five years ago as CEO.  At the time, the company’s growth had slowed and many had assumed it had seen its better days. Tim and his team and began a multi-year turn-around that would eventually lead to last year’s respectable IPO. Last week, the company completed a successful secondary offering. Tim shared with me all of the amazing work that went into reigniting this market leader (a very impressive story), but I was most surprised when he talked about the IPO process. His face broke out into this huge grin as he described watching the stock trade that first day. You could clearly see the type of IPO enthusiasm that once reigned supreme in Silicon Valley. For Tim, the dream was still alive, and more importantly he was able to turn his dream into reality.

Waves of pessimistic analysis can become self-reinforcing and began to influence rather than just inform. That appears to be the case with respect to local attitudes towards high-tech IPOs. Next time you hear someone talking about how broken the IPO market is, please let him or her know that despite what you read, many great companies are going public and are having remarkable success. And if they still doubt you, tell them reach out to Steven Streit at GreenDot, Zorik Gordon at ReachLocal, Doug Valenti at QuinStreet, or any of the 38 other CEOs who recently stood up and walked through the door that everyone else says isn’t open. Their story should be at least as compelling as focusing on the few companies that don’t seem all that interested.

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Note To Timothy Geithner: Do Startups & Venture Capitalists Really Need More Regulation?

Posted on March 26, 2009. Filed under: Internet, Regulation, Uncategorized, Venture Capital | Tags: , , , , |

Mr. Geithner:

In the late 1990’s, in response to the obvious financial shenanigans of large companies like Enron, Tyco, and WorldCom, Washington handed us the Sarbanes-Oxley Act.  I have no idea how effective Sarbanes has been at reducing fraud (it obviously did not prevent our current economic malaise), but I do know one thing.  Sarbox created a significant burden and tax on small companies that desired to tap into America’s public capital markets, and one that could have long-lasting negative impact on the long-term success of startups and innovation in America.  It’s pretty simple, Sarbanes-Oxley can costs $2-3mm to implement, and also is a huge burden on your IT and development staff (taking away from feature expansion and product improvement).  For a company doing $50mm in revenue with a 10% pre-tax operating margin, you only have say $3mm in after-tax earnings to report.  These new Sarbox costs effectively eliminate your profitability, which has a huge impact on valuation.  Of course, what this in fact causes is companies to feel the need to be much, much larger before they even try to go public.  Notably, IPOs have been systematically reduced post-Sarbox, and we are still significantly below 1991-1992 pre-bubble levels.  As David Weild notes for PEHub, “I submit that there is no question that accounting costs and Sarbanes-Oxley costs are a primary (maybe not the only) factor in the diminution of initial public offerings in the United States.”

So today we get news that in light of the recent financial crisis, you want to impose new regulations on hedge funds that will also sweep in venture capitalists (and by association their private companies). Depending on the regulation, this could require VCs to disclose specific metrics about the private companies in which they have invested, robbing these companies of one of the key benefits of being private.  Now it is fairly obvious that venture capitalists and the small venture backed companies in which they invest had nothing to do with the mortgage crisis, Fannie Mae, Fredie Mac, AIG, or anyone of the 8 major TARP recipients.   Yet despite this, your sweeping recommended legislation will impose more undue costs and disclosures on entities that had absolutely nothing to do with the problem you are solving.  

Washington already has given us one overly burdensome legislation (in Sarbox) for a previous problem we did not create.  Please do not do it to us again.  And remember that the largest companies in America that were created in the last 35 years (MSFT, GOOG, AAPL, CSCO, INTC) were all small venture-backed companies at one point in time.  Do we really want to inappropriately restrain or throttle the future pipeline of such companies in America?

I am all for you solving the problems you need to solve, but please be careful of the effects of unintended consequences for others.

Bill Gurley, Benchmark Capital
www.twitter.com/bgurley

Added note:  Some have pointed out that VCs should not be the only class “exempted” from the regulation.  First and foremost, why would they be included?  What did they do to contribute to the current situation? However, if you insist on this viewpoint, then let us instead focus on the specific instruments that caused the harm – leverage and derivatives.  If any limited partnership uses these instruments, they are subject to the regulation.  If not, no regulation.  That is pretty simple and clean.

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    …focusing on the evolution and economics of high technology business and strategy. By day, I am a venture capitalist at Benchmark Capital.

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