I am pleased to host another student guest post, this time by Julian Smith. This is the 23d student guest post this semester. You can see all the student guest posts from my “Monetary and Financial Theory” class at this link.
Following the text of what Julian wrote initially is a lightly edited version of my Q&A with him. Julian and I think you will find that discussion interesting.
The tech companies’ startup blueprint for years was to build their business through valuation rounds with venture capital firms before going public and generating profits for shareholders. At the start of the tech boom there were very few “unicorns,” privately held firms with valuations over a billion dollars. Now, the ground appears to be shifting. Tech firms are no longer chasing profits for a potential initial public offering. The firms seem to fear of entering the stock market by many tech firms that are not longer looking for IPO.
The fear of the stock market and lure of private buyers caused a huge spike in the number of unicorns in the tech industry. These companies have not had a lot of success going public according to the Economist article “The rise and fall of the unicorns.” The article lists Square and Etsy as examples of such failures, stating, “It has become clearer that the high valuations firms achieve in private are not always maintained when they go public.” The lack of broad market reception for these firms compared to their venture capital valuations has scared firms away from the stock market. The Economist authors argue, “Many investors in unicorns had bet that a new generation of technology firms would unsettle the old guard, but that has not happened as quickly as they had predicted. Tech giants like Amazon, Google and Facebook have continued to grow impressively, especially considering their already large size; and they have been adept at entering new markets that startups might otherwise have claimed.” Instead of disrupting the norm, the new tech startups have merely settled into the old tech landscape. While this certainly does not make them failures, it does change the investor outlook.
The slipping valuations and dominance of tech giants altered many tech firms’ goal from IPOs to now being bought by another firm. The success that Amazon, Google, and Facebook have enjoyed entering new markets means that successful and innovative tech firms have an abundance of buyers for mergers and acquisitions. In an article for the Wall Street Journal, Telis Demos and Corrie Driebusch describe the transition of tech firms’ objectives, “At least 18 companies have stopped pursuing filed U.S. IPOs this year because they were being acquired, according to a Wall Street Journal analysis of Dealogic figures. That amounts to about 10% of companies that filed for IPOs and either went public or sold themselves this year.” The authors of the article argue that the volatility in the stock market is causing tech companies to shy away from the public market and seek to be bought by these large companies to maintain their valuations.
The inability of new tech firms to displace the established giants has altered the goals of emerging firms. The tech giants have been successful at expanding and adapting to new technologies, eliminating market share for new firms. This means firms can capture more value by joining the larger firms that competing on their own, leading firms to want to be bought rather than going public.
Miles: This is fascinating, but I still don’t understand why a tech firm would be more valuable to a private value than in an IPO. Are the private buyers overpaying, is the public irrationally pessimistic, or is the firm really worth more to a private buyer? What paragraph would you have written in answer to that question?
Julian: The private buyers see the tech firms as assets they are adding to their business strategy while investors are expecting firms to disrupt markets and succeed on their own instead. New tech companies have repeatedly failed to disrupt the former giants, so public investors do not see their value. The firms do not create high enough profits to return to shareholders. For the larger buyers, they see much more value in expanding their reach and creating more core competencies. Private buyers derive more value from the expansionary possibilities than public investors can derive from independent investment.
Miles: How does this create more profits than in a separate firm:
… they see much more value in expanding their reach and creating more core competencies …
Another possibility: are they buying these firms to rein them in so the new firms don’t disrupt?
Julian: I think that’s a valid reason for some companies, but I also think there is a valuation premium from being bought by a private company because they add more value to a firm that already has the infrastructure and knowledge than they do as an independent company. There are a lot of opportunities for synergy and increased efficiency across the evolving tech space for these large firms that simply cannot by captured by a startup with an IPO.
Miles: I see three factors mentioned in the two articles you linked besides the ones you mentioned. In "The rise and fall of the unicorns“ it suggests that some private valuations are sometimes made to look higher than they really are–for example because the investor is given not just a share of equity, but also a put. The Wall Street Journal article you link to, "Forget Going Public, U.S. Companies Want to Get Bought,” suggests that IPO prices have gotten riskier because of overall market volatility associated with uncertainty about what the Fed will do, and have gone down some because of an overall shift in financial investment toward passive funds.