How venture capital–funded startups have run up massive losses while justifying premium valuations using creative profitability metrics. These private companies are now going public allowing early investors to cash out with sizable gains. Meanwhile, these new publicly traded companies are added to equity indices, forcing passive managers to purchase them for their index funds and ETFs.
In this episode you’ll learn:
- How venture capital and initial public offerings work.
- How many venture capitalists are there and how have they performed.
- Why do startups stay private for longer and then go public while still incurring massive losses.
- What is blitzscaling.
- How startups use creative profitability metrics to attract investment capital at premium valuations
- How the current venture capital regime contributes to income inequality.
- How to get an allocation to an initial public offering.
Show Notes
Private Markets Come of Age: McKinsey Global Private Markets Review 2019—McKinsey & Company
First Quarter 2019 Private Capital Quarterly Review—Fund Evaluation Group
The wave of unicorn IPOs reveals Silicon Valley’s groupthink—The Economist
Uber IPO: the long ride to profitability—Financial Times
BlackRock, Other Big Investors Spoil Uber’s Coming-Out Party – The Wall Street Journal
Riding alone in a car is a luxury—an increasingly unaffordable one – The Economist
U.S. regulators approve new Silicon Valley stock exchange – Reuters
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Episode Summary
IPOs are initial profit offerings often used by startup ventures to fund their growth. Are IPOs a type of Ponzi scheme, however? David dives into how IPOs are funded, how startups use them to grow while losing billions, and how individuals are left with little option to participate, except in helping create a return for the initial investors through sales and passive investing.
The rapid growth of new venture capital firms
Entrepreneurs use private investment capital, such as from venture capital firms, to fund their ideas, build infrastructure, and keep their businesses running during the period where they have to spend more than they make in order to rise to the top of the competition. It’s a winner-takes-all mindset where startups try to push out all the other competitors due to their sheer size and marketing power. Facebook, Pinterest, Uber, and Lyft are all examples of recent new venture capital firm investments. The shocking thing is that about 2,000 new ventures have been funded since 2010. Billions are being poured into these startups, but billions are also being lost. The interesting part is that more and more investors are willing to shoulder the initial loss of a startup in order to capitalize on the gains when the coming conducts an initial public offering by issuing stock to the public for the first time.
The profits and losses induced by blitzscaling
Blitzscaling is when the venture grows at an extremely rapid rate—even while sustaining losses because it’s funded by private investors. Because so much loss is having to be sustained, the ventures hold off going public until ten or twelve years down the road. Unlike in earlier times when companies were profitable when they went public, more and more companies are holding their IPOs even while they continue to sustain large losses. That allows private shareholders to gain liquidity and realize sizable gains while public shareholders are left with a company that still hasn’t figured out a profitable business model.
While the strategies used by startups are beneficial to fast growth, they tend to lead to the view of labor as a commodity—simply part of the process. Employees aren’t as highly valued because of the fast pace, and the price of labor is seen more as a necessary evil rather than an opportunity to invest in the future of the company. Be sure to listen to the entire episode for David’s discussion of Uber and the negative impacts that new venture firms can have on the economy and society.
The roles of individuals and initial investors in IPO profit
As individuals, it is difficult to participate in IPOs and the potential initial price jump. Most IPOs are allocated to institutional investors while the proceeds from IPOs offer liquidity to family offices, institutions and other super-wealthy individuals who invested in them. Less wealthy individuals don’t often get to participate in the initial funding of a startup. Where individuals end up participating is after the company goes public. Once a new venture goes public, it is added to stock market indices, and are held by index funds and ETFs. The initial investors are still the ones gaining most of the profit, while individuals through passive investments have exposure to these new public companies that are still trying to figure out how to make money.
Ideas for making IPOs beneficial for everyone
David points out that not all venture capital firms are bad. Startups inspire innovation and growth in many marketable areas. They are actually self-regulating in many respects. If the expectations of the investors are consistently not met, then fewer investors will be willing to participate in the first place.
Long-term stock exchanges are one solution to the Ponzi-esque scheme of IPOs. If—once a venture goes public—individuals were able to purchase long-term stock, they could participate in the startup for the long run, possibly surviving the short-term loss and volatility that comes with new ventures. If individuals could purchase an index fund on the long-term stock exchange, there would be greater opportunity for larger investment in innovation and all the exciting growth and exploration of startups.
Episode Chronology
- [0:19] What are IPOs?
- [2:12] The growth of new venture capital firms.
- [5:22] Blitzscaling and the willingness of venture capitalists to initially lose money.
- [8:33] How start-ups are choosing to exit.
- [11:18] The cost of going public at premium valuations.
- [13:26] The social and economic repercussions of blitzscaling.
- [18:16] How money-losing firms try to create a profit.
- [19:38] How unprofitable companies convince investors to buy at high valuations.
- [21:20] How individuals participate in venture capital without investing in an IPO.
- [24:08] Possible solutions to IPO’s problems.
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Transcript
Welcome to Money For the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is Episode 253. It’s titled “Are IPOs the New Ponzi Scheme?” IPOs, it stands for initial public offering. It’s when a company sells stock to the investing public for the first time. Ponzi scheme is an enterprise, or maybe it’s not even an enterprise, where early investors are paid off and earn profits from the funds of later investors. The IPO market, the startup market, the venture capital market is very different from what it was really in the ’90s, and up until the year 2000.
Getting a startup moving
The initial venture capital has been around since the 1940s, the idea is an entrepreneur has an idea or a team of entrepreneurs. They get funding for that idea. They take that funding, they build out infrastructure, marketing plans, et cetera, and this initial funding from the venture capitalist, and maybe there’s a couple of additional funding rounds, but the idea is to get a viable enterprise overcome kind of that period where expenses are higher than revenue as the idea catches on, but eventually, after a few years, the company is taken public. They raise additional capital from the public market that allows the enterprise to continue to grow. As investors, we are able to participate in that company’s growth over time, as it expands. Great examples are Google, Amazon, Facebook. Now, it’s very much a different game when it comes to venture capital and private investing overall. The size is much greater.
Back in Episode 219, I did an episode on the shrinking stock market, the public stock market, and I shared how the number of listed companies, publicly-traded companies in the US has gone from 7,000 in 1997 to around 3600 today. At the same time, McKinsey Global Private Market Review, their 2019 report, shows that the value of private companies has grown seven and a half times since 2002, twice as fast as the public market, in terms of the overall market capitalization or the size of the public market.
More and more startups
Since 2010, more than 2,000 new venture capital firms have been founded. Back in 2010, there were only 800 managers in the entire venture capital industry. Now, the amount of money being raised is staggering. Venture funds raised over $80 billion in 2018. That’s the highest since the height of the tech bubble back in 2000. And the number of deals being done—my old firm, Fund Evaluation Group, where I helped co-found our private equity arm where we invested directly in venture capitalists, leveraged buyout deals, et cetera. I did that for a couple of years—They continue, and they do an FEG private capital quarterly, fascinating document. I’ll link to it in the show notes. They show that in 2018, this is data from PitchBook, that there was $225 billion invested in 2018 in new venture capital deals. Close to 15,000 individual companies took on venture capital money. That compares to $130 billion in 2017, so a huge amount in terms of the dollar amount. But that $130 billion was spread over more companies, 16,000 deals.
What you see there, more money has gone to fewer deals, which means some of these deals are getting larger and larger amounts of funding. There are a lot of startups being funded. This is from CB Insights, and it lists the number of firms just in the retail sector that were funded in 2018, 30 in location analytics, 10 in store management POS systems, 4 in music systems, eight in pop-up kiosks, four in smart receipts, 12 in inventory management, 12 in shelf monitoring, packaging tech, dressing room technology, customer loyalty, 12 there. 151 different startups just in 2018 in the retail sector.
What’s fascinating is that’s a lot of experiments and that leads to innovation. Startup investing, it’s a great thing. It leads to innovation. It’s often done through venture capital. You might have an angel investor that initially seeds the idea, but something dramatic has changed.
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