Lessons for entrepreneurs in the late-stage private market

Optimizing your late-stage private placement

The late-stage private market continues to develop and mature, and so do the options available to growth companies that in prior cycles would have simply executed an IPO. These options include trade-offs on deal structure, investor targeting, how much management time a company is willing to commit to the execution of a transaction, and how the company wants this financing to fit into the context of future offerings.

Gadgets, ratchets and hatchets

Late-stage companies and investors have a wide variety of deal structures available to them. In a transaction, it is likely that investors who get all the way to the term-sheet stage will have a fairly narrow consensus around the true economic value of a company. However, investors and issuers alike will typically have different opinions as to how to value key features of a term sheet. As an example, we can take a high growth negative-cash-flow company with reasonable customer concentration and  a typical risk profile. “True economic value” may be around $1 billion; i.e., where would an investor value the company with minimal downside protection. Investor A may offer a term sheet with nominal value of $1 billion with “plain vanilla” terms such as 1x downside protection in the event of an acquisition, no IPO protection, and very limited governance. Investor B may offer nominal value of $1.2 billion but  a 1.5x guaranteed return on an IPO and an acquisition plus governance features to protect the investor. In the event that this downside protection is relevant, it will come at the expense of existing investors. Investor C may offer a convertible security, which converts to an IPO discount that increases over time. It’s important that the issuing company understand precisely what they are selling and the upside and downside features of each security. Selling structure to get a higher equity value should be a calculated risk with a strong foundation of confidence in the business. The best-case scenario is to “sell structure” when the valuation environment is at a trough but business confidence is at a peak. The convertible security is similar. The convertible security defers the valuation of the company to an IPO date in the future. The best case for this is also when the valuation environment is pessimistic but the issuer’s confidence in the business and its one- to two-year IPO prospects are high. This security has the added uncertainty of making a judgment on the future health of the IPO market.

The “plain vanilla” option is the easiest to understand but it also has its costs and benefits. Let’s assume that similar public companies (“comparables”) for a given private company are trading a 2-3x forward revenues today but typically have traded at 3-5x. And let’s assume that this company is at or near an inflection point in its business where there will be a material change to the upside in its margin structure, growth rate, and/or risk profile. If that company goes the “plain vanilla” route today, it is capturing the valuation trough and monetizing the inflection in the business only to the degree it can convince investors to give it full value.

It’s also worth noting that the value investors are willing to pay for downside protection increases when there is market and/or business uncertainty. Finance geeks would say the arb (arbitration) value of downside protection is at its peak, so this is the time to monetize structure. Conversely, many Silicon Valley veterans would argue that entrepreneurs should focus on their businesses and not on optimizing their financial structure for current value at the risk of future value; i.e., there is more than enough risk in the execution of a high-growth business without adding undue financing risk.

All of this can play into the recruiting of top talent, which is very fundamental to the creation of value for growth companies. Adding downside protection to a preferred security transfers risk  to common-equity/equity-linked securities that are so important to attracting and retaining key talent. We are at a point in the cycle where employees are pretty savvy about where they are in a capitalization structure and what it means to their value if a company executes a highly structured fundraising and the value of the company subsequently declines. Overstretching on value, even if it is not via selling structure, can also hurt an issuer’s ability to attract talent. Take two late-stage private companies where company A stretched (aggressive model, aggressive terms, aggressive multiple) on value to get to $2 billion and company B that took a more modest approach to get to only $1.5 billion in value. Company A might have the better headline, but company B may very well have the better pitch to that elusive top Caltech data scientist.

Deal structure is an important topic for issuers. It’s critical that issuers take the time to map out possible scenarios and what it will mean for the company. These scenarios should include the company’s microeconomic performance as well as what might happen should the macro- and/ or financing environment take a turn for the worse. Issuers should also consider the possible consequences for talent acquisition and future financing within these scenarios in addition to their base case.

Who do you love?

Investor targeting is always a major component of any late-stage financing; to whom and to how many? This is a dynamic environment in a constant state of investor entry and exit. In 2014 and 2015 crossover investors were dominant. In 2016 crossover investors were very quiet while we saw substantial market-share gains from Asia, the Middle East, and strategic investors. A simple conceptual model would be probability of investing + valuation framework of the investor + the intangible value of the investor all divided by the time + work required to get those investors to close. Casting the net wide has real cost—management time is valuable. So to the extent possible it’s important to weed  out the “looky loos” that are unlikely to get to market terms. Secondly, it is important to think about what certain investors may bring to the table beyond simple “value x volume.” This is where considering strategic investors can be very valuable. Working with bankers with a keen understating of the industry (especially the orthogonal dynamics), a strong industry rolodex, and a mergers and acquisitions (M&A) mindset will change the game. Strategic investors can both find and create value; i.e., they can validate a technology and they can combine the investment with a commercial relationship. Financial investors can come with their own expertise, rolodexes, and geographic expertise that can also make their capital greener.

What's your number?

It’s been long held true that companies going public need to be very judicious in their projections because missing their first and/or second quarter post pricing will likely precipitate the dreaded “gap down” in stock price the next trading session. And of course this comes with all the attention on CNBC and the wrath of investors and analysts. Perhaps it’s because the private markets don’t have this overhang that the models in late-stage private markets have been more aggressive and therefore have a higher rate of missing forecasts. But this is not to say there isn’t accountability. As a substantial number of tech companies go public this year, they will face many buy-side analysts privy to the projections they showed investors in prior rounds. The variance to those rounds will have an impact on the multiple those investors put into their financial models as well as the financial projections they use. On a more immediate level for companies that are in the private markets now or the near future is the fact that deal execution is taking so long that investors are getting a look at one and sometimes multiple quarters before they submit term sheets. In these circumstances the accountability is immediate as investors sometimes say, “Given the variance to this quarter’s performance, we want to wait to see how the next quarter goes.” Investors may also more heavily discount forward projections and/or begin to discount management’s ability to forecast and execute.

Tech private capital markets set to rebound in 2017

(Data as of Friday, December 30, 2016)

Despite a decline in overall volumes in 2016, global private tech financings outpaced global IPO volumes for the sixth consecutive year. Asia, led by China, is now the largest region by volume on the back of the proliferation and massive scale of unicorns across the Internet, e-commerce, and online finance sectors. Although the private market still recorded large volumes in 2016, down rounds, smaller deal sizes, and longer average deal execution (launch to closing) all point towards a normalization or a return to the mean in the private fundraising market.

Importantly, many of the largest and highest profile private companies have sustained or grown their private market cap with the more than $2 billion market cap companies now representing approximately $540 billion in value. Some (many) of those companies will make their way to the public markets over the next two years as the IPO market recovers. Putting the numbers into context—If we sold approximately 15% of each company at IPO, that would translate into IPO volume approaching $100 billion, a number that equates to the last nine years of U.S. IPO volume, including Facebook and Alibaba. An increase in IPOs will help replenish the depleted landscape of investable public growth companies in technology.

We believe that a once again vibrant tech IPO market offers a twofold benefit to the private markets:

  • Healthy private market financing activity: opportunity for crossover investors (mutual and hedge funds) to deploy more capital to new private investments post the monetization of some of their current private investments in the public markets, and
  • Improvements in the overall valuation environment for private issuers: a dynamic and higher volume IPO market to lower the illiquidity discount ascribed to private companies due to a shorter expected time horizon to liquidity (IPO)

This year’s crop of tech IPOs will provide a new set of valuation benchmarks and comparables for private enterprises raising money in the private markets. Obviously, how this impacts valuations could go either way, depending on the performance of the IPOs. Given we have an optimistic view on the quality and likely performance of these IPOs, we expect that this will benefit the market.

While 2017 volumes are off to a slightly slower start than anticipated, pricing outcomes have been strong and issuer friendly, as is evidenced by the lack of structure we are seeing in the market. Deal duration has subsequently shortened, and diligence requests have become less robust—all signs pointing toward a return to normalcy for 2H2017.

A deep dive into the data on the private technology financing market

Global and U.S. private markets have outpaced IPO volumes for the sixth consecutive year.

However, there are signs of normalization:

  • Global transaction volumes peaked in 2015 and were down approximately 5 percent in 2016, despite meaningfully larger average deal sizes in 2016 (+9 percent) (Table 1).
  • The decline in transaction volume (from $90.3 billion in 2015 to $85.5 billion in 2016) is even more pronounced when excluding large Chinese FinTech transactions (Ant Financial, Lufax, JD Finance, Ping An, 51credit.com, worth approximately $8 billion).
  • Despite the $10 billion decline in financing volume, the private market volume numbers are still far above the 8-year average of $34 billion.
  • Activity in the United States fell slightly faster than the broader market with deal volume in the United States down 16 percent year over year (YOY), with an average deal size of $90 million (-4 percent YOY and -15 percent from its peak of $105 million in 2011).

Global distribution of private deals also mirrors that of public tech markets.

  • In aggregate, Internet and software companies represent 91 percent and 85 percent  of  the deal count in the tech private and IPO markets, respectively (Table 1).
  • Increasingly similar average deal sizes also highlight the degree of overlap between the pool of capital in the public and private tech capital
  • Asian volumes, carried largely by Chinese issuers, now constitute the largest region by volume, having increased in market share during each of the last three years (Table 2).

A deep dive into the executions of private technology financings

While private market deal execution has been challenging lately, the bounceback in the tech IPO market will have positive implications for the tech private capital markets.

  • Beginning in late 2015, many crossover investors (investors who are able to invest in both private and public investments) indicated that their private allocations were approaching levels where they either could not buy more private stock, or would need a very compelling investment thesis to
  • Participation of crossover investors  (mutual and hedge funds) as lead investors have declined from 15 percent in 2014, to 12 percent in 2015, and to 5 percent in 2016.
  • Similarly, the proportion of crossover investors as new investors in private rounds has fallen from a 5-year high of 10 percent in 2014 to only 6 percent in 2016.
  • The previously tepid tech IPO market also impacted valuations because of the higher discount rates associated with a longer time horizon to liquidity.
  • A multiple re-rating in the public  tech  sector will likely result in an uptick for private market valuations, which have been under pressure for most of the year.
  • Amid the more challenging deal environment for private placements, investors increasingly favor “mega-deals” traditional transactions.
  • Over 40 percent of the private market volumes are now attributable to deals above $500 million, versus the 27 percent average from 2011 to 2015.
  • Flat (round) is now the new up (round).
  • Anecdotally, the number of  publicly disclosed down rounds  has  increased  from 5 in 2014 to 15 in 2016, although this number is likely underreported.

Strategic investors have become one of the most important constituencies in private market transactions. While many companies, such as Intel, Google, Qualcomm, Salesforce. com, and Microsoft have been important private market participants for a long time, we have seen new entry from the industrial, retail, automotive, energy, and other typically “non-tech” industries. Technology can even be a crucial defining element for companies that are “non-tech.” Minority transactions as well as M&A are often the most effective way to get access to leading disruptive technology.

  • Deals are also taking longer to execute and have been more broadly marketed, as average deal duration lengthened to about 20 weeks in 2016 versus the approximately 12-week average for deals closed in 2015.
  • The high percentage of private market issuers that have materially underperformed projections provided to investors has led to more intense diligence sessions where a company’s execution and management’s ability to forecast are intensely vetted.

All these directly impact a company’s readiness as a public company.

The bottom line: Even with the recent normalization of private market financings, it is unlikely that the global IPO market will eclipse the volumes seen in the global private financing market in 2017. But with a lively tech IPO market and a large cohort of maturing private companies that have attractive growth, business model, and scale, the gap in issuance should narrow. We will need to see some of the megacap private tech companies come to the public markets in order to have a shot at eclipsing the volumes seen in the private markets, and the timing of those transactions is very hard to predict. The private financing market will remain active as private companies around the globe, especially from China, will need capital to invest heavily in building large, enduring companies. Capital will remain a strategic weapon. We may also find that access to liquidity (secondary selling for employees) becomes a key competitive tool to hire the best talent—and this liquidity could come via IPO or private deals. The uptick in tech IPO activity will help create more liquidity in  the portfolios of private investors, especially for crossover investors. Funds holding private capital will finally be able to monetize their long-held private positions, creating dry powder to invest  in the next class of emerging private companies. A functioning and active IPO market will restore balance to the funding cycle of private and near- public private companies.

Ted Tobiason, Managing Director and Head of Private Capital Markets, Morgan Stanley