Square, venture capital and the late-1990s Internet bubble

a bubble deflating

Internet payments company Square came to market yesterday.  It has a two-letter symbol, SQ, and trades on the NYSE, not NASDAQ.  But the most salient fact about the offering is that the IPO price was a lot below the private market value that venture capital investors had placed on SQas little as a year ago.

At the same time, the small number of mutual funds which have been aggressive venture capital buyers in Silicon Valley have been, more or less quietly, writing down the carrying value of their non-public company holdings.

What we’re seeing is, I think, a smaller and much more benign–both for the economy and for us as stock market investors–analogue of the deflation of the Internet mania of the late 1990s that started in early 2000.

the late 1990s and the internet

I remember noticing in 1998, that earlier- and earlier-stage companies were coming to market successfully.  Some were little more than concepts.  Take Amazon (AMZN), for example, which IPOed in mid-1997.  The pre-offering roadshow that I saw emphasized that investors had made gigantic fortunes on buying unknown companies like Microsoft during the personal computer era and that AMZN was a lottery ticket to a similar outcome in the Internet Age.  Of course, even a success like AMZN didn’t turn profit for its first eight years as a public company, surviving on the proceed from the IPO and follow-on debt offerings.

I thought at the time, and unfortunately committed my theory to writing, that we were seeing a fundamental change in the role of the stock market in capital formation.  Portfolio managers were gradually taking on the role previously played by venture capital.  So, I mused, managers of mutual funds like me might have to think about reserving a small place–no more than, say, 5%–of their portfolios for developing companies that they normally wouldn’t have touched with a ten-foot pole.

Not my finest intellectual hour.

today’s bubble deflation

The slow escape of air from the venture capital bubble that is now going on will not have much effect on publicly traded companies, I think, for several reasons:

–the amount of money involved in this speculation is much smaller

–investors of all stripes still wear the scars of 2000-2001, so they haven’t been anywhere near as crazy this time around

–the people who are losing money now are, or represent, wealthy, seasoned speculators, not retail investors

–maybe most important, much of the original internet froth surrounded highly capital-intensive efforts to build a global physical internet transport infrastructure.  Names like Global Crossing and Worldcom come to mind.

Yes, too much physical capacity did get built back then, and some builders were highly financially leveraged.  But also dense wave division multiplexing, a technological breakthrough in technique (basically, putting glorified prisms on each end of a cable), made it possible for each fiber optic strand to carry 2x, 4x, 8x, 16x ( in 2015 the number is 240x)…  more traffic than initially anticipated.  Thanks to DWDM, suddenly, despite the rapid growth of internet traffic, an acute shortage of signal transport capacity turned to mind-boggling glut.  The transport industry was facing collapse as customers played a ton of potential suppliers against each other for lower prices.  Naturally, new construction–and related orders for all sorts of high-and low-tech components, dried up completely.   So did investment, employment in civil engineering   …and the stocks.

In today’s software world, there’s no equivalent, other than perhaps the market for software engineers.  And there are no signs I can see of recession in this arena.  Quite the opposite.

 

raising capital… (II): venture capital

Although I’ve observed the venture capital industry at work for most of my career and have invested in lots of companies making their first move away from private equity financing, I’ve never actually worked in the venture capital industry.  So this post will be brief.

venture capital

Venture capital is a form of private equity financing.  VCs support early-stage companies that they think have substantial growth potential, but which are too small, and too risky, to get conventional bank financing.  Their small size and immature businesses also rule out the possibility of a conventional IPO.  Again, the risk it too high.  In addition, if the company wants to raise, say, $10 million, fee income would at most be $1 million–too little to interest most reputable investment banks.  (The only time I can recall seeing brokerage houses reaching down into venture capital territory in a big way was in the latter days of the internet bubble in 1998-99–and we all know how that turned out.)

In the US, venture capital is typically associated with Silicon Valley in California.  In their search for start-ups with explosive growth potential, they have acquired deep knowledge of technology-related industries (where that potential resides) and of skilled entrepreneurs who can turn that potential into a fast-growing firm.  So they feel comfortable there.

VC activity isn’t always in the tech world.  But you won’t see venture capitalists backing firms in, say, furniture retailing, where it’s difficult to see earning several times your initial investment in a reasonable period of time.

funding rounds

Venture capital financing isn’t a one-shot deal.  It typically occurs in a number of stages, or “rounds,”  where a company gets more money, so it can move to a higher level of development.

Stages might correspond to company needs for:

–seed money, where the VC firm supplements funds committed by the entrepreneurs themselves, or their friends and family.

–product development

–manufacturing and marketing

–working capital

–expansion.

If everything is going smoothly, each round of funding will be at a higher stock price.  The funding may be done through convertible securities rather than straight equity.  This gives the venture capitalist some income while he waits for the company to mature.  Convertibles can also give the VC a stronger claim on company assets than ordinary equity holders in the case that things go badly.

exit strategy

The venture capitalist has traditionally expected to cash out of the company he has invested in thorough a conventional IPO–at which time he will have the option of selling some or all of his shares.  In today’s world, however, it’s equally possible that a private sale to a much larger firm in the same industry will happen instead.

pluses

Venture capitalists are willing to invest in companies at a much earlier stage of development than others.

VCs also typically provide organizational help, management and technical expertise that may be sorely needed by a fledgling company but which may not be available any other way.

minuses

If you don’t have stellar growth potential, VCs probably aren’t interested.  Simply getting their money back, with interest, isn’t enough.

At some point, usually very early on, part of the price for additional financing will be that the entrepreneurs cede control of the business to the VCs.  In most cases, this is probably a good thing, since risk-taking visionaries don’t often make great managers (look at the early Steve Jobs).

That’s it for today.  More tomorrow.