Too Private To Fail

Originally @ TechCrunch

At a San Francisco Halloween party this year, I ran into a man wearing nothing but bubble wrap, covered in glitter, waving a wand. “I’m a unicorn,” he explained.

Anyone from the bankers on Sand Hill to the barista at Philz can tell you: a unicorn is a startup that reaches the rare and vaunted high-water mark of a $1 billion valuation. Except that it’s no longer that rare. Or vaunted. In fact, there are now over 150 of these companies, almost none of them public.

And that is starting to be a problem. Not necessarily for executives, who nimbly broker “private IPO’s,” or investors, whose preferred shares insulate them from downside risk. The real risk is to the rank-and-file employees who staff these Silicon Valley juggernauts and who stand to lose the most from a tech bubble.

2016 will be a definitive year for tech. Bubbles adhere to a weird uncertainty principle: you can’t be in one if everybody knows it. Yet for years running now, the town criers of Silicon Valley have said the sky is falling, even if we can’t see it yet. If we’re truly in a tech bubble, 2016 will be the year that it bursts (or cools) - and if it does, anyone holding common shares (read: employees) will foot the bill.

Keep your friends close and your private investors closer

Want to see a runaway trajectory? Unicorns have quadrupled in value since 2012 to a paper valuation of half a trillion dollars. Of the 150 or so in the club, over 70 became paper unicorns this year alone.

But why are they private? Because public markets crushed those companies bold enough to offer IPO’s this year. Box, Square, First Data, Pure Storage… the list of companies who’ve struggled with their IPO’s goes on. Compared to $32 billion raised in 2014, tech IPO’s raised only $4.2 billion this year, and over 58% are trading below their opening price.

As the meme goes in Silicon Valley “IPO’s are the new down rounds.”

So companies instead turn to private equity, sovereign wealth funds, hedge funds… anyone who can support their increasingly garish private rounds. But what happens when the money dries up and projections are missed? The only option left is to scramble and sell the company, often at a loss.

Take, for example, Good Technology, which just sold to Blackberry for $425 million - a meteoric valuation - yet was privately valued at $1.1 billion when it raised capital. Or take Fab, which raised a cumulative $325 million and reached a $1 billion valuation, only to sell for $15 million. Or take private companies Spotify, Insacart, and Dropbox, where employees are struggling to find secondary market buyers above the price of their last raise.

I know there's gonna be good times (for CEO’s)

The news isn’t all bad - if you’re a board member or executive.

The case of Good provides a cautionary tale for employees. When the company sold to Blackberry, CEO Christy Wyatt walked away with $4 million in earnings and a $1.9 million severance package. Investors, like Wyatt, held preferred shares, and received $3 per share for the sale. But employees, who held common stock, received just $0.44 per share - about 1/7 what executives and investors got.

Think of shares like lifeboats on the Titanic. As the ship sinks, board members and the C-suite, who hold preferred shares, get First Class access to the lifeboats. Eventually, the cap table waterfall gets to employees, who hold common shares, which don’t have the downside protection of preferred shares and are often valued at less. By the time employees get to the lifeboats, they’re almost all gone.

In theory, this shouldn’t be such a big deal: startups are a risk, just like any other investment. Sometimes you’re flush, and sometimes you’re bust. (I’ve been on both sides of that coin.) But what happens when, as an employee, you pay a tax bill on the company’s private valuation before the board decides to sell it for less?

This is what happened to many Good employees, who paid taxes of up to $150,000 to buy their options, only to find out that not only had the company sold for under the price they bought at, but it had received offers for more. In the lead up to its acquisition, Good turned down an offer of $825 million cash, about 2x what it sold for. What’s more, employees turned down secondary market offers of $3 per share - significantly higher than their eventual value of $0.44 - and bought stock at $3.34 per share, unaware that the company had been recently appraised at a valuation of only $434 million, or $0.88 per share.

Time to rethink private market disclosures

Something needs to change.

Employees of Good are suing the company, claiming breach of fiduciary duty. Whether the claim is merited or spurious remains to be seen, but Good’s example certainly draws striking parallels to another company that went bankrupt not so long ago: Enron.

At Enron, executives withheld actionable financial performance data from investors and employees, who lost millions and had their 401k’s wiped out. The big difference with Good is that investors were protected, so only employees were left to foot the bill.

Unlike Enron, the executives at Good did not purposely mislead employees into buying overvalued shares. (After all, it is a conflict of interest for a CEO to tell employees to sell their shares, so it would be difficult to inform common shareholders of their freefalling valuation.) But this case highlights an important and sometimes deadly issue of private companies: they have no obligation to disclose financial performance, valuation, and cap table data publicly or to their employees. This leaves the majority of workers at unicorn companies completely in the dark about actionable information relevant to their own holdings and investments.

And when employees are the only ones in the dark, they are the only ones who lose. It is time to rethink how executives disclose sensitive financial information to their stakeholders. If this change doesn’t come from within, a bubble may draw enough attention that this change gets handed down to Silicon Valley from Washington.

A bubble by any other name...

It is too early to tell whether Good’s story turns out to be foreshadowing for future unicorns or an isolated incident. It shouldn’t matter as long as private investors willingly continue to pump their respective unicorns with more and more cash. But for the first time in a while, it’s starting to look like this won’t happen.

As Anand Sanwal of CB Insights wryly notes, “we're now in year 5 of folks calling the tech bubble.” Everyone knows the party can’t last forever - at some point the music will stop and not everyone will get a chair - but nobody knows how it will end.

But, Anand continues, “while Q3 2015 was a monster quarter for VC funding & deals, our early read on Q4 shows things are getting downright ugly. Compounding the issue is an exit environment this year that has been terrible. IPOs have been few and far between as have mega-acquisitions. For the first time, our 2016 Tech IPO pipeline has companies that will be dragged into going public because the private markets will close up on them.”

Just like the legal definition of obscenity, nobody can describe why we’re in a bubble, but everyone can tell you “I know it when I see it.”

If the private markets really are drying up, we may see more and more stories like that of Good, where investors get away clean, but employees find their savings and investments liquidated. The same way the 2000 dot-com crash bankrupted unsophisticated retail investors, a collapse within the 150 or so $1 billion unicorns may wipe out the majority of people who work for those companies, the families they support, the communities they reside in, and the businesses who depend on them as customers.

And if the multiplier of these collapses is really so pronounced, it may be time for Washington to take another look at the regulations around private company disclosures. The same way anyone who buys a public equity can get quarterly earnings data, we may need to ask for more transparency from private companies which pass a certain valuation or cumulative equity raise threshold, to dampen the impact of a bubble burst.

One way or the other, 2016 is going to be interesting. Maybe we’ll look back on this as false panic, or maybe 2016 will be the year unicorn hunters begin mounting their taxidermied kill over the mantle as a reminder of what once was. As Sanwal puts it “winter is coming.”

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