Another superb Forbes article
forbes.com
VCs, TV pundits, and fund managers are the new market movers
When private goes public
By Geoffrey Moore
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As we all watch the Internet drive the convergence of our communications systems, we should also note that Internet stocks are bringing about a similar convergence in financial quarters. These volatile beauties thinly clad in seductive valuations have not only attracted a whole new class of trader, they've also turned the heads of many traditional investors. In so doing, they have outraged the established arbiters of valuation. It's at times like these that we need to ask, Just what in the world is going on?
Traditionally, in the public markets, valuation has been a quantitative discipline focused on financial assets and earnings performance, and capital has been supplied based on forecast returns from established operations. By contrast, in the private markets, valuation has been a qualitative discipline focused on business ideas and models, and capital has been supplied based on potential returns from as-yet-nonexistent operations. An IPO was the rite of passage from private to public.
Today the two models are converging. The public markets are adopting the valuation mechanisms of the venture community, most dramatically in the Internet sector, and the venture community is turning to the public market's much larger sources of capital to supply the massive infusions needed to scale up rapidly into a global contender. That is, companies are going public earlier in their market development life cycle to capitalize on first-mover advantage, using the huge inflow of capital to accelerate the build-out of an infrastructure or a brand.
The resulting shift in the risk/reward equation is forcing the public and private investment communities to wrestle with each other's conceptual model, not altogether happily. That's why we see financial analysts and business press continually predicting the Internet bubble will burst. They are clinging to the notion that the public markets must represent a relatively low-return domain because they are relatively low risk. Meanwhile, the venture community is struggling to accept the idea that the bulk of a company's increase in value might not happen until years, or even a decade, after the IPO, so the winning strategy is to hold, rather than cash out, upon liquidity. But the venture community is not well structured to act on this insight, nor is it sure it wants to.
So what does all this bode for the future? Nothing less than the redefinition of both institutions, public markets and private, as each performs in fundamentally new ways. On the public-markets side, the first change will be in financial reporting. Historically, in their quarterly and annual reports, companies have aggregated financial data across multiple markets so that performance in any given market can be determined only indirectly. The traditional rationale for this practice is that investors care only about the bottom line and that any additional information benefits only your competitors.
Today, that rationale no longer holds. Contemporary investors, who know they can diversify through mutual funds and other investment vehicles, look to individual stocks for opportunities to outperform the market. They're focusing on pure-play investments in fast-growing markets, and that in turn makes them want to see cash flows broken out by market category. The emerging growth companies do this by default, since they are only in one category. The cash flow of a mature company with a diversified portfolio, by contrast, appears blurred unless management recasts its financial reporting to reveal competitive performance by category.
A second, deeper change that's restructuring our public markets is investors' focus on how well a company has executed its business model. In emerging markets, where disruptive technologies are creating new competitive dynamics, it is far more important to determine who will dominate the sector for decades to come rather than who made the most money last quarter. Netscape was the first company to really teach this lesson, giving away its flagship product to acquire a client base.
In a product-based market, margins and market share need not be mutually exclusive: The dominant player is often also the stellar earnings performer. But in a services-based sector like the Internet, the two positions can actually become polar opposites, as profit margins diverge from market share. This leads to a finance-driven Old Guard retrenching to preserve profit margins under rules that are being eroded, and a business model-driven New Elite desperate to pour more capital into acquiring new customers before someone else grabs them. Investors are coming down on the side of the business model folks--they may not be sure the New Elite will win, but they are pretty certain that the Old Guard will lose.
A third change overtaking the public markets is a recalibration of the length of time implied by the phrase the future. Traditionally, public-market investing has been driven by a primary constituency, institutional investors, and a secondary constituency, private investors, the bulk of whom were at or near the age of retirement. For institutional investors, the future is a perpetually moving target, with a horizon of perhaps 3 to 5 years. For individuals at midlife or near retirement age, the future is a close-ended affair, with a horizon of perhaps 10 to 30 years.
Now, however, public markets have attracted a new wave of private investors for whom neither of these horizons works: the generation of people in their 20s or 30s who are investing in the public markets, largely through their 401(k) programs. Their horizon is roughly 50 to 75 years, a future that really is "out there." Hence, their primary focus is on very long-range leading indicators, multiyear or even decades-long industry formation models, as well as company business models that may take a number of years to unfold. For these investors, the main value of financial reports is as feedback: The data allows them to calibrate the validity of the firm's business model by comparing the company's projected growth against its actual, quarterly figures.
On the private side, what is all this doing to the venture investor? Here, too, time is being redefined, but on the venture side, horizons are getting shorter, as market development mechanisms have become astoundingly efficient. Today a global market can spring into being virtually overnight. Entrepreneurs can get the capital, attract partners, generate sales, and become the market leader in the time it used to take to pull together a good team, raise a first round, and get a decent Release 1.0 out. Since these new markets are increasingly culminating in a winner-takes-most outcome, and since first-mover advantage is hugely influential in determining that winner, venture investors are left with a chilling conclusion: There is no time. It all has to happen now.
This is transforming the focus of these investors: Money is no longer the scarce resource, time is. Lengthy board meetings are not devoted to the discussion of raising money but of spending time--the entrepreneur or a conservative board member wants to go more slowly, test more thoroughly. But doing so carries a much bigger risk of missing the market, exposing the venture to a bigger chance of failure than ever before. Ultimately, this gets translated into financial risk. Time management is supplanting cash management as the most critical entrepreneurial imperative.
The preciousness of time has also led venture capital firms to expand their network of relationships in whatever direction can help them save time. The goal is to partner with someone who's already in the game rather than staff up to do it yourself. Why are we doing our own administration? Let somebody else find us the space, get the phones in, get the payroll up and running.
It is this frenzied struggle to capture opportunity in time that is driving the public and private markets to converge. The public markets have the massive amounts of capital, and the private markets have the business acumen to develop emerging markets, and both are needed to bring off these global market coups. But to attract the capital, which is now put at venture risk, the market must return venture rewards. That is what the post-IPO market is currently delivering.
But given that VCs are entering the cycle much earlier than before, and exiting it at a correspondingly early stage as well, why wouldn't a venture firm continue to back its own horses in the post-IPO phase? I believe we will see venture funds holding their newly public equities longer, creating a greater share of total fund return from the public market. It just makes sense to maintain a presence until the fundamental promise of the original investment has been realized. This practice will inevitably lead to more VCs spending longer tours of duty on the boards of public companies. And so the ties between the two markets, public and private, are likely to intertwine even further, as the world economy works out its funding mechanisms, dragging us all along as willing, but wondering, participants. |
