Secondary Markets – Do They Serve a Purpose?

Yesterday I came across this article in the WSJ where Ben Horowitz of Andreessen Horowitz expressed his concern over the emergence of secondary trading platforms for private shares.  Firms like SharesPost or SecondMarket.  And while I have a ton of respect for Ben, as an operator, technologist and investor, I don’t think that the idea that squelching secondary trading of private shares via regulation is a great one.  There are several reasons why these firms exist and I think will play an important role (one way or another) going forward.  To be certain, these marketplaces are not perfect, but regulation isn’t the answer to solving the problems that exist:

1. There is a Market Demand:  The fact is that if you or I want to invest with Ben, or the 10-15% of top VCs where much of the wealth is created in this asset class – we can’t.  Access to this asset class is woefully inadequate.  Part of the problem is the VC industry – which as a whole does a poor job of generating risk-adjusted returns (which is something I have discussed at length in the past).  Getting access through a secondary market is pretty much the only chance investors will have to get exposure some of these interesting companies before the public markets or them being sold.

2. All Markets are Asymmetric to a Degree:  The regulation of market information, e.g,. Fair Disclosure (Reg., FD), Sarbane Oxley, etc., has leveled the playing field for investors, but at the cost of information getting into the market at all.  Don’t misconstrue this as my believing these regulations are bad (I believe the benefits of the level playing field outweigh the detriments in the public market).  But the regulation brings a burden that should not be extended to private investments lest they eliminate the market completely.  Even then, asymmetric market information exists in the heavily regulated public market – e.g., professional investors have far more resources to evaluate a particular investment, or certain investors have unique information and insight (though not illegal inside information) that other investors do not.  If asymmetric information is a problem relative to returns, investors will either stop investing in this class or demand more information before investing or adjust the price paid based on different assessment of risk.  Selling insiders will always have an informational advantage – regardless of the market.  That said, investors do need to do their homework or risk the consequences.

3. Valuations Are Not Absolute and Different Depending on the Investor: The idea that an investor might be off by 30% relative to a later round is somewhat inconsequential because it entirely depends on what and how value is being set in that next round (e.g., VCs will have entirely different motivations for pricing a round relative to someone that wants access to ownership of a private company as an individual).  This is particularly true in light of returns that successful private investments garner – e.g., a 30% valuation error is pretty tolerable if the choice is a.) being able to make the investment at all, or b.) the difference between a 70% return and 100% return.  The reality is that different investors have different risk profiles and different investment horizons (both of these result in a different return expectation and tolerance of loss and illiquidity) – to argue for regulation based on the view of being an institutional player in this sector ignores the fact that there are investors of all types interested in these markets and regulation will restrict opportunities for a large number of them based on an “assumption” of the needs of these investors without actually understanding what those needs truly are.

How these secondary trading markets fair in the long term is still an open question in my mind.  Would there be a demand for these if there were a rational IPO market?  I really don’t know.  I think that over the last 8 years a lack of proper understanding of capital markets for private company investments and IPOs has resulted in creating a burning need for these firms because liquidity for private companies has been consistently underestimated, and almost certainly evaluated without a proper understanding of the tradeoffs of liquidity v. valuation v. risk across different pools of capital in the marketplace.  But I believe the lack of an IPO market is not the only reason for these firms existence and I expect them to play a proper role in the marketplace long term – either as a liquidity alternative should markets never sort out the problems associated with capital allocation to private investments or as a part of a more functional and free-flowing future capital markets for private companies.


Venture Capitalists and the Stock Market… Why?

So this post by VC Mark Suster caught my eye yesterday – Stock Market Drops. VCs Hold Partner Meetings. What Happens Next? | TechCrunch.  My immediate reaction was – why is a VC concerning themselves with the stock market?  VCs are long term investors right?  I guess that since exits are few and important events for VC funds – I suppose it makes sense to think about the stock market with regard to the impact on investment monetization.

Then I read the post and got really disturbed.  The post wasn’t about impact of a weak market on exits – it was about how the stock market effects funding decisions on the front end…   Wait… let that sink in.  The stock market tanks – VCs convene and decide to not invest.  Am I reading this right?

Regarding the stock market

We thought the following:

  • No new deals close until we figure out WTF is going on with the market. We need some visibility.
  • Let’s review all of our existing investments. Let’s make sure each has enough cash. Cut where needed. Finance where needed. Anyone not going to make it?
  • Who has deals in process? Let’s help get their funding get finalized or the company sold if it’s already in play.
  • Fawk, man. This is really bad. Depressing. Harrumph.

Wait… seriously?  While I am certain Mr. Suster doesn’t speak for all VCs, the environment he paints is a troubling one for both entrepreneurs and LPs – one where VCs are being driven by short term and business cycle thinking when they are getting paid to be thinking long term and making investments in companies that are game changing – and should be at some minimum insulated from the business cycle.

It seems to me that at the time the VCs should be most focused on making investments – when there is less competition for good ideas and valuation pressure (though I’d be curious to see how much that really matters) they are doing the exact opposite of what you would expect.  Based on the portrayal of the process in this post I had the following points:

1. VCs Appear to be Overly Focused on the Short Term Stock Market When Making Investments.   The mean time from initial funding to exit is in excess of 5 years.  The mean length of a bear market is 310 days, and a bull market is 915 days.  This means that for most start-ups they will ride at least one bear/bull market cycle before exit.  Even if a VCs’s assessment of “what’s going on with the market” is twice as pessimistic that the norm – an investment would expect to live through at least one cycle before being ready for exit.  Essentially, today’s stock market is irrelevant for today’s investments.

2. Is the Business Cycle That Important?  Obviously its easier to build a business when you have a stiff tailwind of economic growth to drive your top line…  but VCs aren’t making investments in restaurants…  they are supposed to be making investments in disruptive technologies.  By definition these are supposed to take share from the companies being disrupted… So while, yes its less risky to invest when the cycle is good, if the idea has true merit, that shouldn’t be a make or break point.   Or is what is being said that VCs don’t actually know and are instead masking selection error with a good business cycle and selling the risk of the business to later stage investors?

3. IPOs Appear to be Overstated and M&A Understated.  Obviously IPOs are heavily influenced by market conditions (though Wall Street has all sorts of problems with the IPO market I won’t get into here) – but the reality is that most exits are M&A driven.  Now M&A is influenced by the market – though not as much as you might expect or as portrayed.  It depends on what size acquisition you are talking about.  The chart below shows the volatility in deal volume quarter-to-quarter compared to the volatility of the Nasdaq.  As you can see the volume of small deals doesn’t change radically from good markets to bad – where it changed significantly is when deals are above $250MM in size.

Even in early 2009 the M&A market was open for sub-$250MM acquisitions.  Volume ebbs and flows with the market – but they still get done – good markets and bad.  This is not like what we see in larger sized deals  (above  $250MM) where M&A volume has a much higher volatility based on the stock market.  Deals above $250MM are tough to do in a bad market.  Perhaps this means that VCs are overly focused, or their business model is overly reliant, on the home-run (where the market would be closed) rather than hitting for average.

I think all three of these points are important considerations in today’s market.  Given that we are in the middle of a systemic shift in the way we deploy technology (cloud) and purchase technology (consumerization of the process) – VCs that pull in their horns because the stock market is flailing about are likely to be left behind.

Angel-gate and its Implications

I have been sitting on this one for a while, but I am finally ready to weigh in on “Angel-Gate” – at least from the perspective of what the implications of its existance mean for entreprenuers and early stage investors. Read more of this post

Paul Graham on the Future of Start-up Investing

Y-combinator’s Paul Graham did an excellent piece on his vision for the future of start-up investing.  Much of what he says echoes things I wrote about last March.

One thing missing from the discussion, however, is the impact that this flood of smaller investments has on the business model of the investors themselves – or not (as is mostly the case) – and more importantly what that means for entrepreneurs. While its true that there is a tremendous amount of room for more players in the seed-round market – that’s not necessarily a good thing for start-up managers. Read more of this post

The Role of Investor Risk in the Lost Decade for Entrepreneurs

Welcome to the Lost Decade (for Entrepreneurs, IPO’s and VC’s) « Steve Blank:

Steve Blank puts together a good overview of the history and current environment for start-ups and why the lack of an IPO market has changed the game for venture investors.

It is also good illustration of how risk-adverse the venture community is when it comes to making investments. Read more of this post

diaspora, Mr. Brainwash, and Why An Article in the NY Times Won’t Ruin Your Start-Up

An interesting piece discusing how group-funding sensation diaspora which had potentially tapped into a well of anti-Facebook sentiment with its open-sourced alternative. The central point of his post was to muse over how this might be a watershed moment for Facebook rather than a validation of diaspora one way or the other. Read more of this post

Y-Combinator and Techstars Performance – Lessons Learned?

The first look at Techstars historical data came out last month and the results showed performance very similar to the early results posted by Y-Combinator. The quality returns would lead us to believe that a.) the guys running these shops are geniusesb.) The systems they use are superior systems for identifying quality teams and opportunities; or  c.) both… Of course its probably d.) none of the above – which isn’t a knock on these organizations – not at all.  Instead, I think its d. because of the sheer size of the opportunity that these firms are tapping. Read more of this post

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