top of page
  • Ian Ritchie : Business AM

Marriages of convenience don't pay in the long run

Start-ups are better off climbing into bed with VCs than rushing to go public

THEY SAID, back in 1995, that it would all end in tears – and six years later, it certainly has.

Once upon a time, start-up companies had to raise the money needed for their expansion from Venture Capitalists (VCs). Providing funding to early stage companies is a high risk activity, and VCs are used to taking risks with investments; it is their purpose in life.

Because of this they are very careful about the companies they invest in; they undertake comprehensive ‘due diligence’ investigations, appoint directors to the board, and insist on all sorts of controls over the company’s behaviour in their investment agreement. It’s like a marriage in which both parties, the company and the VC, agree to stay together in sickness and in health, for better and for worse, until Initial Public Offering (IPO), trade sale or liquidation do they part.

Going public via an IPO, where the company makes its shares available for trading on a public market, was something that was done later in the life of a company, after it established a settled business model and had started making some profits.

But Netscape, in 1995, changed all that.

With the encouragement of their backers, Kleiner Perkins, they did an IPO on Nasdaq even though they had no reasonable expectation of when they would make a profit. Instead of using profit as a measure of performance they asked the market to value them on their spectacular revenue growth.

“The greatest legal creation of wealth in the history of the planet” is how John Doerr of Kleiner Perkins described the resulting technology business boom of the late 90s. This wealth creation however, like many of the business models, was largely virtual. Although the various financial and professional advisors have done well on the fees, very few of the resulting ‘technology millionaires’ have actually managed to get their hands on any cash.

By March last year most of the high flying Nasdaq internet companies that followed the lead set by Netscape were riding on very high valuations. In fact the average internet company would have needed ongoing revenue growth of 80% per year for the next five years to justify their market values of twelve months ago. A bit of a challenge really, considering that even Microsoft only managed 53% growth in its first five years after IPO.

Even worse, much of the revenue growth that these companies did claim were so-called ‘wooden dollars’ – the behind-the-scenes selling and buying of internet banner advertising from each other in which no real money changed hands. It’s all come tumbling down now of course, and the market has totally lost confidence in them.

So from a position of significant overvaluation, most observers now feel that many technology companies (as opposed to the ‘dotcoms’) are actually undervalued.

Businesses with a solid business model and excellent prospects are being sold short.

All this is rather puzzling for those who expect the stock market to make rational decisions about the valuations of companies. But it doesn’t surprise the ‘behavioural economists’, a relatively new discipline which also emerged in the mid 90s. It is behavioural economics that helps to explain the actions of investors: their herd behaviour, their overestimation of their investing skills, their reluctance to sell a falling stock and acknowledge a loss. Robert J Shiller, a behavioural economist at Yale University says “People get overconfident – their egos become involved”.

Even Nasdaq is worried. Last week, Alfred Berkeley, the vice-chairman of Nasdaq told the American Association for the Advancement of Science conference that “it has become easier and cheaper to gamble on the stock market than to go to Las Vegas… this speculative froth in the market works against what we need for long term capital investment”.

Nasdaq asked the Santa Fe Institute to investigate the level of speculative behaviour on the exchange. The scientists came up with animal models that showed investors “acting like shoals of fish or herds of wildebeest”

The range of derivatives, the widespread access, and the speed and low cost of trading, in modern stock markets, actually makes it a more suitable environment for speculation than for creating long-term commercial value.

So, in the light of this, is it sensible for young companies to submit themselves to public markets before they become profitable? In effect, putting themselves up as the chips in a giant global casino game.

Probably not – unless public markets can somehow become more rational in their behaviour, the relatively long term commitment of a relationship with Venture Capitalists looks more attractive than ever.

5 views0 comments

Recent Posts

See All

Too few leading lights in business

Ian Ritchie  Business HQ / The Herald December 21st 2023 It's one of the biggest challenges for the Scottish economy: where do business leaders gain skills to make them capable of driving ambitious gr

Are there too few women in our seats of power?

Ian Ritchie Business HQ / The Herald October 1st, 2023 Are women increasingly dissatisfied with their working lives? Here, Ian Ritchie studies a new book that seeks to answer why many are leaving fi

Should we get in a lather over advent of AI?

Ian Ritchie Business HQ / The Herald June 29th, 2023 Artificial Intelligence could transform the economy but investors should be wary... bubbles do have a habit of bursting, writes Scottish Entrepre

bottom of page