From the Crowd

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3 reasons VCs can get IPOs very wrong

May 21, 2012: 3:42 PM ET

By Glenn Solomon, contributor

In 2010 and 2011, the four hottest pre-IPO Internet companies amongst venture capitalists were Facebook, Zynga, Groupon and Twitter – the "Four Horsemen" of the Internet, as they were commonly called.  To wit, demand to get into the action on these four companies was so strong that venture capital firms starting doing things they hadn't done before – buying secondary stakes of common shares, paying multi-billion valuations and writing very large checks.

With the successful IPO of Facebook (FB) now behind us, it's interesting to look at the performance of Zynga (ZNGA) and Groupon (GRPN), the other members of the Four Horsemen who are now public.

  • Zynga: After raising a fairly modest amount of cash in its first few venture rounds, Zynga's business caught fire.  With tremendous revenue growth, its valuation soared and in 2010, Zynga raised approximately $300 million at approximately $6.44/share.  In 2011, Zynga raised an additional $500 million at approximately $14/share.  The investors in these rounds included venture capital funds, public funds, investment banks and strategic investors.  Today, Zynga's public stock price sits at just over $7/share.  This price clearly isn't what the investors in the '10 and '11 venture rounds were expecting.  Basically $800 million has been invested with little or negative return.
  • Groupon: Groupon raised approximately $135 million in 2010 at approximately $2.70/share.  Later, in 2011, Groupon raised the mother of all venture rounds - $950 million at just about $7.90/share.  Today the stock is hovering between $11- 12/share, so the 2010 investors are sitting on a solid return but the investors in the 2011 round are below 1.5x.  The lock up has yet to come off as well.  If these investors look to rush for the exits and the share price softens, the returns on this huge round may end up even more paltry.

Obviously Zynga and Groupon are amazing companies – they've invented markets, captured huge percentages of these markets and have grown revenues at phenomenal rates. Nonetheless, the last few rounds of venture investments haven't panned out as planned. Why not?

1. Discounting Growth. VCs tend to get very focused on growth rates. The faster something is growing, the better. The really big venture returns have been made in companies that got very large, and unless a company is growing fast, it won't get large quickly. So, almost no price is too high for VCs when they see fast growth in a startup. Public investors love growth as well. But, because they see companies later in their lifecycles, they've been trained to expect growth rates of high fliers to taper over time as the law of large numbers kicks in. As a rule of thumb, public investors rarely pay higher multiples for a company growing 100% versus a company growing 50%, all else being equal.  They expect growth to moderate and equal out over time, so they're just not willing to pay extra for extreme growth.

2. Profit Margin Picture. Most high growth companies aren't profitable early on, and without earnings, there isn't a P/E ratio to measure. In the absence of a P/E, VCs tend to look at price to sales ratios. Public investors do this as well, and there is good evidence to suggest that public investors don't necessarily pay more for profitable companies early on. (See my previous post on profitable vs. unprofitable IPOs.)  That said, eventually public investors want to see profits and, more specifically, they'll pay up for a company that can show profit margins expanding over time. Often it takes a while to prove that profit margins can expand, usually long after VCs are actively engaged with a company. Both Zynga and Groupon show certain forms of profitability, but margin expansion doesn't seem proven, so public investors have been less willing ascribe high prices to these companies.

3. Proven versus Unproven Models. Often times, the fastest growing VC-backed companies operate with new models. Groupon's approach is so new that it tried to invent a metric to help investors understand how it gauges results internally. Zynga is the first large company to leverage the Facebook platform successfully. While their innovative models helped catapult Zynga and Groupon's growth rates, these companies don't have analogous or comparable companies they can point public investors toward. In the absence of good comparable companies, public investors often become uncertain how to value even the most exciting companies. As a result, valuation multiples can swing wildly in the early days of a public company's life until models become more proven.

Not all late VC rounds in pre-IPO companies under-perform. While Zynga and Groupon haven't been strong performers for the investors in the last rounds of venture capital in those companies, there are several newly public venture-backed companies that have delivered for their VCs.

For example, the last VC rounds in Yelp (YELP), LinkedIn (LNKD) and Splunk (SPLK), although less heralded by VCs during their times as private companies, have all performed very well. VCs and other investors in high priced pre-IPO rounds need to think more about what will sell on Wall Street, not just on Sand Hill Road.

Glenn Solomon is a partner with GGV Capital, an expansion stage venture capital firm with offices in Menlo Park and Shanghai. He blogs at www.sandhillrdmeetswallst.com.

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