How Do Venture Capitalists Make Money?

March 11, 2003

While the IPO market for high tech start ups is all but shut down and will probably remain so for a while yet- rest assured- it will return one day. Thus no time is better than the present to ask ourselves who benefits the most when high tech start ups go public on NASDAQ?

Does the public at large benefit? The investors in these companies? The company insiders? How many start ups that go public actually turn into "major league companies"?

Here are the facts:

  • A major study by the M&A firm Broadview Associates concluded that between 1996-l999, the stock price of 85% of all IPOs of start up companies trade below their issuing price within 18 months. Of the 15% that were trading above their issuing price- none were profitable.
  • Since l978 when IPOs of early stage high tech start ups on NASDAQ began, more than 8,000 companies have tapped into the public markets. How many can you count that reached a market cap in the billions, besides Microsoft, Cisco, Dell, Sun, Oracle&&..?
  • Another test to determine how good these companies really are, add up the sales figures of all the companies on NASDAQ, and then their net return on sales and then divide those numbers by the number of companies on NASDAQ. The end result will be a huge, negative market cap as most companies on NASDAQ don't show any net profits (the ones that are still around trading, let's not forget). So when someone tells you that this high tech company has a market cap of $300 million, yet it only has $20M in sales and has yet to turn a profit, ask that person how many people would lay down $300 million in cash to purchase the assets of that company? In mid-2000, Cisco's market cap on NASDAQ was $441 billion yet it could only show net profits of $2 billion. Would any investor pluck down $441 billion in cash to buy a company that could only return $2 billion in net profits at the end of the year?
  • How much money are we talking about? From 1980-l989, there were just over 3,000 IPOs of start ups which brought in about $44 billion to these companies and their investors. From 1990-2000, there were 3729 IPOs which brought in more than $200 billion. In 2000 alone more than $52 billion was raised from the public to finance high tech start ups.

If so few great companies were created in the past 20 years- was this nearly $250 billion of the public's money invested wisely?

How Well Do IPOs of Start Ups Really Do?

So how many of those IPOs did well for their initial investors- the public?

Good question. A better question is how do the venture capitalists of this world make so much money if so few of the companies they invest in become successful and can show real net profits?

How indeed! This is how:

You see when a high tech start company goes public on NASDAQ the entire equation is built around something called "future potential", meaning the public is being allowed to invest in these unsound, unprofitable companies, today- based on the hope that sometime in the future- they will become major companies of the level of a Cisco or a Microsoft.

Yet few do. Fact is, there are only about 300 high tech companies in the US that sell more than $100 million worth of products every year. What happened to the other 7,700 companies and the money they took from the public on their way to becoming "the next big thing?"

Yet that doesn't stop the investment banking houses who issue the shares on behalf of the start ups from claiming that these unproven, unprofitable companies are worth "hundreds of millions of dollars" in market cap. However if calculated according to how company's valuation are calculated- how much net profits the company can show at the end of the year- none of these start ups would be able to claim such rich valuations. . In l994 the total valuation of all the companies traded on NASDAQ was $786 billion. By 2000 it had grown to $5.3 trillion. In 2000 how many of those approximately 10,000 companies traded on NASDAQ- who had a combined valuation of $5.3 trillion, showed any net profits?

But then again, high tech start ups are not judged by the same standard as all other companies and this is precisely the problem. They are "tech companies" and thus enjoy the advantage of having "future potential" which at IPO time justifies huge market caps. While such a system greatly enriches the investors in these companies, and company insiders, it is a disaster for the investing public.

Here is why:

When high tech start ups are taken public and subsequently hyped by the investment banking outfit that is issuing the shares, all they have to declare is 'beware, this is a high risk investment" and their moral and legal obligations are met. While the same can be said of a non-high tech start up that goes public- for its shares can go down in value as well- the difference is these type of companies have an intrinsic market cap based on their track record and the traditional multiples in their industry. The shares of start ups are sold to the public based on nothing more than the "hype" the investment banker and their accompanying cheerleaders in the business press.

What Happens When a High Tech Start Up Goes Public?

Rarely are more than 20% of the companies shares sold to the public. This is because if 50% or 75% of the shares were sold, the company couldn't justify such a high valuation as the hype can only sustain a small amount of investor interest. Thus usually between 15-20% of the shares are sold to the public in the IPO- at a very, very high valuation. But in reality- the company has a much, much lower valuation because invariably it hasn't produced a track record and thus has yet to show any real earnings to justify its high valuation.

However what happens in this exercise is that the all the shares of the company receive a public valuation- even if only 15-20% of the firm's equity is actually sold to the public via the IPO. Hence the remaining 80-85% of the shares that are still sitting in the pockets of the investors and the company founders- is also given a public valuation. Then, within a set time period, called a "lock-up" the investors in the company and the founders, i.e., the insiders, are forbidden from selling any more shares to the public. However once that period ends, usually 8 month-one year later, these shareholders are free to take their un-issued shares (shares that were never issued or registered in any stock market by the SEC) and trade them in at the public markets for real cash. That is the reason why within 18 months 85% of the start ups are trading below their issuing price. It's called "inflation in the number of shares in the market"- an aspect of the system which apparently is perfectly legal.

Of course once the price of the shares have tanked most of the initial investors have cashed out at huge profits. The public at large is the one left holding the shares of the company that were bought at very high prices (based on the hype surrounding the "future potential" of the company". As most of the companies do poorly- it isn't easy to argue with Fortune's Nelson Schwartz when he states:

The fact is, the typical IPO of the last decade proved to be at best a mediocre investment- and at worst an outright wealth destroyer. To be sure, Cisco and Microsoft and AOL were all IPOs at one time too. But picking the next Cisco out of a crowd of unproven companies at their initial offerings is an extremely low percentage bet. The typical IPO of l993 had returned just one-third as much as the S&P 500 by mid-October of l998, according to CommScan, an investment banking research firm. What's more, of the nearly 3,500 companies that have gone public over the past five years, more than half are trading below their offering price. One in three is down over 50%.(Fortune, November 14th, 1998)

How Much Money Do The VCs Make?

Let's turn to the August, 7th, 2000 issue of Business Week for a glimpse into how much VCs make- despite the fact that so many companies they took public never were able to show any real, net profits. The writer described how much money a leading VC like Benchmark Partners earns because they are allowed to take their unproven, unprofitable companies public on NASDAQ.

Overall, the upstart firm turned its first $85 million investment fund into about $7.8 billion- a ninety-two fold increase."

Pointing out the difference in profits between what another major VC, Kleiner Perkins, earned and the investing public at large, Fortune journalist, Melanie Warner (October 16th, l998) writes:

Between l990 and l997, Kleiner Perkins took public 79 information technology and life sciences companies that have not been acquired since. If you would have bought each of those stocks immediately after the first day of trading, you would have lost money on 55 of them. That's right, a loser rate of 70%. If you would have invested $100 in each of the 79 companies, you would now have $11,716; if you'd invested that $7,900 in a fund tracking the NASDAQ index, you would have $15,718. Perhaps you're wondering how this can be, given that Kleiner Perkins funds produce such spectacular returns. The dirty little secret of the venture business is that VCs can be enormously successful even thought most of their portfolio companies may tank in the public markets. This stems from the fact that VCs make money on almost any company that gets to an IPO, because as early private-stage investors, they've likely bought the stock at a price three or four times lower than the public-offering price.

Warner then goes on to help us all understand Silicon Valley lingo:

"Recently, however, Doer (one of the senior partners in Kleiner Perkins) gave Fortune a taste of a talent Kleiner Perkins truly does value: thinking big. @Home made a billion dollars,he told me over dinner at Il Fornaio. That may be true- you just have to understand it in a Silicon Valley kind of way. What he meant was not that the three year old start up generated $1 billion in profits (there have been none) or even sales ($23 million to date is more like it). He meant that @Home has made $1 billion for Kleiner Perkins and its investors."

On how his fund makes their investments, James Breyer of Accel Partners (another Silicon Valley venture capitalist heavyweight) reveals: If the investments doesn't earn a 30x multiple within five years we won't make the investment.

Which means guys like Breyer don't expect the companies they invest in to attain high levels of profitability- which most companies- even the ones that are considered successful and go public- do not. His money is not made on net profits of the companies- but on the vastly overvalued shares of the company at IPO time and the subsequent cashing in of the unissued shares in the public markets once the lock-up period has ended.

His advice for the rest of us: Public investors should approach the investment process with the same rigor.

Who is this guy kidding? When is the public ever invited to invest in these start ups other than at IPO time when the shares are sold at the highest level possible based on nothing but "future potential"?

In his concluding words to the public, Breyer states: Hyping companies, stock, or management teams will come back to bite us.

I wonder if he is referring to the preverbal "we", meaning the public investor and Accel Partners, or just the public investor? By the time the hype takes it's toll; the VCs are long gone and cashed out.

Three guesses as to who the hype winds up biting?

Why Should Any Of This Matter?

The point of writing this essay is to point how little the venture capitalists contribute- and yet how much they reap in return. If they were creating lots of solid companies, that sell $100 million worth of products and return to their investors 20% on net ($20 million in net profits) and go on building these enterprises long after they have gone public- one could argue they have a useful role to play. If the shares of most of the companies they took public went up in price after the IPO- one could argue they are helping the economy.

However the way the current game is structured they make out like bandits for doing very little- and all their profits are due to the astronomically high valuations that are given the start ups at IPO time. In other words, the huge profits of the VCs are being paid for by the losses of the investing public.

While Fortune and Business Week have told us how much profits these VCs made in their heyday, nobody as of yet has documented how much their "profits" cost the general public at large. Worse yet- nobody has even questioned the practice of taking tens of billions of dollars from the public each year and having these monies invested in shaky start ups that for the most part- perform very poorly. When the whole arena is based on something as nebulous as "future potential" it should surprise no one to discover that the VCs make a killing on the backs of the investment public.

There is only one word that describes what happens when high tech start ups attain public monies via IPOs on NASDAQ: a fraud on the public. While the practice may appear to be over for the time being- it will undoubtedly return- enriching the VCs and impoverishing the public.

At the very least, however, the public should be made aware that public pension funds and university endowments- one of the major source for investment in venture capital fund- partake in this public fraud by providing the venture fund managers with their capital. The great returns they have made from the "high flying VCs" comes from the same source as the VC's profits: the high price the public pays for these shares at IPO.

Another major reason why the IPOs of high tech start ups should never be allowed to return is that such a practice in inherently unfair to all those companies in the American economy who are not "high tech start ups" and thus can't rely on their "future potential" when they go public. These companies have to show real net earnings and a serious track record of success or else they won't be able to tap into public capital markets. Their investors, the managers of all the non-venture private equity funds- have to build great companies if they are going to earn stellar returns- for themselves and for their investors.

The floating of high tech start ups is not only a fraud on the public- and costs the public tens of billions of dollars each year- it is also an unfair trading practice as it discriminates against all the non-tech companies by forcing these companies to show real earnings- rather than attain public finance based merely on a nebulous concept as "future potential".

How unfair is it that while high tech start ups receive inflated valuations just because they are "tech companies" while all the other business enterprises are held to a much more stringent- and honest- standard.

11 March 2003

Joel Bainerman has been writing about high tech since the early 1980s. His website can be viewed at www.joelbainerman.com and he can be contacted at isratech@netvision.net.il

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