The capital markets are essential to the expansion of business and the overall health of the economy. Debt markets fund companies in a variety of ways, venture capital and private equity provide a path for start-up private companies to grow, and the stock market provides funding and liquidity for companies when they become public. But as fellow Fool Ilan Moscovitz testified to Congress, the IPO process has left retail investors feeling that they're getting a raw deal, and this critical peg of the capital market appears to be a bit unsteady. Today, I will argue that early stage funding for companies has changed dramatically in the past 30 years or so, and that it has also had a major impact on how retail investors should look at IPOs.
Big money behind little companies
Venture capital funding is usually the first major funding step for an early company, and it's become a huge business. In 1978, the entire industry raised only $750 million in VC funds. According to CB Insights, in 2011, VC firms invested $24.6 billion, not even including money they had on tap for future investments. Deals are also getting larger and larger, which I'll highlight below.
The reason this dynamic is important to us is that it's affecting the performance of highly anticipated IPOs.
Big money keeps the little people out
The reason the capital markets have changed has a lot to do with the dynamics between market participants and companies entering the market. Those changes were evident in recent IPOs such as the Facebook (Nasdaq: FB ) IPO and subsequent performance.
In early stages of Facebook's development, the company had no problem raising funds from venture capitalists willing to invest millions of dollars into the business. As the company's view turned from domestic dominance to international expansion, the company needed billions of dollars in its war chest to battle with the likes of Google (Nasdaq: GOOG ) and Microsoft (Nasdaq: MSFT ) on a variety of fronts. Normally this is when a company would tap the public markets, offering investors a risk/reward that offered strong growth in a company that had yet to reach its peak.
But Facebook didn't need public money. It was able to capture a $500 million investment from Goldman Sachs and Russia's Digital Sky Technologies, implying a $50 billion valuation for the company in January 2011. The company was able to stay private, keeping the upside profit available to venture fund investors and insiders.
At a certain point, all of these players want out, and they will need the public market to cash in an investment of that size. But they have the inside knowledge to know when the getting is good. Any venture capitalist worth her salt would hang on to a company like Facebook as long as possible when the valuation is rising rapidly and financial results are getting better. But when it looks like there's a top, she should bail out, especially when retail investors are clamoring for a piece of the action. By the looks of it, that's exactly what they did with Facebook.
Dumping on the little guy
Here is where the dynamic has really changed for the little guy. Since early investors have the capability to hang on to good companies for a longer period these days, the upside potential is lower for us when the company finally does come public. But that hasn't seemed to trickle its way down to the valuation given to companies when they hit the public market. Why?
An IPO is priced at a level that early investors will be able to profit short term, essentially dumping shares on the unsuspecting public. If Joe Q. Public is willing to buy Facebook at a $100 billion valuation, and I know I'll be able to flip my shares, then of course I'll buy into the IPO if I'm on the underwriter's short list. As an insider, when the value goes up, I'll sell even more, which is exactly what some venture capital firms did in Facebook's IPO.
We could repeat this same story for Groupon (Nasdaq: GRPN ) and Pandora (NYSE: P ) , which hit the public market with high hopes only to be met by accounting questions in the case of Groupon and evaporating revenue growth in the case of Pandora. They were able to raise enough funding as private companies to grow, but owners seemed to time their IPOs perfectly as shares topped out shortly after their respective offerings.
The performance trend after IPOs has been horrendous for high-profile stocks recently, and that's a problem for the whole market. If every high-profile IPO does poorly, retail investors lose faith in the system and pull their money out. That's not good for anyone.
But I don't think it's just the new rules or the system behind the IPO that is at fault; it's the rise of larger and larger amounts of money available to the best private companies that affects post-IPO performance. There are now two things driving successful companies onto the public markets: having a large number of shareholders holding illiquid stock, and simply wanting to cash out while shares still have some value. Insider selling and confusion about how a company will actually make money highlight the companies we should really avoid.
Foolish bottom line
Maybe we shouldn't look at IPOs as the next great growth stocks any longer. If they're going to grow and increase profitability rapidly, private funding sources have grown large enough to capture most of the growth value. We should probably look at IPOs like Facebook, Groupon, and LinkedIn as mature businesses that have exited the growth phase and should be compared to far more mature companies.
The bottom line: Don't be duped by IPOs when there's nothing in it for you.
Not all IPOs are bad, though. Our analysts have found one that's worth buying and it's highlighted in a report called "Forget Facebook -- Here's the Tech IPO You Should Be Buying."