How the IPO market is broken

By Felix Salmon
March 21, 2012
Pascal-Emmanuel Gobry has a very smart response to my Wired story about IPOs.

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Pascal-Emmanuel Gobry has a very smart response to my Wired story about IPOs.

Gobry has one main point. VCs aren’t bad for pushing their portfolio companies to grow at all costs he says; indeed, they have to be that way.

Breakthrough technology startups are different from other kinds of businesses in that they either create a new market or violently disrupt an existing one. This means that they almost invariably require to spend lots of capital in order to stake out a defensible market position against their numerous competitors. In particular, many technology markets have winner-take-most or winner-take-all dynamics, either because of network effects or economies of scale…

Felix writes that Groupon had a profitable Q1 2010 and “it’s easy to see how it could have grown steadily from that point onward.” Except that given the characteristics of the daily deal business, particularly the need for scale, what would have happened if Groupon had tried to “grow steadily” and profitably, is that the company wouldn’t be around anymore.

It’s LivingSocial that would have raised over a billion dollars and be worth $10 billion today, Groupon would have been sold for scrap like BuyWithMe and plenty of other daily deals also-rans, and Andrew Mason would be back to doing yoga on YouTube. Groupon would be a footnote.

This is a good point. If you think about big technology companies, they’re very frequently in markets with just one or two players: if you’re not the biggest, you won’t succeed at all. And so it makes sense, in such markets, to aggressively push to get as big as possible as early as possible. One way of looking at Apple vs Microsoft in the 1980s is that Apple concentrated on quality and failed, while Microsoft concentrated on quantity and succeeded.

But the fact is that the overwhelming majority of VC-backed companies don’t become Groupon or Facebook or Microsoft. Indeed, most of them don’t even IPO. As I note in the piece, 52 VC-backed companies went public last year; 429 were acquired.

It’s certainly true that Silicon Valley is full of ambitious men (and a handful of women) wanting to build enormous companies which will change the world. But from a public-policy perspective, that’s not actually the best way to run an entrepreneurial economy. For one thing, it artificially maximizes failure — many more companies fail than need to. And even the companies that survive do so in a brutal fashion: according to Harvard Business School’s Noam Wasserman, the majority of companies getting to their Series C funding round have already fired their founder from the CEO position, and 18% are on their third CEO or more. Here’s the chart from his book:


This is why smart entrepreneurs avoid VC funding where possible, and if they can’t avoid it, try to maximize the amount of control that they have. They tend to want to build and run their companies for the long term; their backers just want to get the fastest and greatest possible financial return. Those two interests are rarely aligned.

It’s incredibly easy to overestimate the importance of huge companies in the US economy. Here’s a chart showing the S&P 500 as a percentage of total US GDP: I’m not entirely clear exactly what the numerator is, but I’m comfortable saying that the 500 biggest companies in America collectively account for less than 20% of GDP, and quite possibly less than 10%. Meanwhile, the contribution of small businesses to GDP, while shrinking, is still well over 40%


Another way to look at this question is to compare US fight-to-be-number-one capitalism with the kind of capitalism practiced in undeniably successful countries like Germany, Korea, Brazil, and Japan. Those countries don’t have nearly as many world-beating behemoths as the US does, but overall their economies and current accounts are doing very well on a bedrock of medium-sized firms and family-owned corporations.

So in a way, Gobry is making my point for me. The IPO market and the VCs who feed off it are playing a game which might make a small number of people extremely rich, and which will create a very small number of hugely successful world-beating companies. They’re not playing a game which is good for founders; they’re not playing a game which is good for healthy, long-lived companies; and they’re not playing a game which is good for the economy as a whole. That’s kind of the point I’m making in the piece when I say that “Silicon Valley is full of venture capitalists who have become dynastically wealthy off the backs of companies that no longer exist”.

I agree, then, with Gobry when he says this:

Felix also notes that according to a study, most of the fastest-growing (in revenue) companies in the US aren’t venture-backed. Here’s the thing, though: you haven’t heard of most of those companies. Not to diss any of them, which we’re sure are great businesses founded by great entrepreneurs, but when you take the world-changing companies, the ones that come up with radically new products and create new markets or disrupt existing ones, almost all are venture-backed. Those are the breakthrough technology companies. There’s nothing wrong with other kinds of companies. But breakthrough technology companies operate in a specific way which means they will have a huge appetite for capital, which means they’ll need VC and IPOs.

I just disagree with Gobry if he thinks that placing long-odds bets on breakthrough technology companies is a sensible way of running an economy. And certainly the IPO market, and the stock market more generally, should exist to do much more than just serve that tiny sliver of corporate America.

Gobry has some secondary points, too. I simply disagree with him on the degree to which private markets will ever display the kind of correlations we’re currently seeing in public markets. That’s one advantage of private markets: they’re off-limits to index funds, which drive correlations ever upwards. And yes, the HFT algo-bots also serve to increase correlations in the stock market as a whole.

And to answer another of his questions, yes, I’m still worried about the way in which the move to private markets will essentially remove from most of us the opportunity to invest in America’s fastest-growing companies. I say in the piece that the US stock market worked very well from about 1933 to about 1998; there’s no reason we can’t somehow return to those halcyon days. But as Gobry and I agree, the stock market is broken right now, at least with respect to its primary function of providing equity capital to growing companies which need it.

Gobry thinks that I want to make it harder for companies to go public; that’s not true at all. One of the main things I complain about in my piece is that it’s so hard to go public, the role of injecting equity capital into early-stage companies has been taken on by the VC industry instead. We would be better off if that role reverted to the public markets, even as many entrepreneurs managed to fund medium-sized companies without putting themselves on an IPO path, thereby remaining closely held and being much less at the mercy of violent market swings. That’s how other successful companies do it, and that’s how many successful medium-sized US companies do it, too. And even huge ones, like Mars and Cargill. It worked in the past; it can work again in the future.


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um, aren’t most S&P 500 companies multinationals? and don’t plenty of foreign listed companies do business here?

Posted by q_is_too_short | Report as abusive

Funny, when I look at the daily deals business, I mostly see factors that work *against* scale. The prevalence of winner-take-all markets is vastly overstated.

Posted by AngryInCali | Report as abusive

“when you take the world-changing companies, the ones that come up with radically new products and create new markets or disrupt existing ones, almost all are venture-backed”

A list please. And define what you mean by venture-backed. Because if you mean the professional firms, I don’t think that’s true at all.

Posted by BrPH | Report as abusive

IPOs are not broken, they’re fixed. A billion dollars for Facebook and Mark Z for example and he thinks he has the bragging rights to IPO himself and his company. I’d respect the IPO of a firm who has 80 billion in revenue and another 300 bil in total assets.

It’s always some venture cap mooch being disorderly and cutting in line.

I second BrPH’s emotion completely.

Posted by laguardia23 | Report as abusive

laguardia23, welcome to the capital markets! When was the last time a company IPO’d when it had $80 billion in revenue (seriously?! WTF) and 300 billion in total assets (WTF squared). If that company had a 5% net margin its ROE would be a pathetic 1.25%, awesome. Do you waste much time reading balance sheets?

Posted by johnhhaskell | Report as abusive

sorry ROA

Posted by johnhhaskell | Report as abusive

The falling capital requirements for most businesses are not going to go away, so capital requirements in most cases will stay small. The VCs who get this are going for even smaller and earlier funding (eg YCombinator), so public markets are just not going to be required. The ultra high growth companies are just there to provide something to spend the money the VC industry has on, you are right they have to push this model. What is less clear is that this is a problem at all, public equity markets can just go into long term decline. If individuals want to participate in economic growth they might have to start up a business!

Posted by JustinCormack | Report as abusive

The graph is apparently showing the market capitalization of the S&P500 against GDP, which frankly is not much of an indicator of anything. I suspect that what you would like to see is Total Revenue (or even total US Revenue) for the S&P500 vs. GDP. I’m pretty sure at the moment that would be about 50%, but I could look it up.

Posted by richclayton | Report as abusive

@richclayton: The S&P500 had revenues of about $10.8 trillion in 2011. U.S. GDP is around $15 trillion, so S&P500 revenue is about 70-75% of U.S. GDP.

Source: (had to divide total net income by total net margin to estimate total revenue)

Posted by SteveHamlin | Report as abusive

Rich and Steve – the appropriate numerator to compare the S&P 500 vs. U.S. GDP is not all the revenue of S&P 500 companies, but rather domestic payroll spending plus domestic operating profit (EBITDA). This number is, admittedly, difficult to impossible to find from public filings. The total revenue of companies in an economy can exceed GDP, potentially by a large margin, because of resale of products from 1 company to another. I think of it in terms of a retail supply chain – if a manufacturer makes a product and sells it to a retailer, the GDP generated is the end selling price of the product, not the total revenue for both the retailer and the manufacturer.

As an aside, this relationship (or lack thereof) is why I’m always annoyed when a commentator notes Wal-Mart’s revenue as a percent of GDP. It’s apples and oranges – Wal-Mart’s contribution to GDP is dramatically less than its revenue.

Posted by realist50 | Report as abusive

How are any of the latest big tech companies IPO-ing “breakthrough” companies? Exactly what difference is LinkedIn, Zynga and Groupon bringing to the business world? Or Facebook?

VCs are pushing for “companies to grow at all costs” because that is what is going to give them a story to cash out – either by finding a greater fool privately or publicly.

Posted by Danny_Black | Report as abusive