Why VC-backed firms can’t stay private

By Felix Salmon
December 17, 2012

Talking of VCs who don’t like it when founders decide to sell, here’s Marc Andreessen on the subject of the $1.26 billion sale of one of his portfolio companies, Nicira:

That company, standalone, would have done about $2 million of revenue this year; we just sold it to a public company, VMware, for $1.26 billion. We think that [the founders] sold too soon and too cheap. We wish that they hadn’t done that. We’re happy for their outcome, and they’re at VMware, and I think they’re going to be a huge success at VMware. We wish they had stayed an independent company. Because if they had succeeded in their vision as an independent company, it would for sure have ended up being worth many multiples of the $1.26 billion.

But there’s a problem with this kind of attitude, which Andreessen is well aware of: he doesn’t invest forever, and at some point his limited partners are going to want to see a return on their investment. If companies don’t sell, and they don’t go public (Andreessen isn’t a fan of going public, either), then how can VCs get their exit? Andreessen has an interesting answer to that one:

We want to fund the companies which are so successful, and so in control of their own destiny, that they don’t sell, and they also, ideally, don’t go public. And then in 10 years, 15 years, they’re all sitting in our portfolio; they’re all big, and successful, and private. And then we get  just enormous pressure and backlash from our limited partners, our investors, saying, basically, where’s my money. Why haven’t you taken these companies public, why haven’t you distributed the stock.

It’s a smart way of putting it: most VCs would love to have the problem of (a) owning the next Google, or Amazon while (b) not having returned the relevant stake to their investors. But there are two big problems with this model, beyond the hypothetical-future-fights-with-LPs problem. The first is that VCs concentrate very much on something called compound annual growth rate: they tend to want to maximize their annualized return on any given investment, rather than their total return. And the bigger and more mature that a company gets, the harder it becomes to generate annual returns in the 25% range. If the LPs aren’t complaining about not getting their money back, they might well be complaining about being invested in large, mature companies — which is not the point of VC investments at all.

The second problem is bigger: you can’t build a large, mature company in Silicon Valley (where Andreessen Horowitz makes substantially all of its investments) without paying smart engineers in equity. Silicon Valley employees don’t dream of working for the same private company all their lives: they dream of the riches that flow from options and restricted stock. If the employees of one of Andreessen’s companies genuinely believed that the aim was to be a closely-held mature private company in 15 years’ time, it would be much more difficult to attract top-tier talent.

No one has yet cracked this nut. There might be ways of selling non-voting minority stakes to investors with genuinely permanent time horizons — university foundations, for instance, or sovereign wealth funds — but that still leaves the question of price discovery: how is anybody to say how much the company (and therefore the equity) is worth? So long as the founders and investors have an interest in keeping that valuation as low as possible for as long as possible, any employee selling equity into such a scheme is likely to wonder whether they’re getting ripped off.

So while I applaud Andreessen for aspiring to staying private as long as possible, I doubt he’ll ever have the problem he’s talking about here. Which is also why his LPs won’t be concerned by these statements in the slightest.

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