Venture capitalists in Silicon Valley have participated, knowingly or otherwise, in the largest scale “spoofs” of the equity market in modern history. For the past couple years, the financial press has been abuzz with the concept of spoofing, a relatively arcane term from the wizards of our securities and derivatives markets. The term became synonymous with Wall St. cheating after Michael Lewis’ book, Flash Boys hit book shelves. Spoofing itself is essentially another name for something people do all the time: bluffing. This simple habit is at the core of the investor frenzy feeding the tech bubble.
Think of the classic scene when Tom Sawyer convinces another boy to paint a fence for him by pretending it’s the most fun thing he’s ever done. Tom does not force Ben Rogers to do anything; he pump-fakes and lets Ben fall under the weight of his own gullibility. Spoofers do basically the same thing, pretending they want to buy something until someone comes in and says, “Me too!” At this point the spoofer will happily sell it to them, at a premium price of course. This is against the rules in most major markets, for obvious reasons. However, there is one market that consistently pulls this move on a huge scale: the software startup IPO market.
Venture capitalists, have a tendency to buy into hype as a predictor of future growth. In virtually every other industry, a company’s value is a small multiple of its profits or a smaller multiple of revenue. Say you have a company that sells dog clothing, it does $1 million in revenue and $300k in profit annually. A sane investor will likely see your value at somewhere between $1.5 million (5x profit) and $3 million (3x revenue). In many other industries the multiple is much smaller. Watch any episode of Shark Tank to see how viciously an investor will tear down the pie-in-the-sky valuations proposed by their overly optimistic owner-CEOs. Until about 2011, these rules still seemed to apply across the board and ‘software as a service’ companies were still limited to less than 4x-5x revenue for their valuations. Today however, if you’re a tech startup going to VCs, traditional rules have no bearing. Valuations have mysteriously grown to dozens of times revenue with no real change in the revenue models themselves. The only viable explanation is an attempt to hype up values so the next investor buys at a higher price while earlier investors get paid.
A notorious example of overhyped valuation is Groupon. In 2010, venture capitalists invested $500 million, valuing the company at around $5 billion. That year, Groupon made about $760 million in revenue but lost money after expenses. This means the company was valued at over 6.5 years of revenue while it was losing money. About $75 million of the money raised was quietly paid to early investors and founders, a reward for their early validation and hype of the company. Investors, unsurprisingly, were driven by a future hope of selling their shares at a higher valuation in later funding rounds or at IPO. The company went public in 2011 at $20 a share, valuing the company at $12.65 billion. Like the year prior, revenue for 2011 came in at a respectable $1.32 billion, but profit was almost $375 million in the red. The framework is a notable improvement on old Tom Sawyer’s ingenious ruse: “I have this great thing, but I guess you can take it off my hands, at a premium of course.” Venture capitalists in this way, hype companies with their own huge investment so they can sell it down the road to someone else who hopes to do the same thing. When Groupon hit the public market it briefly went higher on the hype that had sustained it til that point. This allowed pre-IPO investors to get out at a multiple of their original investment as the stock price hit over $26 per share. On February 9, 2015 Groupon was trading at $2.22 per share.
Even Facebook, a powerhouse of the tech industry and the stock market alike, suffered from this spoofed value leading up to its IPO. The company had huge reach and respectable revenues, but the valuations assigned by investors again defy logic unless viewed from the perspective of adding financial hype for a future buyout. Facebook’s valuation went from $87.5 million in 2005, to $500 million in 2006, to $15 billion in 2007. This, at a time with no revenue, means investors were pricing the company solely on users, which had just barely reached 50 million by their 2007 valuation of $15 billion. By December 2010, Facebook had revenues around $2 billion and profit of $500 million. Astoundingly, a month after these figures came out, they were funded at a valuation of $50 billion. This means Facebook was valued at 25 times revenue, or 100 times profit. When Facebook went public in May 2012 it was valued at $104.2 billion, or $38 a share. At this price any and every early investor could sell at a 100% profit at least, into the open arms of a public which trusted the valuation set by people supposedly much smarter than them. Less than 4 months later, Facebook’s shares were worth less than half their IPO price.
Tech darling Zenefits has been in the news recently for causing trouble, but also for raising huge amounts of capital on the venture investment circuit. Their most recent funding round valued them at $4.5 billion dollars in May 2015 on a hopeful, projected revenue of $127 million. 2015 showed revenues that barely topped $60 million. There is a pattern emerging; these companies, for all their hype, consistently fail to justify their valuations. This is not necessarily the fault of companies. Facebook, in our example, was an exceptional company with huge growth and value. The fault lays with investors making huge overvaluations that are careless at best and deceptive at worst. The VC game has become, pick up a rock, spit shine it, and sell it as a gemstone to whomever takes the bait.
This is common practice in markets everywhere; it’s called searching for the greater fool. There’s little harm to this as long as the game is played amongst billionaires throwing their money around at the hot new toy to come out of Palo Alto. You’d be hard pressed to find someone deeply saddened that a billionaire’s tech investment went south because another group of billionaires sold it to him at an overinflated value. But spoofing is still, justifiably, against the rules. The reason we have these types of regulations in other markets has always been to protect the little guy. It is always the little guy that eventually pays for these deals. That is where this pattern becomes toxic. Venture capitalists hype up software companies with large funding rounds regardless of - often despite - lack of supporting assets. When the company eventually goes public, the public buys everything up, thinking smart money has already priced it where it should be. The prior investors are presumably, as one gushing Forbes article put it, “the smartest valuers in the world”. The problem is they're right - ‘smart money’ has valued it where it should be, for themselves. Not at a stable reasonable value, but at a trumped up, hyper value to be unloaded on ‘dumb money’ at IPO. Today, ‘dumb money’ means you and me. It’s your college roommates talking at Starbucks, excited to buy Facebook stock. It’s your grandmother, trying her best to manage her investments in retirement. It’s the mutual and pension funds investing in hundreds of almost random things for “diversification’s sake.” ‘Smart money’ does its job and ratchets up valuations of sexy tech companies to decades worth of revenue. Then it can take its payment by graciously giving ‘dumb money’ a turn at whitewashing Tom Sawyer’s oh-so-appealing fence.
Now this is a bit reductive, of course. Let me add the caveat that most VCs are likely not top-hat wearing villains with glowing red eyes, nor are they looking to ruin the whole economy, or steal from your grandma. They are, however, complicit in a massively disruptive habit that, when done on a smaller scale, has ended up in jail time for traders like Michael Coscia. Why then, does no one so much as wag a finger at those who spoof the entire investing public?
