Why are tech companies going public?
In the past few months, Silicon Valley has seen some of the most highly anticipated IPOs (and/or direct listings) hit the market, and several more are due before the year is up. It kind of makes you take pause and wonder, what is the reason a company would want to IPO at all? (No? Just me?)
Doing a cursory Google search gives us really lackluster and unsatisfying answers, as if the marketing opportunity of an IPO makes it worth it, or you’d do it for the additional leverage when financing loans. 🙄
IPOs are costly, and a huge distraction: you expose yourself to regulatory risk, public scrutiny, and you face the potential of high turnover as your employees are newly rich and without the need of salary.
On that last point, however, a reason often given for going public is that it’s a liquidity event, a reward for those who invested time and energy and allow them to cash out, but this is in many ways an unsatisfying answer.
It’s feasible, I suppose, to imagine a few years into a successful startup one cofounder saying to another: “Hey let’s go public so we can reward our colleagues for their efforts,” and the counterpart saying, “Yes, that is a great reason to undergo this incredibly complex, costly, and painful process.”
But hopefully you can see how it’s an unsatisfying explanation because companies are incentivized to delay this event as long as possible. By locking in the value of the company in non-liquid ownership of a private company, employees are often times pressured to stick around, especially if leaving the company triggers a series of difficult decisions. (Do I exercise my stock options? What does that mean from a tax perspective?)
And let’s be real, in general businesses are going to make decisions that benefit the business. So what’s the deal here?
Tiny bit of history
Historically, an initial public offering was used as large capital infusions, where business trade off some ownership of the company (and with it, its future profits and prospects) in exchange for a large capital infusion. The idea was with this enormous war chest, the company can now take its business and open new doors and possibilities: new markets to explore, product lines offered, and fresh potential customers.
This is still somewhat true, as an IPO is often times still going to be the largest capital infusion in the history of many of the companies going public this year, yet as of the past few years it has no longer been the only option.
Recent mega rounds with companies raising hundreds of millions, even billions of dollars challenge the value of IPOs from a capital standpoint. Why go through the lengthy and complicated procedure that is going public when the Softbanks of the world are injecting billions of capital into the startup world? There’s evidence this is true, as we’ve seen the time it takes for a standard VC-backed tech company to go from founding to IPO increase over time.
In many ways, money is commoditized for a high-performing startup.
It’s not pretty…
The downsides to being publicly traded are numerous
For one, the act of going public alone is costly and draining. And once you do go public, you introduce many layers of corporate governance into the business, which invariably means more bureaucracy, scrutiny of the public market, the fear of activist investors, and more chance of securities fraud. While it’s often a large capital infusion, it also marks really the last time that raising a lot of money is bound to be accompanied with good press.
So for the modern, successful tech company, what reasons remain?
Maybe exposing one to public markets generates financial discipline that is actually a positive force for good. Perhaps an IPO may be the sheer bravado of the company saying to the world, “we no longer need external capital to be a sustainable company.” What else?
Is game theory the answer?
To return to our earlier example of locking in employees, perhaps the answer is similar to a complex game of prisoner’s dilemma.
The prisoner’s dilemma gives us a thought exercise where two criminals are apprehended, and individually questioned by the police. We know that when two prisoners cooperate (i.e. both lie to the police), they are both modestly punished, but they avoid the heaviest sentence because, well, the police can’t prove anything. If one party flips and tattles, however, they are rewarded for their cooperation by being let off easy, but their hapless buddy is completely screwed.
To spice things up, however, if both prisoners betray each other, the police have enough evidence to book both of them away (a modestly reduced sentence for their honesty).
If you’re not familiar, it’s satisfying to read about the most “efficient” ways to play the game as one of the prisoners, particularly in iterated games where you have repeated opportunities to cooperate or betray against the same partner.
The conclusion, to be short about it, however, is there are outcomes where stable strategies emerge, where participants either always defect, or always cooperate, or some combination of the two.
In situations where participants can decide whether or not to play at all, often times it’s in the best interest for both to continually cooperate, lest the game abruptly ends with no further opportunity to gain.
In similar terms, if the industry standard were for companies to remain private forever, employable individuals would no longer make the choice to work for startups, and instead go to established public companies that pay liquid stock, or even other industries and companies where pay is more competitive. It would completely deprive the startup industry of talent, and ruining the game for everyone.
Instead, we arrive at a Pareto efficient frontier, where companies implicitly agree that given reasonable success, they will IPO in a reasonable timeframe that allows all to reap benefits, and employees continue to agree to postpone the liquidity of their earnings until then.
That way, everyone’s happy. Companies get talented motivated employees, and the employees get the payoff if the company they work for does well. I mean, it’s either that, or maybe the founders just can’t wait to get rich themselves, right?
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