Silicon Valley Startups Begin Taking ‘Haircuts’ in IPO Market

Even as funds continue throwing cash at private companies, sending valuations to record heights -- including Uber Technologies Inc. reaching $40 billion last week -- investors in recent initial public offerings aren’t paying up.

This week, venture-capital-backed startups New Relic Inc. and Hortonworks Inc. are projected to price their IPOs at valuations equal to or lower than their last private funding rounds. The same thing happened to customer-service platform Zendesk Inc. in its May IPO. Other startups, such as Box Inc. and online-dating site Zoosk Inc., have delayed going public, partly out of concern that they can’t fetch the same valuation in the stock market that they did from private investors.

The trend highlights how there’s increasingly a disconnect between the valuations of closely held companies and publicly traded ones in the technology industry, which may end up serving as something of a check-and-balance to the froth among Silicon Valley startups. The developments remain nascent and some of the companies, such as Zendesk, have gone on to boost their market capitalizations after going public.

“The public market is still rational when they’re buying these IPOs, while in some cases private-market investors are irrational,” said Leslie Pfrang of Class V Group, which advises startups on going public.

Public Valuations

Part of the problem is that many of the big technology giants that serve as barometers in finding valuations for newly public companies have declined in the stock market in 2014. Google Inc., Inc. and Twitter Inc. -- peers to Internet startups -- are among those that have negative returns this year.

Technology companies that recently debuted on the stock market also haven’t produced strong gains for investors. U.S.- listed technology IPOs this year have climbed to a median of 1.2 percent, according to data compiled by Bloomberg, compared with about an 11 percent rise in the benchmark Standard & Poor’s 500 Index over the same period.

Meanwhile, venture-capital investments in the first three quarters of 2014 totaled $37 billion, the highest since the late 1990s dot-com boom, according to a report by law firm Fenwick & West. The flood of money has helped push up startup valuations, including vaulting 14 U.S. technology companies to a valuation of at least $1 billion in the first half of the year, more than double the number of startups that did so in all of 2013, according to researcher CB Insights.

Nervous Investors

“The disconnect between private and public market makes me nervous,” said venture capitalist Jim Breyer, who led Accel Partners’ investment in Facebook Inc. in 2005 and is now focused on Breyer Capital, the family office he started in 2006. “In many cases, private market valuations are simply too high, even for outstanding high-growth tech companies.”

The result is a “haircut” to valuations once the startups reach the stock market, said Anand Sanwal, CEO of New York-based CB Insights. He said the trend is inevitable, given the frothiness in private-company valuations.

Exhibit A is Hortonworks. The Palo Alto, California-based startup, which focuses on a free suite of software known as Hadoop, earlier this month filed a document with the U.S. Securities and Exchange Commission that showed its implied valuation is $496 million to $579 million, almost half the $1 billion valuation it got in a March financing. The company is set to price its IPO on Dec. 11 and start trading Dec. 12.

New Relic, a San Francisco-based app analytics company that is also set to go public this week, is pricing its IPO so that its value stands at about $921 million to $1.01 billion. New Relic was worth at least $1 billion in its last round of financing, according to a CB Insights report.

Zendesk’s Lead

Hortonworks and New Relic follow Zendesk, which went public at a market valuation of $631 million in May. That was lower than what the San Francisco-based company was worth in the private market, said a person familiar with the matter, who asked not to be identified because the details are private and who wasn’t specific about the numbers. Zendesk’s stock jumped 49 percent on its first day of trading, putting its market capitalization at $943 million.

Representatives for Hortonworks and Zendesk declined to comment. A New Relic representative didn’t respond to a request for comment.

Barry Schuler, a managing director at DFJ Growth, said the disconnect between private and public investors is a sign of a healthy market.

“Growth investors will have to question the risk they’re taking and learn to behave rationally from public investors, who don’t share their exuberance,” said Schuler.

First-Day Pop

Some of the IPO pricing may be deliberately low in order for the companies to gain a first-day pop in the stock market, said people with knowledge of some of the offerings, who asked not to be identified because the details are private.

LendingClub Corp., a peer-to-peer lender, was able to boost its IPO range above an April funding round valuation amid investor demand, according to a person familiar with the matter. The San Francisco-based company had initially priced its IPO at a range that put its value at $3.6 billion at the low end, which was less than the $3.8 billion it received in its latest private financing.

This week, LendingClub raised the price range to set its value at $4.3 billion to $5.1 billion. The company is projected to decide a final price on Dec. 10 and start trading the next day.

A representative for LendingClub declined to comment.

Hitting Pause

Other companies have decided not to make their market debuts if their valuations can’t hold up in the public market. Box, which filed to go public in March, has delayed the IPO amid stock market volatility and after disclosing that its costs had soared far ahead of revenue. In July, Box raised more private financing at a $2.4 billion valuation, just slightly above the $2 billion it was valued at in December 2013.

Box CEO Aaron Levie said in November that “we should not have filed when we did” to go public.

Ashley Mayer, a Box spokeswoman, said the company plans to go public “ when it makes the most sense for Box and the market.”

High valuations in the private market could dampen the number of IPOs that will occur if public investors aren’t willing to pay the same price, said Cully Davis, co-head of Equity Capital Markets at Credit Suisse Group AG.

“It does create a difficult dynamic,” Davis said in an interview with Bloomberg Television at the firm’s annual technology conference in Scottsdale, Arizona. “Going out at a level below where your last round was creates a psychological barrier for existing investors.”

The disconnect may be temporary, as some companies will be able to grow into their valuations, he said.

Taking Time

The upshot for some startups that are priced high in the private market is that they won’t seek to go public, especially those that are still unprofitable and are spending quickly -- factors that have tended to deter public-market investors. Hortonworks, Box, New Relic and Zendesk all were unprofitable at the time of filing their IPOs, as well as showing climbing expenses.

Frank Artale, a managing director at venture capital firm Ignition Partners in Seattle, said in an interview with Bloomberg Television at the Credit Suisse Technology Conference in Scottsdale, Arizona, that startups don’t need to rush to go public if the stock market will push down a valuation.

“With the availability of capital, we do have the flexibility for companies to stay private for longer and grow into those valuations,” he said. “That great availability of capital does enable us to make those decisions.”

Before it's here, it's on the Bloomberg Terminal.