Photographer: David Paul Morris

Silicon Valley’s Hottest Startups Get a Taste of Going Public Without the IPO

After the writedowns came to light, mutual fund companies are said to face difficulties accessing hot technology deals in the future.

Dropbox’s decision to raise funds privately last year was supposed to buy the cloud storage provider time to prepare for life as a public company. The financing round, which valued the company at $10 billion, would allow Dropbox to focus on growth and build a viable business. “Our investors are happy. Things have been going well,” Chief Executive Officer Drew Houston said on Bloomberg TV in June. Dropbox had no plans to go public anytime soon, he said. But in some ways, it already had.

Dropbox got a shock recently when Fidelity Investments and BlackRock wrote down the value of their investments in the company by at least 15 percent this year. Fidelity also marked down its stakes in Snapchat, Zenefits, and other closely held technology companies, according to data from research firm Morningstar. The disclosures, which were made in routine regulatory filings, surprised Silicon Valley. Not even many of the companies were aware that certain investors regularly adjust the value of their holdings and report the estimates publicly, say people with knowledge of the situation, who asked not to be identified.

Technology companies have increasingly put off going public, in part to avoid answering to impatient investors. There are now more than 140 private companies with valuations exceeding $1 billion, according to researcher CB Insights. The Valley initially welcomed Fidelity, BlackRock, and other big money managers, because they could afford to throw around the amounts of cash that oversized tech startups needed. More transparency was an unanticipated consequence. “They’re sort of semipublic companies now,” says Matt McIlwain, a managing director at Madrona Venture Group. “It’s an awkward space to be in.”

Venture capitalists say stamping a value every quarter on a company such as Snapchat, which still periodically reinvents its business model, doesn’t make sense. Two backers of the recently devalued companies, who asked not to be identified discussing a sensitive topic, say startups may now be more reluctant to take money from mutual fund companies. McIlwain blames them for driving up valuations in the first place by overpaying for access to hot deals. “They wanted to get into these companies before they went public,” he says. Fidelity declined to comment.

Mutual funds are required to assess the value of their assets and report the numbers each quarter to the U.S. Securities and Exchange Commission. For holdings that aren't publicly traded, the companies have committees that weigh factors such as growth rates and the market value of similar companies. The process is “more art than science,” says Greg Smith, senior director of fund accounting and compliance at the Investment Company Institute, a mutual fund trade association. Mutual funds have been investing in private startups for years, but the practice has gotten more attention as valuations have skyrocketed.

Snapchat Evan Spiegel

Snapchat CEO Evan Spiegel.

Photographer: David Paul Morris/Bloomberg

Snapchat, an app for sending disappearing photos and video, was valued at $16 billion in a funding round this year before Fidelity wrote down its stake by 25 percent. Zenefits, which makes human resources software, saw its estimated value drop 22 percent from $4.5 billion. Snapchat, Zenefits, and Dropbox declined to comment.

That they were surprised by the reevaluation practice, established by the Investment Company Act of 1940, and unprepared for the consequences suggest they could benefit from more scrutiny, says Max Wolff, chief economist at Manhattan Venture Partners. “It’s become de rigueur for companies to double in value because 12 months have passed and they found new investors. If that doesn’t trip your alarm bells, then your alarm bells have failed,” he says. “The companies are overvalued. They shouldn’t kill the messenger.”

Other cracks in the high valuations are starting to show. Square Inc., set to start trading tomorrow, is seeking a valuation lower than its last funding round. Venture capitalists are wrestling with how to respond to writedowns by their co-investors, says Fred Wilson of Union Square Ventures. “VCs are now facing the choice of whether to markdown our portfolios in reaction to Fidelity’s markdowns, or explain to our investors and auditors why we did not do that,” he wrote in a Nov. 16 blog post. Wilson, whose firm backs Kickstarter and Foursquare, expects the line between public and private markets to continue blurring.

At least one investor sees the lowered valuations as an opportunity. A backer of one company recently written down by Fidelity, who asked not to be named because the talks were private, says he received an inquiry about selling his shares through a secondary transaction. The offer was at a 25 percent discount to the last round’s price.

—With Eric Newcomer

(Correction: A previous version of this story was corrected to clarify the process for evaluating private companies in the fifth paragraph.)

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