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The Public Company Discount

Don Dodge wrote recently about public company valuations vs. private company valuations.  This is a subject that is near and dear to my heart.

You can find many examples of public companies that have solid businesses and very low valuations.  Most public tech companies that are financially stable and have enough revenue to be sure to be around for a while are valued at less than 1x revenue these days, plus cash.  Think about that in terms of a start-up:

What's a start-up worth that has $15M of revenue, runs at break-even, and has $5M in cash?  In more typical times, you might expect this company to raise money at $40-70M pre-money, depending on what the long-term upside is.  Currently, a public company with this financial profile is probably valued at less than $20M, including the cash.

This class of public companies are really forgotten.  They are too small to be tracked by most analysts.  They don't trade at very high volumes.  They sound a lot like private companies, but they have the transparency, and costs, of being public.  Investors can probably get a venture-type multiple on these types of companies, with less risk than that start-up.

I think that these types of opportunities will definitely compete with private companies for capital.  In fact, I'm betting on it...Limited Partners of venture capital and private equity funds are starting to see that this is an interesting complement to their usual investing.  They do have the asset allocation issue that Don mentioned since their alternatives are a higher percentage of their portfolio than they would like.  But, as that returns to normal, I expect some capital to flow toward more VC-like investing in the public market.

And, what happens to that start-up that has the attractive financials?  They'll get financed, but they may not get the valuation that they would like.  If they are really cash-flow break even, they'd be better off tapping some debt until better valuation times return.


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Thanks for the comment.

On the first point, I think that it depends on the LP. Some are beginning to see the vc-like opportunity in the public markets. Others, by either mandate or habit, are focused only on private company investing. Like any other new investment category, it takes different skills to evaluate this type of investment. That means that LPs will have to develop some new skills and will have to allocate capital to investors who have the necessary GP skills for this investment, too. Some of these will be existing funds that migrate their strategy. Some will be new funds that focus on this market opportunity.

On the second point, I think that there are many small public companies today asking themselves this same question. The problem with many of these companies is that their current stock price is so low that it's hard to convince existing shareholders to accept this price and go private. The easiest path here is if existing public sharesholders are willing to go along for the ride as a private company. If they see that as their chance for upside, they will vote in favor of it. But, that's tough if their investors don't want them investing in private companies. So, there is a bit of a circle here.

Mike, though-provoking post! I'd appreciate your thoughts on two questions:

1) You pointed out that LP's, in the near-term, may be looking to reduce their exposure to alternative investments. However, after this re-balancing happens you expect these institutions to engage in vc-like investing in the public equity markets. I'm curious, how soon do you see this trend starting to catch on and do you think that these LP's are equipped to do this type of investing themselves or do you think these LP's will allocate capital to a new breed of funds that are focused on this investment approach.

2) At what point does it make sense to take a small public company, with the characteristics you described, private instead of buying a significant equity stake like a traditional VC does in a private company? It would seem that because this small public company has inherently low trading volumes, there remains significant liquidity risk, and you're still burdened by the constraints of operating as a public company.

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