From Private to Public Markets: The Detrimental Impact of Investors’ Expectations
How to Inoculate Your Business Against the Whims of the Crowd
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This piece was originally written for an audience of founders and entrepreneurs, but there are lessons for investors as well. (Forgive us for generalizing at several points in the piece for brevity.)
Your Reality, My Rounding Error.
In theory, there should be nothing different for a company between being private and public beyond new compliance standards and disclosures. You could be forgiven for thinking that having your shares traded by anonymous parties in a stock exchange transaction would have a limited bearing on your business, but in reality, it can drive your business.
Let’s start from the beginning.
Your company was born as an idea. When you went to raise money, you sold that idea to an angel investor or venture capitalist. In their minds, while they might have believed you’d really achieve your dreams, you were nothing more than a bet for them.
Almost by nature, a “venture investment” implies a risk of impairment of capital.
Two Extremes.
If we were to exaggerate, great venture investors look at how everything can go right, whereas prudent public market investors look at how everything can go wrong. Softbank’s Masayoshi Son (Masa) once invested $20mn in a one-year-old company led by an English teacher with no tech background who was working out of an apartment. That doesn’t happen if you are thinking about how you can lose your money. On the flip side, Warren Buffett passed on an opportunity to invest in Google at a reasonable valuation for years despite learning that Berkshire’s subsidiary, GEICO, was spending tens of millions of dollars on Google search ads, which he knew firsthand to be highly effective. Buffett would later call this a big mistake of omission, but why he ultimately missed the opportunity was because he couldn’t assure himself how the internet search market would look in a decade out. He was looking at his downside risk if things went wrong.
That single Masa investment we all know today as Alibaba almost defines his entire career in VC investing. They sold their original 30% stake in many tranches, so it’s hard to pinpoint their exact profits, but it’s been estimated to be around $50bn, or a 2,500x. While Masa focuses on huge successes, Buffett focuses on avoiding huge losses. Buffett talks about his two rules of investing: Rule #1 don’t lose money, Rule #2 don’t forget Rule #1.
Masa invests based on a vision of what the future could be for a company, whereas Buffett invests only when he is convinced a very different future for the company won’t be.
Either, Or.
Now, these are two extremes, but there is much truth to them.
When you started your company and went to raise money, you were one of many of your angel or VC investors’ investments. You painted a picture of a massive TAM and an ambitious plan on how you would attack it. While they might have believed you’d really execute, you were still nothing more than a bet for them.
This means two things: (1) you need to think big to get them excited because they need the relatively small amount they are investing in you to not only yield material profits, but also potentially make up for the losses their other bets will incur. It is usually just one single investment that is responsible for the bulk of a VC funds returns, whether that be Facebook, Snowflake, eBay, WhatsApp, or Spotify. (2) The second implication is that it’s their base rate expectation you fail.
Look at the expected value formula below. There are two variables: probability and outcome. VCs are most concerned with opportunities where that outcome is as large as possible. Large positive outcomes tend to come alongside tiny probabilities, but multiplied together, the results can be meaningful: a 5% chance of a 100x is still an expected value of 5x. If they make 20 of such bets then they can reasonably expect to return 5x on their entire fund, even if every other investment besides the 100x one is written off to zero. This would be a 20-25% annual return over a 7-9 year period, or more than twice the historic average public stock market return.
In short, VC’s trade-off lower probabilities for higher outcomes.
We will pick back up here after a quick digression.
Myths.
There is an idea called “inter-subjective myths”. These are “stories” that we basically all believe so they become true. Examples are “law” and “money”, which only really “exist” because we all agree and act as they do. There is nothing in our world that you could point to where a law truly exists—just books, texts, ornate halls with people in robes, jails, and old documents, but none of these are what a law truly is.
The same way certain concepts supersede their material representations, a great company will try to do the same thing. Amazon prides itself on customer obsession, but how that manifests in Amazon is beyond the customer service department and grading systems they have—they have imbued in the minds of every manager and employee that they will never trade off customer satisfaction for short-term financial gains. Apple employees don’t make electronic devices for the consumer market, but rather magical and intuitive products that “just work”. In both cases, these inter-subjective myths can be traced back to their founders.
It is the role of the founder (or founding team) to create and instill a set of values that grows with the company. For Amazon, what started as a focus on customer experience becomes not only a set of behaviors employees mimic, but over time, it changes their thinking too. It essentially changes the weightings of their internal decision making to heavily weigh customer experience over everything else. And incredibly, over time, these myths extend out to consumers too. Almost everyone has very different expectations for a Dell product versus Apple. There is much more we could say about the intersection of these founding myths, company culture, and consumer expectations, but we are bringing this up to make a different point.
For a company’s entire history as a private company, the founder(s) have an essentially dominant control over its narrative. When a company goes public, there is a new loud voice that commandeers the narrative: the stock market.
Mr. Market.
An obsessive customer focus is just as easily touted as poor cost management. A focus on only putting out quality products can also be seen as problematically slow product cycles, issues internally innovating or delays with production.
Every analyst who has never run a business nor has any idea about what it truly entails can now regularly push different stories about how your company is on a path to imminent demise. Naysayers may be nothing new, but they now have a power they didn’t before: they can impact your company’s stock price.
In 1949, The Intelligent Investor, one of the canonical books on investing was published by Benjamin Graham, Warren Buffett’s Mentor. In it, he described Mr. Market, a fictious character who, with his business partner, owned a private business. Mr. Market would some days feel elated and offer his partner shares at irrationally high prices. Other days, Mr. Market would feel very depressed and think the world was going to end, and would reflect that by offering to buy his partner’s shares at silly cheap prices. The vicissitudes of Mr. Market’s exultation and pessimism should not be taken as indicators of the business itself, but rather just the mood of Mr. Market. This analogy is meant to be extended to the stock market as a whole, with the prices it places on the businesses on a given day having little to do with the businesses themselves on that day, but rather just the “mood” of the market.
While this is a great framework from a public stock market investor’s perspective, for a public company manager, it is not entirely true. While the stock price in theory is merely a reflection of a group of investors’ opinions about your current prospects, in practice, the price itself impacts your business. George Soros calls this reflexivity. Reflexivity is when a participant’s expectations influence the outcome. The stock price will now influence the day-to-day work of your business through impacting employee mood, recruiting, press, and potentially supplier relationships and ability to execute in financial transactions.
As much as people should understand the stock price as nothing more than the whims of Mr. Market, they will instead interpret it as a report card. Employees, who are heavily incentivized in stock-based comp, especially in technology and venture-backed companies, will look at a moribund stock price as potentially being indicative of a struggling business. They may understand day-to-day that stock prices are largely random, but will they be as understanding if their stock options evaporate 3 years later? If you just watched $1mn of RSUs shrink to $100k, how understanding are you going to be that just the market value changed, but not intrinsic value? How many employees have an understanding of how much cash flow the company will ultimately produce and how to value that?
The affect heuristic, which is when current emotions influence your decisions, is omnipresent.
When the stock market is strong like in 2021, employees feel elated at their exploding paper net worth. Managers will greenlight lofty and unrealistic projects “feeling” great about their prospects. Others will wonder why they are working for someone else, or at all, with such new wealth and will leave.
When the market crashes, like in 2022, companies will look at the slew of expensive and likely unworkable initiatives they are pursuing and axe them. In the minds of most employees, the stock they own is only as good as the price they can currently sell it at. And if they just watched their paper net worth melt away, they are incentivized to change jobs and get a new equity incentive package. To get employees to stay, the company may have to issue new comp packages which dilute existing equity holders, driving the stock price down more. The best employees are likely to have other options, leading to talent drain.
In theory, a business should have an easier time recruiting when the stock price is lower because the amount of ownership an employee would receive is higher, but in reality, most take the weak stock price to be indicative of a weak business.
In more cases than not though, a large drop in stock prices is not symbolic of the business prospects changing for the worse, but rather a recognition that the businesses prospects were always overinflated.
The inflated business expectations now come not from enthusiastic founders, but the investors. These public market investors no longer just contribute to your narrative, but directly drive its valuation higher, which in turn looks like evidence of the extremely rosy narrative being true.
Investor’s Reflexivity in Investment Theses.
The same way employees’ and managements’ emotions may follow the stock price, investors just as easily fall prey to the belief that a stock price movement holds information that they lack. In ebullient markets, investors start looking to increasing stock prices as evidence that their investment theses are too conservative. They increase their growth rates and terminal assumptions of market share.
No longer are investors buying companies on tempered expectations, they start giving value to unlikely outcomes. If they cannot justify the valuation off the markets a company is currently in, then they will start to assign value to moonshot ideas. When Grab IPOed at a ~$40bn valuation, you didn’t just need to assume ridehail and food delivery dominance, but that they would be a leading financial service app as well. Investors didn’t just assume Sea would be the leading ecommerce player in Southeast Asia, but gave them a valuation as if it already happened.
As investors place ever higher valuations on companies, management starts to play along by entering new markets, new businesses, and resetting expectations higher. Klarna and Affirm aren’t just BNPL apps, but potential leading ecommerce marketplaces. Shopify isn’t just a SaaS platform, but also will be a leading logistics provider with their own fulfillment network. Zillow and Redfin wouldn’t just be real estate marketplaces, but would buy and sell houses directly with iBuying. Uber and many financial services will now reconceive themselves as Superapps with no limit to the services they could eventually offer. Many start-ups and SPACs are starting to be priced as if they already are well on their way to dominating their markets, if not already dominating them. The return an investor would receive for their success is increasingly dropping. Instead of getting a 100x or even 10x for a nascent company achieving incredible levels of success, investors’ implied returns are dropping to a mid-single digit annualized return—just a thin premium over the risk free rate.
Whereas typically public market investors focus on opportunities that are likely to yield a moderate return, but with a high probability of success, they now have dropped their caution. Public market investors start investing like VCs, but without the associated return for home runs.
Simply pull up the market cap of any “growth” stock from 2021 and try to pencil out how much in revenue they would need to trade at a 17-19x earnings multiple. This is the stock markets historical average multiple for a company of average quality with average growth prospects. Perhaps you thought these companies were special, so you increased the multiple to 25x or 30x. Then keep in mind such a valuation would only justify their current market price. If you wanted to make a return on the company after that, you needed more earnings growth or a higher multiple.1
Such miniscule returns for colossal assumptions tend to be the result of investors not critically thinking about what cash flows a business must generate and how they will do that. Investors will start saying they found the next “Amazon” and since no one could have saw AWS coming out of Amazon in 2000, basing your expectations off of what you can conceive of is foolish since a great company will just continue to outperform all expectations. Such logic is fallacious.
While it is true that truly great companies tend to outperform expectations, this doesn’t mean that you should expect the unexpected. Doing this creates risk, as an investor is no longer guided by their own sense of judgement, but rather relies on good luck to rationalize a valuation. When you lose your ability to tie a valuation to various plausible scenarios that you are okay paying for, you are no longer investing.
To clarify, it is worth “something” that great companies tend to outperform, but there is a difference between paying a premium for quality and willingness to pay anything because you blithely assume that after whatever scenario you can come up with, the company will do better. Such specious reasoning will drive stock prices during especially ebullient markets, and they will attempt to hijack companies’ narratives in the process, only to then question management’s competence when they cannot live up to the investors’ fairytale.
Tempered Expectations are the Only Inoculation.
Valuation will always be a simple formula. No matter how much “disruption” a company may cause or how revolutionary a product is, the true value of a company is always dictated by the sum of all future cash flows, discounted back to today. Now, we can have a vibrant discussion around what that “discount rate” should be, but what is not up for debate is that a company must earn cash flow eventually in order to be worth anything at all. (As a founder, you may profit by selling your company to another company before ever generating cash flow, but the acquirer still expects it to bring them a return through reduced R&D costs, product churn reduction, less competition, monetizing it directly, etc.).
Now, in a company’s nascency, investors may appear to value a company on price to revenue, price to gross profit, or some other metric that does not encompass all of a company’s costs. When this is done in earnest though, these metrics are used as barometers of future cash flow. A company trading at 10x revenue could also be thought to be trading at ~31x “mature” earnings (see the table below for math).
In super bull markets, when Keynes’ “Animal spirits” are stampeding, investors become more willing to entertain paying up for non-existent businesses and assume ludicrous levels of risk for paltry returns. But this will not last. It never does. As a public company, you have less control over your valuation, which will drive your narrative.
While in reality private companies also tend to raise the highest valued round they can, they do have more control over what they price the round at. It would be advisable to not let your private valuation reach a unjustifiable level, even if investors are willing to pay for it at the moment. Too much of anything can be a bad thing. Too often a very high valuation is succeeded by down rounds, demotivated employees, and upset investors.
Public companies are supposed to be more mature companies than private companies and not in need of on-going capital raises in order to build their businesses. If you are in need of subsequent capital raises, then going public early risks giving the whims of the public markets a lot of control over your company’s destiny.
The point is that a misvalued company, whether drastically over or undervalued, is of virtue to no one. Many may think a higher valuation is good, but it can disrupt the very business you are trying to build. Tie everything back to plausible cash flows to keep for sober expectations. Don’t enter new businesses just increase the TAM or entertain public market investors’ fairy tales to justify your valuation. Public investor feedback can be much more fickle and more self-serving than private investor feedback.
Full Circle.
We started with the idea that there are two ways to invest at the extremes. When you are a young company, you want to attract the Masas who will give you credit and money for ideas that are nonexistent. However, you do not want the Masa-type investor as a public company2, as they will push you to be ever more ambitious, often to the detriment of the company. When you go public, you want the Buffetts as your investors. They will let you patiently build what you are trying to build. They won’t push you to partake in risky business expansions and they won’t blow up your valuation to the impairment of your business later on.
Putting out tempered expectations, which are rooted in realistic cash flow metrics, is the best way to attract the investors who will be with you as your businesses grows instead of just as your valuation grows.
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Your return then only comes from the multiple staying flat or increasing, or earnings growing high enough to handle a multiple contraction. Remember, a multiple is a short hand for a DCF. Mathematically, the DCF must either assume high growth for a long period of time to support the valuation, or a lower discount rate. So, a high multiple on a business where growth slows to “average” levels implies a low discount rate, or in other words, a small return to the investor. This is just a fancy way of saying assuming too much growth will often lead to sub-par performance because the growth doesn’t last long enough to support an adequate return, or the growth investor is willingly accepting a negligible risk premium.
This is a bit of a hyperbole as Masa has been very patient with Alibaba and other holdings.