Investors in recent years have been shifting their cash from the public to private markets: Since 2014, private IPOs, or mega financing rounds in which companies raised at least $100 million, have raised 3 times more capital than public tech IPOs, according to data from Pitchbook and University of Florida business professor Jay Ritter.
The result has been some pretty sizable unicorn valuations. Payments unicorn Stripe recently raised a staggering $245 million, giving it a valuation of $20 billion. Delivery startup Postmates closed a $300 million round, pushing its valuation to $1.2 billion.
The question is whether these valuations are justified. Or put more specifically, what do investors see in the private markets that they don’t see in the public?
Over the years, some compelling research has emerged that suggests that private tech firms are outperforming their public peers in a very specific metric: innovation.
From on demand services and data analytics to clean energy and space rockets, unicorns have been disrupting industries on a scale and speed like never before. Meanwhile, publicly-traded firms like General Electric and IBM, once the preeminent symbols of U.S. innovation, have fallen into stagnation. You can perhaps even argue that Silicon Valley stalwarts like Apple and Google have lost a bit of their old magic.
In 2014, Shai Bernstein, an associate professor of finance at Stanford’s Graduate School Business, authored a study that examined the patent citations of publicly traded tech companies and compared them to private tech firms that planned to go public but ultimately did not.
He concluded that going public causes innovation novelty to fall about 40 percent versus staying private.
In addition, “the quality of innovation produced by inventors who remained at the firm declines following the IPO,” Bernstein wrote.
In some ways, Bernstein’s findings seem counterintuitive. The prevailing theory that a startup would create a technology and then raise the necessary capital on the public markets to further develop, perfect, and bring the technology to the mass market.
But it seems the unicorns are already doing that as private firms. Moreover, they have experienced unprecedented sales growth.
From 2013 to 2017, Uber’s revenue jumped from $104 million to $7.04 billion. Airbnb saw its revenue increase from $250 million to $2.6 billion. By comparison, Facebook generated half of Uber’s revenue when the social media giant filed for an IPO in 2011. Google never crossed the $1 billion mark before it went public.
Bernstein offers a few explanations of why innovation quality falls after a company goes public. The first is that the company suffers a brain drain after an IPO as its best inventors cash out and leave the business-- perhaps to launch their own startups. Bernstein also surmises that a public company, which must answer to shareholders each quarter, are more risk averse and therefore focus on incremental innovation.
But publicly traded companies don’t even produce incremental innovation that well. In her book “How Innovation Really Works,” Anne Marie Knott, a professor of strategy at Washington University in St. Louis, says public companies’ R&D efforts have worsened over the years even as they spend more on it.
Knott developed a scoring system to measure the effectiveness of corporate R&D called “RQ,” or Research Quotient. In short, RQ is the percentage increase in revenue a company obtains from a 1 percent increase in R&D spending.
Knott concludes that returns from corporate R&D spending has dropped about 65 percent over the past three decades, a reason why U.S. GDP growth has also declined in this period.
“Despite the importance of innovation to companies as well as to the broader economy, despite the growth in real R&D by both the government and companies, and despite all of the experts dedicated to helping companies innovate, companies have become worse at it!” Knott writes.
“The money companies spend on research and development is producing fewer and fewer results,” she wrote.
Another reason why corporate innovation has become less effective is a bloated, inefficient tax system that directs precious public resources to large corporations that do not need them but still collect them to satisfy Wall Street.
Take California, the fifth largest economy in the world and home to Silicon Valley. The state offers companies a 15 percent R&D tax credit against income taxes that never expires. Instead of using the credit, however, companies have been mostly stockpiling them.
According to a report by the California State Auditor, companies held about $14 billion in unused R&D tax credits as of 2012. That’s more than the GDP of Nicaragua, Mongolia, and Rwanda.
In 2017, Alphabet, the parent company of Google, reported it held an astonishing $1.8 billion in unused credits, about 4 times the number of credits it held 5 years ago.
Since unicorns already attract huge amounts of private growth capital, they don’t need to chase R&D tax credits. (Besides, in order to qualify, they would need to generate profits for the government to tax and many do not.) Over the past nine years, investors have poured about $330 billion into emerging growth companies. The number of mega financing rounds of $100 million or more has jumped 830 percent in recent years.
With plenty of capital and no quarterly demands from Wall Street, private firms can focus on innovation that can truly disrupt industries, create new markets, and generate rapid sales growth. That’s why private innovation is increasingly worth more to investors than innovation created at publicly-traded firms.
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