Private firms are attracting more capital because they are more innovative
November 14, 2018 | Blog

Private firms are attracting more capital because they are more innovative

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.

Brain drain and risk aversion

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.

Declining returns from R&D

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.

Tax perversion

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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This report is being published by SharesPost Research LLC, and distributed by SharesPost Financial Corporation, a member of FINRA/SIPC. SharesPost Research LLC, SharesPost Financial Corporation and SP Investments Management, LLC, an investment adviser registered with the Securities and Exchange Commission, are wholly owned subsidiaries of SharesPost, Inc.

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This report does not constitute an offer to provide investment advice or service. Registered representatives of SharesPost Financial Corporation do not (1) advise any member on the merits or advisability of a particular investment or transaction, or (2) assist in the determination of fair value of any security or investment, or (3) provide legal, tax, or transactional advisory services.

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The analyst(s) certifies that the views expressed in this report accurately reflect the personal views of such analyst(s) about any and all of the subject securities or issuers, and that no part of such analyst compensation was, is, or will be, directly or indirectly related to the specific views contained in this report.

Analyst compensation is based upon various factors, including the overall performance of SharesPost, Inc. and its subsidiaries, and the performance and productivity of such analyst, including feedback from clients of SharesPost Financial Corporation and other stakeholders in our ecosystem, the quality of such analyst’s research and the analyst’s contribution to the growth and development of our overall research effort. Analyst compensation is derived from all revenue sources of SharesPost, Inc., including brokerage sales.

DISCLAIMER

This report does not contain a complete analysis of every material fact regarding any issuer, industry, or security. The opinions expressed in this report reflect our judgment at this date and are subject to change. The information contained in this report has been obtained from sources we consider to be reliable; however, we cannot guarantee the accuracy of all such information.

Any securities offered are offered by SharesPost Financial Corporation, member FINRA/SIPC. SharesPost Financial Corporation and SP Investments Management are wholly owned subsidiaries of SharesPost, Inc. Certain affiliates of these entities may act as principals in such transactions.

Investing in private company securities is not suitable for all investors. An investment in private company securities is highly speculative and involves a high degree of risk. It should only be considered as a long-term investment. You must be prepared to withstand a total loss of your investment. Private company securities are also highly illiquid and there is no guarantee that a market will develop for such securities. Each investment also carries its own specific risks and you should complete your own independent due diligence regarding the investment, including obtaining additional information about the company, opinions, financial projections and legal or other investment advice.

Accordingly, investing in private company securities is appropriate only for those investors who can tolerate a high degree of risk and do not require a liquid investment.

SharesPost, the SharesPost logo, My SharesPost, the SharesPost Index, and SharesPost Investment Management are all registered trademarks of SharesPost, Inc. All other trademarks are the property of their respective owners.

Copyright SharesPost, Inc. 2019. All rights reserved.

Thomas Lee

Thomas Lee

Thomas Lee is the Senior Writer at SharesPost. He was previously a business columnist at the San Francisco Chronicle. Lee has written for the Star Tribune in Minneapolis, St. Louis Post-Dispatch, and Seattle Times. He is author of “Rebuilding Empires” (St. Martin's Press), his book on the future of big box retail in the digital age.
PLEASE READ THESE IMPORTANT LEGAL NOTICES & DISCLOSURES

CONFLICTS

This report is being published by SharesPost Research LLC, and distributed by SharesPost Financial Corporation, a member of FINRA/SIPC. SharesPost Research LLC, SharesPost Financial Corporation and SP Investments Management, LLC, an investment adviser registered with the Securities and Exchange Commission, are wholly owned subsidiaries of SharesPost, Inc.

Recipients who are not market professionals or clients of SharesPost Financial Corporation should seek the advice of their own personal financial advisors before making any investment decisions based on this report. None of the information contained in this report represents an offer to buy or sell, or a solicitation of an offer to buy or sell, any security, and no buy or sell recommendation should be implied, nor shall there be any sale of these securities in any state or governmental jurisdiction in which said offer, solicitation, or sale would be unlawful under the securities laws of any such jurisdiction.

This report does not constitute an offer to provide investment advice or service. Registered representatives of SharesPost Financial Corporation do not (1) advise any member on the merits or advisability of a particular investment or transaction, or (2) assist in the determination of fair value of any security or investment, or (3) provide legal, tax, or transactional advisory services.

ANALYST CERTIFICATION

The analyst(s) certifies that the views expressed in this report accurately reflect the personal views of such analyst(s) about any and all of the subject securities or issuers, and that no part of such analyst compensation was, is, or will be, directly or indirectly related to the specific views contained in this report.

Analyst compensation is based upon various factors, including the overall performance of SharesPost, Inc. and its subsidiaries, and the performance and productivity of such analyst, including feedback from clients of SharesPost Financial Corporation and other stakeholders in our ecosystem, the quality of such analyst’s research and the analyst’s contribution to the growth and development of our overall research effort. Analyst compensation is derived from all revenue sources of SharesPost, Inc., including brokerage sales.

DISCLAIMER

This report does not contain a complete analysis of every material fact regarding any issuer, industry, or security. The opinions expressed in this report reflect our judgment at this date and are subject to change. The information contained in this report has been obtained from sources we consider to be reliable; however, we cannot guarantee the accuracy of all such information.

Any securities offered are offered by SharesPost Financial Corporation, member FINRA/SIPC. SharesPost Financial Corporation and SP Investments Management are wholly owned subsidiaries of SharesPost, Inc. Certain affiliates of these entities may act as principals in such transactions.

Investing in private company securities is not suitable for all investors. An investment in private company securities is highly speculative and involves a high degree of risk. It should only be considered as a long-term investment. You must be prepared to withstand a total loss of your investment. Private company securities are also highly illiquid and there is no guarantee that a market will develop for such securities. Each investment also carries its own specific risks and you should complete your own independent due diligence regarding the investment, including obtaining additional information about the company, opinions, financial projections and legal or other investment advice.

Accordingly, investing in private company securities is appropriate only for those investors who can tolerate a high degree of risk and do not require a liquid investment.

SharesPost, the SharesPost logo, My SharesPost, the SharesPost Index, and SharesPost Investment Management are all registered trademarks of SharesPost, Inc. All other trademarks are the property of their respective owners.

Copyright SharesPost, Inc. 2019. All rights reserved.