April 1, 2010, 1:19 am
For Start-Ups, Late Bursts of Private Cash
By CLAIRE CAIN MILLER
A FEW years ago, Facebook, which brought social networking to college students and grandparents alike, was expected to be a public company by now. Founded in 2004, it is cash-flow positive and is expected to bring in $1 billion in revenue this year.
Yet it is stubbornly staying private and has turned to a new kind of investor for the money that otherwise might have come from a public offering.
In May, Facebook raised $300 million from a Russian investment firm called Digital Sky Technologies, known as D.S.T. In November, Elevation Partners, a private equity firm in Silicon Valley, quietly invested $90 million, according to a person briefed on the deal.
Such big investments so late in a Web start-up’s life are unusual. But these deals have another twist: $100 million of D.S.T.’s investment and all of Elevation’s millions went to buying shares owned by employees or early investors.
“That’s what’s new about these deals,” said Marc Bodnick, a managing director at Elevation Partners. “The private market is emerging as a substitute for what used to be done only in the public markets.”
At Facebook, which was facing the collapse on Wall Street and a shriveling ad market, “this seemed like an opportunity for us to create insurance and long-term flexibility” while letting early employees cash out, said Vaughan Smith, head of corporate development.
Asked about the Elevation Partners investment, Larry Yu, a Facebook spokesman, said, “Facebook is a private company, and we don’t typically address rumor or speculation about equity-related matters.”
An initial public offering used to be the obvious route for high-flying Web start-ups like Facebook, Yelp, Zynga and Twitter. Instead, they are all staying private for now and have raised large late-stage investments, sometimes called growth capital, big chunks of which have gone to buying shares from early employees and investors.
This new type of investment “has filled a very important void in Silicon Valley,” said Jim Breyer, a partner at the venture capital firm Accel who is on Facebook’s board.
The deals have earned the nickname “D.S.T. deals,” a reference to the firm that started the trend. In addition to its $300 million investment in Facebook, in December, it led a $180 million investment in Zynga, which makes online games.
“Transactions of this nature are proving to be pretty efficient for the fast-growing business where the founders are focused on optimizing for the long term, not necessarily doing an early I.P.O.,” Yuri Milner, chief executive of D.S.T., said after making the Zynga investment.
In September, Twitter raised $100 million from its previous investors and a new, unusual source: T. Rowe Price, the mutual fund company. And Elevation Partners, which typically invests in older companies like Palm and Forbes, in January pledged $100 million to Yelp, the six-year-old Web site for ratings and reviews of local businesses.
Late-stage private equity firms, like Warburg Pincus and General Atlantic, have invested in Silicon Valley start-ups before. But typically, the Valley’s start-ups have grown up on a diet of $10 million to $50 million in venture capital over five to seven years, at which point the successful ones have been acquired by a bigger company or gone public.
For the most promising start-ups, like Twitter or Yelp, selling is not always an attractive option. Twitter turned down an offer from Facebook in 2008, and acquisition talks between Google and Yelp fell apart last year.
Yet the public markets have been virtually closed to tech start-ups for the last few years.
“Companies that need additional growth or expansion capital can’t count on the public markets, so to make sure they have enough financial runway to achieve whatever their financial goal is, many are doing large, late-stage financings,” said Gordon K. Davidson, chairman of Fenwick & West, a Silicon Valley law firm.
Founders and executives of start-ups are also discovering that there are some big benefits to remaining private, if they have the money to do it.
“We were able to push off the burdens and distractions of being a public company until it made sense strategically, while still gaining the liquidity benefit for longtime employees and remaining independent so we could double down and really focus,” Jeremy Stoppelman, chief executive of Yelp, said about the Elevation Partners investment.
Private companies can take a longer view without worrying about the demands of quarterly earnings, entrepreneurs and investors say. They also avoid the costs of complying with public company regulations like the Sarbanes-Oxley Act, and can keep innovations under the radar of competitors.
“A lot of people look at what Google did, and they said that was smart — staying private until they had built an enormous audience and nailed an ad product and a business model,” said Mr. Bodnick of Elevation Partners.
But early investors and employees get antsy: investors expect a return in less than a decade, and workers agree to lower salaries and long hours in exchange for stock options they may someday sell in a hot public offering.
With the new breed of investment, employees can buy a house or a new car, and remain loyal to the company without the proceeds from an offering. “It’s really a way for us to keep people motivated,” said Mr. Smith at Facebook.
D.S.T. bought $200 million of preferred shares of Facebook, and at least $100 million in employee-owned common stock. Of the $100 million that Elevation Partners agreed to invest in Yelp, $25 million will go to opening offices, hiring ad sales representatives and developing mobile applications. The rest will go to buying back shares.
For such investments to pay off, the companies must eventually have a successful I.P.O. That is one reason these investors are looking for companies that already have the revenue and profit to contemplate going public, like LinkedIn or Tesla Motors.
“My guess is that the companies with the billion-dollar and above market caps have all been approached,” said Greg Brogger, founder of SharesPost, a marketplace for shares of private companies.
These deals will continue to be attractive to both start-ups and investors, even if the public markets become more hospitable to tech start-ups, some analysts say.
“Imagine if you could have bought Google stock a year before it went public,” said Bing Gordon, a partner at Kleiner Perkins Caufield & Byers who is on the board of Zynga. “You could have looked pretty smart.”