thecarol's soup

(Editor’s note: This is the third installment in a series about the late stage, secondary investing craze sweeping the venture capital business. For the first two installments go here and here.)

On May 26, 2009 Mike sat down with Yuri Milner, Mark Zuckerberg and a Flipcam to talk about the then-scandalous $200 million investment DST made in Facebook, at a price that valued the company at about $10 billion. The camera-work is Blair-Witch-Project-like at best. You can barely hear the audio,  and Zuckerberg can’t for the life of him figure out whether to look at the camera or Mike. It doesn’t really matter because, just after he asks, Mike proceeds to cut off half his face anyway.

But shoddy production aside, this may have been one of the most pivotal moments TechCrunch has ever captured on camera.

We didn’t know it at the time, but this was something more than an unexpected investment by an unheard of investor in a seemingly overhyped social network. It was a moment we’d been waiting for for more than a decade. Something we’d been obsessing about. It was the moment when a Web startup fundamentally broke all the normal rules of gravity that govern all Web startups. It was the moment that would eventually spawn a new, unchartered frenzy of late stage dealmaking. In my opinion, it was nothing short of the Web 2.0 generation’s answer to “the Netscape moment.”

THE. NETSCAPE. MOMENT. Anyone who was in the Valley in the 1990s likely hears dramatic music when they read those words. It refers to Netscape’s 1995 IPO, when an 18-month-old company that wasn’t yet profitable electrified the public markets generating one of the biggest first day stock pops in history. It wasn’t just the dream team of the Svengali-like Jim Clark, king of the geeks Marc Andreessen and the operationally rigorous Jim Barksdale. It wasn’t just that Netscape stood at the forefront of a multi-billion wave of Internet creativity that would transform nearly every industry and the lives of the billion people online today. And it wasn’t just that Netscape was a better business then than people like to remember, doubling revenues quarter-over-quarter.

It was also Netscape’s timing: The IPO coincided with a greater democratization of stock market investing. It wasn’t the banks– it was the everyday retail investors flooding brokerages to buy a piece of a product they loved that caused the stock to pop so dramatically. And Andreessen was a symbol to every hacker or geek that you could move to Silicon Valley and build something huge (and get rich) in a matter of months– something that had never been possible in business before.

Put the two together and there was an irresistible new reality where a smart idea posting dramatic growth that a huge number of consumers loved could now operate by new company formation and liquidity rules. Was it any wonder a flood of new companies followed? Of course, everyone knows the inevitable happened next: Greed and latecomers pushed things too far, and we ended up with a dramatic crash that psychologically much of the Valley is still reeling from. (Don’t believe me? How many times this week have you read an alarmist report about whether or not the Dot Com Bubble is back?)

It didn’t take long for nostalgia over Netscape’s IPO to set in. One of the biggest stories when I first moved to the Valley was the hotly anticipated IPOs of Loudcloud, Andreessen’s second company. It was the fall of 2000 and the IPO market had ground to a halt. But there were still plenty of people who believed it was only the frothiest companies that would die and that, after a pause, the new economy would keep surging. Quarterly venture capital investments were still increasing, launch parties were still held, and the Red Herring was still as thick as a phone book.

As times got worse, everyone needed something concrete to pin their hopes on, and for many that became the Loudcloud IPO. Afterall, Andreessen had changed the markets once, why couldn’t he do it again? The story that rang across CNBC, the Wall Street Journal and countless other media organizations: Could the Loudcloud IPO be the new Netscape moment?

It wasn’t. And yet, the press still yearns. Since then there have been no fewer than 10 million Google mentions of the phrase, as the press and analysts have predicted that each impending liquidity event by an outperforming company lead by a charismatic CEO would be the thing to get the broader public markets moving again.

Would Salesforce.com be the Netscape Moment?

Would Google be the Netscape Moment?

Would Tesla be CleanTech’s Netscape Moment?

Each IPO above has been newsworthy and an industry milestone in its own right, but each has fallen short of the Netscape yardstick. Here’s a spoiler alert: When LinkedIn becomes the first social network to file later this year, no doubt the same story will be written, and LinkedIn won’t produce a Netscape moment either.

As each IPO fails to be the next Netscape, more expectations pile onto the IPO everyone really wants to see: Facebook. Since 2007, stock “experts” have been reading tea leaves to predict its imminent arrival, and even today every move the company makes is pinned to speculation that the IPO is coming soon, nevermind executives take every opportunity to say there are no immediate plans for one. Facebook has a young wonder-geek CEO. Facebook is growing a fast rate. Facebook has 650 million users, who no doubt will produce a strong retail pop. Couldn’t Facebook be it? The obsession is palpable.

Of course none of these things will be the next Netscape moment, because Netscape has already happened. Crash-aside, the new rules created by the Netscape IPO are still pretty much the rules high-growth startups play by today. It’s no longer shocking that a 20-something kid could move to the Valley and build a billion-dollar world changing company. We’ve seen it dozens of times– in good economic times and bad. And it’s no longer shocking that an Internet company can grow very fast because of quick product cycles and a huge market of 1 billion people these companies can reach. These trends have developed and intensified, but today they are the norm.

In our obsessive zeal to witness the next Netscape Moment, I submit we missed it.

As a business reporter, the Netscape moment wasn’t so pivotal because it was an initial public offering; it was pivotal because of what it represented. It was pivotal because of the impact that it had on entrepreneurs– allowing them to build companies based on a set of new rules, not the old rules that had been defined for them. It was about a company not only disrupting an industry, but disrupting the laws of gravity associated with being a startup itself.

Just as Netscape proved you didn’t have to be profitable or fully-baked to go public, Facebook has proved the inverse: That you don’t have to go public to get liquidity for investors, a huge marketing event, and cash to acquire competitors and keep growing. That you don’t have to go public just because the playbook says so. One was about pushing a wave of companies to surge towards an IPO faster; the other has been about giving permission to a wave of companies to put off the IPO as long as possible– but the two have been equally dramatic changes that have impacted the broader economy. Netscape gave Wall Street and investors a new high growth industry to pour money into; Facebook– starting with that first DST deal– has deprived the market of it. But because we were so conditioned to view the next pivotal moment in startup economics as an IPO, we continually saw these secondary deals as something leading up to that pivotal moment– not as the pivotal moment that changed everything itself.

Facebook and DST won’t comment on the record about things like this– particularly since it involves IPO specualtion– so the natural people to talk to are the two guys who have been in the middle of it all: Marc Andreessen and Ben Horowitz. Andreessen was the co-founder of Netscape and the Mark Zuckerberg before Mark Zuckerberg. He was the reason Loudcloud had so much hype. And he’s not only on Facebook’s board, his and Horowitz’s firm has been one of the most aggressive investors in the Web 2.0 late-stage frenzy DST sparked. Horowitz gets fewer headlines, but he was a manager at Netscape, the co-founder and CEO of Loudcloud and the co-founder of Andreessen Horowitz too.

When I mentioned this story to Andreessen at a dinner party a few weeks ago, I could see the involuntary facial tick as his smile faded. He was polite, but his face said: “You’re not actually asking me about the Netscape moment? You must know me well enough to know how much I’ll hate that.” Indeed. I do. There’s a reason I quickly added: “HEAR ME OUT!” I sat down with Horowitz this week for his take and I saw the same look momentarily cross his face– the fleeting desire to throw me out of his offices for bringing up such a silly, overused press gimmick that they’ve been asked about thousands of times. It’s the only thing worse than asking if the current wave of frothy valuations are “ANOTHER TECH BUBBLE.” It’s the same look I give when someone asks me if China is the next Silicon Valley. Um… for starters, one of those is a huge country with a billion people surging out of poverty, and one is a 50-mile stretch in California full of millionaires…

Both Andreessen and Horowitz granted the dramatic change prompted by both the DST and Netscape deals – but to them, DST’s investment in Facebook was still just a precursor to a potential IPO. They argue what was so revolutionary from within Netscape was the retail pop– the sense of every rabid user owning a piece of the company and that reinforcing the marketing of the company itself. “It was one big feedback loop,” Horowitz says.

Granted, just like a comparison of 2011 to 1999 is inane, so too are there huge flaws with my comparison. As Andreessen likes to say, “There are no ‘nexts’.” To call Facebook the next Google misunderstands what each company has built. Predicting the next industry changing moment is like predicting the next industry changing technology– by definition it’s something we can’t envision before it happens. And that’s why we didn’t realize at the time just how transformative that DST-Facebook deal would be.

In the Milner-Zuckerberg video above, Mike asks a few times why the company would raise this much money when it didn’t need the cash and why Milner would invest so much without a board seat. Zuckerberg says, “We have no plans to use this money immediately and we may never use it. We may use it to make an acquisition or to open up data centers, if some strategic option makes itself available, and now we might be able to do it whereas otherwise we wouldn’t have been able to, that’s the option value that we gain through this investment.” Was he being cryptic? Maybe. More likely, even he didn’t realize the flood of follow-on secondary opportunities the deal with unleash allowing Facebook to put off an IPO for years without hurting the company’s growth.

Some more parallels jumped out at me, the more I thought about the two moments:

Both had key enablers from outside the establishment. In the late 1990s four San Francisco-based boutique investment banks were the first to spot the potential of small tech IPOs that could get huge. The incumbent Wall Street vets missed it completely, obsessed with playing the old-economy game. This time around it was DST that was the outsider to the establishment who spotted an opportunity that all the billions of dollars in Silicon Valley was ignoring: Facebook couldn’t go public, and it needed money and liquidity.

The deal was reviled at the time and DST was deemed to be paying an outrageous price for such a speculative company– the same thing that’s been said at every Facebook valuation, by the way. But pretty soon everyone around the company warmed to the idea: With Facebook’s earliest investors using these secondary deals to lock in returns, Facebook’s earliest employees using them as a pseudo-IPO, major firms like Kleiner Perkins, Elevation Partners and Andreessen Horowitz using them to manage to get a pre-IPO chunk of the company, and of course, Facebook using them to put off going public, but still get the benefits.

Just as the boutique investment banks spotted an inflection point in the market to break the traditional rules that the establishment initially mocked and then jumped all over, so too did DST spot an inflection point in the market, broke traditional rules, was mocked and then billions of dollars and many of the biggest names changed their strategies to follow.

The Macro-Economic and Cultural Backdrop. The impact of each of these moments was about so much more than the companies themselves, and that’s what makes them different from, say, Google’s IPO which was a huge moment in tech, but didn’t have much of a macro-economic impact beyond Google, Google investors and Google millionaires. Netscape’s IPO came at a point in time that it represented a catalyzing of the birth of the modern startup, the birth of the Internet and the impact of a truly democratized stock market. The latter was continually goosed by CNBC and only become more pronounced with the birth of subsequent companies like eTrade and Ameritrade. The role so many individuals played in the bubble was what made the crash so devastating.

Likewise, Facebook’s reluctance to go public is wrapped up in a lot of bigger macro trends that have been more than a decade in the making. It’s not so much the psychological impact of the Dot Com Bubble, Mark Zuckerberg has always been one of the few people in the Web 2.0 world immune to that. As he once told me, “I was in middle-school then.” It’s the transformation of what it means to be a public company. To many CEOs, the benefits– liquidity, marketing and a stock currency to purchase other companies– have been outstripped by mounting costs.

There are hard costs like Sarbanes Oxley compliance, but more problematic are things like Regulation Fair Disclosure, or ‘Reg FD’. It was created to make sure all shareholders got the same information at the same time, but in practice means a company can’t defend itself against rumors started by hedge funds without the dangerous precedent of issuing a press release to rebut every rumor. That’s augmented a new reality where gossip and perception drives a stock price, not the actual health of a company. Technology has also changed how quickly investors can trade in and out of stocks, giving the entire ecosystem an increasingly obsessive short-term mindset. And the separation between research and banking meant research had to tailor to brokerages, who mostly want reports about the large-cap companies. As a result, smaller companies that manage to go public wither and die with no one evangelizing them to investors.

These changes help explain why the concept of going public radically shifted from something companies couldn’t do fast enough in the Netscape era to something companies wanted to put off as long as possible in the Facebook era. Without these changes, we wouldn’t be seeing the explosion of late stage funding. DST’s investment in Facebook might have been singular secondary deal, because by the time the markets opened back up, companies like these would have just filed. The public markets are starving today– it’s these companies that are dragging their feet.

Coming into the Web 2.0 movement, the appeal of the IPO was gone. Founders had three choices they didn’t like if they were lucky enough to succeed: Suck it up and go public, hire a new CEO who wanted to deal with Wall Street, or sell the company before it got to that point. Mark Zuckerberg gave everyone a fourth option: Put off the IPO for years, until you have $1 billion in revenues and are so dominant you can operate by your own rules and continually do secondary rounds to give anyone who doesn’t like that strategy a way to get a return in the meantime.

While Google’s IPO didn’t have an immediate impact ala Netscape, there are roots in all of this that go back to Google. Google was the first company to dramatically stand up to the new unpleasant Wall Street reality, going public by dutch auction and announcing it would never give guidance among other non-traditional terms. Horowitz describes Googles IPO without words– by dramatically lifting his arms over his head, pulsing two middle fingers in the air and making a face like a headbanger. And Google paid the price: The stock didn’t have a dramatic Netscape-like pop. But over the next few years it soared from $85 a share to more than $700 a share.

That sent a powerful message to Greylock’s David Sze of how much growth you could still have in Internet companies after the IPO when you weren’t operating in the dot com bubble– especially now that more than a billion people are online. He says that insight was a big reason he invested in Facebook in 2006 at the then-outrageous $500 million valuation and why Greylock has increased its late stage appetite in general.

The Ripple Effect. Of course the biggest similarity is how both Netscape’s IPO and Facebook’s lack of an IPO have set a new model for others. In the case of Netscape, the floodgates opened wide. In the case of Facebook, it’s been far more measured in terms of the number of deals. Less than a dozen startups have raised these kinds of late-stage secondary mega deals, and the total activity on secondary markets is estimated to be less than $1 billion a year. But in the case of Facebook, the best companies have followed suit, and that matters because venture capital is a home run business where the top 5% of companies make 95% of returns. Anything they do, effects the entire industry and the absence of those companies from the public markets has a big opportunity-cost impact too.

Within Silicon Valley, the impact has been massive– dictating the investment strategies of some of the Valley’s biggest and best firms, and impacting lives of thousands of employees of Facebook, Zynga, Twitter and every other company doing these secondary deals. This much liquidity before an IPO was unheard of before that DST-Facebook deal, and we don’t yet understand the impact. I’ve argued before that it makes the rank-and-file Valley executives more short-term focused and more mercenary, which isn’t necessarily a good thing. Pre Facebook-DST, companies could hold onto the best and brightest employees up through the IPO and its trading lockups. Now, the churn out of companies happens before they even file to go public. And the appeal of getting pre-IPO shares in a company like Facebook is a lot more nuanced when a company is valued at double-digit billions and employees are given restricted stock units instead of options.

But you could argue the downside for a company’s ability to retain employees through an IPO is the Valley’s upside. In the case of Facebook, we’ve already seen a handful of promising companies developed from early employees who were able to cash in and leave. Usually “mafias” like these don’t start to bear fruit until a company is purchased in the case of PayPal or Netscape.

The big question with the ripple effect is whether things get pushed too far as they did post-Netscape moment. Netscape itself turned a profit quickly after it went public and had heathy revenue growth. While that IPO was speculative compared to what had come before it, it was boring and rational compared to what came next. So too are we already seeing the degradation of quality in late stage deals. There is only one Facebook, and while  Spotify was “only” valued at $1 billion in its recent DST deal, that’s ten times what Pandora– a company that has solved its legal issues with the RIAA– was valued at back in 2009. I don’t care how much smaller the price tag is, $1 billion for a company that can’t legally operate in the world’s largest Internet market despite two years of trying is a different risk profile than buying shares in Facebook at a $30 billion price. Facebook, after all, is already doing more than $1 billion in revenues, used by more than 650 million people and growing.

It’s not just macro-greed the Valley needs to worry about: It’s micro-greed. Last week, we reported a story about a Facebook employee named Michael Brown being fired for insider trading. We use those words, because we were told those were Facebook’s words to describe the internal rule he broke – and that fact wasn’t disputed by any of the sources we spoke with.

We didn’t take the allegation lightly. Contrary to suggestions from Brown’s friends and associates, before we wrote the story we talked to several people around the case including the employee’s attorney. Moments after the piece posted, we talked to the attorney again and later that night we spoke with Brown himself for more than an hour. We would have preferred to speak to Brown sooner, but his attorney denied our initial request. The content of those conversations was off the record and will remain off the record, but we updated the story with information gleaned during those conversations and remain comfortable that, on several points, we gave Brown the benefit of the doubt.

But the fact that so many people rushed to the employee’s defense without knowing the facts could be a worrying sign that others view what he did as rational and reasonable, and not equivalent to insider trading at a public company. Maybe it was an isolated incident and a naive mistake. Hopefully shining the light on it will show how serious such mistakes are. But one thing is clear: Even if companies act as swiftly as Facebook did in this case, if more employees view this behavior as acceptable, the Securities and Exchange Commission will come down on secondary markets like a hammer, effectively shutting down a new way to get liquidity as quickly as it started. The SEC already made IPOs an undesirable route, through well-meaning reforms that had unforeseen consequences.

It’s up to the Valley to show restraint and make sure this is one way history doesn’t repeat itself this time.