Can private equity help Silicon Valley's startups?

According to venture investor Bill Gurley, an IPO is often the only way that all stakeholders - from employees to later -stage investors - in a startup get treated fairly. Photo / Getty

Investors have driven up the shares of the hottest tech startups in the land and sent their valuations - on paper, at least - into the stratosphere. Uber is now valued at $41 billion! Airbnb could be worth $20 billion! Snapchat is pushing for $19 billion! Palantir and SpaceX are already worth more than $10 billion each!

Headline-grabbing valuations are usually an illusion, of course. Investors who buy late in the venture game generally demand preferred shares that, as the name suggests, come with perks and protections that lessen (or eliminate) the risk of losing money on expensive shares. If the company is sold for a modest sum rather than a windfall, later stage investors get more, earlier investors get less, and employees - who have common stock, not preferred - get comparatively little or nothing at all.

That gagillion-dollar valuation that everybody in the startup was hoping for goes poof when the preferred holders cash in.

Venture investor Bill Gurley wrote about some of this last week: "The only way to escape this capitalisation chart calcification is to actually go public... All preferred shares are converted to common shares, and the pile of liquidation preferences goes away."

Gurley is pretty much correct, and an IPO is often the only way that all stakeholders - from employees to late-stagers - in a startup get treated fairly. But a few private companies have found alternatives to selling late-stage, preferred stock: private equity investors.

The idea is to let a private equity firm buy out the VCs, wipe out all of the preferred stock and convert all shares to common. In this second-stage privatisation (of an already private business), the PE firm saves a company from a complicated investing structure. It also saves it from VCs that can eventually have narrow and self-centered financial interests if the company has remained private for a long period.

A handful of companies and PE firms in California say that they've discussed the buyout option, but the practice is still relatively rare. That's usually because founders are reluctant to give up majority control, and an unwieldy group of venture investors all have to jointly agree to the buyout.

This week, however, a software company called Trax Technologies announced such a deal with a private equity firm, Strattam Capital.

Private equity won't be a solution for every company that's raising money right now. And it may not catch on in Silicon Valley, where big valuations, along with founder control, are sacrosanct principles.

Trax's chief executive Scott Nelson told me that at first it was hard for him to accept the idea of giving up control.

"When different investors have a lot of preferences, they can have blocking rights or veto power or control over compensation or some other aspect of the business," he said. "There's really no such thing as control in any pure sense when you have investors involved who have far more money than you do."

Aligning founders and investors' interests is far more important and, in some ways, more honest than a relationship based on battling over who has the most shares, Nelson said. He liked the idea of being aligned with one private equity player versus a VC collective that could have different opinions about when and how to exit via a sale or an IPO.

Strattam's co-founder, Robert Morse, says he invests in companies that have a specific set of traits: Growing businesses with happy customers, a functioning business model not in need of repair, and an ability to continue introducing new, potentially high-profile products.

Trax, which makes logistics software for big, Fortune 100 companies, is ancient at 22-years old. For the first dozen years of its existence it was a self-funded lab that earned money through contract software development work. During the last decade it raised two funding rounds.

"The deal with Strattam was too good [for the venture investors] to pass up," Nelson says. "If I raised a C-round, it would be under another layer of preferences."

Nelson estimates that the market for what his company does - gathering and scrubbing huge amounts of data for big companies - is $54 trillion but that it's hard for smaller companies to scale. One way to scale is to have a company like Trax roll up other players in the same or in adjacent areas - a strategy that's a core part of the private equity playbook. That's one reason why Nelson thinks that Strattam is an interesting partner.

It's a good idea to find new mechanisms that might unbundle layers of often conflicting financial interests that can stunt a startup's prospects in Ventureland.

Strattam did a similar deal last September with a business software company called Doxim. Trax and Doxim are located outside of the whirl of Silicon Valley, in Arizona and Ontario, respectively. The thunder of huge funding rounds is more muted in those locales, even if the idea of preferred stock and downside protection among late-stage investors is still a reality.

Strattam notes that Trax and Doxim are growing fast enough to make a private equity investor happy, which is typically a growth rate in the teens, rather than fast enough to make a venture investor happy, which can mean a track record of doubling users or revenue every year.

Private equity won't be a solution for every company that's raising money right now. And it may not catch on in Silicon Valley, where big valuations, along with founder control, are sacrosanct principles.

Still, it's a good idea to find new mechanisms that might unbundle layers of often conflicting financial interests that can stunt a startup's prospects in Ventureland.