Private shareholders can only cash in when prices are high? That’s the definition of a crazy market.
Tuesday, July 18, 2023
Author: Stuart Lucas
‘In the short run, the market is a voting machine but in the long run it is a weighing machine.’
That quote, made famous in Warren Buffet’s 1987 letter to Berkshire Hathaway shareholders, has been a regular reference point throughout my career, guiding me well in both private and public investments. Today, however, the logic that ‘the market may ignore business success for a while, but eventually will confirm it’ seems to have been forgotten or ignored by many in private businesses, often to the detriment of shareholders and the companies themselves.
Now an entirely new generation of investors, whether they’re employee equity holders, crowdfunding enthusiasts or experienced retail investors, find themselves at the mercy of unrealistic expectations, static pricing structures and a lack of liquidity events. They are locked in, unable to cash out at any time other than when it best suits the company they own shares in.
Unlike public markets, where the push and pull of third-party sentiment provides transparency and oversight, private share price discovery is essentially non-existent. Instead, share prices are often set by a small group of individuals and based on valuations that may no longer be justifiable.
With valuations currently dropping (some early stage companies are down over 60%), many founders have opted to ban secondary sales or delay liquidity events until a time that suits them. This is the very definition of a crazy market; one which is only capable of admitting an increase in share price.
To a degree, this has been exacerbated by the increased participation of less experienced investors. With startup equity models and private markets now commonplace, ownership of this domain has shifted from solely venture capital and private equity firms to a broader range of people. Often less experienced, these new investors can be a problem as many enter the market without understanding the nuances and risks involved, which in turn can drive prices up and down irrationally.
This is all made worse by mismatched expectations and flaws in the mechanisms for creating liquidity. The crowd funding vintages of 2012-2018 all promised exits in three to five years via an AIM IPO or a trade sale and I’m seeing many of today’s startups promise the same. How can this be when it’s common knowledge that companies are staying private for much longer? The average now being between 8-10 years. For shares that can be sold, the options are primarily the bulletin board style marketplaces which simply announce a set price, or the daily liquidity provided by sub-markets such as AIM, where the value offered is often illusory.
Periodic auctions, though less frequent, can prevent market stagnation while also providing legitimate price discovery driven by market forces measured over time. They provide a time and place that corrals people into the liquidity process and a chance for interactions with buyers to determine a price.
Asset Match helps private shareholders value their shares through demand and supply, encouraging participants to assess the intrinsic value of holdings rather than relying on erratic valuations. Just as Buffett encourages investors to think independently and make rational decisions based on fundamentals, Asset Match enables private shareholders to do the same.
That 1987 letter contained another Graham-coined theory, that of Mr Market. I.e. All investors should imagine the market as a man with ‘incurable emotional problems’, who appears daily to offer you a price. Buffet wrote ‘If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game.’
Private companies would do well to remember that.