Over the past 20 years, private equity and venture capital firms have created a virtuous circle that has made them the preferred choice of capital for the talented entrepreneurs behind the most promising, young tech companies. And, ironically, it was the dot-com crash in 2000 that set into motion a perfect storm that allowed the private markets to supplant the public markets as the primary source of capital for these innovative companies that are driving the expansion of the New Economy. Understanding this series of events is important to understanding today’s gap between private and public tech company valuations and why it’s likely to continue. (To learn why private capital will continue to dominate New Economy finance, please read “Individual Investor Access to the New Economy Comes at a (Hefty) Price.”)
Government Regulation Raised Private Equity’s Profile
As the stock market bubble expanded in the late 1990s, many public investors were willing to invest in companies at almost any valuation, especially if they included the “.com” suffix. Between 1995 and 2000, the Nasdaq Composite stock market index rose 400%, reaching a peak price–to-earnings ratio of 200. Individual investors helped drive the frenzy and some even quit their jobs to day-trade. Almost 20 percent of the ads for Super Bowl XXXIV in 2000 were purchased by dot-com companies, which may not seem surprising today, but was remarkable at the time.
Then the bubble burst in March of 2000 and the public markets pulled back sharply from the internet-based companies. The number of small company IPOs plummeted from 270 in 2000 to just 20 in 2001, and in the aftermath, many investors swore off IPOs altogether.
Subsequently, the Sarbanes Oxley Act was passed into law in 2002, making it even more difficult for smaller companies to access the public markets. The law introduced strict new governance requirements and increased the costs and compliance work associated with a public listing.
Soon afterwards, small-cap company research coverage began to fade following the Global Analyst Research Settlements in 2003, which created “orphan stocks” that, without analyst coverage, struggled to attract interest from investors. All these events and factors unfolded just as the New Economy was beginning to take off and the adoption of the internet by consumers started to accelerate around the world; the number of people accessing the internet grew from around 900 million in 20041 to 4.6 billion in 2020.2
Individual Internet Use (in millions)
A Secular Change in Tech Company Finance
As a result, in a relatively short timeframe, the public new issuance engine that had fueled the hyper-growth phase of many of the most promising tech companies almost shut down, creating a void in the market. Private capital stepped in to fill this financing gap and assumed a dominant role in powering the growth of the New Economy. Venture and private equity managers had historically grasped the intrinsic value of digital assets, which was essential because tech businesses often have few hard assets to pledge as collateral, and seek valuations far in excess of their book value. So, they moved quickly to expand their penetration and never let up. The amount of private capital raised for late-stage startups increased from $11 billion in 2001 to $28 billion in 2011 to $108 billion in 2020.3
Private markets also started winning the battle for operating talent, which became increasingly critical as capital became a commodity and the competition between private and public financing for high-quality companies shifted to being mostly about strategic vision and human capital. Venture and growth equity firms have been able to leverage their networks of operating professionals and their own expertise in helping tech entrepreneurs navigate their markets and scale their businesses.
So, this perfect storm forever changed the relationship between public and private markets and, in a sense, created a world of investor haves and have-nots as it relates to accessing the tech giants of tomorrow early in their development. Most individual investors must wait for these companies to come public at often breathtaking valuations and thus take on greater risk with less upside, compared with institutional investors and the very wealthy who can access these companies at more favorable entry points through venture and growth equity funds.