Until recently, rapidly growing technology start-ups, aspiring
to perhaps one day be public, seemed to embrace the old adage: It takes money to make money. When money
was readily available to finance growth as long as management could tell a good
story, start up after start up scrambled like four-year olds at an Easter egg
hunt to gather up as much as they could.
However, they may have been adhering to the wrong proverb. Perhaps the more appropriate wisdom came from
Thomas Jefferson: “Never spend your money before you have earned it”. We think it highly likely that over the next
few quarters, participants in the IPO market will have data to conclude which was better advice.
Just six months ago, spending to grow, even if the positive unit
economics and cash flow were on the come requiring a leap (and a bound) of
faith, a young company’s management team appeared wise to pursue a competitive
moat based on scale, growing as fast as possible. Let the P
part of the P&L sort itself out over time. Damn the torpedoes; go for growth and scale funded
by enormous private fund-raising rounds.
Ah, but some of the key “sugar daddies”
didn't see the opportunity through quite the same lens. Public
markets did not sing from the same hymn book as their private market
brethren. In 2015, realized IPO
valuations did not reflect that same optimism for growing companies in big
markets with hefty losses. Companies
that successfully executed an IPO in 2015 often - as in close to 60% of the
time according to Renaissance Capital’s 2015 US IPO Review - saw their stocks quickly
tumble below issue, and now are living through the painful aftermath with employees,
partners, customers and board members.
If it is true that misery loves company, then there is some
solace. According to the same Renaissance Capital analysis, if an investor bought
the entire IPO class in 2013 and held through 12/31 of that year, that portfolio
would have appreciated 40.8%. Had they
repeated the exercise in 2014, the gain would have been 21%. Had they followed that tried and true
strategy in 2015, those investors would have lost 2%, versus a 0.7% loss for
the S&P500 last year. Worse still and again according to Renaissance
Capital, had one invested in every VC backed tech IPO in 2014 and 2015, the
portfolio would have returned 7% by year-end 2015. Alas, if one had simply parked money in a
NASDAQ index fund, the gain during those two years would have been 20%. No
wonder many public investors went to the sidelines and participation in IPOs
narrowed dramatically as 2015 progressed.
Fast forward early 2016. As lore has it, March, often a
robust IPO month, did indeed come in like a lion. Unfortunately, it was Cecil. The good news is
that while that poor beast is in permanent repose, the 2016 IPO market may yet
stretch, stir and awake from the long nap, refreshed, perhaps healthier and
ready to go.
Why the optimism in the face of no visible evidence?
First, the VIX is
falling. Volatility is the enemy of the
IPO. When all equity positions look
risky, who needs to pile on the incremental challenge of unproven, statistically
likely to trip, always unpredictable new issues? Conversely, when the market chills a bit, and
the VIX falls as it has been doing each week since the beginning of February,
investors turn their attention from risk avoidance to incremental upside, a
mindset favoring IPOs.
Second, public equity
is looking increasingly compelling if for no other reason than the private
funding environment has grown much more challenging. Companies relying on unending, generous access
to late stage equity to fund further growth are scrambling to come up with a
new game plan. Of course, many raised
enormous piles of cash while the getting was good and therefore have a robust bank
account. However, history suggests that when money flows freely, emerging
companies have a tendency to develop free-wheeling, slow to break habits that
eat through bank balances like termites through grandma’s back deck. When
private money is hard to come by, public money, even with inherent attached
obligations, looks increasingly appealing.
Third, Last
year’s “growth, at any cost, is good” mentality has given way to that old
bugaboo, insistence on potential profitability. Public investors want to see proof not only of growing ongoing engagement from existing customers, a
sign that the offered product or service has convincing value, and therefore a reliable,
sustainable, expanding revenue base, but also a tangible demonstration of how
that revenue stream will someday yield positive free cash flow. Companies investing rationally in their
product roadmaps and in deepening integration with (and value to) customers,
will likely have a much easier time winning the hearts and minds of IPO
investors (when they come out from under their desks).
When investors are fearful that private company secular
tailwinds will slow, leaving them becalmed in a big market with hungry shark
incumbents competing for the same, dwindling school of customers, the upstarts can only prevail if they offer something compelling, proprietary and
sustainable. As of March 2016, our
conversations with investors suggest that competitive barriers, an ability
to maintain a leadership position even in a long economic slog and a rational view of valuation are now more
critical to the investment decision than yesterday’s secular trends, fairies
and sugar plum TAMs. The market where “land-grab-today-at-any-cost-and
trust-we-can-monetize-this-big-opportunity-later” wins has left the room.
Conversely companies that embrace the mindset and work to deepen moats today while keeping spending under control should be well served when public
investors’ un-circle their wagons and again seek out new territory.
Our strong sense is that the uncertainty created by a
tighter private funding market is leading companies to rapidly embrace the
principles that public investors say they want, a more balanced approach
towards growth and profitability and a focus on moats and again, justifiable valuation expectations. Our optimism for the new
issue market ahead is based on our belief that this revised thinking will
result in stronger, more compelling IPO candidates.
So, once the clouds clear and a brave bellwether opens the
market, is it all clear skies and sunshine ahead? Of course not. Some companies will come to market with
models reminiscent of that FarSide cartoon mathematician “And then, a miracle
occurs”, and some of those IPOs will fly off the shelves. What happens to those companies after the
lock-up release 180 days later will be anyone’s guess. Having seen this movie before, we can say
that if history is any guide, emerging companies that are hunkered down in the
current environment, perhaps foregoing triple digit growth in the drive toward
the sustainability afforded by a viable model displaying balanced growth and
profitability, are the best bets.
The
current IPO forecast is gloomy; no doubt.
However, what is going on beneath the visible cloud cover just may be
enough to afford public investors positive returns again in the IPO pool when
the sun shines and it is time to dive back in.
