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Tag: IPO

How IPOs are Doing in the Public Markets

After reading my last post on what the decline in recently IPO’d startups means for the broader tech industry, a friend of mine encouraged me to look closer at how IPO’s in general have been performing. The answer: badly

Recent IPO performance vs S&P 500 over last year

The chart above shows how Renaissance Capital’s US IPO index (prospectus), which tracks major IPOs in US markets, has performed versus the broader market (represented by the S&P500) over the past year. While the S&P500 hasn’t had a great year (down just over 10%), IPOs have done even worse (down over 30%).

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What Happens After the Tech Bubble Pops

In recent years, it’s been the opposite of controversial to say that the tech industry is in a bubble. The terrible recent stock market performance of once high-flying startups across virtually every industry (see table below) and the turmoil in the stock market stemming from low oil prices and concerns about the economies of countries like China and Brazil have raised fears that the bubble is beginning to pop.

Company Ticker Industry Stock Price Change Since IPO (Feb 5)
GoPro NASDAQ:GPRO Consumer Hardware -72%
FitBit NYSE:FIT Wearable -47%
Hortonworks NASDAQ:HDP Big Data -68%
Teladoc NYSE:TDOC Telemedicine -50%
Evolent Health NYSE:EVH Healthcare -46%
Square NYSE:SQ Payment & POS -34%
Box NYSE:BOX Cloud Storage -42%
Etsy NASDAQ:ETSY eCommerce -77%
Lending Club NYSE:LC Lending Platform -72%

While history will judge when this bubble “officially” bursts, the purpose of this post is to try to make some predictions about what will happen during/after this “correction” and pull together some advice for people in / wanting to get into the tech industry. Starting with the immediate consequences, one can reasonably expect that:

  • Exit pipeline will dry up: When startup valuations are higher than what the company could reasonably get in the stock market, management teams (who need to keep their investors and employees happy) become less willing to go public. And, if public markets are less excited about startups, the price acquirers need to pay to convince a management team to sell goes down. The result is fewer exits and less cash back to investors and employees for the exits that do happen.
  • VCs become less willing to invest: VCs invest in startups on the promise that future IPOs and acquisitions will make them even more money. When the exit pipeline dries up, VCs get cold feet because the ability to get a nice exit seems to fade away. The result is that VCs become a lot more price-sensitive when it comes to investing in later stage companies (where the dried up exit pipeline hurts the most).
  • Later stage companies start cutting costs: Companies in an environment where they can’t sell themselves or easily raise money have no choice but to cut costs. Since the vast majority of later-stage startups run at a loss to increase growth, they will find themselves in the uncomfortable position of slowing down hiring and potentially laying employees off, cutting back on perks, and focusing a lot more on getting their financials in order.

The result of all of this will be interesting for folks used to a tech industry (and a Bay Area) flush with cash and boundlessly optimistic:

  1. Job hopping should slow: “Easy money” to help companies figure out what works or to get an “acquihire” as a soft landing will be harder to get in a challenged financing and exit environment. The result is that the rapid job hopping endemic in the tech industry should slow as potential founders find it harder to raise money for their ideas and as it becomes harder for new startups to get the capital they need to pay top dollar.
  2. Strong companies are here to stay: While there is broad agreement that there are too many startups with higher valuations than reasonable, what’s also become clear is there are a number of mature tech companies that are doing exceptionally well (i.e. Facebook, Amazon, Netflix, and Google) and a number of “hotshots” which have demonstrated enough growth and strong enough unit economics and market position to survive a challenged environment (i.e. Uber, Airbnb). This will let them continue to hire and invest in ways that weaker peers will be unable to match.
  3. Tech “luxury money” will slow but not disappear: Anyone who lives in the Bay Area has a story of the ridiculousness of “tech money” (sky-high rents, gourmet toast, “its like Uber but for X”, etc). This has been fueled by cash from the startup world as well as free flowing VC money subsidizing many of these new services . However, in a world where companies need to cut costs, where exits are harder to come by, and where VCs are less willing to subsidize random on-demand services, a lot of this will diminish. That some of these services are fundamentally better than what came before (i.e. Uber) and that stronger companies will continue to pay top dollar for top talent will prevent all of this from collapsing (and lets not forget San Francisco’s irrational housing supply policies). As a result, people expecting a reversal of gentrification and the excesses of tech wealth will likely be disappointed, but its reasonable to expect a dramatic rationalization of the price and quantity of many “luxuries” that Bay Area inhabitants have become accustomed to soon.

So, what to do if you’re in / trying to get in to / wanting to invest in the tech industry?

  • Understand the business before you get in: Its a shame that market sentiment drives fundraising and exits, because good financial performance is generally a pretty good indicator of the long-term prospects of a business. In an environment where its harder to exit and raise cash, its absolutely critical to make sure there is a solid business footing so the company can keep going or raise money / exit on good terms.
  • Be concerned about companies which have a lot of startup exposure: Even if a company has solid financial performance, if much of that comes from selling to startups (especially services around accounting, recruiting, or sales), then they’re dependent on VCs opening up their own wallets to make money.
  • Have a much higher bar for large, later-stage companies: The companies that will feel the most “pain” the earliest will be those with with high valuations and high costs. Raising money at unicorn valuations can make a sexy press release but it doesn’t amount to anything if you can’t exit or raise money at an even higher valuation.
  • Rationalize exposure to “luxury”: Don’t expect that “Uber but for X” service that you love to stick around (at least not at current prices)…
  • Early stage companies can still be attractive: Companies that are several years from an exit & raising large amounts of cash will be insulated in the near-term from the pain in the later stage, especially if they are committed to staying frugal and building a disruptive business. Since they are already relatively low in valuation and since investors know they are discounting off a valuation in the future (potentially after any current market softness), the downward pressures on valuation are potentially lighter as well.
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How Often Does a $3 Billion Valuation Come Along?

Snapchat-reportedly-said-no-to-3-billion-in-cash-from-Facebook

I blogged recently about why companies like Facebook are willing to pay large amounts for barely-in-revenue-if-at-all companies like Snapchat – but that’s a question about the buyer. The question dozens of entrepreneurs and venture investors are asking themselves is: should Snapchat have taken Facebook’s rumored bid?

While the right answer to that is a combination of personal (what does the team want to do) and business (what do we see as the likely path forward for the company), one question we can answer objectively is how often does such an exit happen?

As part of an exercise to try to better understand when and where big venture-backed opportunities lie, I pulled together data from Dow Jone’s Venturesource service and cross-matched it with companies from S&P’s Capital IQ to try to identify the home runs that venture capitalists pat themselves on the back for since 2002 (the end of the 2000’s dot-com bubble and burst).

My dataset showed 23 venture-backed outcomes that exceeded $3 billion in valuation (factoring in a 180-day lockup period that accompanies most IPOs where investors and key employees cannot sell stock, except for companies listed which haven’t had that 180-days of history then which I added the most recent market cap). Five of these (Yandex, Hibu, Biosensor Applications, Carmat SAS, and CTC Media) are not U.S. companies and an additional three (MetroPCS, Antero Resources, and First Republic Bank) are what I would call “unconventional” (i.e., an organization which does VC investments was involved in a pre-exit financing but they don’t fit the usual profile). So, more practically, since 2002, only 15 U.S.-based venture-backed companies have achieved exits in excess of $3 billion.

Company Valuation ($M) Exit Date Type Sector

Google

$53B

Aug 2004

IPO

Search

Facebook

$48B

May 2012

IPO

Social

Twitter

$22B

Nov 2013

IPO

Social

Workday

$9.8B

Oct 2012

IPO

Business Software

LinkedIn

$7.2B

May 2011

IPO

Social

Groupon

$6.9B

Nov 2011

IPO

Coupon

Veeva

$4.8B

Oct 2013

IPO

Business Software

FireEye

$4.5B

Sep 2013

IPO

Security

Tableau

$3.9B

May 2013

IPO

Business Software

Palo Alto Networks

$3.7B

Jul 2012

IPO

Security

Service Now

$3.7B

Jun 2012

IPO

Business Software

Zynga

$3.7B

Dec 2011

IPO

Gaming

Hyperion

$3.3B

Mar 2007

M&A

Business Software

Doubleclick

$3.1B

Mar 2008

M&A

Adtech

Splunk

$3.1B

Apr 2012

IPO

Business Software

Of those 15, only two are acquisitions — Hyperion Solutions (a business intelligence software company bought by Oracle) and DoubleClick (a leading ad exchange bought by Google) – the remainder are IPOs, and only 5 or 6 (depending on if you count LinkedIn) are direct-to-consumer in the same way that Snapchat is.

In short, Snapchat supposedly walked away from an outcome which is extremely rare and so the Snapchat founders/board, if they’re being “rational”, are clearly focused on building a standalone, IPO-able company of the size of a Google/Facebook/Twitter/Groupon/Zynga.

They have had remarkable traction to date and it will be interesting to see if they look back on this as a big mistake or the beginning of when the rest of the world understood just how big of a company they could become.

(Image source – PhoneArena.com)

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The Goal is Not Profitability

I’ve blogged before about how the economics of the venture industry affect how venture capitalists evaluate potential investments, the main conclusion of which is that VCs are really only interested in companies that could potentially IPO or sell for at least several hundred million dollars.

One variation on that line of logic which I think startups/entrepreneurs oftentimes fail to grasp is that profitability is not the number one goal.

Now, don’t get me wrong. The reason for any business to exist is to ultimately make profit. And, all things being equal, investors certainly prefer more profitable companies to less/unprofitable ones. But, the truth of the matter is that things are rarely all equal and, at the end of the day, your venture capital investors aren’t necessarily looking for profit, they are looking for a large outcome.

businessgrowthBefore I get accused of being supportive of bubble companies (I’m not), let me explain what this seemingly crazy concept means in practice. First of all, short-term profitability can conflict with rapid growth. This will sound counter-intuitive, but its the very premise for venture capital investment. Think about it: Facebook could’ve tried much harder to make a profit in its early years by cutting salaries and not investing in R&D, but that would’ve killed Facebook’s ability to grow quickly. Instead, they raised venture capital and ignored short-term profitability to build out the product and aggressively market. This might seem simplistic, but I oftentimes receive pitches/plans from entrepreneurs who boast that they can achieve profitability quickly or that they don’t need to raise another round of investment because they will be making a profit soon, never giving any thought to what might happen with their growth rate if they ignored profitability for another quarter or year.

initial_public_offering

Secondly, the promise of growth and future profitability can drive large outcomes. Pandora, Groupon, Enphase, Tesla, A123, and Solazyme are among some of the hottest venture-backed IPOs in recent memory and do you know what they all also happen to share? They are very unprofitable and, to the best of my knowledge, have not yet had a single profitable year. However, the investment community has strong faith in the ability of these businesses to continue to grow rapidly and, eventually, deliver profitability. Whether or not that faith is well-placed is another question (and I have my doubts on some of the companies on that list), but as these examples illustrate, you don’t necessarily need to be profitable to be able to get a large venture-sized outcome.

Of course, it’d be a mistake to take this logic and assume that you never need to achieve or think about profitability. After all, a company that is bleeding cash unnecessarily is not a good company by any definition, regardless of whether or not the person evaluating it is in venture capital. Furthermore, while the public market may forgive Pandora and Groupon’s money-losing, there’s also no guarantee that they will be so forgiving of another company’s or even of Pandora/Groupons a few months from now.

But what I am saying is that entrepreneurs need to be more thoughtful when approaching a venture investor with a plan to achieve profitability/stop raising money more quickly, because the goal of that investor is not necessarily short-term profits.

(Image credit) (Image credit)

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Our Job is Not to Make Money

Let’s say you pitch a VC and you’ve managed to avoid the classic VC pitch pitfalls I outlined before and have demonstrated thoughtfulness regarding the scalability illusion. Does that mean you get the venture capital investment that you so desire?

Not necessarily. Now, there could be many reasons for a rejection, but one that crops up a great deal, at least in my experience, is not anything intrinsically wrong with a particular idea or team, but something which is an intrinsic issue with the venture capital model.

One of our partners put it best when he pointed out, “Our job is not to make money, its to make a lot of money.”

What that means is that venture capitalists are not just looking for a business that can make money. They are really looking for businesses which have the potential to sell for or go public (sell stock on NYSE/NASDAQ/etc) and yield hundreds of millions, if not billions of dollars.

Why? It has to do with the way that venture capital funds work.

    • Venture capitalists raise large $100M+ funds. This is a lot of money to work with, but its also a burden in that the venture capital firm also has to deliver a large return on that large initial amount. If you start with a $100M fund, its not unheard of for investors in that fund to expect $300-400M back – and you just can’t get to those kinds of returns unless you bet on companies that sell for/list on a public market for a lot of money.
    • Although most investments fail, big outcomes can be *really* big. For every Facebook, there are dozens of wannabe copycats that fall flat – so there is a very high risk that a venture investment will not pan out as one hopes. But, the flip side to this is that Facebook will likely be an outcome dozens upon dozens of times larger than its copycats. The combination of the very high risk but very high reward drive venture capitalists to chase only those which have a shot at becoming a *really* big outcome – doing anything else basically guarantees that the firm will not be able to deliver a large enough return to its investors.
    • Partners are busy people. A typical venture capital fund is a partnership, consisting of a number of general partners who operate the fund. A typical general partner will, in addition to look for new deals, be responsible for/advise several companies at once. This is a fair amount of work for each company as it involves helping companies recruit, develop their strategy, connect with key customers/partners/influencers, deal with operational/legal issues, and raise money. As a result, while the amount of work can vary quite a bit, this basically limits the number of companies that a partner can commit to (and, hence, invest in). This limit encourages partners to favor companies which could end up with a larger outcome than a smaller, because below a certain size, the firm’s return profile and the limits on a partner’s time just don’t justify having a partner get too involved.

The result? Venture capitalists have to turn down many pitches, not because they don’t like the idea or the team and not even necessarily because they don’t think the company will make money in a reasonably short time, but because they didn’t think the idea had a good shot at being something as big and game-changing as Google, Genentech, and VMWare were. And, in fact, the not often heard truth is that a lot of the endings which entrepreneurs think of as great and which are frequently featured on tech blogs like VentureBeat and TechCrunch (i.e. selling your company to Google for $10M) are actually quite small (and possibly even a failure) when it comes to how a large venture capital firm views it.

(Image credit)

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