The last few months have seen a lot of discussion about the viability and importance of IPOs (Initial Public Offerings of stock), especially for US tech companies. There is a theme among tech writers that IPOs are out of date. Earlier this week we pointed out the flaws in one high-profile example of this from Spotify’s CFO. Given the generally favorable reception this piece received in our social media feeds, it seems that many are questioning not only IPOs but the role of public market investors entirely.
Our response to all this is: enjoy it while it lasts, because someday soon the public markets and IPOs are going to look a lot more interesting than they do today. The pendulum will swing back, and faster than expected, companies will start to long for these days when an IPO seemed optional.
A quick Google search can demonstrate the clear decline in the number of public companies in the US. The number of IPOs is way down as private companies, especially in tech, wait longer to go public.
For some, this is seen as a function of the dwindling of the utility of being public. Going public comes with a real price both in terms of financial costs and in management headaches. The thinking seems to be, “Why go public when the private markets are so willing to throw bundles of cash?”. And as things stand now, it entirely makes sense for private companies to behave this way. But these conditions will not last.
At some point, quite possibly very soon, capital markets will tighten up again. Certainly, the growing US budget deficit and looming trade wars should be seen as storm clouds on the horizon. The reality is that capital has been looser and cheaper for the last 10 years than in pretty much any other period in modern financial history. Cheap capital makes low-yielding bonds unattractive investments. Investors seeking higher returns are willing to turn to riskier investment classes to seek even meager returns. When interest rates start to go up, this will change.
To be fair, we have been saying this for a long time and little has changed. But this does not mean nothing has changed. It is clear that venture investors have been tightening investment requirements for several years. It is much harder to fund a company’s B- and C-series venture rounds than it was two or three years ago. This is a key inflection point as company’s at this stage tend to be of the size where they need larger checks, and there is a much smaller, more professional pool of investors capable of writing those checks.
The low-rate environment we discussed above also means that there are still many investors putting money to work at start-ups without the requisite experience in venture investing. This creates headlines about unicorns raising huge amounts of money at incredible valuations. However, dig a little deeper and those headlines distract from a tougher outlook. These less experienced investors are not dumb, and the terms they demand in investment contracts are almost punitive. These include all sorts of dilution protection and valuation guarantees, all of which come at the expense of management teams and employees. More over, they are there to protect those investors in tough times. It has been a long time since we had any such ‘tough times’, so people have forgotten how much those terms can bite when business conditions turn sour.
There is also another important corrosive impulse buried beneath those headline valuations. Investors continue to encourage companies to swing for the fences. Big venture funds want their portfolio companies to provide big returns measured in X’s not %’s. Sometimes that is not the right approach. If you are building an enterprise-facing software company, swinging for the fences comes at the expense of building a solid, albeit slower-growing business. We are not painting all venture investors with a nefarious “hyper-growth” brush, but we do think the subtle incentives and biases all humans contain are coming into play, distorting start-ups’ business decisions.
This matters because many companies that are today foregoing public offerings may someday face a very different market, one in which going public is not an immediate option. The unfortunate reality is that the IPO market is prone to its own cycles, and in a tough interest rate environment will likely shut. This creates that zombie zone we last saw in the early 2000’s when companies found the venture dollars cut off and the IPO window closed, and then had to massively cut staff and lower their ambitions just to survive.
Many investors we talk to on the Street actually look forward to that time. Today, they are unable to participate in the valuation increases of high-growth companies. A hard rain cleaning out the Street would change that dynamic.
Our point is simply that IPOs look unappealing today, but that is just indicative of conditions at this very particular point in time. In the not too distant future, the ability to tap into public markets will once again become a sought-after outcome.