From Olivier Verhage – Kennet Partners (@OlivierVerhage)
So why are tech companies going public at the slowest pace since 2009?
Before we start looking forward to 2016 and 2017, it’s important to take a step back and to take a look what happened in 2015. Last year should have been a banner year for tech IPOs as the Nasdaq and FTSE 100 were at their highest levels since 2000. Public market investors expressed appetite for risk, bidding up Amazon.com, Facebook, Google, Apple and Netflix. Tech was on top of the large cap star performers.
Low interest rates: The Fed would have had to raise rates much more substantially before mutual funds and other crossover investors stop chasing yield in alternative markets. There’s a lot of dead capital tied up, not just in the VC and PE market, but also with alternative private investors such as mutual funds, traditional asset managers and even large corporates that are looking to diversify their investments into technology in their hunt for yield.
Down-rounds: In the public world, the lofty private valuations may not hold up. Some companies in 2015 went public at down rounds, meaning their IPO prices were lower than their valuations at their last round of private funding. The highest-profile of these is the digital-payments company Square, whose IPO valuation was even lower than that of its second-to-last round of funding. Box and Apigee are among other companies with down-round IPOs this year. Overall, seven out of ten tech companies that went public in 2015 were trading lower than their initial offering and this has withheld others from going public. However, the fact that a high-profile start-up like Square has traded relatively well since its IPO, could signal that it’s OK to go public at down rounds.
A volatile start of 2016
The start of this year saw a lot of tech companies being slaughtered on the public markets, with some companies losing more than 50% of their market value. LinkedIn was down 51%, Fitbit 47% and Twitter 32%. Even three of the four vaunted FANG stocks ― Amazon , Netflix and Google were underwater. So what’s going on in technology investing right now and what caused the correction in tech valuations? Is this another 2001, when tech imploded? Well, I’d say not really.
Decreasing sales efficiency: The ratio between quarter on quarter revenue growth and the sales and marketing costs required to generate that growth has continued to decrease over the past 2 years. So rather than referring to a complete crash in 2001 with many pre-revenue businesses, investors have started to realise that companies can’t continue to burn cash while sales growth is slowing. Investors will focus on smart growth, rather than sloppy growth funded by cheap money. A great example here is Veeva Systems, a SaaS leader in CRM technology for pharma companies. In comparison to the $100 million+ mega rounds, Veeva only raised $4 million and currently has a market cap of more than $4 billion and continues to show profitable growth. The company lost around 25% between Nov-15 and Feb-16, but is already back up with a higher market cap higher than in 2015.
Uncertainty around the Fed: Tech wasn’t the only category that saw a big slump and one of the reasons why we’ve seen the market go down was due to the uncertainty around the Fed. High market volatility is usually related to not knowing what is going to happen to interest rates and the respective timing of a potential rate hike.
Can we expect the tech IPO market to improve in 2016 and 2017?
There are certainly a good number of companies that probably do want to go public in 2016 or 2017. Given how bad 2015 was, you could argue that 2016 and 2017 couldn’t get worse. However, it’s really some of this volatility and overhang that’s preventing them from doing so. For VCs, this is all troubling. Big IPOs are their lifeblood. That’s how venture investors make outsized profits and justify the billions of dollars they pour annually into start-ups that ultimately go bust or fail to generate returns.
In terms of IPO activity in 2016, the window seems to be closed for tech companies. The only IPO so far has been the one from Dell that spun out their security software unit SecureWorks. It’s been trading below its initial offering price since April. Rocket Internet also pulled its IPO for HelloFresh, their reasons remain unclear but given the evidence of 2015 and the correction in early 2016 it’s probably not very convincing to go public at this stage.
It’s hard to say when IPO activity will pick. Some factors that will certainly impact IPO activity include the following:
Interest rates: The Fed would have to raise rates significantly before mutual funds and crossover investors stop chasing yield in alternative markets. So unicorns and other start-ups can still throw new money into their burn ovens, albeit often at less ambitious valuations.
Private IPOs: Given the advent of the proverbial “private IPO” (large private market $100M financings) may not need to go public because well-heeled private market financiers have already made them flush with cash.
Valuations and liquidity: VCs are always hunting for liquidity, but as long as private markets are willing to participate in crazy valuations, VCs will opt for the private exit route. Private and public market valuations have to get in line with each other before we’ll see the next big IPO.
Cash burn and smart growth: I can’t mention it often enough, but there’s a reason that some investors like bootstrapped companies, profitable growth is key. Once Fed rates will go up and alternative investors realise that a high cash burn is not sustainable, private market valuations will come down and the IPO market will become more attractive.
And what’s the difference between Europe and the US?
Looking at tech IPO performance in 2015 and 2016, there isn’t a big difference between the US and Europe, it’s all looking bleak. However, one big difference is that the European tech scene is usually more conservative than in the US. Europeans are more risk-averse and thus don’t like burning cash without showing results. Some key differences are:
Number of IPOs: There are nearly three times as many technology start-ups valued over $1 billion in the United States as in Europe, this explains why Europe sees fewer tech IPOs than in the US.
Post IPO performance: Based on the statistics of 11 European and 13 US tech companies that priced their IPOs last year, newly listed tech stocks in Europe rally 20% on average in the first month after their initial public offering, handily beating the 6.7% gain for newly public technology companies in the US. Generally speaking, European technology IPOs are attractively priced compared with those from Silicon Valley with large late-stage private valuations.
It’s difficult to determine where the tech IPO market will go in 2017, but it’s clear that both the US and Europe have a great pipeline of tech companies that are keen to go public. It all depends on the Fed, alternative asset managers such as cross-over funds, private market valuations, post IPO performance and the fact whether tech businesses can get used to down rounds. Overall, I’m sure that both Europe and the US have a great pipeline and I’m bullish that we’ll see some of them go public in the next 12-18 months.