Floating or sinking? 5 questions to understand the IPO challenge

Mark Zuckerberg at the NYSE in 2012
Mark Zuckerberg at the NYSE in 2012

In this post I would like to take an interest in ‘Initial Public Offerings’ or ‘IPOs’. We all remember the big tech offerings of the last two decades (Yahoo in 1996, Google in 2004, Facebook in 2012) which made their founders join the billionaire club. Today a company founder is usually considered as ‘unanimously successful’ if he has managed to ‘float’ a significant share of his company – and if the share price has not collapsed since then, meaning that he has won a ‘seal of approval’ from the stock market. Behind this phenomenon, I have highlighted 6 questions worth thinking about in my view.

 

What are the pros and cons of public as opposed to private ownership?

‘Public ownership’ means by definition that shares are made available to the public. Shares in a public company are therefore much easier to buy and sell through marketplaces (stock exchanges) or ‘over the counter’ (where the buyer and the seller negotiate directly). Private company shares can only be exchanged through the latter way. This largely prevents small shareholders (such as employees) to monetise their shares.

Credits: www.cartoonstock.com
Credits: www.cartoonstock.com

Public ownership requires that all potential investors benefit from the same level of information. This explains why public companies’ annual reports are usually hundreds of pages long. Producing this information and, more importantly, making it compliant with regulatory requirements, comes at a (significant) cost, notwithstanding the fact that a public company may have to reveal competitively sensitive information – one of the reasons why they tend to have recourse to cryptic jargon. Conversely, private companies do not need to release any data to the public -they just need to maintain an even level of knowledge within their current investor base.

The fact that information is limited and that share trading mechanisms are more difficult to implement makes the potential shareholder base narrower in the case of a private company. As a consequence, the investor base in a private company is usually much more concentrated, meaning that it is easier for shareholders to push management in the same direction – this one of the core governance principles underlying private equity – and this may seduce ‘activist’ investors.

On the contrary, public companies can attract a higher number of small investors and could thus raise a higher amount of money – a few years ago raising money to fund growth was one big reason for companies to go public, at least in Europe. Nowadays, with quantitative easing in place and interest rates in negative territory, private companies can fund their growth without having to go public – see Uber’s recent $3.5bn fundraising round.

Source: Financial Times
Source: Financial Times

So, to summarise, going public provides liquidity to existing shareholders and enables the company to tap into a wider investor base, but this comes with a price associated with the publication of regulated information.

 

Why is there a push for private tech companies to go public? Is this push unanimous?

Tech company shareholders (e.g. venture capital funds) perceive the current environment (excess of liquidity, stock markets reaching all-time highs etc.) as extremely favourable for introducing new stocks at a relatively high price compared with historical standards. These funds typically have 10-year lifespans and are in a pressure to return liquidity to their investors. Pressure has been formalised in Spotify’s last debt fundraising round terms: the more the company waits to file for an IPO, the more expensive the debt will become. Separately, employees in these companies accepted to trade a share of their cash compensation for shares (‘stock-base compensation’ represents 31% of revenues at Twitter) and would like to see their hard-working, poorly remunerated efforts ultimately pay – as mentioned earlier, it is nearly impossible for an individual shareholder to sell the shares he owns in a private company.

On the other side, you have management teams which, as mentioned above, do not perceive the need to go public any more to fund growth, although they can clearly see the regulatory burden associated with public ownership.

Source: Financial Times
Source: Financial Times

To hep the two sides meet, ‘secondary markets’ have recently developed as a middle ground between unstructured private ownership and fully-fledged public stock markets. These secondary markets enable early-stage investors to cash out while maintaining the ‘private’ nature of the company.

 

Why is the IPO window said to be narrowing?

The number of IPOs has over the last few months collapsed – only 14 since the beginning of 2016 compared with an annual average of 49 since 1980. Not that the flow of candidates has dried up: Misys, a UK financial software provider, cancelled its IPO last month while O2 has indicated that the company’s planned IPO would not happen this year.

After having been attracted by the new shiny unicorns, ‘public investors’ are now proving much more cautious in their approach – possibly still having in mind the misfortune of past so-called ‘success stories’ such as Zynga. See for example this list of ‘top 10 IPOs to watch in 2016’ and compare it with the actual number of completed IPOs to get a feel of the chilly market weather.

Yes, 2015... Credits: www.turner.com
You could recycle the list for 2017. Credits: www.turner.com

Now a shiny brand name and a glossy equity story are usually not enough and the days of valuation based on revenues (i.e. putting aside any profitability consideration) or eyeballs (the mantra of the late 1990s) are over. Investors are looking for an established business model, a diversified product portfolio (suspected to be the cause of Dropbox’s IPO delay), a clear strategic edge, proven profitability (at least in some geographies) or a clear path to achieving so in the short-term, and a robust and fully committed management team with significant ‘skin in the game’.

This list of selective criteria does not prevent some IPOs to successfully complete. Coupa (despite having not made any profit) or BlackLine are two recent examples of recently floated companies which experienced significant share price growth on their first day of trading.

 

If the environment happens to be so favourable, why are Airbnb or Uber delaying their IPO?

Airbnb and Uber are often announced as the ‘hottest IPOs of 2017‘ – alongside with Snap. Those two brands however have been enjoying success for years now and one could wonder why these firms have been waiting before testing the public markets.

Credits: www.licdn.com
Credits: www.licdn.com

The reasons can be found in the previous questions. Airbnb currently does not need public markets to raise new money. Uber is burning cash at a gigantic speed – more than $1bn in H1 16 according to estimates – which makes the aforementioned ‘path to profitability’ tedious at best. Another less honourable reason is that the firms’ current valuations ($68bn for Uber, $30bn for Airbnb) would probably not withstand public markets scrutiny. Indeed, these valuation figures are purely based on extrapolations of the last fundraising round (see my previous post for further explanation) and tend to be substantially higher than the value allocated to a larger share of the equity.

As another example we could have mentioned Palantir which, despite being privately valued at $20bn, has yet to report a profit. According to Alex Karp, the company’s CEO, the IPO was postponed on the belief that large public companies struggle to recruit the most talented engineers – this statement must have been welcomed by Alphabet‘s teams.

 

Many of the tech start-ups, from small to very large, will have to face the ‘IPO hurdle’ in the coming months or years. In a world where investor liquidity does not represent a discriminating factor any more, public markets may become the next justice of the peace.