Unicorns - To IPO or to Not IPO?

The Public Markets have long been lauded as the primary source of capital to efficiently promote growing companies. However, over the last several years there is an increasing trend where young companies with the potential to IPO are shying away from the prospect in favor of private capital.

Young promising technology companies are choosing to delay IPO for the main belief that staying private longer is in the best long term interest of the company and its growth trajectory.  

In this blog, we examine a few factors a young company considers when choosing how to finance operations and the valuation considerations that come along with these.

 

The Data: Private Markets are growing at a Faster Pace than Public Markets

The graph below presents the total IPOs, private equity buyouts & secondary offerings, and venture capital investments since 20131.

As the graph shows, VC & PE are experiencing significantly larger growth than the IPO market. From 2013-2017, the PE and VC activity grew at 19% and 39% CAGR, respectively, while the IPO market grew by 1% over the period2:

IPOs, PE and VC Deals since 2013 (USD Billions)

 

In addition to the faster growth in VC and PE fundraising compared to the IPO markets, we have seen a considerable slow-down in young companies choosing to go public. Whereas in 1997, the average age of US-listed firms was a sprightly 12 years old. Now the average age is 20. Why are companies choosing to stay in the private markets longer?

 

Private Markets now provide Capital Needs

With the growth in private market capital available for investment, startups can raise billions of dollars in a closed funding environment without disclosing sensitive financial information to the public.

Growth stage investors such as CapitalG (Google) have provided the cash necessary for firms like Airbnb to raise a series F round of nearly $1b. Funds such as SoftBank’s Vision Fund have injected unprecedented amounts of capital into high-potential startups like Uber and WeWork while the media has speculated potential IPOs of these companies for a few years already.

Why are these trendy companies choosing to stay private for longer periods? The answer mainly lies in the desire to avoid share price volatility and overburdened regulator requirements during a company's critical growth period.

 

Private Valuations Provide Cover in Price Volatility

While private valuations revolve around investor perceptions of the company itself, IPO valuation is very much the result of general market conditions. While the general sentiment is that the "market knows best" and prices risk appropriately when compared to private investments, the public markets have exhibited pricing volatility that can hurt employee stock options and affect strategic planning initiatives.

Unicorn companies (those with a valuation of $1b or more before an IPO) continue to attract attention and high valuations. Multiple unicorns have listed on major exchanges since 2010 only to be met with ire from Wall Street and dramatic devaluation of their stock.

From the perspective of a high-growth start-up CEOs (many of whom are able to retain approx. 20% equity in their companies before going public) are becoming weary of granting Wall Street access to their financials and the authority to determine their value.

Take for example, DropBox Inc. (DBX: Nasdaq), the Silicon Valley cloud storage company which issued public shares in March 2018. In 2014, DropBox raised $1.1 billion in a private financing round, which valued the Company at $10 billion. When pricing the IPO in March, the Company aimed to issue shares at $16-18 each. These prices valued DropBox at $7 billion, lower than the 2014 valuation.

Ultimately, DropBox issued stock for $21 a share, at a valuation of $8 billion, and by the end of its first trading day, the Company's share price rose by 36% with a market cap of $11 billion. This example goes to illustrate the volatility of market prices on company valuations, especially in the IPO process4.

 

Liquidity Considerations

Another factor that shareholders consider on the decision to IPO, are issues of liquidity. In private valuations, a discount for lack of marketability ("DLOM") is often applied to the valuation in order to reflect the difficulty in exiting the position.

The timing of when to exit and at what threshold can be ultimately impacted by when investors are looking to exit the position in a liquid market and cash out.

 

R&D Costs and Investor Pay Back Time Horizon

Furthermore, a shift toward the knowledge-based economy has caused a shift in how companies do business: research and development has become ever more important to stay competitive and technology firms must continually invest in innovation to keep up. Private investors have longer investment horizons and are more patient with regards to R&D in the hopes of gaining a sustained long term competitive edge that will lead to a dazzling exit.

 

The Burden of Heavy Costs Regulatory Costs

The process of going public is costly with underwriting, accounting, advisory, tax, legal, reporting and exchange listing fees. All of these are in addition to the costs of a global roadshow to market shares to institutional investors. The total costs of going public can amount to 10% of proceeds raised.  

Once a company is public, they endure further additional direct costs which amount to approximately $2 million annually. There are also the long term costs such as setting up investor relations and human resources departments. The prospects of all these additional costs are discouraging for young growth companies who have access to private capital – with less hassle.

 

Summary

In short, it depends: a company's sources of funds and the decision to source from private markets or public markets, has ramifications on the Company's short and long term goals. In addition, external market factors can often influence the decision. Some companies looking to focus on technological development and a sustained recurring revenue stream may seek to avoid capital markets if they can sufficiently fund the operations from private markets. Other companies, may believe that the time is right for an exit and to IPO in order to heighten the Company's exposure, raise larger funds, and cash out.

 

Bloomberg Terminal, IPOs - October 17th 2018
2018 figures through the middle of October indicate similar CAGR growth rates on an annualized basis
Quartz. US startups don’t want to go public anymore. Feb 1, 2018
Bloomberg, Spring is Coming for IPOs, March 2018