I am a capitalist and in the words of Gordon Gekko “Greed is Good”. I believe in the continuity of self-interest, the invisible hand, and greed to drive the markets.
However, the manner in which “high-growth” companies are looking to get to their public offerings is a systemic problem. Here has been the formula for a number of companies that were once darlings in the tech world to get seemingly ahead and parts of this same formula are being used by a multitude of startups that will never get to an IPO:
- Pump marketing dollars, which comes easily thanks to abundant venture dollars, into acquisitions costs that are unsustainable long term for businesses that do not have compelling unit economics. Grow top-line revenue.
- Raise more venture capital to support this unsustainable growth strategy, increasing arbitrary “valuations” along the way for you and your investor’s illiquid shares. Increase valuation.
- When there are no more levers to be exploited, file S1 to go public. Declare
- Hope and pray that the public markets are forgiving when you go public and you and your investors can liquidate your artificially propped up shares when lockup expires, taking a small haircut on the last private valuation while the bulk of shares is worth several multiples than at the cost of investment (e.g. Softbank would have been happy to make an average of 2-3x on the $5.5B it invested before the last round in WeWork; while losing 50% on the last $2B it invested at a $47B valuation – these figures are for the pre-bailout investments). This all while the mainstream public that invested at the time of IPO loses in totality as the stock sinks (see Uber or Lyft stock chart since IPO). Liquidate
The speed at which you can do the above, determines how much you can prop up the value of your company. Butting propping up the value of your company is not a sign of strength despite the headlines they garner.
If you are founder now, building a high-growth business that’s venture backed, you should already understand the following. The nature of the venture capital business is built so that a few successful investments drive the returns for the funds and its LPs – the home runs. Seemingly the interest of your investors and founders are aligned. Build a huge company. But at what cost?
The public markets have caught on to this game and it will disappear with a number of companies dying from the inability to raise further capital. Why?
- Founders have been able to achieve some degree of partial liquidity in subsequent private funding rounds by selling shares. This will not be viable. Just as your S1 includes disclosures, the Form Ds filed for private rounds contains a section that outlines how much of a capital raise is going directly to management and directors. This will be scrutinized by investors and serve as a red flag that was once overlooked.
- If you do try and build a company that wants to go public, know that the public markets are not forgiving. Once public, your company will be valued appropriately on the basis of what your shares are traded at in real-time and on the expectation of future cash flows. Nothing else. Nothing more. The valuation that you last raised will never matter anymore. You are now your stock price and the expectation of your business’ cash flows have to justify that stock price. You’ll also be judged against a stack of competitors and similar businesses that are also vying for dollars from public market investors that have access to transparent information about all companies. Unlike your startup.
- IPOs should not be looked at as liquidity events for founders but as a new stage of growth for the company where they are able to benefit from raising capital from a new arena of institutional investors as well as have access to secondary markets that will result in a reduction in the cost of capital. These institutions, unlike your venture investors, do not have an interest in propping up the value of your company and have a vast universe of investment opportunities to choose from. Venture investors are not to blame here either; they are also playing the game but the approach must change for everyone.
What Can be Done – Recalibrate How You View an IPO
In order to satisfy the appetites of public market investors, founders and their investors need to be more cognizant of the stage where the company is at and leave some growth on the table for public market investors to enjoy as well when going public. This hasn’t happened. The time to go public is not when you have no hope of raising more capital from the private markets, when there is no meaningful growth left, or when you have exploited every acquisition channel and the only ones remaining have higher average acquisition costs than average revenue per user.
Most successful IPOs since the dotcom bubble have been businesses that were growing fast but with some semblance or the prospect of sustainable economics. Even Amazon, which heavily reinvests in its business, to keep profits down, has impressive cash flow growth. The company’s cash flows exceed the revenues of Twitter, Snap, and Pinterest combined. That free cash flow also allows Amazon to reinvest in the company’s ancillary business lines that tend to have higher profit margins like AWS and make acquisitions for continued growth.
There is nothing wrong with growing sustainably and a bit slower, despite venture considerations, and getting to a level where you can go public with great prospects for future growth. Going public and cashing out isn’t the end-all and be all. Long term, public markets are the main driver of wealth creation for all stakeholders in a company – employees, shareholders, and management. Right now, the focus for IPOs has been tilted in the interest of the management and private early shareholders in a perverse game of the “greater fool theory”. Someone is always left holding the bag and most of the time if it isn’t you, you don’t care. This is the same type of thinking that led to the demise of LTCM, Bear Stearns, and Lehman Brothers.
Suppose, you are at or you get to a point in life, where you are able to sell your company and create substantial wealth. Would you reinvest the majority of your proceeds into companies that have poor prospects in the public markets at propped up valuations from the private markets? Should you be asking public market investors to do the same?
A little recalibration of how the tech industry, the investors, and the bankers view an IPO, will lead to a fertile environment for growing companies instead of a reputation for something akin to the boiler room “pump and dump” that we’ve recently seen due to a few unfortunate bad apples – some of them that were potentially great businesses that were too callous in their desire and/or need to get to an IPO or liquidity event.
