Unicorns Should Kiss Being Private Goodbye

By Thomas Lee
San Francisco Chronicle

WWR Article Summary (tl;dr) According to Thomas Lee of the S.F. Chronicle, the market for tech offerings has been weak and that’s not likely to change soon. As a result, hundreds of companies waiting at the IPO gate will have to suck it up and go public in less than ideal conditions — even if that means exposing the embarrassing gap between what venture capitalists and other private investors say a startup is worth and how much Wall Street is actually willing to pay for it.

San Francisco Chronicle

You know how Facebook lets you describe your relationship status as “It’s complicated?” If he had to check a box to sum up his feelings about an IPO, that’s the one MuleSoft CEO Greg Schott would pick.

The San Francisco enterprise software firm, valued at $1 billion, is one of many so-called unicorns — highly valued, late-stage tech companies that have yet to go public. But given the weak demand for initial public offerings, MuleSoft has avoided pulling the trigger. So far.

“We have every intention of going public,” Schott recently told me. “We don’t have a huge sense of urgency to get out quickly. But we don’t have a huge desire to stay private for a long period of time. So we are going to go when we are going to go.”

Like I said: It’s complicated.

MuleSoft can afford to operate in the gray zone a bit longer: The company generated more than $100 million in revenue last year, a 92 percent jump from 2014. But as Schott acknowledged, the company can’t stay private forever.

“At some point, venture investors have to get their returns,” he said. “One way or the other.”

The question is when. Sure, the market for tech offerings has been weak. That’s not likely to change soon. The U.S. economy is slowing just as the Federal Reserve is set to raise interest rates again. So far this year, the market has priced only 34 IPOs, a 53.4 percent decline from the same period in 2015, according to Renaissance Capital. No tech companies went public in the first quarter, a drought only broken when Dell spun out its SecureWorks unit in an April IPO.

That means the hundreds of companies waiting at the IPO gate will have to suck it up and go public in less than ideal conditions — even if that means exposing the embarrassing gap between what venture capitalists and other private investors say a startup is worth and how much Wall Street is actually willing to pay for it.

When a private company raises money from investors at a lower valuation than a previous financing, that’s called a “down round,” and it kicks in some painful adjustments as venture capitalists take advantage of protections built into their investments that give them a bigger stake in the company when the valuation goes down.

Similar things can happen when a company sells its shares to the public at a price lower than in previous private rounds.
Take Square. To garner more financing before its IPO, the cash-starved company offered investors a guarantee they would make a 20 percent profit on shares they bought for $15.46 apiece, even if the IPO came below expectations. Sure enough, Square went public at $9 a share, and Square issued them an extra 10.3 million shares to make them whole. Their gains came at the expense of other shareholders, including co-founder and CEO Jack Dorsey, early investors and employees.

“The IPO is the new down round,” said Anand Sanwal, co-founder and CEO of CB Insights research firm in New York. “That may just be the reality.”

The reality-defying exception seems to be Uber, which has managed to keep its valuation at $62.5 billion, even as it raised another $3.5 billion. Most unicorns, however, are not going to get billion-dollar handouts from the Saudi royal family.

“At some point, you have to realize that you’re not Uber,” Sanwal said. “You’re not growing at the rate that your last investors thought you were.”

So going public may be the only viable option, even it means investors need to take a haircut. About 40 percent of the unicorns that went public in 2014 and 2015 are now trading at or below their private market valuations, according to a report published late last year by venture capital firm Battery Ventures.

Investors generally don’t think about how much money a late-stage startup can fetch on Wall Street until the company actually decides to go public, said David Larsen, managing director of Duff & Phelps, a consulting firm that advises investors on how to value companies.

Perhaps they should. The growing disconnect between private and public valuations is becoming a major problem.

“Optimizing for high valuations instead of fundamental business metrics can put you at risk for a down-round IPO,” the Battery report said. “As business cycles ebb and flow, investors and entrepreneurs need to realize that high-priced, pre-IPO rounds many not be matched by pragmatic public-market investors.”

The venture firm looked at publicly traded companies whose last private round of financing was in 2014, including Etsy, OnDeck, New Relic, Box and Hortonworks. Their stock prices are an average of 10 percent over their pre-IPO valuations.

Companies whose last private financings happened between 2008 and 2010 and then went public — a group that includes LinkedIn and Demandware — saw their stock prices rise between 8 and 12 times their last private valuation.

Going public also has advantages: It can clean up complicated ownership structures created when companies raise money from a dizzying array of investors. Most of the protections venture capitalists get for their shares go away once the company has an IPO.

It can also pay off with a buyout. Salesforce agreed to pay $2.8 billion for Demandware last week, almost six times the value the company achieved in its 2012 IPO. Private companies can hope for an acquisition lifeline, but those prices are set by negotiation, not the market.

One might argue that avoiding the public markets is a sensible response when public-market investors are lukewarm. They could hunker down, cut costs and conserve cash until the markets recover.

But when exactly might that be? We have already enjoyed more than five years of economic growth, marked by modest gross domestic product increases and a robust stock market. A downturn is inevitable. If you think it’s bad now, what will the IPO markets look like then?

Unicorns may just have to bite the bullet and go public now. I’m pretty sure investors will get a better deal from Wall Street than a Saudi prince.

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