AGILEVC My idle thoughts on tech startups

March 8, 2012

In the fall of 2010 I laid out reasons why all the tech “bubble” chatter was really more the hallmark of a reasonably sustained boom, and then revisited the topic almost one year ago to the day.

Well what’s happened since then?  Three of the five “blockbuster” tech IPOs I predicted have happened (LinkedIn, Groupon, Zynga) and the biggest of all (Facebook) has filed and will likely go public within the next 90 days.  The secondary wave of VC-backed IPOs has also come to fruition… both consumer facing (Yelp, Demand Media, Pandora, Carbonite, HomeAway, Angie’s List, et al) and B2B (Jive Software, Brightcove, Imperva, Responsys, etc).  The pipeline of companies in registration has continued to grow.

It’s taken more than a decade since the tech bubble’s inflation and bursting but to me all of this is part of a long-term normalization of the tech IPO market.  New regulations (Sarbanes-Oxley), changing dynamics in the public investor landscape (greater influence of hedge funds, HFT, etc), and a shifting focus of investment banks all contributed to the lull too.  But even during the macroeconomic boom of 2004 to early 2008 (inflated by various credit bubbles – housing, sovereign debt, LBOs) tech IPOs were extremely rare and then the global economic crisis of late 2008 – 2010 only further dampened hopes for a recovery.  I remember when it was a rare, extraordinary thing for a software/internet startup to even file an S-1.  Now there are filings virtually every week and quite a few of these companies have already gone public.

So now what?  What are the implications for other late-stage private companies thinking of making the transition to public markets in the near to midterm future?  What’s the impact for early-stage startups?  I see several dynamics at work in today’s IPO markets.

1) Macro Environment Still Dictates IPO Windows – While 2011 saw dozens of tech IPOs, macroeconomic conditions still dictate when companies can successfully complete an offering.  There’s some natural seasonality to the capital markets, but if you recall companies like Zynga and Groupon originally expected to price offerings in September 2011 after the summer lull.  But the latest fit in the slow motion train wreck that is the European sovereign debt crisis quickly dashed those hopes.  Groupon didn’t manage to get out until November and Zynga in December.

Right now the macro economic conditions are comparatively calm.  The US economy is still in a weak recovery mode, but fundamentals are sound and continue to progress.  But another flare up of the Euro crisis could happen at any time, or oil shocks prompted by Mideast conflict and escalation are still very real possibilities.  While I believe the tech IPO market is normalizing when taking the mid-long term view, short term disruptions are still likely to occur.  Would be issuers may have to be patient, but hopefully only for months and not years.

2) Viable Businesses – The Bar Remains High – By and large, the only companies (and by extension their bankers and existing VC backers) attempting IPOs are ones that have viable businesses of meaningful scale.  Investment banks of varying size and prestige might say slightly different things, but typically it means over $50M in trailing sales and a run rate near or above $100M.  For SaaS or other recurring revenue businesses these figures might be on a bookings basis rather than GAAP revenue, but conceptually they’re similar.  Also top line growth rates matter… a $50M business that’s still doubling every year is in a strong position, a $50M business growing 10-20% a year will struggle to get public.

Most companies in the IT sector are profitable at least on an operating or cashflow basis, though often not on a GAAP basis when non-cash expenses are taken into account.  It’s pretty rare to see smaller scale businesses or wildly unprofitable ones in the IPO pipeline, which is again good for the overall normalization of the market.  And finally margins matter… a $50-100M software company can go public given it’s 80-90% gross margins, an e-commerce company with 20-30% gross margins and high customer acquisition costs needs to be much bigger (probably 5-10x at least).

3) Public Markets Distinguish Strong From Weak – It takes 6-12 months for public market investors to get “comfortable” with a newly public company, and also for idiosyncratic factors like small float, insider lockups, etc to work themselves out.  We can have a healthy debate about what the multiples of rapidly growing software & internet companies should be in absolute terms, but the public markets are very clearly distinguishing between the stronger and weaker businesses based on profit margins, growth, competitive advantages, etc.

Bill Gurley’s post last year does a great job analyzing why some businesses are valued at 10x+ revenue and most aren’t.  If you look at newly public companies in the software & internet sector you see a wide spread.  As of this week, here’s a sample of multiples:

  • LinkedIn – 16x+ trailing revenue
  • Zynga – 8x+ trailing revenue
  • Carbonite – 3.4x trailing revenue
  • Active Network – 2.4x trailing revenue

My point isn’t that Active “should” be valued at 2.4x or Zynga “should” be over 8x or any other specific company is appropriately valued.  Some tech IPOs have performed very strongly in the secondary market, others have struggled.  But importantly,  public market investors are clearly distinguishing between companies based on a variety of intrinsic and sector-specific factors and valuing recent IPOs pretty differently.  This is a good thing for the overall health and sustainability of capital markets… it’s bad for the ecosystem if all recently public companies go straight up or straight down.

4) Post IPO Consistency is as Important as Ever – If your company’s revenue and profitability are still quite unpredictable, you’re probably better off staying private for now.  Recently public companies that surprise to the downside are brutally punished.  Hardly the only one but Pandora was the latest to experience it this week with their earnings announcement for Q4 2011, the stock price dropping about 25% and well below the original IPO price of $16.

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So now what?  Well for entrepreneurs running late stage companies prepping for IPO in the next 12 months, it’s an excellent time.  If we experience additional macro disruptions (Euro zone, etc) it might constrain your ability to IPO for a brief period, but as of now the normalization of the IPO market appears healthy and sustainable.

For startups many years from IPO, it’s harder to predict what things will be like 2-5 years from now but I’m more hopeful the last 10-12 years were an aberration.  I’m not predicting a return to the unsustainable late 90s but rather a long-term normalization, where strong and rapidly growing tech companies have a decent shot at IPO’ing.  And even if your startup is unlikely to IPO someday, an aggregate increase in the number of public tech companies (coupled with large cash piles for big established ones) should make the M&A climate more favorable in coming years.

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