Nizar Tarhuni February 11, 2016
We all know what the recent environment has been like in the Silicon Valley muddy fish bowl. LPs and non-traditional investors have funneled tons of money into the venture capital asset class and valuations have subsequently moved to record levels. Today, we’re at a crossroad. Many companies are staying private at a point in their lifecycle where traditionally we'd expect to start seeing them move to the public side, yet the sense is that the current environment isn't conducive to that.
There’s been a notion that tech stocks in particular are getting hammered recently, but that might be a bit overblown. If you look at the broad market, you’ll notice the entire thing has tended to get washed together. That said, what we saw following the earnings releases of both LinkedIn (NYSE: LNKD) and Tableau (NYSE: DATA) last week has brought heightened concern to a wary market, and has led many to start questioning the incentive for private companies to go public.
Let’s take a look at three of the biggest concerns for today’s skeptical public investor.
Top-line and bottom-line performance
We’ve seen consecutive quarters of declining organic earnings growth. With that, strategics have looked to M&A to bolster bottom lines. Strategics are able to overpay as they look to validate those inflated price tags in the future via both cost-savings and enhanced productivity that can translate to the top and bottom lines. This plays into the VC space in a couple ways. On the tech side, many of these companies don't have the revenue and earnings growth needed to induce someone to participate in an IPO in an uncertain environment. In this scenario, when investors look for liquidity, it can typically be a much easier process to move to a strategic, similar to what we’ve seen on the PE side. You might solidify a quicker close on that front, at a higher (and arguably undeserved) price, saving you the time and effort of floating on a public exchange. There’s a well-founded argument about the collateral damage this behavior may have on the economy, but at the end of the day, executives have a fiduciary obligation to their respective shareholders and the higher price tag will likely come from a strategic at this point in time, not the public markets.
g (growth rate)
What we saw with LinkedIn and Tableau recently sheds light on investor sentiment in a handful of ways. While both beat analyst expectations, they missed on guidance and revised lower. Simply put, most know the value of a stock is equal to the present value of its future cash flows, and if you're guiding lower, well, your present value is lower. The notion of paying an inflated price for a “growth” stock only really works when things are good. When markets get shaky, investors look to shed their most expensive holdings to raise cash and we see this across the board. We even saw Facebook and Google give up their post-earnings release gains, and they reported great results.
Moving back to the private side, we don’t know what the financials look like, but if you're best-in-class, we think the market might actually help you out if you look to go public. Take a look at Atlassian (NASDAQ: TEAM)—while it has recently gotten hammered along with other stocks, it had a fairly impressive listing a couple months ago, able to not only increase the amount of shares it was issuing, but also to raise its expected price range and ultimately price at the high end of that range. On the flip side, if you’re continuing to burn cash and fostering a massive plow back ratio to continue growing, you probably won’t get much love in the public markets right now.
One last thing to consider is the type of market saturation your business is facing and whether or not you can adequately mitigate that. Take a look at GoPro. You cannot continue incrementally improving older versions of your product and expect units to keep making their way out the door. For single/couple-product, venture-backed companies, this will be a big challenge to overcome. In addition to a broader product mix, if you are looking for tech valuation multiples, you need a set of recurring revenues that can ultimately drive the lifetime value of your customer. For GoPro maybe that comes through a content service, but regardless, it needs to provide the cohesiveness and connection to its core products that can help continue penetration. To further amplify this example, think of Under Armour (NYSE: UA)—it's been active in the wearable space, acquiring a handful of companies, yet the end goal is to use that vertical as a medium to ultimately drive consumers to its apparel, not to pivot into the tech business.
Tableau faced issues with sustaining the growth rates in its license revenues. It added new customers but faced challenges growing licenses across its existing customer base, causing some second thinking about its LTV growth potential. With the multiples on these types of stocks trading at astronomical levels, any hiccups force massive sell-offs in this environment, and if you’re a private company potentially facing similar issues, you’re looking at that sell-off and cringing.
What we’re getting at is that while many might still call for these private companies to go public, clearly the incentive isn’t there. Mark-to-market accounting rules certainly move these private company valuations lower as their public comps get hit, but their ability to maneuver, invest and shape their businesses is still much easier in the private realm. If you’re facing some of the issues described above, an IPO isn’t best for you, yet if you’ve continued to address some of those issues, you might fend better than you think going to market.