This past year has been a turbulent period for the IPO market. With investors facing compounding disappointment from the lacklustre market performances of unicorn companies, and with the jarring flop of the WeWork IPO, general IPO stock performance is worse than it has been since at least 1995.
Raising a $1 billion valuation is no small feat. On the contrary, it’s such a remarkable accomplishment that the venture capital (VC) industry has reserved a special name for startups that cross the ten figure threshold. These select ventures that join the rarefied ranks of truly disruptive behemoths are called “unicorns.” Six years ago, Ailen Lee – an accomplished American investor and founder of Cowboy Ventures – coined the term “unicorn” and estimated that only 0.07% of venture backed startups achieve the coveted status. At the time, only 39 companies had been identified as members of the club. Today, that roster has grown to include a whopping total of more than 452 companies.
As the number of unicorns grows rapidly and as private venture valuations become increasingly loftier, the pressure for companies to scale at an accelerated rate is immense. Attempts to respond to these pressures manifest themselves in a number of ways. For example, some companies set out to acquire others, some opt to drive aggressive market expansion at the expense of their long-term sustainability and others supercharge their funding with an Initial Public Offering (IPO). Across the board, responses to growth pressures, namely the pursuit of large IPOs, have yielded mixed results. On one hand, there are a number of success stories – like that of Tradeweb, a trading platform that raised $1.2 billion at its IPO and has since yielded returns in the neighbourhood of 42%. But on the other hand, there are grim tales about some serious burnouts – like that of WeWork, a commercial real estate company whose IPO failure was attributed to outstanding governance challenges, serious business model issues and a lack of profitability.
The uptick in unprofitable startups seeking IPOs is an interesting product of growth pressures and a trend worth keeping an eye on. In recent months, analysts covering the IPO market have noted that the last time unprofitable companies raised such prodigious amounts of cash was during the dot-com era, and its subsequent bubble. In some ways, times haven’t really changed much. Investors continue to speculate on the ability for unprofitable companies to turn a profit, and startups continue to ask buyers to take a leap of faith on unproven technologies and revenue models. The major difference this time is market sentiment: Investors are weary to bet on the projected growth and expected development of startups. This was demonstrated by the underwhelming IPOs of Uber, Lyft, Snap, Fiverr, and Peleton – to name a few. And the takeaway is that even though today’s ventures are raising sizable amounts of capital, because the cash is being raised by a larger number of non-performing ventures, this year’s IPO class is said to be the least profitable since the tech bubble burst in 2001.
Looking back at the past ten months, it is evident that at some point investors had been interested in onboarding shares of unicorn companies. For starters, Pinterest and Zoom kicked off the year with strong IPOs. Then, over the course of the year, 158 companies collectively raised $5.31 billion on US exchanges. And even after Uber, Lyft, and Slack stumbled coming out of the gates, market demand had remained relatively strong. But now, with nearly half of all companies to go public this year currently trading below their offer prices, investors are keeping a distance from Silicon Valley stocks. If things had started on such good footing, what happened?
Overall, the lackluster performance of unicorns on the public market can be attributed to a confluence of factors, with two being especially relevant. First, inflated IPO expectations ballooned valuations. The combination of heavy bankrolling from massive venture funds and low interest rates created a capital saturated environment that was conducive to the neglect of business fundamentals. As ventures headed into their IPOs, the excessive hype from their private valuations informed their IPO projections and they were soon blindsided by the public market’s displeasure with untested revenue models and weak corporate structures. And second, the macro uncertainties caused by trade tensions, recession fears and the slow growth of emerging economies diminished investors’ appetite for risk. As IPO disappointments compounded, public investors were dissuaded from increasing their positions by the fear that they would be worsening their financial exposure.
Ultimately, the inability for unicorns to perform on the public market has been indicative of overly optimistic private valuation frameworks and a misalignment between startups the market’s investment appetite. Moreover, it truly begs the question whether all ventures are best served by venture capital and its growth intensive model. Take for instance the cases of Uber and WeWork. Both were financed by SoftBank and both their IPOs were negatively impacted by the pressures to provide investors a quick exit and by the expectation to propagate upside overoptimism. Did they need to pursue such aggressive VC funding heading into their IPO? I’m not sure. At the end of the day, the silver lining is that the challenges of the past year reinforce the efficacy and good health of our capital markets. More specifically, because market interactions are redirecting investments from value-destroying businesses, we can trust that decisions made in capital markets reflect a good proportion of the data available and the system is working at an optimal level.
In the coming months, unicorns like Airbnb will hit the exchanges and be taken public. While we don’t know what those IPOs will look like, we can certainly expect to see some private market corrections and more realistic private valuations. Furthermore, we can also expect for investors to continue being relatively risk-averse. Regardless of what happens, it will certainly be interesting to see how the next year unfolds because as Mike Wilson, Morgan Stanley’s Chief US Equity Strategist, said, “[The] days of generous capital for unprofitable businesses is over.”
Ben Winck, “The IPO market is rebelling,” Market Insider, October 2, 2019.