Wall Street Isn’t As Excited As We Are Part 1: Down-Rounds and Contracting Valuations on the Horizon

Bullish Private Markets and an Unwelcoming Public Market

I apologize for the time lag between posts; I will be producing regularly this year. Similar to the last series of posts, this begins a new discussion on the outlook for valuations and IPOs in 2016. This first post discusses the disequilibrium between overinflated private market valuations unreciprocated by the public market. In the following post, I will discuss implications for valuations and fundraising in 2016.

In the past few years, we have noticed extreme growth in tech valuations within the private market. High valuations, often based on distant projections and unproven business models, indicate that private investors expect an equally enthused and responsive market, but this was not the case for 2015’s tech IPOs.

Sluggish 2015 IPO Performance

2015 had a respectable number of IPOs–169, tech and otherwise, in fact–but they only netted a low volume of capital: $30B in aggregate value on U.S. exchanges. This is in contrast with 2014 which produced the greatest number of IPOs (273) since 2000 (406 IPOs). 2015 produced the lowest number since 2009 following the Great Recession in 2008, according to Business Insider Australia (data from Renaissance Capital).

Here is BI’s graph demonstrating the disparity between the number of IPOs in 2015 and their volume/value in US billions:

image

Specifically within tech, the article articulates several of the “highest-profile initial public offerings have performed poorly–Box, Etsy, and Fitbit are all below their IPO prices, although there are standouts like GoDaddy.” Fitbit was considered an IPO winner, raising the largest VC-backed IPO of the year with a significant opening day price pop at $30.40. However, it hasn’t performed well in the long run and yesterday closed at $18.87, below its IPO price.

Here is a table of a few prominent 2015 tech IPOs with updated prices as of yesterday’s close (1/14/16). Etsy, Box, and Fitbit (slightly) are performing below their IPO price. Etsy’s price recently took a plunge, reaching its lowest price as its lockup period for 21.9 million shares ended on Monday the 11th.

Company IPO Price Opening Pop Close Price (1/14/16)
Fitbit (6/18/15) $20 $30.40 $18.87
Etsy (4/16/15) $16 $30.00 $7.07
Square (11/16/15) $9 $11.20 $10.82
Box (1/5/15) $14 $23.23 $10.71

Underwriters valued Square at $9 per share upon IPO, corresponding to a market value of $2.95B, just less than half Square’s Series E financing valuation of $6.03B. As of Tuesday, January 2016’s close, Square had a market cap of $3.99B, up from IPO, but still below the Series E valuation (Source: PitchBook Data). While Square is young–thus, volatile–could this “down-round” be a harbinger of a continued trend in 2016?

Your answer will depend on where you are in the investment chain. Bullish investors could view IPO “down-rounds” as discount opportunities (to new investors) that will grow in the long-run similar to Facebook. It’s true most companies offering IPO are still in the revenue-growth stage. For example, bullish investors argue that while Square faces growing competition from Paypal, Alphabet, and Apple, it has only reached a fraction of its addressable market. Bearish investors, however, might look at other companies such as Box that have been in the public market for longer. Box, which also faced an IPO down-round ($1.7B IPO to $2.4B Series F, Source: Pitchbook Data), is now trading well below its IPO price more than a year after its debut.

Maybe these examples are outliers. However, the companies above are only a snapshot of 2015s IPOs. Overall, the average IPO return has decreased dramatically over the past years, from 40% in 2013 to 21% return in 2014, to negative 5% return in 2015 (Source: Renaissance Capital). Renaissance Capital’s IPO ETF (IPO), a bundle of 60 of the most recent IPOs, fell 9% in 2015, below the S&P 500.  

Do public investors value our companies as highly as we do?

Is there disequilibrium between the public market and inflated private market valuations, as indicated by previous down-rounds and public market performance?

According to Bloomberg Business, the largest unicorn, Uber, is now valued higher than 80% of the companies in the S&P 500. Valued at $62.5B, Uber will have to IPO at a market cap of $86.25B, to match Facebook’s 1.38X multiple ($104.2B at IPO to $75B on its previous valuation). Facebook was the second largest IPO in history; the largest was Visa. Does the public market feel the same way as the private market in terms of this valuation? While it’s difficult to compare the companies precisely without Uber’s financials, a similar thought exercise could be applied to any of the unicorns, and the same question asked. Nevertheless, 2015’s lagging IPOs and mediocre company performances indicate, yes, there is a disequilibrium between the two markets.

What Caused This?

Opaque, Nonstandardized Private Metrics vs. Requisite, Transparent Public Metrics

So, if you’ve made it this far, you’re probably wondering, if there is in fact a disequilibrium, what’s the cause? The root of the cause is an incongruity between private market valuations and public market valuations. This is an intrinsic result–and accepted risk by venture investors–of lacking standardization, regulation, and quantification of private companies financial and growth metrics compared to their public market counterparts. It’s not entirely the fault of venture investors, but the nature of the venture game. How can you accurately value a company that has yet to produce revenue or determine its business model? For example, large components of Snapchat’s valuation history are illiquid indicators such as user retention, engagement, and growth. Investors believe these will convert in the future to significant and reliable returns once Snapchat secures its business model. Only recently, with actual revenue numbers, can the investors more accurately assess their Snapchat.  

Even when there is revenue or net income for a private company, investors vary widely in determining which public market comparables or industry multiples to set these numbers against to determine a valuation. Investors in the same round can vary widely–sometimes by orders of magnitude–in these determinations. It is up to the lead investor to convince everyone else their valuation is justified.

Because of lacking standards, unreliable or nonexistent financials, and only general methodologies, the lead investor often gets the benefit of the doubt. Even when the lead investor of AirBnB, for example, provides a $24B valuation based not on 2015s EBITDA but an 8X multiple (8-9X are current M&A multiples) on AirBnB’s projected EBITDA in five years when it will equal the current EBITDA of the chosen market comparable, Priceline ($3B at the time of the article’s publication). In this particular example, it’s comforting to know the lead investor of AirBnB’s $1.58B Series E round is General Atlantic, an early stage investor in Priceline, so they may understand growth potential in travel startups better than other investors. A projection out five years might seem even more plausible when you consider AirBnB is growing 3X as fast as Priceline right now, or that it has overcome recent regulation concerns, or that it has enormous opportunities for expansion. But how do you translate these phantom variables into EBITDA, debt-equity, price-to-earnings, price-to-book, or any of the other tangible metrics used for valuation in the public market? Even if, as a potential private investor in AirBnB, you developed a new valuation, what would make it more plausible and accurate?

In addition to this root difference between the markets, the disequilibrium is becoming only more evident as tech companies continue to perform poorly in the public. Other factors include the intrinsic size disparity between markets, infectious high valuation fear, and public market corrections.

Concluding Thoughts:

So What Now? Down Rounds, Valuation Contraction and Searching for a Winner

It is a sensitive time for the private market with many companies waiting for another to take the first step into the unpredictable public arena. Meanwhile, private investors hold their breath and withhold their investment dollars, hoping for a winner. I think the IPO outlook for 2016 could tilt either way, depending on whether we see winners first out of the gate, or losers.

One thing is certain: we will see a number of IPOs this year, some of them unicorns. They will be pushed out by difficulty fundraising further at progressively greater valuations and investors seeking liquidity. Due to 2015s performance, it is likely we will see more down-round IPOs to incentivize buy-in from cautious public market investors. Down-rounds will not only affect IPOs, but the private market as well as valuations contract across the entire market. Today, unicorn-hopeful, Foursquare, announced a down-round in its latest-round of financing. They raised $45M in a new round at “roughly half of the approximately $650 million that it was valued at in its last round in 2013.” This is in addition to recent mark-downs of Snapchat and Dropbox. (Source: New York Times)

Update: Jawbone just raised a new round of $165M from Kuwait Investment Authority, dropping their valuation to $1.5B, half of its $3B valuation in 2014. The last time Jawbone was valued at $1.5B was in 2011.  (Source: re/code)

The metamorphosis of a company from an opaque, private entity into a transparent, publicly accountable organization is analogous to the high school valedictorian transitioning into a college (or perhaps, moving from college into the workforce). High school performance may indicate future success–along with a few standards such as the SAT–but previous success is only roughly correlated with future success when considering the vastly different environments, their standards, and the growing number of entities to whom the student is now accountable. There is similar incongruity between the private and public markets at this time, a result of the differences in complexity, transparency, and degrees of accountability standard for each market type.

The bubble isn’t going to collapse. I don’t believe there is even a “dot-com”-esque bubble susceptible for collapse. Bullish, risk-on investors will continue to contribute to inflated valuations while bearish, risk-off investors are going to begin asking harder questions regarding valuations and investor protections. But, expect the proportion between the two investors to shift as the private market corrects itself to bring its values in line with the public market. For tech this means a slow-down: valuations will contract as investors become more risk averse, seek liquidity, and have difficulty themselves in raising future funds. This could lead to a cascade of effects–which I will cover in my next post–on IPO outcomes, secondary market froth, public perception of tech companies, investor mentality, and startup fundraising.

 

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