The IPO Process – Reality check.

The companies are the problem, not the IPO process.

• The way to fix the IPO system is to stop bringing immature, overpriced and badly governed companies to the public market.
• In the wake of a series of very disappointing and high-profile IPO’s, the silicon valley financial community seems to have assumed that it is the IPO process that is the problem and is having a conference to discuss how it can be fixed (see here).
• As far as I can see there is no real problem with the IPO process other than it lies at the juncture when the valuation expectations of the private market are transferred to the public market.
• The private market is illiquid and does not represent an accurate market price because the headline valuation only changes when there is a transaction which is typically fundraising.
• In the public market, shares are changing hands all the time meaning that new information can be immediately represented in the share price.
• In the public market fundamentals like earnings, cash flow and profitability are the lynchpins of valuation which is why it is so important to bring more mature companies to market.
• In the private market, valuation lacks the rigour of the public market which allows dreams and blue sky to creep in.
• Furthermore, in the private market, the valuation is almost always set by those who are bullish on the company as it is they that put money in.
• The bears have little or no say in the valuation.
• However, In the public market, both the bears and the bulls have a full say in the valuation of the company creating a much more accurate representation of reality.
• In recent years, the supply of money to the private market has grown significantly and companies have been able to raise a lot more money from these sources before going public.
• The problem is that the private market has few, sometimes no way to properly ascertain the valuation of a company which often leads to a lot of blue-sky valuations.
• It is when this blue-sky valuation meets the harsh reality of the public market that problems occur, and this is the only reason why many of the high-profile IPOs have gone wrong in my opinion.
• Bringing the same companies to market via a direct listing will not improve the situation as it is the conversion to fundamental valuation drivers that are driving performance post-listing rather than the method that was used to bring the company public.
• Consequently, I think that the answer to the problem is not to tinker with the process of listing but to bring better governed more mature companies to market.
• In my opinion, a company coming for an IPO should have:
  • First, profits and cash flow: positive or have a clear and credible route to profitability within a fairly short time horizon.
  • This will allow the application of fundamentals to the valuation rather than just greed and fear.
  • Second, governance: I have long believed that large public companies should have the economic interest of the company and its control in direct alignment.
  • The problem is that companies like Google, Facebook, Baidu and Alibaba set a very bad example of acceptable governance in public companies which has allowed founders to hang onto control of their companies while owning a tiny fraction of the economic interest.
  • I deal with this issue by discounting the fair valuation of these companies by 10 % – 30% to compensate investors for the added risk they are taking in owning shares of companies where they have no say and can’t remove management.
  • Third, maturity: the company’s proposition and market position should be reasonably well established and not in a state of great change or flux.
  • This is why I think that Spotify should not have come to market as its destiny is to replace the labels and it is very early on that journey.
  • Uber and Lyft are two more who are fighting tooth and nail for market share which would be much better conducted away from the harsh glare of the public market.
• Companies with these characteristics have solid metrics by which they can be assessed meaning that expectations in the private and public markets can be more aligned.
• Better alignment would lead to better post IPO performance as there will not be a great discrepancy that needs to be resolved.
• Continuing to rely on blue-sky thinking for valuation will only result in more public market disasters, no matter what changes the silicon-valley financial community decides to make to the listing process.
• The IPO window is closing and I hope that when it re-opens, we will see a slate of properly run, more mature and well-governed companies coming to market.
• I think that failure to do this will result in another run of IPO disasters and a short window of opportunity.