How Companies Approach Going Public in Today’s Market
Not until Y 2009 did the market see a pre-IPO company reached a $1-B valuation. The majority of today’s Unicorn companies reached that valuation level in just the past 18 months.
They move in a few distinct herds, as follows:
- About 35% of them are in the San Francisco Bay area
- 20% are in China
- 15% are on the US East Coast
- 30% elsewhere
Notable shifts in funding and valuations have accompanied the rising number of these companies.
The number of rounds of pre-IPO funding has increased, and the average size of venture investments more than doubled between Y’s 2013 and 2015, which saw both the highest average deal size and highest number of deals ever recorded.
Increases in valuation between rounds of funding have also been dramatic, and it is not unusual to see funding rounds for Chinese companies involving valuation increases of up to 5X over a period of less than a year.
Whatever the quality of new business models emerging in the technology sector, it is unmistakable that the venture-capital industry has built up an unprecedented supply of cash.
The amount of un-invested but committed funds in the industry globally rose from just over $100-B in Y 2012 to nearly $150-B in Y 2015, the highest amount of VC money ever. And where buyout, real-estate, and special-situations funds all have the luxury of looking across a range of deal sizes, industries, or even asset classes, venture capitalists have less flexibility. Many venture funds “fish” in the same pool of potential deals, and some only within their geographic backyard.
The liquidity in the venture-capital industry has been augmented by the entry of a new set of investors, with limited partners in some funds looking for direct investment opportunities into venture-funded companies as they approach IPO.
This allows companies to do much larger pre-IPO funding rounds, marketed directly to institutional investors and HNWI’s (high-net-worth individuals). These investors dwarf the venture-capital industry in scale and can therefore extend the runway before IPO, though not indefinitely, their participation is contingent on the promise of an eventual exit via IPO or sale.
Thus, valuations of individual pre-IPO start-ups need to be viewed cautiously, as the actual returns their venture-capital investors earn flow as much from protections built into the deal terms as by the valuation number itself.
In a down round (when later-stage investors come in at a lower valuation than the previous round), these terms become critical in determining how the pie is “cut up” among the different investors.
Private-equity markets do not exist in isolation from public markets.
With few exceptions, the companies venture capitalists invest in must eventually list on public exchanges, or be sold to a listed company. The current disconnect between valuations in these 2 markets will somehow be resolved, either gradually, through a long series of lower-priced IPOs, or suddenly, in a massive slump in pre-IPO valuations.
Several factors incline toward the former.
Some late-stage investors, such as Fidelity and T. Rowe Price, have already marked down their investments in multiple Unicorns, and it’s increasingly common for start-up IPOs to raise less capital than their pre-IPO valuations. Given the still-lofty valuations, this no longer attracts the extreme stigma that it did in Y 2000. Regardless of how the profits divide up, the company is still independent and now listed.
Tech companies also are staying private for, on average, three times longer.
A much greater share of companies wait until they are making accounting profits before coming to market. From Y 2001 to Y 2008, fewer than 10% of tech IPOs were launched after the company had reached profitability.
And since Y 2010, almost 50% had reached at least the break-even point.
The number of companies coming to market has remained relatively flat since the 1990’s technology bubble. But the average capitalization at IPO time has more than 2X’d in the past 5 years, reflecting the fact that the companies making public offerings are larger and more mature.
What happens post-IPO?
Over the past 3 years, 61 tech companies have gone public with a market cap of more than $1-B. The median company in this group is now trading just 3% above its listing price. The valuations of a number of former Unicorns are lower still, including well-known companies like Twitter (NYSE:TETR) in the United States and Alibaba (NYSE:BABA) in China.
History paints a challenging picture for many of these recently listed companies.
Between Y’s 1997 and 2000, there were 898 IPOs of technology companies in the United States, valued collectively at around $171-B. The attrition among this group was brutal.
By Y 2005, only 303 of them remained public. By Y 2010, that number had declined to 128. From Y’s 2000 to 2010, the survivors among these millennials had an average share-price return of –3.7% a year. In the subsequent 5 years, they returned only –0.8% per annum, despite soaring equity markets.
The current crop of pre-IPO companies is far more diverse than in Y 2000.
It will be particularly interesting to see which of the 2 largest geographic groups, the US and the Chinese Unicorns, weathers the shakeout best.
Consider just Internet companies.
The total market value of listed Internet companies today is around $1.5-T. Of this, US companies represent about 63%, and Chinese companies, mostly listed in the United States, almost all of the remainder. The rest of the world put together amounts to less than 5%.
The differences between the Unicorns in these regions are revealing.
Of the more than 100 Unicorns operating in the United States and China, only 14 have overlapping investors, and just 2, the electronics company Xiaomi and the transportation-network company Didi Chuxing (formerly Didi Kuaidi)—account for 67% of the combined valuation of all of them. And 75%of the Chinese Unicorns are primarily in the online space, compared with less than 50% of the US Unicorns, and these serve separate user bases as a result of regulatory separation of the 2 countries’ Internet markets.
It is not obvious which group holds the advantage.
The local market to which Chinese Internet companies have access is substantial, with well over 2X as many users as in the United States; the e-Commerce market is significantly larger and growing almost 3X as fast. Moreover, the 3 Chinese Internet giants, Baidu, Alibaba, and Tencent, have invested in many of the Chinese Unicorns, giving them easier access to a platform of hundreds of millions of users on which to operate.
The Chinese Unicorns also have a much higher proportion of “intermediary” companies (start-ups that act primarily as channels or resellers of other companies’ services and take a cut of earnings.
Around 33% of the Chinese Unicorns have business models of this kind, compared with only 12% of their US counterparts.
Finally, the US start-ups tend to adapt faster to a global audience. Although there are several established Chinese technology companies that have successfully made the leap to the global stage, such as Huawei, Lenovo, and ZTE, very few of the companies founded in the past 5 years have reached that point.
To the extent that valuations are excessive, the private market would appear to be more vulnerable.
For all the differences between the tech start-up markets of today and those of Y 2000, both frames are marked by excitement at the potential for new technologies and businesses to stimulate meaningful economic change.
The market capitalization of the US and Chinese equity markets declined by $2.5-T in January 2016 alone. Any correction to the roughly half a trillion dollars in combined value of all the Unicorns as of their last funding round is likely to seem milder than the correction of the last technology bubble.
By David Cogman and Alan Lau
Mr. Cogman is a Principal in McKinsey’s Hong Kong office, and Alan Lau is a Director there.
Paul Ebeling, Editor