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Tech Stocks

To IPO, or Not to IPO?

By Jason R. Koepke, on Apr. 28, 2016

Some analysts argue that 2016 will be a blowout year for initial public offerings (IPO) in the tech sector, in part because activity languished in 2015. According to their logic, this lack of deal flow must have created a backlog of companies that are primed to go public.

At the same time, growing economic uncertainty and our outlook for a bear-market correction this year suggest that the bumper crop of tech IPOs could be deferred. Against this backdrop, analyzing the IPO environment may strike you as a waste of time; however, the evolving role of private capital in the tech space has important implications for the timing and characteristics of future public offerings.

A Step Back

Despite analyzing the same data sets, analysts have reached vastly different conclusions about whether 2016 will be a busy year for tech IPOs or a bust.

The number of tech IPOs announced last year (35) declined by about a third relative to activity in 2014 (53). Either a backlog of companies is chomping at the bit to go public this year, or economic uncertainty will translate into another fallow year for IPOs.

Among the 10 sectors, only last year’s crop of financial IPOs delivered a superior average return to the class of 2014’s performance. IPOs in the tech sector posted the second-highest initial return (17 percent), but many of these debutants evidently crashed to earth; on average, these stocks gave up 2 percent of their value on the year.

Last year’s subpar equity returns may give some tech companies second thoughts about going public, potentially winnowing the field for 2016.

And the public exchanges also compete with opportunities in the private market. Several institutions own equity interests in prominent tech start-ups that have yet to go public; valuations of these holdings appear in various publicly available filings.

For example, Fidelity Investments reported the following markdowns in December 2015:

  • Dropbox: Haircut depends on fundraising round;
  • Snapchat: About 15 percent below the asset manager’s entry price; and
  • Zenefits: A 44 percent decline in estimated value relative to the initial purchase price.

How you interpret these write-downs is a matter of perspective. Some view these refreshed valuations as a sign that Silicon Valley isn’t ready to hit Wall Street; others assert that the private market’s declining confidence in these investments could force a slew of companies to seek financing on the public market.

What about the population of so-called unicorns, or private start-ups that have reached valuations of more than $1 billion? More than 20 companies reached unicorn status in the second quarter of 2015 and the third quarter of 2015, while only 12 outfits joined this elite group in the fourth quarter.

Does this trend suggest that late-stage companies are failing to achieve sufficient exit velocity? Or have investors focused on preparing the next stage for existing unicorns instead of nurturing new ones?

More Context

Although the number of tech IPOs declined by about a third last year, the overall IPO count fell 43 percent from 2014. In fact, the percentage of tech IPOs increased to 30 percent of total transactions from 26 percent.

However, when you view the annual number of IPOs over a longer time frame, 2014 stands out as an exceptional year for deal flow; however, 2015 appears to align with recent norms.

(Click graph to enlarge.)Annual IPOs

The fourth-quarter slowdown in the number of new companies achieving unicorn status also appears to be a reversion to the mean after a strong first three quarters of the year.

(Click graph to enlarge.)Unicorn Graduation party

What’s the Meaning of All This?

Although 2014 marked a solid year for late-stage private companies and IPOs, last year’s shortfall remained within the longer-term trend.

Some of this slide also reflects the increased capacity for private markets to handle a late-stage start-up’s financing needs, implying that mature companies have more funding options and don’t need to tap the public equity markets as soon.

With less of an imperative for private companies to go public, expect the annual number of tech IPOs to remain volatile and reflect near-term financing conditions in the private market. The median age of tech companies going public has also remained remarkably consistent since the Great Recession ended.

(Click graph to enlarge.)Tech IPO Age

However, data points also indicate that the private markets have ample capacity to provide financing to later-stage start-ups. According to KPMG, the number of late-stage financing rounds has increased significantly, while overall deal values have grown to the point that the quarterly median routinely exceeds $30 million.

And in 2015, several financing rounds raised more than US$400 million in proceeds:

  • China Internet Plus Holdings, which specializes in online retail and classified ads, netted $2.8 billion;
  • Palantir Technologies, a software and data analysis company, raked in $1.3 billion;
  • me, an online ordering and food-delivery service in China, raised $1.25 billion; and
  • O3B Networks, which focuses on network communication services, gathered $460 million in private capital.

Research conducted by famed venture capital firm Andreessen Horowitz likewise suggests that the trend toward increased funding capacity and participation of private markets has been underway for a while.

The expansion of the private market’s appetite and ability to fund promising start-ups reflects a willingness to invest at various points throughout the company’s life span in an effort to deliver market-beating returns.

Institutions have also sought to pass on investment opportunities to their customers, with Morgan Stanley (NYSE: MS) and Bank of America Corp (NYSE: BAC) offering their private-wealth clients opportunities to invest in Uber and other start-ups. An increasing number of mutual funds have also started to take stakes in promising tech companies that haven’t gone public.

What does this mean? Late-stage fundraising rounds have supplanted the IPO as a source of funding, and mutual funds and other institutional investors have become increasingly active in the private market.

Investments of this nature involve significantly more risk because of the relative lack of transparency, disclosure and liquidity. Shareholders’ position in the company’s capital structure can also change dramatically with each funding round.

All of these drawbacks explain why we focus on the public markets and the tried and true methods that can help you to build wealth over the long haul. However, investors should keep the evolution of the private markets in mind when considering forthcoming tech IPOs.

Jason Koepke heads GNT®, a data-management and technology consulting firm that serves the public and private sectors. Before becoming a consultant, Jason was an editor for and contributor to Wall Street Winners and other investment newsletters, focusing on technology and health care.

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