Thinking IPO? Look Before You Leap

Startups are still more likely to get bought than go public, despite recent hype. But if the timing is right, an IPO can be just the ticket.

Looks like the IPO isn’t a dying art form after all. The market for initial public offerings of stock experienced a prolonged hangover after the late 1990s dot-com/telecoms binge. The roster of listed companies in the US has halved since then to about 3,500, and the pipeline of new issues dropped by two-thirds.

Yet an echo boom appears to be gathering force. IPOs raised $205 billion globally during 2018, twice the total from two years earlier, according to Ernst & Young. Deals were diversified geographically, with go-slow Europe only slightly lagging behind the go-go US. A few Old Economy stalwarts even sneaked in among the fast-moving herd of tech and health-care hopefuls. Example: German brakes maker Knorr-Bremse raised €3.9 billion ($4.4 billion) in October.

While blockbusters like Japan’s SoftBank ($23.5 billion) and US ride-share provider Lyft ($2.3 billion) grab the headlines, plenty of smaller players have tapped investors, too. Average IPO proceeds worldwide were $111 million last year, EY reports. “The IPO is back big time,” enthuses Barrett Daniels, US IPO Services leader at Deloitte. “The window is wide open for companies of all shapes and sizes.”

Whether your company is the right shape or size to go public is another matter, however. The current hot-ish IPO climate stems from a confluence of factors that might not last long. First is the stampeding herd of so-called unicorns—companies valued at more than $1 billion in private-funding rounds—which has burgeoned from just 39 when the phrase was first coined in 2013 to nearly 400 today. The bigger these beasts get, the narrower their options outside of going public. Many of the unicorns are approaching 10 years old, the limit for even patient private-equity investors to cash out, not to mention key employees waiting to get rich off their options. Lyft’s much-bigger rival Uber was launched in 2009, while next-wave social network Pinterest—which lately joined the IPO line—traces its beginnings to 2010.

Investors around the globe are in good humor, thanks to the roaring start to 2019. Yet a 10-year bull market has made big kills scarce, increasing the incentive to gamble on IPOs. Chinese startups are finally reaching their stride and hungry for capital as non-market financing tightens up. China is the world unicorn champion, with 149, followed closely by the US at 146, according to TechCrunch. The rest of the world has produced just 64 billion-dollar startups.

Except for the Chinese flowering, all these elements look cyclical, says Jay Ritter, a University of Florida professor who studies IPOs. Investor enthusiasm might not survive a few more disappointments like Lyft or Xiaomi, the phone maker that was China’s biggest offering of 2018. Both were trading well below their listing price at press time. Ritter predicts markets will revert to the new normal, which is cash-spewing incumbents acquiring promising startups well before they reach IPO strength. “What we’re seeing is a blip,” he says. “Organic growth takes too long, while Oracle, Microsoft or [Google parent] Alphabet make dozens of acquisitions a year.”

Investor appetite may be broad, but it isn’t indiscriminate. The Lyft and pending Uber IPOs address the question of whether markets will still buy companies that are “pre-profit,” as bankers like to say. They will: Uber lost $1.8 billion in 2018. But that doesn’t mean a return to the days when any catchy idea and photogenic management team are enough to cash in, says Jackie Kelley, EY’s IPO Markets leader for the Americas. The golden ticket these days is a platform that can be leveraged across multiple industries. The paradigm is Amazon, which expanded from selling books to selling everything to also managing a big hunk of the world’s data. “The ’90s IPOs were backed by particular products,” Kelley says. “Now investors want to see where the next revenue stream could come from.”

In the age of the platform, mundane businesses—say, cab services—can become thrilling. That fosters an illusion of IPO magic dust being accessible to all. But companies must offer “tech disruption in the mix,” Kelley says, while looking post-disruption and “running a predictable business” themselves.

The big exception to these rules are biotech startups, which investors seem willing to snap up based on one promising drug-to-be at test-tube stage, but which also seek much smaller sums than the tech unicorns and “decacorns” (tens of billions in private valuation). “With internet companies, investors expect profits between a few quarters and a few years from the issue,” says Jason Draho, head of asset allocation in the Americas for UBS Global Wealth Management. “With biotech companies, it’s a lottery that pays off or it doesn’t.”

Tempted to rush to catch the IPO wave? Kelley has one word of advice: Don’t. “We encourage clients to go when they’re ready, not when the market is ready,” she says. Getting ready is an 18- to 24-month process that involves bookkeeping headaches, rethinking strategic priorities and, not infrequently, personal trauma. The latter can arise, for instance, when a board needs to be “right-sized.”

Some would-be public companies may have past acquisitions that have never been consolidated, Kelley continues. Most have likely been investing for growth and market share, leaving their back-office control functions stunted. But the heaviest burden stems from adapting to legal compliance and a rigorous schedule of financial disclosure. “Everything changes when you become a public company, and it involves a lot of pain,” Deloitte’s Daniels says. Kelley recommends preparing financial statements and guidance for two quarters in dress-rehearsal mode.

That’s the consultants’ wisdom for US and European companies, anyway. China’s hundreds of IPO aspirants face a different calculus, says Drew Bernstein, an auditor focused on China for the New York accounting firm Marcum Bernstein & Pinchuk. The pool of private capital at their disposal is more limited, and authorities have been reining in the so-called shadow banking system that financed much of the startup world. That makes going public a more urgent matter.

In China, options are widening. The Hong Kong stock exchange altered its rules to allow dual-class share listings (which let tech entrepreneurs maintain voting control while raising oodles of cash) and money-losing companies. The Shanghai Stock Exchange promises to launch a Technology & Innovation Board later this year, opening access for smaller companies to risk-tolerant domestic investors. “A lot of Chinese stocks haven’t lived up to expectations so far, but 150 unicorns is still exciting,” Bernstein says.

Chinese firms may have a steeper hill to climb toward international compliance standards, he says. Boards that push back on CEOs remain a rarity, while self-dealing with suppliers or customers linked by common owners is not. But the benefits of cleaning up their act can be substantial. “We believe a lot of Chinese stocks are discounted by up to 70% because investors don’t trust the numbers,” Bernstein says. “That’s an opportunity for the company to discover free money.”

Like most decisions in life, choosing to do an IPO has a big emotional component that defies the accompanying blizzard of financial analysis. Founders and managers get to see the corporate entity they labored to create live on, and likely gobble others, with its now-liquid shares as a so-called acquisitions currency. “It’s rare to see a superstar company that wants to be acquired,” Barrett Daniels says. But stardom comes with a price.