What a Difference a Month Makes
The fading weeks of 2015 and the first weeks of 2016 were very difficult in tech. Markets sold off, down rounds, downgrades and share price sliders were the order of the days, weeks and months. It was down right down out there and private tech was not spared. We are outside the public markets and outside of the public market spotlight. However, IPO’s were put on ice, mutual fund downgrades caused some to panic. We stayed the course, of course. March was far kinder to risk, oil, tech and private shares as well. Now we have the twin opportunities to take stock and factor lessons going forward.
For many investors in private, pre-IPO technology the recent return of fear was overdue and taken in stride. However, the growth in late stage start-ups and the increase in late stage start up investing have changed the volatility and attitudes in the market. We saw large slides in the public company comparables that many use to judge the valuations of pre-IPO firms. These slides and a widespread sense of overdue draw down in valuations, combined with jitters driven by recently expanded ranks of private technology investors, created a partial swoon. This allows us a rare and valuable chance to look back and learn from a stress test.
Late stage private firms are more vulnerable to public market conditions than earlier stage firms. This arises because the comps from public companies weigh in valuation decisions and talk of IPO is always close. These firms are not hurt directly and there is no necessary, not even a likely, effect on their business or growth rates. All that changes is the multiples enjoyed by the public comps and the market’s sense of the size of the opening in the IPO window. Lately, that has been enough to create dislocation, correlation and concern.
We see the recently increased concern coming, ironically, from the growing size of late stage pre- IPO valuations and a change in the types of holders of shares. As more retail investors have entered the space, less specialized and experienced holders of shares have come to own more shares. Many have entered through investment vehicles and a growing number own exposure through mutual fund positions. These owners see private shares largely as one among many types of shares that they own. Thus, rising general fear and falling share prices raise the prospect of selling. The relatively more involved and expensive process of selling private shares creates anxious feeling and sometimes complaint. This rankles holders of shares and increases regulatory pressures to write down shares, further rattling nerves.
What have we started to learn? As private markets have grown and valuations increased, a broader and less specialized class of investors has entered the space. As the recent stellar run, over 6 years old, sails into rougher seas, we see that the growth in the space has changed the role of public markets. Newer owners of pre-IPO tech have proven more likely to assume correlation with public shares and to mark portfolios accordingly. As private shares continue to grow and emerge as an asset class, the correlations between public and private share price movements appears to be growing. In the short run that is encouraging. In the longer run, that is good to know.
Pre-IPO Returns Top Post-IPO Returns
Why are traditional mutual funds buying pre-IPO technology shares? Is pre-IPO investing prudent given the opaqueness and poor visibility into the viability of the start-up companies? Why rush into an investment, when you can wait for an IPO, have full access to all the financials and then make an informed decision? These are fundamental questions that most pre-IPO investors have, and they are all good questions in the face of ongoing reratings in the public and private markets. We decided to crunch a few numbers to find the answers to these questions.
We compiled the investment returns of 20 technology companies that had their IPO since 2011. The sample is random, unbiased and wide enough to be meaningful, in our opinion. This is important given the changing and sometimes challenging industry dynamics of the respective companies and doubts about the viability of their business models.
The following figure summarizes the results of our study. Please see Page 7 for a detail breakdown, by company.
The 20 companies in our sample include the following: Atlassian, Box, Etsy, Facebook, Fireeye, Fitbit, GoPro, HortonWorks, LinkedIn, PaloAlto Networks, Pandora, Pure Storage, ServiceNow, Shopify, Splunk, Square, Tableau, Twitter, Workday and Zynga.
We tracked the investment returns of the 20 companies in our sample universe from Series A all the way upto their IPO. Additionally, assuming most early stage investors are restricted from selling before the 6-month lock-up period after the IPO, we complied returns through the respective 6-month periods (the boxed line on the chart). We also added the 9-month and 12- month return post-IPO in case the investors did not sell immediately after the lock-up period. Finally, we looked at the return if an investor bought on the first day of IPO and held onto the investment for 6 months [lock-up period], 9 months, 12 months and is still holding the shares at the current price [last column in Figure 2 and the detail exhibit on page 7].
The return spread between pre-IPO investing and post-IPO investing is glaringly wide, in favour of pre-IPO investing. The Pre-IPO Returns Top Post-IPO Returns return, it turns out, far outweighs the risk.
In aggregate, the early investors earned triple-digit returns at the lock-up expiration (from 376% to 55,423% depending on funding round) versus a public market investor who purchased on the opening day at the offer price and held onto it for 6 months until the lock-up expiration (55% return). Similarly the returns at 9 months after IPO, 12 months after IPO, and life-to- date returns favour pre-IPO investments to buying at the open market – by a long shot;
Series A investors realized the highest returns, and Series F the least – for obvious reasons;
The best performing company for an investor who bought at Series A, B & C rounds and held the investment upto 6 months after the IPO was Facebook at 497,620%, 40,109% and 7,881%, respectively;
The best performing company for a Series D and E investor upto 6 months after IPO was FireEye at 17,131% and 4,841%, respectively;
The best performer for a Series F investor to 6 months after IPO was Pandora at 1,260%;
All but three private companies produced robust returns 6 months after their respective IPOs. The underperformers were Zynga, Box and Etsy. At the lock- up expiration Zynga’s Series B investors lost 14%, Series C investors lost 60% and Series F investors lost 58%. Similarly, Box’s Series E investors lost 8% at lock- up and Series F investors lost 17%. Etsy’s Series E investors lost 31% at lockup;
Most of the post-IPO returns underperformed the early stage investment returns. One exception was Box where Series E & F investors underperformed.
When it comes to investing in private companies, earlier the better. Investors who bought these 20 stocks ahead of their respective IPOs, barring a few exceptions, realized outsized returns compared to investors who waited until the IPO to buy the shares. The spread is wide and underscores the age-old fact of investing: more risk more reward.