Market backdrop

Increasingly selective IPO market over the last 2 years: Since 2001 (exclusive of crisis years in 2002, 2003, 2008, and 2009), we have averaged around 40 tech IPOs amounting to $8 billion in issuance annually. The tepid tech IPO activity over the last two years meant that there were only 23 and 16 IPOs in 2015 and 2016, respectively. Companies are now staying private for longer as they focus on scaling their business towards a critical mass and closer to profitability. Notwithstanding the vibrant private financing market that has been useful in funding long-term growth aspirations, investors are also exercising more restraint, preferring companies with seasoned management teams that operate under a more stable competitive landscape.

Multiyear expansion of M&A activity continues to exacerbate scarcity in investment opportunity: Since 2015, the technology sector in the United States has lost a net of more than $200 billion of publicly traded free float. This number is a net number that takes into account only cash, mergers and acquisitions (M&A) transactions, and all  IPOs and follow-on transactions completed. The confluence of the increase in pace, volume, and size of M&A transactions, and the abysmally low new issuance volumes have dramatically reduced the investable  universe  of  tech  companies  (especially those with growth) in the sweet spot of $1 billion to $10 billion in equity value. The   lack of investing choices is particularly acute across  the  software  and  Internet sectors. These will lead to favorable demand dynamics for the tech IPO market over the next two years, as the current class of tech unicorns matures into companies with growth, profitability, and scale.

IPO success factors for prospective public companies

“History does not repeat itself, but it does rhyme.”  – Mark Twain/Joseph Anthony Wittreich

We applied our magnifying glass to analyze more than 250 tech companies that have gone public since 2010. There were a number of key takeaways from the subsequent pattern recognition for successful public companies.

Growth rate trends (primarily revenue before other measures of profitability): It was not too long ago that the “growth at all cost” mentality was in vogue. Investors now adopt a more holistic approach in sizing companies, often scrutinizing the quarter-on-quarter (QoQ) and year-on-year (YoY) pace of growth (deceleration). Once bitten, twice shy. They now demand the pain associated with revenue decelerations to be offset by accelerations in free cash flow and/or profitability.

Having said that, our sample analysis still suggests a minimum threshold of 40 percent YoY growth in quarterly revenue in order to stand out from the madding crowd. This is imperative, given the global scarcity of high-growth stocks with decent scale (market cap between $1 billion and $10 billion) in the tech sector (mostly Internet and software). For instance, of the 160+ Internet companies with market cap between $1 billion and $10 billion globally, there are only 9 companies that are expected to grow their respective revenues above 30 percent YoY. In the equivalent software universe, there are only 8 out of 195 companies.

Revenue scale: Revenue scale is indicative of a company’s ability to capture its addressable markets (serviceable and total) and its competitive edge vis-à-vis peers. Gems are often uncovered for companies with trailing 12-month revenues that are greater than $150 million because they usually are able to generate enough top line and become operationally feasible (breakeven) from the subsequent operating leverage. This threshold has been raised recently, driven as the quest for faster growth.

For instance, the older class of IPOs used to break even at about $200 million to $250 million in revenue. Now we are seeing some companies break even at $400 million to $500 million in revenue. This is also attributable to the increasingly intense competitive landscape, especially in verticals that have large total available markets (TAMs) but niche serviceable available markets (SAMs), which all create execution issues in allowing companies to punch through to $200 million to $250 million, let alone $400 million to $500 million, at a sustainable revenue growth rate of 30 percent.

Profitability: The perennial question for both investors and companies in regards to which lens to view the world is, profitability versus growth. Does it have to be one or the other, or is there a way to balance the two? As the paradigm shifts from the “grow, expand” mentality, as it has been doing over the last few years, we have seen broad-based multiple compression, especially for companies which do not have GAAP (generally accepted accounting principles) earnings. In that regard, investors have flocked towards perceived safe havens in the form of larger $100 billion or more market cap companies that continue to accrue a disproportionate amount of value in the public markets via consistent outperformance in delivering both top and bottom lines.

Beyond longer term considerations around the ability of nascent public companies to augment their profitability profiles, we have found that prospective public companies with better  than 20 percent operating margin at time of listing often have a better chance of success, in terms of longer-term value creation for shareholders.

Business model: Growth rates, revenue scale, profitability—in our view, all these ultimately collapse into a point of singularity in the form of your business model. How do you expect to make money? What are your unit economics? Why are you special? Impressive growth rates and revenue scale may arouse investor interest, but a clear articulation of your business model will ultimately command buy-side interest. Technology may change with time, but investors have always preferred predictability, visibility, and maturity of the business model. These translate into convincing investors that their risk is low through consistent execution, a sticky user base through cohort behavior over time, attractive lifetime value to customer acquisition cost, efficient marketing spend, low user churn, and an upside that can be achieved with low friction.

Understanding the buy-side psyche: "risk vs. reward"

In recent years, the tech IPO market has been dominated by software and Internet, 89 percent of the issuance in 2014 to 2016, compared to a decade ago when it was 44 percent. The IPO market is likely to have a similar composition in the near future, especially looking at which companies have been funded over the past few years. We examined the dataset of software and Internet IPOs since 2004. The playing field has been pretty even, with 121 Internet IPOs versus 116 software IPOs.

An investor who invested in the entire basket of 237 Internet and software IPOs would have more than doubled the S&P’s performance since 2014 (up 194 percent for software/Internet IPOs vs. 85 percent for the S&P). While that is a lot of alpha or outperformance over a couple of market and economic cycles relative to existing public companies, not all Internet and software companies are created equal in regards to public market returns and risk profiles.

Internet investing: Internet investing is best characterized by a paraphrased quote from William Faulkner: “You cannot swim for new horizons (returns) until you have courage to lose sight of the shore (value).” Internet investing is not for the faint-hearted, with the return profiles barbelled towards massive value creation for a few companies but value destruction for many.

Having the attention of billions of users while continuing to innovate to maintain engagement (video, virtual reality, messaging, health, e-commerce, autonomous driving) and at the same time delivering massive cash flow, GAAP earnings to acquire key technologies or companies (YouTube, Android, Whatsapp, Instagram, Qunar, etc.), and hire top talent is akin to tackling the impossible trinity—the ultimate juggling act that ultimately will yield very few winners.

Despite $900 billion of value  being  created by 121 Internet companies, the concentration of performance has been from a very small number of IPOs, with 74 percent of the value being created by Google (Alphabet), Facebook, and Baidu. Excluding these  three  companies, we saw only $69 billion of net value creation by 118 Internet companies. Meanwhile, 64 Internet companies (54 percent) lost $54 billion in shareholder value.

Software investing: Software investing magnifies the virtues of compounding in the form of lower returns but has lower beta and lower risk. Compared to Internet companies, the switching cost for software is higher (harder to rip out) and relationships are typically contracted over  a period of years, providing a stable and visible base to anchor revenue growth. Add that to the “land and expand” component of successful software companies, and we would have a set of companies that are able to consistently compound growth on a yearly basis. The next generation of software companies are also valuable in an M&A context to legacy software companies because they provide them with much needed growth and access to new technologies/ business models, thereby introducing a valuation floor for newly public software companies.

Of the 116 software IPOs that we have seen  since 2004, there has been $174 billion of value creation, with Salesforce being the largest value creator at $51 billion (29 percent). Excluding Salesforce, the 115 other companies created $123 billion in value, arguably a more diverse set of positive data. Meanwhile, only 39 software companies are currently  trading  below  IPO price, having experienced $11 billion of value destruction.

Final thoughts and takeaways

“I am awfully greedy; I want everything  from life (investing) . . . You see, it is difficult to get  all (returns) which I want. And then when I do not succeed I get mad with anger.” – Simone   de Beauvoir

Regardless of economic market climate, investors will always seek the path of least (seemingly) resistance, i.e., strong returns with limited risk. For Internet companies, this means higher returns but lower beta and overall riskiness. For software companies, this means dial up the returns but keep the low volatility and predictability. In other words, investors all want to buy growth and scale that are inherent in Internet winners but with the predictability and stability of enterprise.

While utopia in the form of perfect investment does not exist in the real world, the following translate into a few key organizing principles as you move toward being a public company:

• Do your best to articulate your company’s story, particularly the overall riskiness of the In that line, scale matters as much as your company’s path towards profitability.
• With a prevailing “show-me” approach, investors would need to be convinced that the risk is low through execution, solid business model, defensible TAM, expanding SAM, as well as a team that understands the tradeoff between profitability and growth and has a handle on growth as you execute towards $1 billion of revenue and beyond.
• Have a team that is able to focus as much on the qualitative aspects (vision, mission, long-term strategy, competition) as much as the quantitative side of things (TAM and SAM sizing, user data, cohort behavior, salesforce efficiency, daily active users/monthly active users [DAU/MAU], engagement, renewal rates). Our recent experience suggest that investors have come to expect user data as they build long-term models that take into account the ramp-up in sales.
• Size matters but is not This is especially true when it comes to TAM sizing. Time and time again, we have seen “too good to be true” TAM sizing being heavily discounted by the Street. What matters is leaving enough margin of safety in terms of the bottom-up sizing in order for you to consistently deliver a beat-and-raise quarter.

Colin R. Stewart, Head of Global Capital Markets Technology Group, Vice Chairman, Morgan Stanley