Tipping Point in an IPO

Posted in Business, Economics, Finance, IPO, Psychology, Tipping Point, Venture Capital by bursto on February 13, 2013
IPO Capital Raised Y/Y

IPO Capital Raised Y/Y

Although the economy is not near its peak before the global financial crisis in 2008 and still suffers from the current lackluster US macro indicators such as the national unemployment rate still at around 8%, the US IPO market has seen quite a recovery in the past 3 years with +493% in annual capital raised from its lows in 2008 & 2009 (according to E&Y Global Venture Capital Insights and Trends Report). Further combined with the the entrepreneurial spirit of the people, faster internet connection, and the eagerness to protect the value of investors’ assets, the digital technology space has been one of the leading sectors. Starting from the notorious GRPN’s $13B valuation to glitchy FB’s $104B valuation, the IPO funding records have been broken multiple times in 2012. Such plush valuation, it seemed as though any company that associated itself with ‘digital’ has managed to snag a deal with both private and public investors, pushing the boundaries of presenting fledgling companies as exotic investment opportunities. While this shift in investment has created many opportunities and fueled economic growth, there were plenty of disappointments.

So then how should after-market investors navigate such an eager and ambitious IPO market? On my blog, I do not plan to provide an ideal 3 step guide to picking the right investment opportunity, but I do want to share my two cents on a subtle variable that I believe is critical to the buying decision in the IPO market.

Couple years ago, I was offered a corp finance opportunity at the fastest growing startup. During my position with this startup, I saw pretty much the corporate roadmap to IPO and executive conversations, close up. The company grew double digits in revenue and headcount, new markets opened left and right, and prepared for one of the largest IPOs all at the same time. So many moving parts at once, there was no time to figure out what the real business cycle was for the most fundamental product line of the company, what the basic definitions of the KPIs were, what the essential back-office business tools were, and how the organization is/will be structured. The company was moving so fast that everybody, including all executives’, at the company was busy running around fulfilling the immediate needs in order to not fall apart. After the IPO, the chaos continued on but with more deadlines and scrutiny. Then came the optimization phase where the HQ foisted targets and SLA requirements to its arbitrarily defined revenue and cost centers. And, this chaotic journey ended for me when I switched over to a more established tech company…

What I experienced during those years was eye opening. And by contrasting this startup experience with my experience in a more established tech company, what I realize is that this high-level cycle of (1) market expansion, (2) funding rounds, and (3) resource optimization is a process that all mid- to large-sized companies have to go through in the beginning and requires a longer story than mere balance sheets, cash flow, and income statements available on the S1. Specifically, one subtle variable of company’s leadership and organization, I believe, needs a deeper understanding by the market.

First, the appetite for the public market liquidation often has a correlation to insiders’ realization on market saturation.  Insiders – as profit maximizing, early shareholders – want to cash-out their equity in the company at the peak of valuation; in other words, when market saturation that leads to slowing of growth becomes inevitable in the near future, insiders have an incentive to sell their shares right before that signal gets published to the market. Related to this incentive, the company becomes overly optimistic about its next generation of revenue pipeline, and the prospectus tends to harp on the m/m, q/q, or y/y change with the highest growth figures, in order to highlight the momentum it carries into the point of IPO. With all of these emotional conundrum, the market needs a leader that has a long-term view of their own assets and can filter out the noise in order to provide an impartial view of the company’s performance and outlook.

Second, if the insiders’ incentive implies a timeline of market saturation, the after-market investors should be wary of how the company will move forward. Regardless of historical growth trends, the momentum in business and the street perception in outlook can quickly change its direction in a fast growing company where the fundamentals of the business have not gone through an extensive testing period, as seen with ZNGA and GRPN. As the company attempts to avoid this turn by optimizing resources and exploring new revenue pipelines, a deep understanding of its resource constraints and revenue levers is required. Leaders need to help the company through its not yet fully understood business cycle and competitive landscape and carefully mold its revenue pipeline. Without such charismatic guidance and clear vision from its leaders, the company is likely to mismanage its steps and fall short of its sequential earnings expectations.

Third, for most young companies, going public means unsettling emotions due to constant outsider scrutiny and criticism. Employees that make up companies’ knowledge and skill base will have a unique tolerance to this kind of emotional volatility; and when the leaders do not manage and develop a shield for the intricacies of the organization, the company will see an exodus of its people. Any resulting process interruption, product knowledge drain, and client relationships loss is an added risk to the promised future.

Tipping Point Illustration

Tipping Point Illustration

Of course, there are those basic micro-economic pieces to investing – such as financial strength, initial pricing, holding period, supply & demand balance, etc. – that after-market investors need to consider foremost; but I believe the company’s leadership and organization can be a significant tipping point for a long-term success / failure of an IPO. Often this variable is so subtle and beyond its growth metrics that it can seem like a nebulous and quixotic indicator, but understanding the details of a company’s org psychology can be a key to unlocking the mystery of the IPO market. After all, the devil is in the details.