“Square’s IPO popped on the first day. What does that say about unicorn valuations? #SquareIPO”
The IPO process is fascinating. Back in the dotcom era every tech nerd including me wanted to take a business public. I was fortunate enough to be a part of Orbitz going public twice (NASDAQ: ORBZ; NYSE: OWW). However, sometimes you have to be careful for what you ask for – you may actually get it… What we found on the other side of the IPO was a scary place that we were not ready for. Orbitz was overly hyped when we went public both times. It is an exciting feeling before an IPO seeing the initial sale price set high and we were all doing the mental conversions of our options in our heads. I was even in lucky enough to be in NYC ringing the opening bell!
The unfortunate fact about tech IPO’s is that it is more a game of chance than any of us would like to believe. Apple, Google and Facebook are the success stories we all aspire to be like; however, truth be told most tech businesses that go public drop like a rock out of the gate – in the industry they call this rollercoaster ride a “Market Correction.” Orbitz for example, was listed around $20 something a share on NASDAQ as the initial strike price and hovered around $6 after. The stock fell losing millions for our initial investors. Our second IPO on NYSE wasn’t much better. We went out around $15 and no matter what the leadership team did the stock price never reached that value again.
Orbitz and Square are not alone in the rapid decline of valuation after an IPO. Chicago Based Groupon (NASDAQ: GRPN) have found themselves in a similar position. There 5-year high was $26.19. As of this writing, they are trading at $2.79.
So what is the deal with IPO’s?
Personally I think it comes down to how the valuation process works. Everyone wants to experience the ride that Google and Apple had. The process of getting there, however, is not easy. The vast majority of IPO’s I’ve seen end up overestimating their valuations through a process that is not easy for startup tech leaders to navigate. There are tricks that seed investment firms use to alter the formulas that calculate the valuation of a pre-IPO company.
As an example, when a Company gets to a certain FTE count then their valuation increases. When they burn through their rounds of funding they get more money because their valuation goes up. Every time a pre-IPO business hits a stage the hypothetical valuation of their business increases. What is mind-blowing to me is that revenues are not weighted heavily in the valuation process. They can be losing millions a day and continue to have a high valuation. Unfortunately no one wants to admit that their numbers are overly inflated. If a valuation goes down a pre-IPO a business is very likely dead. No one will invest in them. They will be out of money and are either acquired at a discount or bankrupt.
What happened to Square?
I don’t have any personal insight on Square, but chances are they fell victim to the same catch-22. They have a good product, they have market recognition and they have experienced leadership. So what happened?
I found this October 22, 2012 quote on the web that makes me think they were going through the cookie cutter increase our valuation process:
“Square, the mobile payments company started by Twitter co-founder Jack Dorsey, announced today that it will be moving its corporate headquarters next year to 1455 Market Street in San Francisco’s Central Market neighborhood (next to Twitter). The move will help accommodate the company’s hiring plans, which include adding about 600 employees over the next year to reach a total of 1,000. Square expects to move into its new location, which will have a chef’s kitchen and rooftop deck, by mid 2013.”
1000 employees is a big number! How can any business manage the rapid growth in employee population? Why would they need to grow to 1000 FTE’s? What are the additional 600 people going to do for them? Why not outsource and take advantage of more competitive labor rates? Why? They can’t. They very likely had an objective to hit 1000 to get to their next round of funding and increased valuation. If they don’t hit whatever the magic target is then chances are they can’t get the next round of funding and die on the vine.
“A decrease in valuation is a big deal for everyone, not just the employees of Square. The Venture firms investing in them lose their money. The people who invested in the Venture firms lose theirs.”
Ok, I’m sure by now you are all saying yea great. What are we to do about it? First, don’t invest in IPO’s just because there is a lot of hype. Take the Warren Buffet approach. Invest in businesses you personally understand and love. Accordingly, look at their product objectively and do your own evaluation. Is the business truly unique? Is it worth what they are selling it for? Why is this product better than others out there? Ask yourself if you, your friends, family and coworkers would buy/use it and continue to buy more as products evolve (public companies are expected to have solid quarterly revenue growth). Then look at their competitive landscape. In Square’s case, it isn’t that difficult to find formidable competitors. Google, Paypal and Apple are in the mobile payment business. Stable Businesses like Intuit is as well. How is Square or any startup going to compete in a marketplace they do not control with highly capitalized and experienced competitors?
Step back and think about Apple, Facebook and Google. Why have they been a big success? They have a solid business plan that is clearly tied to revenues. Facebook resisted for awhile, but they were smart about implementing a profitable revenue stream. They monetized their captive audience well and respond quickly to their customers. Google did the same with search, which is still by far their #1 profit center. Google is so good they cornered the market in search and turned their company name into a verb Googling. Apple lives by clearly understanding their customers. People buy Apple products without even knowing what it does — and they pay top dollar for it. Apple has a very loyal following. They have done an amazing job cultivating their customerbase.
The business plan with realistic revenue streams, not the employee count or how many rounds of investments they have had is what makes the difference. My recommendation is to read the SEC Filings carefully before investing in any IPO. Some of the stuff in those documents make my hair stand up on ends. Here are some quotes that I pulled directly out of Square’s S1 filing:
“Our growth may not be sustainable and depends on our ability to retain existing sellers, attract new sellers, and increase sales to both new and existing sellers.”
“Our business has generated net losses, and we intend to continue to invest substantially in our business. Thus, we may not be able to achieve or maintain profitability.”
“We derive substantially all of our revenue from payments services. Our efforts to expand our product portfolio and market reach may not succeed and may reduce our revenue growth.”
“Our quarterly results of operations and operating metrics fluctuate significantly and are unpredictable and subject to seasonality, which could result in the trading price of our Class A common stock being unpredictable or declining.”
“An active trading market for our Class A common stock may never develop or be sustained.”
“The market price of our Class A common stock may be volatile, and you could lose all or part of your investment.”
Another area to explore with the SEC is who is actually making the money from the public offering. In the case of Orbitz’ second IPO (NYSE OWW) we didn’t actually benefit a penny from the investment. We raised somewhere around a billion dollars and the money was transferred from our bank account to Travelport (NYSE: TVPT) who owned 49% of the Company and was private at the time. They in-turn transferred the funds to to their owner Blackstone who was also private. I’m told those funds were eventually paid to Blackstone investors as dividends. Another area in the Orbitz case was we were over valued from when we were acquired by Cendant. We were actually carrying a loss on our books for being over valued by savvy investors that had nothing whatsoever to do with our leadership team.
Orbitz had outstanding leadership and we did what we could to keep the company going. The Company survived for 15 years (I was there for 11 of those years); however, in the end the pressure from investors to grow stock eventually took the toll on the company leadership and they sold the company to Expedia (NASDAQ: EXPE) – our arch rival. Chance are Square will eventually take the same path. It is going to be challenging for them to move their stock price up with the cards already stacked against them.