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The purpose of a tech company IPO has changed.

Summary: An IPO is no longer a way to show a company's legitimacy and fuel its development

By Conor Sen, Bloomberg

One of the themes of this economic cycle has been that tech start-ups have stayed private for a long time, choosing to raise money via venture capital rather than going public. When a downturn inevitably arrives, some may regret that.

As prior cycles have shown, even if good start-ups technically can go public in a bad market, they generally don't -- and that might mean being forced to stay private for several years longer than they want. A few big start-ups are avoiding that trap as they finally look to go public -- Dropbox and Spotify have forthcoming listings -- but many other mature companies have stayed private, like Airbnb.

It's a sign that the purpose of initial public offerings has changed. At one time, going public was considered a rite of passage, a necessary step for a start-up on its way to maturity. When Amazon went public in 1997, it raised $54 million, giving it a valuation of $438 million. Going public served several purposes for companies. Not only did it provide a bump of funding for start-ups that often weren't yet profitable, but also it created a mechanism to raise more money if needed in the future. It provided transparency and legitimacy to investors and potential clients and business partners of the company. And it provided liquidity to the private investors and employees who had financed and built the company, allowing them to cash out their holdings and stock options.

QuickTake Unicorns

If there's one new force in markets that has changed tech start-ups in the business cycle since the last recession, it's the emergence of "late-stage venture capital." Whereas before, once start-ups got to a certain size they may have needed an amount of funding that only public markets could provide, now there are private sources of capital able to put hundreds of millions or billions of dollars in start-ups to fund their growth. (See Uber's $3.5 billion infusion from Saudi Arabia two years ago.)

These private sources of capital are willing to put large amounts of money in more mature start-ups in part because of the success of some of the "Dot-Com 1.0" companies. There has been a winner-take-all dynamic with tech and internet start-ups, in which a handful of companies become big winners, worth billions or tens of billions of dollars, with most everything else flaming out or being worth a relative pittance by comparison. Or being acquired by the mega companies.

If only a handful of companies are going to be the big winners, why would the founders and investors of a contender want it to go public early in its growth cycle? That would allow public markets to capture their gains. If Uber is destined to be a $100 billion company, better to fund its growth in private markets and then dump it on the public markets only when it's fully valued. An IPO is no longer a way to show a company's legitimacy and fuel its development; it's a way for successful speculators to cash out for maximum gains.

In essence, late-stage venture capital investing is a form of momentum investing. In the public equity markets, momentum investing often takes the form of riding companies with strong growth and price performance until there's a break in the trend, at which point the shares are sold, often resulting in a violent stock-price reversal as momentum investors all sell at the same time. Momentum investors often don't concern themselves with valuations; all that matters is strong growth and price appreciation.

The best example of a company going public right as its growth was decelerating but before the momentum story fell apart might be Snap. Snap went public on March 1 last year at $17 a share. Snap's growth slowed significantly in the second half of 2016 following the launch of Instagram Stories, a competing product. That may have provided the impetus for Snap to go public. Since going public, Snap's growth concerns have persisted, with the stock currently priced around $17 a share. At the time of this writing, private investors have captured all of Snap's value creation, with public markets getting nothing.

But in a downturn, this is unlikely to work. By definition, markets get jittery in downturns and prefer the safety of cash, bonds and blue-chip stocks to the uncertainty of tech start-ups and initial public offerings. Momentum investing goes out of favour. Venture capitalists won't have anyone to sell their shares to -- at a price they're willing to accept.

Quality companies might be able to go public in a downturn, but they generally wait instead. In the last cycle, the Nasdaq bottomed out in October 2002, but Google chose not to have its IPO until August 2004, nearly two years later. Similarly, in this cycle, LinkedIn was the first high-profile tech start-up that chose to have an IPO. It went public in May 2011, more than two years after equity markets bottomed out in March 2009. Only fools sell assets at bad prices in bad markets if they can afford to wait until conditions and prices have improved.

As we get late into this economic cycle, with the unemployment rate near 4 per cent, inflation pressures building and the Federal Reserve slowly increasing the pace of its interest-rate increases, tech start-ups choosing to remain private are playing a dangerous game. At the moment the tech sector, both public and private, has huge momentum and remains the darling of investors. But that will change. And once it does, it'll probably be years before tech start-ups will realistically be able to go public, frustrating their investors and employees alike.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Conor Sen is a Bloomberg View columnist. He is a portfolio manager for New River Investments in Atlanta and has been a contributor to the Atlantic and Business Insider.

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Publication:Gulf News (United Arab Emirates)
Date:Mar 15, 2018
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