The Tech IPO and M&A Conundrum

M&A and Stock Market Up, But IPOs Way Down

Historically, technology sector IPOs, M&A and stock performance tended to move in tandem. However, this correlation has materially broken down in the past 18 months as technology IPOs have dwindled while the tech stock index approaches new highs and tech M&A surges. This is shown in the following couple of charts. The successful technology IPO of Twilio today (up 92% from the IPO price) was, thus, a sight for sore eyes for technology investors, venture capitalists and employees. In fact, Twilio was the first $1B+ MCAP venture backed IPO since Square went public in November of 2015. While time will tell if Twilio is the beginning of a resurgent tech IPO market, my sense is that the current stock market fundamentals, sentiment and some unique favorable attributes of the Twilio IPO will not make Twilio the beginning of major broad new tech IPO wave in the near term.

ipo techM&A Tech

Low Economic Growth and Bond Rates Driving “Yield” Investing

I would characterize the current overall stock market sentiment and fundamentals driven primarily by the forces of low global bond yields and lack of economic growth in both developed and emerging markets.   Bond yields are now close to zero and even negative in major countries across the world (e.g. Germany, Japan, Switzerland etc.) while economic growth has fallen short of expectations in most of the world including the US, Europe, China, Brazil etc. At the same time, the US stock market is interestingly approaching new highs. This, however, is likely due to the chase for a “safe yield” as returns in cash and bonds are negligible. This is clearly manifested in the S&P sectors of Utilities and Consumer Staples leading the stock market performance in the past 12 months with several of the leading stocks in these sectors (e.g. Procter and Gamble, Coke, Duke Energy etc.) hitting multi-year highs in valuation metrics (e.g. EV/Sales and PE multiples).   When safety and dividend driven sectors lead the stock market, it is typically reflective of low global growth, which is not typically the backdrop for a strong tech IPO market.

Cheap Money and Embolden Activists ==> Surging M&A

At the same time, there are many fundamental and financial forces in the technology sector that are resulting in significant discontinuity and low growth for established public companies but at the same time increased M&A.   The fundamental impact of cloud on traditional technology companies is clearly very disruptive as demand for traditional products is either diminished, as workloads move to the public cloud, and/or technology company business models are transitioning from appliance/hardware sales to lower revenue software based sales. These forces are making public equity investors less enthusiastic about most of public technology companies unless they are high growth, cash flow generative pure plays in this cloud transition.   At the same time, the surge in M&A can be explained by the very low cost of debt (allowing for deals to be more easily accretive) and increased fund raising of private equity and activist investment funds. Over the past 18 months we have witnessed the largest ever technology takeover by a private company (i.e. Dell buying EMC), Microsoft further trying to accelerate its transition to the new enterprise software sales model with its planned acquisition of LinkedIn and activist and private equity investors being more collaborative in taking low growth, but highly profitable tech companies private.

Twilio Was Priced Favorably; Will Other Unicorns Follow or Wait?

For tech IPOs to roar back, I think we will need to see better overall economic growth to encourage an offensive rather than defensive/yield driven investment psychology. Otherwise, there will likely need to be more companies that have the characteristics of the Twilio IPO, namely, high revenue growth rate driven by the transition to the cloud, approaching or already cash flow positive and favorable valuation metrics to the public investor.   This last piece on attractive valuation cannot be overstated. It appears that Twilio was priced very favorably at ~8x sales in the IPO, which for its growth rate and size was likely very compelling to the public investor. I do not recall any other software cloud or SaaS tech IPO in the last few years that went public at a similar revenue scale and growth rate at less than 10x sales. Luckily for Twilio’s private round investors, this compelling public valuation was still higher than the most recent “unicorn” venture round. Twilio was also a relatively small “unicorn” to go public. For the tech IPO market to truly bounce back, we will likely need to see some of the higher profile “unicorn” companies (e.g. Snapchat, Uber etc.) go public.

Is NY Ready for IPO Primetime?

This week two NY tech IPOs are expected to price, namely Etsy and Virtu Financial. Given that there were only six NY venture capital backed tech/healthcare IPOs in 2013 and 2014 combined that I am aware of, having two IPOs in one week is a rare event; at least for now. With NY based On Deck Capital going public only just this past December, the increasing pace of NY IPOs and the potential pipeline of future IPOs raises the question whether NY is ready to break out in terms of generating IPO caliber companies.

As I wrote about in January in my prior post regarding NY’s tech ecosystem, NY’s relatively young tech ecosystem when compared to Silicon Valley or Massachusetts has shown tremendous success in total venture dollar investments and M&A exits, but relatively limited success in IPO exits. It is my view that an increasing number of IPO exits, followed by growing market capitalization companies that can be consolidators in their respective markets will be needed in order for the NY tech ecosystem to maximize its prosperity over the longer term.   While NY’s tech ecosystem is broad based from a vertical perspective, chances are NY will be most successful in producing innovative and disruptive companies in new tech verticals that have roots in traditional NY based industries such as financial services, retail, fashion etc. Thus, it is not surprising that On Deck Capital and Virtu Financial are players in fintech while Etsy is a player in e-commerce/retail.

The following table shows some of the recent NY tech/healthcare IPOs in the past couple of years.   Besides being a somewhat short list, the after market stock performance of these recent IPOs has been mixed with Shutterstock so far being the only tech/non-biopharma company on the list to show robust after market appreciation post the first day of trading.   Time will tell if On Deck, Etsy, Virtu Financial and other NY IPOs in the pipeline will become good public investments. As a homegrown New Yorker and current angel investor in NY start-ups, I am clearly rooting for the home team to be a winner!

IPO Date IPO Price Closing Day of IPO 4/10/15
Varonis 2/28/14 $22 $44 $27
Tremor Video 6/27/13 $10 $8.50 $2.40
Borderfree 3/20/14 $16 $20 $6.72
Shutterstock 10/10/12 $17 $22 $71.14
Everdadyhealth 5/28/14 $14 $13.50 $12.57
Intercept Pharma 10/11/12 $15 $19.05 $179.25
Ophthotech Corporation 9/25/13 $22 $26.30 $50
On Deck Capital 12/17/14 $20 $27.98 $19.53

NY Start-Up Ecosystem: What I Am Keeping An Eye On

While working in the technology and finance industries for 30 years, including eighteen years as a Wall Street technology equity research analyst, I have witnessed dozens of Silicon Valley start-ups go from the seed phase to successful exit. I characterize Silicon Valley as a “well oiled machine” in how it can consistently over multiple decades create, fund and successfully grow the most innovative companies in the technology industry.   As a long time resident of the Greater New York City region, I am truly excited that over the past decade the NY start-up ecosystem has achieved enormous momentum and has the potential of also creating new innovative companies and perhaps even defining new subsectors of the technology and media industries.

Many have opined in the media on whether NY will ever catch up to Silicon Valley or if it is even relevant to compare the two start-up ecosystems. In this regard, I agree that it is not extremely relevant to compare the two regions given the maturity and decades of success of the Silicon Valley start-up ecosystem vs. the relatively young NY ecosystem of roughly only a decade.   NY has a different culture and industry roots than Silicon Valley that will likely result in its own unique ecosystem evolution. For example, the historical entrenchment of industries in NY such as media, fashion and finance make talent in these industries more prevalent in NY than classical technology sectors in Silicon Valley such as semiconductors, enterprise software, data networking etc. These strong industry foundations in NY are evident in two of the few NY start-ups that have actually gone public in the past three years, namely Shutterstock (Media/Content Tech) and On Deck Capital (Financial Tech).

As someone who was educated in both NY and Silicon Valley and is now an angel investor, board member and advisor to companies in NY and California, I read with intrigue the “2014 U.S. Venture Capital Year in Review” by CB Insights as it relates to the topic of NY as a blossoming start-up ecosystem and how it metrically compares to other regions of the US. I wanted to highlight a few key metrics from this report that demonstrate both the momentum and scale of the NY start-up ecosystem, but also the coincident realization that this ecosystem is still relatively young and has more to prove to compete with Silicon Valley and other parts of the US in attracting the absolute best financiers, entrepreneurs, scientists/engineers, students and academics to the region.

Table: 2014 U.S. Venture Activity

Metric Calif. Mass. NY Total US
Number of VC Backed Deals (Growth Over 2013) 1,631 (13%) 346 (9%) 422 (7%) 3,617 (8%)
$B Amount of VC Backed Deals (Growth Over 2013) 26.8 (81%) 4.2 (37%) 4.5 (53%) 47.3 (62%)
VC backed IPOs (vs. 2013 figure) 45 (31) 18 (10) 5 (1) 101 (73)
VC backed M&A Exits (vs. 2013 figure) 265 (188) 70 (33) 59 (49) 637 (440)

Source: CB Insights report “2014 U.S. Venture Capital Year In Review”, January 2015

The CB Insights report shows that NY was 2nd only to California in venture backed funding in 2014 both in terms of number of deals and total dollars funded as it surpassed Massachusetts in both these categories. This clearly reflects the enthusiasm, momentum and scale of the NY start-up ecosystem. However, NY continues to lag in terms of exits as it only generated 5 IPOs in 2014 (and only 1 in 2013) and its M&A exits in 2014 did not keep pace with California, Massachusetts or the US as a whole.

NY will need to improve its exit conversion rate in the next few years or it might be at risk of being viewed as the “gold-rush” region of the current technology and media era. I personally view the talent, innovation and entrepreneurial energy level in NY as too powerful for such a scenario to play out.   Time will tell whether NY will follow its strong growth metrics in deals and funding values with also an improving performance of exits.   While the numbers will ultimately speak for themselves, here are three important dynamics that I will also be following to measure the progression of the NY start-up ecosystem.

Minting Serial Entrepreneurs that VCs Will Follow: As exits grow in absolute numbers and valuations, it will be important for NY to establish its own set of serial entrepreneurs that stay local to the region, come up with the “next big thing” and can easily raise money from VCs given the returns they delivered to them in the past. This profitable cycle will also help drive the best VCs to put better talent in NY.

Fading of The “Trader” Mentality: Perhaps its because NY is the financial capital of the world, or perhaps its because the NY start-up ecosystem is still fairly young that I find many NY entrepreneurs (and NY start-up financiers) think primarily of a quicker M&A exit for their companies rather dreaming of building a company that can go public.   While I stated earlier that I don’t think it is relevant to compare Silicon Valley to NY, this is one big difference between the two regions. Silicon Valley tends to dream relatively more of building big innovative and disruptive companies, while NY tends to dream of the quick exit or “trade”. Perhaps NY first needs to “mint” its serial entrepreneurs through M&A exits to create the stage for more far reaching company goals. Having more public companies I think would make NY even more attractive to the best talent in the nation to come here to work. Achieving an IPO with a valuation of multiple tens of billions of dollars would be a momentous event for the region and also allowing for a NY based consolidator.

Fostering Entrepreneurship At Local Universities: NY has a solid list of universities. These universities historically, however, have not had a culture that has fostered entrepreneurship. This is changing quite rapidly but will need to continue. As a member of the Columbia Engineering Entrepreneurship Advisory Board, I have witnessed how one such university is making such strides and it is a pleasure to be a part of the progress. NY still has more to go in this area including being supportive of professors that want to be more actively engaged with start-ups and being more creative and less bureaucratic in intellectual property ownership rules when dealing with campus-based start-ups.



Update on Communications Equipment Stocks

I recently wrote an article on Seeking Alpha where I discussed my positive outlook on communications equipment suppliers exposed to telecommunications service providers.  The main points that formed the basis for my positive view were:

  1. Data points from Ciena, Cisco and Juniper in the month June that suggest spending in the US, particularly at AT&T, is improving in 2Q and should help communications equipment providers report decent results for the June quarter.
  2. The outlook for LTE spending into 2014 for the US and China is improving given LTE spending plans by Sprint and T-Mobile in the US and China Mobile and China Telecom in China.

For those interested, you can read the full article here.  Keep in mind, several of these stocks have rallied recently, so stocks in the communications equipment sector may have already begun to discount good results for the upcoming June quarter reporting season.