In early February 2016, a study of financing deals reported by The Wall Street Journal found that investors are increasingly protecting themselves from IPOs that don’t perform as expected. This fallout is a continuation of the demise of the so-called “unicorn,” a tech startup with a pre-IPO valuation of over one billion dollars.
As these companies secure late-stage funding before their public market exit, smart private investors are setting terms that ensure they don’t lose a dime if the IPO falls short of expectations. This comes at a great cost to the startup if the exit doesn’t deliver, as was the case for many of the IPOs of 2015.
As a former VC, the former president and COO of enterprise flash memory pioneer Fusion-io (which made a public exit in 2011 before being acquired by SanDisk in 2014) and now CEO of data virtualization startup Primary Data* (which has raised about $60 million in our first round of venture funding so far), I watch investment trends closely.
I have noticed a few things about the challenges faced by the companies that have reached the mythical “unicorn” status before they deliver a return for their investors through an acquisition or initial public offering. (If your memory needs jogging, Fortune provides a good recap of unicorns in 2015 as a refresher on the past year.) Put simply, many of these companies are just out of runway before their business really needs to take off.
Starting the engines
The goal for any startup — at least, what they better be selling to prospective investors in order to raise capital and fund business growth — is to build a scalable and profitable company. Typically, companies with venture funding aim to return a profit to their investors through a liquidity event (or “exit”), such as an acquisition or IPO.
To get there, the company needs to increase its market value by building an innovative product, gaining customer traction and generating revenue, eventually becoming profitable. Doing this quickly while keeping an eye on spending ensures the company can minimize the dilution of its shares and maximize the return on investment for those who fueled its growth.
As the company begins to make money rather than burn through it, fewer funding rounds will be needed to get on its feet as a grown-up enterprise. However, taking less funding because the company can operate independently can mean that the startup forgoes the marketing achievement of a unicorn crown.
Given the last year of exits below valuations created by late-stage investment, it’s no secret that the bloom is off the unicorn rose. Looking ahead to what will create more stability in the technology investment market and a critical pillar of our American economy in the long term, I hope to see more companies focus on building a sustainable business rather than generating revenue at any cost and dealing with the burden of becoming a unicorn.
Stalling on the runway
Acquisitions can happen for any number of reasons before a company delivers a public market exit for its investors, so let’s leave that discussion off the table for now. Looking at the IPO exit, part of the problem is actually tied back to the bursting of the last big tech bubble. Historically, IPOs were riskier businesses as they came to market, but that risk was offset by huge potential reward.
Consider Amazon’s 1997 IPO, which created a $438 million market cap with an $18/share debut on the public market. Today, the company is worth $257 billion and shares are about $530 each (at the time of writing). Although this valuation is the lowest for the company during the past 18 months, analysts expect more double-digit gains ahead.
Amazon was undoubtedly the exception rather than the rule. When the bubble burst, more regulations were introduced. As a result, startups are reducing growth potential for public market investors and now are advised to show more sales growth before listing, resulting in reduced growth curves. For example, most startups considering an IPO today report revenues of more than $100 million/year run rates and are already at or on track to profitability, which was the case for us at Fusion-io.
The unicorn investment cycle has been consuming the growth ramp of an IPO-bound company. Unlike previous eras when a public exit occurred earlier in the company’s growth, leaving the best days ahead of the company, the fastest growth for an IPO-bound startup now happens in the last funding rounds before an IPO. This leaves a 20-30 percent growth rate post-IPO, which is pretty good for a company at $100-$200 million/year revenue, but bad for anyone looking for greater than 2X ROI from an IPO investment.
Addressing these issues requires a little course correction as companies work toward an IPO. To ensure ample room for future growth, a startup should be careful not to push its market cap too high by taking more funding rounds than needed during the growth-stage period before IPO. This can be a challenge because funding often generates media interest and credibility, which are certainly not things a young company wants to leave on the table.
However, leaving a portion of its growth for the IPO will ensure that the company has enough runway to continue to grow and deliver for its public market investors, just as the company has done for its VCs. Otherwise, you create yet another unicorn where the late-stage investors garner all the potential gains, and even force guarantees on returns. This is bad for new investors in the open market, and worse for the employees of the company who only receive poor post-lockup stock performance as compensation for years of hard work and sacrifices.
The other critical element for the C-suite and board of pre-IPO companies is the basic building block of ensuring the growth strategy itself will deliver revenue returns and continued growth. This is where the acquisitions come back into play. Even newly public companies are suddenly subject to mitigating risk and spend, which is why we are now in such a hot market for acquisition deals. R&D on long-term projects can hurt a company’s balance sheet in the eyes of public investors; instead, companies purchase innovation to deliver growth opportunities.
Technology markets move fast, so this strategy can help a company keep pace with changing times. Even better, having an experienced executive team and board with the foresight to plan for long-term revenue can deliver the capital needed to make strategic decisions and invest wisely in how the company can continue to move with market opportunity.
Hopefully we will see wiser times ahead as we learn about building long-term growth and value for not just investors, but also customers, employees and the economy itself.
This post originally appeared in TechCrunch in March of 2016
*Denotes a current or former Battery portfolio company. For a full list of all Battery investments and exits, please click here.