3 Takeaways on the “Down Round IPO”

We noted last month that IPOs are back – but that we shouldn’t get excited.

Yes, the IPO window has opened with the largest tech IPOs since the VC meltdown began.  They weren’t quite as overhyped as Taylor Swift getting all melty at a Chiefs game.  But they got massive attention

Unfortunately, Instacart, Klayvio and Arm generated a “meh” response from investors.  And two of the three went public at a down round valuation, most notably Instacart, which priced at $9 billion, 77% lower than the $39 billion valuation on its last private round.

The last Instacart round that actually generated alpha by outperforming the S&P 500?  The 2015 C round.  Every subsequent investor would have been better off investing in an S&P index fund – and that’s before pricing in illiquidity.

We’ve already noted that when the strongest, most IPO-worthy companies go public at a down round, it suggests that many, many (many) private holdings may be significantly overvalued, given that many investors have taken only modest writdedowns to date.

Here are three other takeaways from the “down round IPO”:

1. Beware the Late Stage Investment.  Conventional wisdom is that early stage investors will make 10x to 100x on their successes; late stage investors on the other hand, will make only 3-5x, but do so with far less volatility.  Turns out that simply isn’t true: statistically, late stage is much more volatile than generally understood.

When things go badly, do late stage investors at least make up for smaller returns, by losing less of their investment than early stage investors?  Well, yes. But not by much.  When an investment fails, early stage investors lose 83% of their invested capital. But late-stage investors still lose 60%.  Seems like a bad trade: vastly less upside, but only slightly less downside.  In fact, data suggests that rather than cherry-picking a few late stage investments that look the strongest, investors would improve their returns by investing in every credible deal they see at the seed stage. Rather than using a rifle to pick off one or two late stage targets, investors may be better off with a shotgun that hits any credible startup.

2. Raise Less.  From our blindingly obvious department, capital efficiency is king in generating an attractive exit.  WhatsApp raised only $60 million before exiting in a sale to Meta for $21 billion, generating north of a 50x return for Sequoia.  Instacart, to pick on just one, had raised more than $2 billion privately before its IPO.  Klayvio had raised nearly $800 million privately (even though weirdly, they didn’t need the money).  The amount raised is only one variable, and ignores hold time and entry valuation, among other factors.

But all things being equal, a big exit will be vastly more attractive when the company has taken on less capital.  So, all the other investors who previously piled into an investment may create social proof that a target company is attractive.  But all that invested capital can make it harder to make money on exit.

3. Valuations are Still Wacky.  Yes, public SaaS multiples are down sharply from their Covid peak.  Forward multiples were 20x then, and they’re 5.7x now.  So are they now reasonably priced? 

Actually, no.

The 10 year treasury from 2010 to 2020 averaged 2.3%.  Today, the 10 year has doubled to 4.7%, but SaaS multiples are nearly the same as the 2010 to 2020 period.  The disconnect is even more stark in looking at “growth adjusted multiples” (revenue multiples, divided by forward growth rates).  Even though interest rates are at their highest in 16 years, that multiple is 0.39x.  That’s actually 40% higher than the long term average pre-Covid of 0.28x.

When risk-free returns are approaching 5% (and structured credit is yielding 11-13%), these SaaS multiples just don’t make sense.

So, beware of private companies referencing public SaaS valuation comps.

So the takeaways:

  1. Invest early;
  2. Raise small;
  3. Raise cheaply.

Easy to say.  Hard to do.  But get that right, and you can make it rain.

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