Less Rush to Go Public

Overnight billionaires are the public face of public offerings. A hot young company sells its shares in the open market, catapulting its hot young entrepreneurs into 10- or even 11-digit wealth. From Alibaba to Zynga (along with Facebook, Google and others), the initial public offering (IPO) is the crowning moment when founders and friends cash in their years of hard work and risk.

Or at least it was. Increasingly, hot young entrepreneurs are waiting longer to take their companies public. Yet they are still cashing in. The trend is called pre-IPO funding. A better name for it might be "staying private for longer."

And It's Booming

Five years was the time a typical tech start-up in 2000 took to go IPO, reports the Financial Times. Now, says the FT, this has risen to 11 years. The difference is that ventures are more able to find venture funding than they used to be. "Pre-IPO funding is extremely abundant," observes Credit Suisse Managing Director Philippe Cerf. "So abundant," says investment analyst CB Insights, "that the number of American tech companies valued at more than 1 billion dollars – yet still in private hands – nearly doubled from 2014 to 2015, from 25 to 42." Other observers such as Fortune magazine, PwC's MoneyTree and the National Venture Capital Association report slightly different figures, but always the same story: pre-IPO is a big-money movement.

Rise of the Unicorns

Its poster children are the so-called unicorns, private firms valued at 1-billion-dollar plus. Named after something that is extremely hard to find, these are becoming ever easier to find, including outfits such as Airbnb, Docusign, Pinterest, Spotify, Square, Survey Monkey, Uber and so on ("so on" being just two words, not a company). All these are tech ventures, and nearly all of them are based in America's Silicon Valley. That latter concentration is beginning to disperse. Israel, for instance, hosted its first unicorn in 2012, a company called Conduit. Its second one, named Infinidata, crossed the billion-dollar mark in 2015. Most unicorn founders fit the start-up stereotype: twenty-something, male computer-geeks made good. But in one respect, they tilt against typecasting. Unlike their cash-burning, profitless progenitors of the millennial dot-com era, many unicorns already are in the black. "Pre-IPO funding is about young companies, yes," notes CS's Head Private Equity Origination & Due Diligence, Sven-Christian Kindt, "some of them very well-established and solid."

Because I'm Worth It

"The main reason start-ups are staying private for longer," Kindt adds, "is because they want to. In pre-IPO mode, the entrepreneurs are financed by long-term investors, who understand their industry. Unlike public companies, they don't have to worry so much about quarterly earnings targets, investor relations and all the work involved in the IPO itself. They can focus more completely on building their business." The second reason is because they can. Obviously there is the abundant funding, but also, the belief is becoming widespread that this is another box to be ticked, another stepping stone to cross, another phase to go through. Pre-IPO finance is going mainstream. Probably the best evidence is the proliferation of pre-IPO funds. Russian tycoon Yuri Milner started the trend in 2005 with DST Global that famously backed Groupon, Facebook, Spotify, Twitter and other tech icons. More heavyweights followed, and in time, the game opened up to lightweights. Over the past five-ish years, venerable mutual fund companies such as BlackRock, Fidelity, T Rowe Price and Vanguard all have begun offering pre-IPO stakes as part of their ordinary offering to ordinary investors.

So the Winners Are…

…nearly everybody, it seems. Founders like to keep their freedom, and at the same time they like to cash in some of their chips. This latter possibility makes pre-IPO particularly popular with friends, family and initial employees. Although there are cases of early investors such as David Choe, who took shares in exchange for painting Facebook's offices and then sold them for 200 million USD when the social network IPO-ed, these tend to be exceptions. "Employees often want to sell their shares rather than wait for an IPO or go through a lockup period," says CS's Kindt. "Pre-IPO funding usually gives them a chance to do just that."

And What about Investors?

As for those supplying pre-IPO money, some question whether they are winning. A cross-section of investment bankers, surveyed by accountants BDO USA, said "the limited volume of shares in the private market is inflating valuations of these businesses to the point that [there are] concerns that a bubble may be developing." That was back in 2011 already, and as billions in pre-IPO returns have cashed out in the ensuing years, warnings of 'frothy' valuations have continued. While there might be individual exceptions, these seem in general to be overwrought. Valuations are harder-nosed than most realize. "These [pre-IPO] transactions are done by long-established formulae," notes CS's Kindt, "and those tend to change only slightly over time." At 30 percent forward revenue growth, he notes, a Software-as-a-Service (SaaS) venture is currently valued at approximately four times revenues; at 50 percent that can climb to a multiple of around 6. Moreover, just because funding volumes have soared doesn't mean that due diligence has decreased. Funding companies will always involve risk. Whether pre-IPO or IPO, the intelligent investor's challenge hasn't changed: to quantify that risk and then match it to an appropriate appetite and reward.