In a post earlier this week, Josh Kopelman coined the term Private IPO to describe patterns in the runaway late stage financing market. In addition to the points Josh makes about the dangers of stale valuations, there is another important and related implication for founders.
When entrepreneurs pursue a Private IPO as the ultimate round before they go public, they make an implicit bet about the growth rate of their businesses: company revenues will more than double before a public IPO. If the bet doesn’t pan out, then the IPO is a down round - a fund raise at a lower share price than the last private round.
This phenomenon isn’t uncommon. In fact, 25% of 2014 IPOs were down rounds, according to an analysis by Ben Narasin and Jeremy Abelson.
Why is this the case? There is a substantial difference between the multiples investors pay in the private and the public markets. Internal Redpoint analysis concludes many private growth rounds occur at about twice the forward multiples of the public markets.
Let’s make this more concrete. Suppose a company raises a Private IPO at 20x Enterprise Value / Forward Revenue multiple (close to the top of the private markets). When the company files for Public IPO, it will more than likely trade at somewhere in the 10x EV/FR multiple range, the industry average today for fast growth software companies. At half the forward multiple, the company must double revenues to be worth the same.
This multiple disparity is very much a new phenomenon in the last few years. Some historical context: in the past, private markets paid smaller multiples than the public markets. After all, investors bear substantially more risk investing in startups than established businesses. Today, private market investors' optimism has inverted the multiple curve, and earlier investors are valuing businesses at substantially larger multiples. This inverted multiple curve has created an investor risk bubble.
Alarmingly, in the last year, the difference between private and public multiples has widened. While private multiples have remained constant, public software multiples halved. This multiple disparity creates a situation wherein entrepreneurs must make the implicit bet mentioned above. With each decrease in public market multiples, the growth requirement becomes larger.
These Private IPOs and substantial growth rounds are terrific financial products for entrepreneurs. They enable founders to grow their businesses to massive scale through a far less taxing fundraising process than Public IPOs. But it’s important to reconcile the differences between public and private market multiples when considering valuations, and weigh the risks of the implicit bet a team makes on its growth rate when raising a Private IPO.