Tech IPOs: Will The IPO Parachute Fail To Deploy?

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Includes: AVXS, BGNE, DBX, DHERO, EDIT, JSYNU, PTI, ROSE, SNDX, SPOT, SRAQU-OLD, ZFIT
by: Tanuki Capital LLP

Summary

Only 8 tech-related IPOS in 2016 (YTD). This signifies a significant decline in tech start-up investment exit opportunity.

Hedge funds, private equity, and VC firms are investing cautiously in tech start-ups and leveraging weakness in the IPO market for better investment terms. Cash-hungry start-ups are acquiescing.

The March 30 deal between Spotify and its investors TPG (private equity) and Dragoneer (hedge fund) indicates investors are largely motivated by IPO enabled exits.

Increasing focus on bottom line numbers is encouraging, but we remain broadly cautious of tech IPOs as current shareholders attempt to financially engineer their way toward successful exits.

Venture Capital Strengthens as Their Investment Targets Weaken

Venture capital firms (which are leading investors in technology start-ups) are raising money at the highest rate in more than 15 years. They raised a total of US$13 billion in 2016 YTD (Source: WSJ). This fund-raising coincides with a near-dry IPO market (only 8 tech IPOs YTD) and significant financing difficulty for tech start-ups resulting in down rounds, as well as write-downs by companies such as Fidelity Investments in portfolios including Zenefits (ZFIT) (-14%) and Dropbox (DROPB) (-10%).

Fortune Magazine published a list of the Fidelity's tech start-up write-downs here.

The successful IPOs YTD are listed below. The following 5 are from the Biotechnology sector: Editas Medicine (NASDAQ:EDIT), Proteostasis Therapeutics (NYSE:PTI), AveXis Inc. (NASDAQ:AVXS), BeiGene Ltd. (NASDAQ:BGNE), and Syndax Pharmaceuticals (NASDAQ:SNDX).

The following 3 IPOs were classified as Special Purpose Acquisition Vehicles (SPAV). Silver Run Acquisition Corp. (NASDAQ:SRAQU-OLD), KLR Energy Acquisition Corp. (KLREU), and Jensyn Acquisition Corp. (NASDAQ:JSYNU).

Although Fidelity's markdowns were a noble endeavor, we note that investments in tech start-ups are very illiquid, and valuations are often speculative until the companies meet the IPO market. The markdowns at Fidelity, and ostensibly other firms with tech start-up investments on their books, does not indicate it is faring poorly on these investments. However, it can be viewed as an indicator that the speculative valuations at many tech start-ups are contracting. Many companies are reportedly now being valued at a multiple of 2-3x revenue. This is a notable conservative shift away from more exuberant pre-2016 valuation calculations.

Outside the balance sheet and valuation headlines, we are seeing evidence of real-world contraction as a litany of tech start-ups are cutting costs (including workers) and, in some instances, are completely shuttering. It is clear the focus has shifted away from top line numbers (revenue, or user growth for companies with no revenue) in favor of bottom line numbers (profit/loss).

Worrisome Spotify Investment: Structured For an IPO Exit

While we are Spotify (MUSIC) users and supporters of its product, we believe the company's recent US$1 billion debt financing deal with TPG (Private Equity firm) and Dragoneer (Hedge Fund) is a negative harbinger for tech start-ups and their investors (venture capital, hedge funds, private equity firms). The reported deal between Spotify and TPG/Dragoneer indicates that both TPG/Dragoneer do not believe in Spotify's long-term prospects and are angling for a quick cash out of their investment via an IPO parachute. We believe this because:

  • The deal was structured using prohibitive interest rate increases on the debt. Should Spotify fail to tap the IPO market in the next 12 months, it will pay an additional 1% in interest (above the 5% base rate) every 6 months until a 10% interest rate is reached. For a company that is still not profitable, such interest rates on US$1 billion in financing will weigh heavy on its balance sheet. Spotify is currently valued at US$8.5 billion.
  • TPG/Dragoneer will be able to convert the debt into equity at a 20% discount to the share price in the event of an IPO, and after 12 months, this discount will increase 2.5 percentage points every six months. This clearly telegraphs their desire for Spotify to file for an IPO.
  • TPG/Dragoneer will be able to cash their shares out after 90 days instead of the customary 180-day lockout period applied to employees and other early investors/shareholders.

The final caveat of the reported deal is what worries us the most. TPG/Dragoneer are essentially signaling that they will cash out very quickly after an IPO is offered, and are guaranteeing they will be able to cash out while all other early investors are locked out from selling. This shows a clear lack of confidence in Spotify from its backers, as they likely will not hold the stock for long after the IPO.

Absent an IPO, the fact that TPG/Dragoneer are willing to saddle Spotify with high interest rate debt indicate they are not concerned with the company's long-term growth prospects. High variable interest rate financing will likely serve as a drag on growth for Spotify, an unprofitable company operating in an increasingly crowded music streaming marketplace.

The most likely outcome is that TPG/Dragoneer are using the aforementioned terms to force Spotify into an IPO, even if the timing is not in the best interest of the company or its existing shareholders.

Problems in Unicorn Land

The above investment/debt financing indicates that tech start-ups on the whole are negotiating from a position of weakness. It also shows that tech start-up investors (hedge funds, etc.) are eager to cash out. Luxor, a US$3.6 billion hedge fund, recently informed its investors that it could not honor withdrawal requests in their entirety due to the illiquidity of assets, such as shares in Delivery Hero (DHERO), a food delivery start-up.

Many tech start-ups are responding to the pressures of a weak IPO market and contraction in financing in one of two ways:

  1. They close their doors, or look to get acquired (often at a discount), due to an inability to raise funds and continue their start-up business. Jumio, an Andreessen Horowitz-backed start-up, recently filed for bankruptcy.
  2. Or, they cut staff and costs (likely at the expense of growth) to appease their investors and to make their balance sheets more attractive to a more scrutinizing IPO market. Pebble (a smartwatch start-up) and Practice Fusion (a healthcare start-up) both recently announced significant layoffs.

Our Take: The IPO Parachute May Not Deploy

Previous tech start-ups, such as Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), and Google are evidence that there are profits to made from tech IPOs. However, there are an equal, if not greater, number of cautionary tales, such as Fitbit (NYSE:FIT), LinkedIn (LNKD), and Twitter (NYSE:TWTR), where pre-IPO investors got rich, while secondary market investors got burned.

We believe investors should take the recent lull in the tech IPO market as an opportunity to pause and hone their tech IPO acuity, especially as tech IPOs may soon start hitting the market again - possibly in the next 6-12 months, based on the Spotify deal. The Spotify financing deal is a harbinger of a future IPO market that is increasingly structured to provide early investors a parachute at the expense of retail investors and, in the instance of TPG/Dragoneer, other early stakeholders. The deal is emblematic of why we are comfortable watching technology start-ups and their subsequent IPOs from the sidelines.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is intended for informational purposes only.