The Great Public Market Reckoning

Dan Primack wrote in his friday newsletter:

Public market investors have become less willing to leave their comfort zones, and it’s manifesting most obviously in the IPO market.
Novel disruption has fallen out of favor, with many preferring more time-tested models like enterprise SaaS and biotech.
Peloton yesterday raised over $1.1 billion in its IPO, pricing at the top of its $26-$29 range, but its shares then got crushed (although still valued well above the last private mark). Its CEO talked to Axios yesterday about the falling stock price.
Endeavor, the live events and artist representation firm led by Ari Emanuel, last night canceled an IPO that originally was to raise over $600 million, before it was later downsized.
WeWork… well, you know the story there.
Yes, all three companies have dual-class shares. Yes, all three were highly valued by venture capital or private equity investors. Yes, all three were unprofitable for the first half of 2019.
Those characteristics are also true of Datadog and Ping Identity, both of which had successful IPOs this month and continue to trade above offering.
The trio’s real similarity was that each had a very complicated story.
Peloton is a high-end hardware and SaaS business that produces original media content, sells apparel, and runs its own delivery logistics.
Endeavor began life representing movie stars and Donald Trump, but later expanded into a massive live events business that includes the UFC and Professional Bull Riders. Plus, it’s got a streaming platform.
WeWork… again, it’s different.
All of this comes against the backdrop of Uber, which also had a very complicated story and an IPO that emboldened short-sellers.
Up next: A lot of biotech startup IPOs, but no high-growth, complicated tech unicorns.
“We’re about to get a bit of a break from those sorts of deals, which I think is good for everyone,” a top Wall Street banker told me this morning.
Private markets follow public markets, so don’t be surprised to see some valuation and/or deal size pullback for these “hard to comp” companies.
Particularly if SoftBank fails to raise Vision Fund 2.
Goodbye to egregious governance terms. Dual-class will survive, but WeWork laid a third rail for others to avoid.
U.S. IPOs have still outperformed the S&P 500 in 2019, although the gap has shrunk significantly this month.
Or, put another way: The sky isn’t falling, but it’s gotten a lot darker. And, for some, downright stormy.

While all of this is true, I think it is a lot simpler than that.

The public markets are a lot different than the private markets.

Financial transactions in the private markets are controlled by the issuers, happen when the issuers want them to happen, and are generally auctions, particularly in the late stage markets.

Public market investors can buy and sell stocks every day based on what is attractive to them and what is not. If they feel like they missed out on something, they can get into it immediately.

For this reason, valuations in the private markets, particularly the late-stage private markets, can sometimes be irrational. Public market valuations, certainly after a stock has traded for a material amount of time and lockups have come off, are much more rational.

For the last five or six years, I have been writing here that I very much want to see the wave of highly valued and highly heralded companies that were started in the last decade come public. I have wanted to see how these companies trade because it will help us in the private markets better understand how to finance and value businesses.

And now we are seeing that.

And what we are seeing, for the most part, is that margins matter. Both gross margins and operating margins.

If you look at the class of companies that have come public in the last twelve months, many of the stocks that have performed the best are software companies with software margins. One notable exception to that is Beyond Meat.

  • Zoom – 81% gross margin
  • Cloudflare (a USV portfolio company) – 77% gross margin
  • Datadog – 75% gross margin

If you look at the same list, many of the stocks that have struggled are companies that have low gross margins.

  • Uber – 46% gross margin
  • Lyft – 39% gross margin
  • Peloton – 42% gross margin

Some other notable numbers:

  • WeWork gross margins – 20%
  • Spotify (down almost 30% in the last two months) gross margins – 26%

I believe that we have seen a narrative in the late stage private markets that as software is eating the world (real estate, music, exercise, transportation), every company should be valued as a software company at 10x revenues or more.

And that narrative is now falling apart.

If the product is software and thus can produce software gross margins (75% or greater), then it should be valued as a software company.

If the product is something else and cannot produce software gross margins then it needs to be valued like other similar businesses with similar margins, but maybe at some premium to recognize the leverage it can get through software.

But we have not been doing it that way in the late-stage private markets for the last five years.

I think we may start now that the public markets are showing us how.