The IPO Dream

We can all picture the scene effortlessly. The smile is picture perfect, flashes come from all angles, the company ticker flashes on the big board, and she rings the bell signaling the open of trading at the New York Stock Exchange. The company has gone public. It’s happened. Every entrepreneur’s dream, right?

Taking a company public holds a special place in a founder’s (and investor’s) imagination. We’ve all been sold on it being the greatest possible outcome. Unfortunately, it is highly unlikely. How unlikely? Well, let’s put it this way, Y Combinator – the premier accelerator in the world- has invested in over 1,450 companies in its 13-year history and only 1 of its companies has IPOed (Dropbox, in case you were wondering).

If it is difficult for US based and funded companies, just imagine how much more difficult it is for Latin America based companies. Until very recently MercadoLibre was the only Latin American technology startup to have gone public. It now has been joined by Globant, Netshoes and Despegar. Still a very short list.

There are three main reasons why an IPO is so hard to pull off. The first one is size, for a company to gain liquidity in an exchange it needs a certain size and growth rate. The second problem is reporting, after the dot-com bust debacle the US implemented much more stringent regulations that required a very complex reporting structure and can conflict with a company’s long term strategy. And the third problem is investors’ need for liquidity, going public is not the same as receiving cash and it may take investors a long time to receive liquidity following an IPO.

The problem with size, or the 1B-30-30 rule

The minimum market capitalization nowadays for a company to have a successful public offering is U$1B. The reason is that any company with a smaller market cap than this will not receive research coverage from an investment bank. No research coverage means no trading volume, and without trading volume the stock price is highly susceptible to trades, making it very difficult for investors to sell any stock, which will in turn keep them from buying it in the first place. Bear in mind that the U$1B market cap is at the very low end and reserved only for “exciting” companies, those that make it easy to build a story around them. Ideally, an underwriter would prefer a market cap of U$5B or more.

The 30-30 part of the rule concerns a company’s growth rate and EBITDA margin. Pre-IPO investors for technology companies expect that a company going public is growing revenues at more than 30% year-on-year and that its EBITDA margin is more than 30%. And the numbers can be even higher for companies from emerging markets. The 30-30 rule is not ironclad. Investors are willing to compensate one number with another. For example, for a company with no EBITDA they will require a much higher growth rate, say 80-100%. While for a company with a slower growth rate, for example 20%, they will want to see EBITDA margins closer to 50%.

This problem is best seen in NetShoes IPO (NYSE:NETS). The company came out with a market cap of U$550MM – well below the U$1B market cap discussed above. That left the stock extremely vulnerable to any bad news from the business as any seller would substantially move the stock’s price. The company has consistently underdelivered in its financial results with the stock losing almost 90% of its market cap. With little trading volume, a very small sale of U$10,000 of stock can move the stock by 3%. Not what you want for your company.

Size is probably the main reason why we don’t see Latin American startup IPOs.

The Tyranny of Reporting

The main effect of the dot-com bust aftermath was the promulgation of Sarbanes Oxley regulation which created much more stricter reporting and oversight of public companies.  While we can debate how much it has helped shield investors form fraud, to this day no one has gone to jail as a result of the 2008 financial meltdown, what is clear is that it considerably increased the man hours required for filing and the amount of scrutiny public companies are subject to.

As a result, startups face two problems. On the one hand, putting together the administrative structure to serve all the SOX requirements is incredibly cumbersome. And on the other hand, it makes it much less appealing for a young, growing company to subject itself to the tyranny of the three-month reporting cycle which could force it to make some ill-fated decisions sacrificing the long-term success of the company.

Let’s remember that when it comes to start-ups the majority, if not all, of the company’s value is in its terminal value. Take PayPal (NASDAQ:PYPL) which was acquired by EBay for U$1.5B in 2002, a price deemed high at the time and now, after being spun-off from EBay, it has a market cap of over U$100B – 99% of its value was in the future. So being able to build a company for the long run makes all the difference.

The problem with reporting is a slightly smaller problem than the issue of size for Latin American companies wanting to go public (so few have the size to even try), but being able to comply with regulations, and wanting to do so, generates some important reservations.

Investors need for cash

For a company to have a successful IPO it needs to have a very good explanation of why it is selling a part of itself. If you remember the market for lemons theory, you should always be suspicious of willing sellers. Hence, when a company goes public the majority of cash it receives should be put to work in making the company more successful and only a small part should be used to cash out existing investors. While there can be exceptions to this in very hot markets, like in the dot-com boom, investors will see with very strong suspicion insiders cashing out in large numbers.

The problem this generates for existing investors is that in a public offering it may take them a long time to exit their investment. So, in a comparable price scenario, they will always prefer cash from an acquisition.

This is probably the smallest problem for Latin American would be public companies.

Summary

While going public might be every founder’s dream, the likelihood of it occurring is very slim. Therefore, I suggest when founders pitch investors on their exit strategy they leave an IPO off the table and instead really think hard about what type of company would be interested in buying. Almost certainly that will be the case.

Cristobal Perdomo is Co-Founder and General Partner at Jaguar Ventures. You can follow him on twitter @CPerdomoR. Cristobal shared his experience investing in startups in Latin America with Nathan Lustig here: (Crossing Borders Podcast #34).