Successful startups need to give customers a significantly faster, cheaper, more convenient or just plain better experience than what they’re used to. In venture capitalist circles, the experience must be at least 10 times faster, cheaper or more convenient in order to invest. Otherwise, powerful legacy companies with vast amounts of marketing dollars and customer loyalty could still win out against a startup’s superior user experience.
Seeking these successful startups is part of an early investor’s playbook. But just because a company thrived in the private markets doesn’t mean it will succeed in the public markets.
In the private startup markets, hypergrowth companies are rewarded with higher and higher valuations. But things can fall apart when these startups enter the public markets, often with a big splash and a high initial public offering (IPO) price.
One of the first problems these post-IPO companies encounter is slowed growth. In some cases, like Uber’s, the growth slowdown happens even before these companies launch their IPOs. Without profitability or fast growth, the IPO hype surrounding these companies can fade quickly.
Another reason things fall apart: Startups tend to issue IPOs when investors are paying high prices for similar stocks and their valuations are peaking. No wonder the average IPO – according to a recent Fortune report – underperforms otherwise similar stocks by 7% to 8% in the three years following the offering.
These are some of the reasons why I’ve never been a big IPO fan. My colleague Adam Sharp and I have talked a lot about how the bulk of a company’s growth now happens in the years before it IPOs.
Legacy companies don’t like IPOs either. A Journal of Financestudy shows firms experience a 3.3% decline in sales growth and a 2.9% reduction in profitability during each of the three years following an IPO in the industry.
But that doesn’t explain why entire industries see their stock prices (and profits) decline following the typical IPO.
Take Uber’s recent IPO, for example. It unleashed new technology and competition in the ride-hailing markets – a good thing for customers. But it’s not such a good thing for legacy taxi and limo companies. And with Uber’s stock price scuffling, the entire ride-hailing industry is now a danger zone for investors.
This is more typical than you may realize. Success breeds success, whether it’s in the private or public sector. Pre-IPO startups compete against each other not only for customers but also for investment dollars. And the ones that attract the most investment dollars deploy those funds to grow their customer base. It’s a virtuous cycle where a single company usually emerges head and shoulders above its competitors.
But once this company joins the public sector, the cycle tends to break down. A large startup in terms of revenue in the private sector often becomes a small company in the public sector. The Fortune report says that when firms go public, they typically have a market share of less than 1%. Just as importantly, they stay small. Most increase their market share by less than 1% in subsequent years.
In the meantime, competition ratchets up. When startups with compelling products enter the space, legacy companies respond with new products and strategies. Two months after Blue Apron’s IPO, Amazon purchased Whole Foods. Blue Apron’s price has plunged 92% since then. HelloFresh went public later the same year. Its price is down “only” 18%.
Thanks to increased competition, customers now have more choices than ever. And they’re more likely to exercise that right to choose. So previously loyal customers have become easier for competitors to steal.
It’s true that competition is what makes free markets work. But fierce competition can hurt profitability across an entire industry. And it can keep investors from knowing who the winners and losers will be.
Observers accuse the pre-IPO startup world of being unpredictable and chaotic. But I’d argue the opposite: It’s the post-IPO world where technology disruption wreaks the most havoc among companies.
Co-Founder, Early Investing
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Source: Early Investing