Why I think we might be in a significant tech IPO bubble

[Guest ajc]

 

 

IMO including biotechs into any kind of "tech" P/S calculations makes no sense. Biotechs IPO at infinity P/S all the time. That's the game in bio town.

 

Not that we can't expect 50%+ drops from IPO or post-IPO+++ prices. Look at STNE today. Might get to 50% off the top.

 

Disclosure: I am long STNE.

 

 

 

Yeah, that was done because that 40-year table of tech IPO valuations by Prof Ritter that I've cited, includes biotech, if I remember correctly.

So if you want to compare current tech multiples to the Dotcom era using that data, like I've tried to, then they'd need to be included.

 

 

 

[gjangal]

One way to play this for fun is to put some play money and participate in a mania. You never know when it ends and you don’t know if it’s 1998 or 2000.

[rkbabang]

One way to play this for fun is to put some play money and participate in a mania. You never know when it ends and you don’t know if it’s 1998 or 2000.

 

I just wish I had the foresight to have bought ZOOM at $0.01 a few months ago so that I could have sold it >$5 today.  Anyone with a sufficiently low opinion of humanity should have been buying ZOOM as soon as they found out that Zoom Video Communications was going to go public.  I completely missed this.

 

[Cigarbutt]

IMO including biotechs into any kind of "tech" P/S calculations makes no sense. Biotechs IPO at infinity P/S all the time. That's the game in bio town.

 

Not that we can't expect 50%+ drops from IPO or post-IPO+++ prices. Look at STNE today. Might get to 50% off the top.

 

Disclosure: I am long STNE.

It is the name of the game and recent postmortem comments about Theranos mentioned that, to varying degrees and perhaps sometimes in a greater fool kind of way with sequential rounds of financing, it is expected that promoters will "lie" as the frontier with an effective sales pitch can be moot and, in certain circumstances, the level of willful blindness can be high. Theranos went through ten rounds of financing!

 

Anyways, in the biotech IPO sector, there is definitely a new era sky-is-the-limit mindset that has permeated and which, I find, is manifest in valuation levels and earlier phase projects (Preclinical and Phase 1 and 2 offerings versus Phase 3 and later offerings) are met with a wave of increasingly optimistic investors, at stages when a leap of faith is part of the game plan.

Somebody seems to see the same phenomenon from a bird's-eye view:

https://www.forbes.com/sites/brucebooth/2018/09/24/the-rising-tide-of-biotech-ipo-valuations/#2036ed6165a8

 

BTW, I have nothing against the $ funding these ventures as the likelihood of positive outcomes is likely to increase, on a net basis, the same way I don't think casinos should be regulated.

[Guest ajc]

 

 

Yeah, that was done because that 40-year table of tech IPO valuations by Prof Ritter that I've cited, includes biotech, if I remember correctly.

So if you want to compare current tech multiples to the Dotcom era using that data, like I've tried to, then they'd need to be included.

 

 

 

 

My mistake. I went back and saw that biotech wasn't included in the analysis.

 

 

 

"There are 3,086 tech stock IPOs, after excluding those with an offer price below $5.00 per share, unit offers, ADRs, closed-end funds, natural resource limited partnerships (and most other LPs,but not buyout firms such as Carlyle Group), acquisition companies, REITs, bank and S&L IPOs, and firms not listed on CRSP. Missing and questionable numbers from the SDC new issues database are supplemented by direct inspection of prospectuses on EDGAR, information from Dealogic for IPOs after 1991, Howard and Co.’s Going Public: The IPO Reporter from 1980-1985, and the Graeme Howard-Todd Huxster collection of IPO prospectuses for 1975-2006. Tech stocks are defined as internet-related stocks plus other technology stocks including telecom, but not including biotech. Loughran and Ritter (2004) list the SIC codes in their appendix 3 and sources of founding dates in appendix 1. The definition of technology stocks has been changed from that in Loughran and Ritter (2004 Financial Management), with SIC=3559, 3576, and 7389 added to tech. Some 7389 (business services) companies have had their SIC codes changed into non-tech categories, such as consulting and two new SIC codes: 5614 for telemarketing firms and 7388 for non-tech business services such as Sotheby’s Auctions.

 

For the column with VC-backed IPOs, there are 3,091 IPOs including both technology and nontechnology companies. For buyout-backed IPOs, the founding date of the predecessor company is used. Price-to-sales ratios are computed using both the offer price (OP) and the first closing market price (MP) for computing the market capitalization of equity. Market cap is calculated using the post-issue shares outstanding, with all share classes included in the case of dual-class companies. The undiluted number of shares is used, which is some cases (e.g., Facebook, Twitter, and Castlight Health) understates the market cap due to the existence of substantial amounts of in-the-money employee stock options that are highly likely to be exercised. Sales are the last twelve months (LTM) revenues as reported in the prospectus. The median sales, in millions, is expressed in both nominal dollars and in dollars of 2014 purchasing power using the CPI. The median age, in years, is the number of years since the calendar year of the founding date and the calendar year of the IPO. The percentage of IPOs that are profitable measures profitability using trailing LTM earnings (usually using after extraordinary items earnings, and usually using pro forma numbers that are computed assuming that any recent or concurrent mergers have already occurred, and the conversion of convertible preferred stock into common stock). In some cases, last fiscal year earnings are used when LTM earnings are unavailable.

 

Even concepts like market cap (for the price-to-sales ratios) become ambiguous when you realize that companies like Facebook have many deep in-the-money options outstanding, so whether you use the fully diluted number of shares or the undiluted number can affect the calculations substantially for some companies."

 

 

 

From page 12 of https://site.warrington.ufl.edu/ritter/files/2019/01/IPOs2018Statistics_Dec.pdf

 

 

[oddballstocks]

Here is the other side of the argument.

 

In the last few months I've talked to a LOT of VC investors, talked to a lot of startups.  All non-public (obviously).  I think the VC world looks confusing to all of the Debbie downer value investors, but it actually makes a ton of sense, it has a significant value component imbedded in it.

 

First off, for anyone not in the arm-chair investing world and working in operations you know and understand there is a LOT of digitization that can occur in the business world.  There is so much low hanging fruit that people are practically getting knocked over by it.  By this I mean companies are filled with people doing things inefficiently and repetitively.  Yes, there are some stupid ideas out there, but also there are a lot of stupid ways of operating that everyone caulks up to "this is how we've always done it."

 

I've really enjoyed getting involved in the entrepreneur community, it's a huge breath of fresh air.  People are smart, creative, and optimistic.  As the market has continued up value investors seem to have become cynical and tired.  I'd rather hang out with someone who has new ideas vs someone who keeps repeating "that will never work.."  You get my point.

 

When you talk to VC's almost all of them will say "grow with revenue, you don't need VC money."  And by in large this is true.  The VC money is appropriate when you have a large startup cost that you need scale to achieve unit efficiency, or there is a land grab aspect to the business.  If you don't have those then you can just grow via sales.

 

There are two other corner cases, biotech and materials.  In biotech it's obvious.  You have FDA costs and trials that you need to get through before ever selling a thing.  My experience is VC firms are either "we do biotech and medical devices" or "we don't touch it"  it's very specialized for obvious reasons.  Materials are the same.  You need to hire a bunch of PhD's to develop the thing, work out the manufacturing and then sell.  You can't bootstrap something where you need a $5m lab.  This is why universities usually fund these ventures.  A professor and students invent some thing, the school funds it then invests in the company.

 

Venture Funds are typically small compared to the hedge fund world, maybe $40-80m at the most.  There are a few whales, but it's rare.  They create a new fund, it has a ten year life and they work to fill it.  The idea is within a decade the company will work out or fail. 

 

I know the stereotype is these funds are just throwing money into the wind, but it's difficult to get money.  The primary thing they're focused on is personalities and avoiding losses.  Just like value investing, if you lose money your gains have to be that much greater.  VC investing is like job interviewing.  They are talking to the Founders, and all of the clients.  They're talking to friends and looking out for personality flaws.  If the business is excellent but the people aren't then it's possible the people won't be in charge too long if they take money.  That's how the game works.

 

If you look at the growth path, or how some of these companies plan on taking over a market then paying some crazy high multiple can work at the start if they can execute.

 

I don't mind seeing crazy IPO's.  That's what the market was for originally.  It was the original venture market.  New ventures would IPO, they'd take public money and try to execute.  Now we have this weird system where the only companies that are public are stodgy old companies, or massive things. 

 

It should be easy and cheap to IPO.  But as we all know being public is expensive, so that door is closed.

 

The disadvantage that a public investor has is they can't do the DD that a VC firm can. 

 

I have this maxim in life that if something doesn't seem to make sense then I probably don't understand it well enough.  There are reasons people and industries do a lot of things, and once I understand it always makes sense.  It doesn't mean it's right, but it makes sense as to why things happen the way they do.

 

I like buying cheap things, but I also like optimism.  Instead of just saying "all this dot-com stuff is crap and it's a fad" I'd prefer to have a bit more of an open mind about things.  It's possible some of these companies are legitimately cheap, or the second possibility remains that in a downturn some of these companies will become cheap.  If you've closed off your mind then you'll never have the opportunity to buy.

 

And for the record I don't think we have a bubble.  Access to cash for speculative companies is down hard over the past few years.  Three to five years ago you could do series A round with $0-$10k in monthly recurring revenue, now it's $50k or more with a lot of VC funds wanting $100k+ MRR.  This means the people raising now have figured out how to grow and scale to a million in revenue before they're able to raise a significant round.

[Spekulatius]

Oddball - good perspective. We are talking about late stage funding here vs early stage funding. Both are different areas, The complaint here is not about viability of the business, but rather the valuations being assigned to these late stage ventures. I believe the evidence points to valuations being high, but I also believe that the quality of the companies IPO’ing now is better than the cohort in 1999/2000.

[Jurgis]

Oddball - great to hear your thoughts again. I've been looking at/involved with some pre-revenue companies and it's great to hear about the VC funding situation.

 

I agree with Spek regarding valuations and quality of IPOs.

[SHDL]

This discussion reminds me of a nice quote from a VC who lost a fortune in the aftermath of the dot com bubble that went something like “no great thing has ever been accomplished without irrational exuberance.”  His point was that financial bubbles can actually have a social purpose, which is to encourage people to take chances on certain high-risk-high-return endeavors that otherwise would have trouble getting adequately funded.  That is a great observation, and my guess is that the human brain evolved in a way that makes them susceptible to occasional manias for exactly this reason.