Armanino Blog

Despite a Hot IPO Market, Startups Face Tougher Investor Scrutiny

by Michael Hogan
July 17, 2019

Explosive gains in the immediate aftermath of some recent high-profile initial public offerings suggest a robust IPO market, but the success of a few unicorns is unlikely to translate broadly to the startup sector. As a result, investors have become more selective, and companies seeking public or private funding now need to prove not just growth, but also their path to profitability.

A Hot Market Across Industries

By all measures, the IPO market has been hot this year. According to Renaissance Capital, the second quarter of 2019 was the most active quarter by deal count in the past four years. Overall, 62 companies raised $25 billion, the highest total in five years. This activity compares with 191 IPOs in 2018, which was dominated by healthcare and biotech startups.

A number of the 2019 IPOs triggered large gains and excited headlines that suggested an attractive environment in what Pitchbook has dubbed the "Summer of Unicorns." But the strong returns at the top of the market may be masking dimmer prospects for private companies struggling to gain additional investment. Many analysts, including at Pitchbook, believe the wildest days may be behind us.

The newly public companies that resonated with investors have come from different industries but shared attractive growth and a clear path to profitability. (How they'll fare in the longer term remains to be seen.) This year's successful IPOs include online pet supply retailer, security software provider Crowdstrike, collaboration tool Slack and food company Beyond Meat.

In contrast, two offerings that so far have proven disappointing — ride-booking companies Uber and Lyft — have yet to demonstrate to investors how they'll be able to reverse continuing losses.

This dichotomy is creating stratification among private companies that hoped to become public, with potential medium-to long-term challenges for their ability to obtain later-stage funding.

The Impact of Delayed IPOs

Much of the growth in this year's IPO market is coming from private companies that have long been large enough to become public, but have delayed doing so for a variety of reasons. Those reasons may include attractive returns in the broader market that reduced investor pressure for startups to issue IPOs, or a desire among private companies to avoid the heightened compliance and reporting requirements that follow a public offering.

Having so many companies remain private for this extended period has had two effects. First, pent-up demand for IPOs may be skewing investors' perceptions of the market's overall strength.

Second, delays in public offerings meant that a lot of the gains that investors may have expected from an IPO were instead realized in mid- and late-round capital raises. As valuations increased in these rounds, companies that couldn't demonstrate current or near-future profitability became less attractive for IPO investors.

At the same time, a growing number of startups have become large enough that, regardless of profitability, they all but have to go public to provide liquidity for earlier investors and employees.

Investors Are Focused on Profitability

Despite compelling returns for many leading companies that went public, investors are showing less interest in continuing to fund growth based on vague notions of how a startup will become profitable.

Private companies that would have raised series C or D rounds of capital easily a year ago (merely by suggesting "hockey stick" growth projections) are likely to find challenges doing so this year and next unless they can tell a credible story about customer growth and profitability.

In this environment, venture capitalists will likely be reluctant to continue funding companies that are unable to demonstrate profitability. This reluctance is spreading to companies, or sectors, that appear to offer less-attractive returns.

Similarly, VCs that have achieved significant gains on other portfolio companies are less inclined to continue funding companies with less attractive prospects. Many would prefer to close a fund and invest their realized gains in a new fund.

Startups Need to Evaluate Their Options

For startups in this middle or lower tier, continuing to pursue growth for its own sake is no longer likely to provide a viable path to the public markets. These companies are likely to face financing and strategic challenges and may need to evaluate their alternatives carefully.

Those options may include an earlier exit through a strategic transaction, pivoting the company's business model, or refocusing on revenue or profitability.

Some companies may need to moderate their growth expectations to increase their potential profitability. For instance, instead of investing with an expectation that they need 1 million customers to achieve a high degree of profit, they may be better off recalibrating so 750,000 customers enables a lower degree of profitability, but with lower investment requirements.

Despite today's IPO headlines, startups need to consider their alternatives carefully and objectively to find the best strategy for their short- and long-term success.

To learn more about optimizing your strategic options, contact our Corporate Finance and Restructuring Services team

Stay In Touch

Sign up to stay up-to-date with the latest accounting regulations, best practices, industry news and technology insights to run your business.

Related News & Insights
Costco Travel Webinar
One of the world’s top retailers reveals their cloud upgrade process.

May 19, 2022 | 11:00 AM - 11:30 AM PT
Overview of Sage Intacct R2 Release Webinar
Learn the newest features and enhancements in Sage Intacct from the 2022 Release 2.

May 18, 2022 | 01:00 PM - 02:00 PM PT
Foundation Cuts Manual Data Entry, Empowers Staff With Robotic Process Automation
Case Study
RPA tech enables lasting growth, boosts savings and frees up staff to redirect their time to meaningful strategies.

May 18, 2022