2019 has proven to be a challenging year for a number of tech IPOs.  The swooning media speculation about mega-valuations has given way to the hard reality of investor skepticism and declining share prices for many.

Analysts and the media have written much about business models and tortured paths to profitability.  However, after having read a number of the prospectuses I think the more interesting question is: what exactly was management thinking when they drafted them (or rather, had them drafted?)

After all, most unicorns remain unprofitable despite operating for years and some growing to substantial size.  Yet they were asking public investors to give them billions of additional equity to support further growth (and cash out their private investors in the process.)

The truth should have been obvious – that many of these offerings were not going to be a slam dunk with investors.  One would think that management would realize that and strive to craft credible investment stories supported by meaningful disclosure to win over skeptical investors.

Nope.  That didn’t happen.

What investors read in a number of prospectuses was a lot of puffery, extensive risk factors (understandably) and the minimum required GAAP disclosure.  Needless to say, they were unimpressed.

Whether these were sins of omission or commission is hard to say, but a successful IPO requires a real shift in senior management mindset from the world of private backing.  Going public is many things, but it is ultimately an exercise in corporate self-awareness.  Markets tend to uncover a lot of hard truths about companies that may have been conveniently ignored when private.  Yet many of this year’s share debuts suggest that the needed transition from private to public in management mindset has not gone well.

Given the lack of meaningful content in a number of prospectuses, it seems few managers understood (or cared?) how investors would assess their companies.  Obviously, management should care.  IPOs are high-profile affairs.   Difficult flotations do not enhance a management’s market credibility and they generate a lot of unhelpful media coverage.

Public markets are different and that needs to be understood.  Investor motivations are unlike those of private/VC backers.  While by no means definitive, here’s a list of how public investors approach investment decisions differently:

Profits matter.  Duh.  Investors seek returns and profits are the engine of generating market returns.  That said, there is no requirement to be profitable when going public, ongoing growth is great, but investors ultimately frame everything around profits.  After all, to an investor future growth without credible prospects to achieve profitability is just more losses.  Investors don’t do the “vision thing” well if their models show an income statement that is perpetually red.

Growth isn’t always a panacea.  With good reason Amazon is the favorite example of the “growth first, profits later” plan (although other examples could include Webvan, E-Toys and Pets.com.)  But some things are different with a lot of today’s IPOs that make the growth story a bit more complicated.

First, many unicorns have operated for much longer periods as private companies and are much bigger than the IPOs of the past.  Amazon went public less than 3 years after its founding, and it reported just $16 million of revenues in its last quarter as a private company.  That left a lot of future growth for the public investors to model in their analytical quest for profits.  Uber by comparison had $2.8 billion of adjusted revenues in its last quarter as a private company yet is still losing billions of dollars annually.

The challenge here is the law of large numbers weakens the “don’t worry, be happy” growth pitch as investors will inevitably model slowing growth rates.  That leaves less maneuvering room for the company to achieve profitability in the future.  It also heightens investor scrutiny of why the current business model is unprofitable despite its size.

Investment horizons are shorter for institutional investors.  A typical portfolio manager has an investment horizon measured in quarters, not years.  No public investor can hold a money-losing investment for as long as a VC may hold a private investment.  That doesn’t preclude him from owning a company that remains unprofitable for many years, but the investor needs to have credible evidence that profitability is more than a distant promise.

Every position matters to a public investor.  A VC investor knows that many of his investments will not pan out.  However, the VC also knows that across the portfolio there will be some monumentally successful investments that will more than offset any losses.  Investment managers do not have that luxury as a successful equity holding will never match the returns of a successful VC investment.  So, investors have little appetite to hold an underperforming position in a portfolio (and unlike the VC investor, they can exit quickly).

The pressure of daily valuation.  Public investors know the performance of their portfolio daily.  That performance is typically governed by a rigid internal infrastructure of investment committees, performance benchmarks, and the quarterly letter to their own investors.  They can’t hide underperformance in their portfolio or put off realizing it until the next funding round.  That “tick tock” of the daily price focuses the investor’s mind and limits the patience to keep an underperforming position.

It seems these rather obvious observations were lost on a number of unicorn management teams given the content of their prospectuses.  Apparently some seemed to approach an IPO prospectus as another private funding pitch.  The transition from private backing to public markets was clearly underestimated.

Hopefully, for some a lesson has been learned.  The good news is there’s time.  An IPO is just a single step on a company’s long journey and frankly too much media attention is focused on that single step.  Good management teams understand that they are running their companies for the long term.  So, no matter how rocky the IPO may have been, there is time to adjust and management can learn how to engage their public shareholders more effectively.  It will certainly be in their interest to do so.   A famous quote from Winston Churchill (obviously in a very different context) following the Second Battle of Alamein in 1942 captures a thoughtful perspective that those doing, or just having done, an IPO should keep in mind:

“Now is not the end.  It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”