Are IPOs Good Investments?

How have software IPOs performed and should you buy the next big IPO

Klaviyo’s IPO debut will start trading today and will represent the first software IPO in almost 2 years, with the last true cloud IPO being Samsara in December 2021. As things start to stabilize from a market volatility and market multiples perspective, the IPO window is starting to open.

There are two primary factors that lead to the IPO window opening up:

1. Valuation multiples - want as high as possible

2. Market Volatility - want as low as possible

Valuation multiples will probably never come back to the levels seen in 2021 but they have seen a recovery from their lows and appear to be fairly stable. Also, companies have had time to adjust to the new investor expectations — get to profitability faster! It’s amazing how fast public companies have adjusted in such a short period of time.

High investor demand for a stock is a critical attribute for a successful IPO. And this is why companies are quickly focusing on efficiency and those who don’t will struggle to attract investors. Revenue growth is still important but investors want to see increasing profit margins. This is why it makes sense Klayivo feels comfortable being the first software company to IPO since 2021 — its growing 51% with 24% free cash flow margins, which is pretty incredible.

Market volatility (2nd piece of an opening IPO window) has decreased significantly as well which is positive for the IPO market. Volatility in the stock market makes investors nervous about investing in a newly public company which will likely be even more volatile than the general market. This creates significant challenges in pricing the IPO. A terrible outcome is when a new IPO breaks issue, which means its stock falls below the original IPO price. This becomes much more difficult to predict/control during times of high volatility.

Are IPOs a Good Investment?

To answer this question you also need to consider “for what type of investor?”. We need to understand the different investor and market types:

Investors:

1. Pre-IPO investors: Venture capitalists (VCs), Private Equity (PE) firms, and sometimes institutional investors.

2. Institutional investors - this group gets to buy the stock at the "IPO price”. These are mutual funds, banks, hedge funds, etc.

3. Retail investors (you and me) - who get to buy the stock on the normal stock exchange.

Markets:

1. Primary market - original issue shares from the company (creation of securities). The primary market is almost always for the pre-IPO investors and then institutional investors at IPO.

2. Secondary market - existing shares are traded amongst investors. The secondary market is where you and I play. We buy/sell stock that already exists on the stock exchange.

Pre-IPO Investors

These investors take the most risk because a lot of things can go wrong, especially the earlier stage the company. But these investors rely on the power law of returns - that a small number of investments in a venture capital portfolio will generate the vast majority of returns. Some will work and some won’t, but hopefully the ones that are successful do REALLY well to make up for all the losses and provide a return commensurate with the risk. Generally, the later stage a company (closer to an IPO) the less risk and less return the investors expect.

But this doesn’t always work out…

Instacart IPO’d yesterday at 24% of its prior $39B pre-IPO valuation. Ouch! At the close of Instacart’s first day of trading, any investments made after 2018 is currently underwater (trading at a smaller valuation).

VC firm Sequoia invested in Instacart’s Series A (very early) and also some of the following rounds. Sequoia invested ~$300M in total and as of yesterday (the first day Instacart’s IPO) has a return of ~$1.7B. However, the majority of this return came from its $8M investment in the Series A.

Source: Aswath Damodaran

Institutional Investors

These investors may participate in funding late stage private companies, like Fidelity and T.Rowe seen above in Instacart’s pre-IPO fundraising. Institutional investors are also the ones who primarily invest in the IPO (primary market) and get the “IPO price”. In limited circumstances retail investors can invest here too but it is generally small and very limited on who, if any, can participate.

Companies work with their investment bankers to set the IPO price based on demand from these investors. Setting the price is a balance between getting the highest price, ensuring they get the investors they want, there is a nice pop in price on day 1, and the stock trades at a price above the IPO price (i.e. it doesn’t “break issue price”).

A key point is that retail investors (you and me) usually cannot generally buy shares at the IPO price, but rather we have to wait until the stock trades on the open stock exchange. As an example, Instacart’s IPO price was $30/share but shares at that price were allocated by the company primarily to institutional investors. You and me had to wait until yesterday to buy shares when they started trading at $41 and eventually closed at $34.

This is the “IPO Pop” that gets headlines like the below. But typical retail investors aren’t getting this amazing immediate stock gain on day 1….In fact if you bought as soon as you could yesterday then you probably lost money as the price slid from $41 to $34

The “pop” benefits the institutional investors. Some may sell on day 1 but most will be long-term investors and plan to hold the shares.

Retail Investors

These are the folk like you and me who can only buy on the secondary market via the stock exchange.

We don’t get to benefit from those juicy IPO pops with a median 1 day gain of 38%. Rather we are the suckers who buy at the post pop price…

It’s important to remember that typically the only shares tradable on day 1 of the IPO are the shares just barely purchased by the institutional investors (and potential some “friends and family” who were allocated shares). The rest of the stock held by prior investors and employees is typically locked up for 180 days, which means they can’t sell their stock until the lockup expires. The “float” refers to the tradable shares. Because most IPOs restrict all equity held previous to the IPO, the float is often quite small (as seen below).

Also, the float is total potential tradable shares, but many of the institutional investors that purchased IPO shares are holding long-term so the actual % of shares trading hands can be really small. This can create a lot of volatility and unexpected movements in the first 6 months until the lockup expires and all shares are tradable.

How have historic software IPOs done?