Are Initial Software IPO and VC Valuations Converging?

Background

Software Initial Public Offering (“IPO”) valuations have skyrocketed over the past decade, climbing 430%+ since 2010, with a majority of the gains realized over the past 2 years. (Figure 1) This doesn’t come as much of a surprise given the S&P 500 has appreciated 109% over the last 5 years, while the Russell 2000 saw an 86% increase over the same time span. On the other hand, Venture Capital (“VC”) investments in the broader software space have always commanded elevated valuation expectations, as it relates to other tangential product niches, or simply other forms of investments that may carry a vastly disparate risk/reward profile.

Figure 1: Historical North American Software IPO & VC Valuations [1]

IPOs are a common exit measure for VC firms (although still dwarfed by M&A which is the primary path to exit). (Figure 2) With VC’s clear influence on IPO valuations, coupled with the unprecedented levels of public market euphoria, this begs the question – are we seeing initial software IPO and VC valuations converge? This blog post will explore the North American landscape of both the software IPO and VC markets in order to develop an understanding of whether the convergence exists, or if it is even possible.

Figure 2: Historical North American Software VC-backed IPOs

The Current State of the IPO Market

There has not been a better time in recent history for companies to pursue an IPO than in today’s environment. As mentioned previously, fresh public companies have been able to raise capital at levels not seen since the dot-com bubble. Ultra-low interest rates have played a major factor to the IPO market taking off. Moreover, software stocks in particular have been able to reap added success, as their valuations are often based on high expectations for their future earnings potential. In many cases, a decent portion of software companies filing for IPOs today have achieved great success despite displaying unproven profitability. As these companies are able to sell compelling growth stories and instill confidence to prospective investors, this generally has been enough to convince investors to put their money to work. (Figure 3)

Figure 3: Number of historical North American Software IPOs

Over the past few years, we have seen ultra-low interest rates cause people to desert cash, treasuries, the money-market, and high-grades to move out of the risk curve in pursuit of what they consider as acceptable returns. Due to the low returns on safe instruments, we see competition to continue to splurge into the aggressive instruments, and when individuals compete to put money out, they do so by being willing to receive low prospective returns at higher degrees of risk. This form of investor sentiment rooted in jubilation and desperation have acted as a key contributing element to why public market valuations are where they are currently.

The Nature of Venture Capital Investing

As seen in Figure 1, we see that initial VC investment valuations were at a record high in 2019, before lightly dipping in 2020, then drastically trampolining to levels well surpassing 2019 figures in the current 2021 YTD. For starters, it is clear that there are correlations between the public and private markets to an extent, with public market convictions typically leading private markets. Although the general YoY trends prove the relation from one market to the other, the differences in fundamentals between the VC and IPO markets are also important aspects to consider.

When considering any sort of investment, one must always consider an investment’s risk / reward profile. VC funds are often deployed towards early-mid staged companies with minimal levels of proven revenue and profitability, in comparison to its public counterparts. However, the growth potential in these early-stage companies is what separates VC investments from all others. In order to contend with other venture capitalists, VC investors have to put forth competitive equity investments at sky-high valuations. With the immense risk that comes with investing in unsubstantiated companies, VCs usually target a 30%+ internal rate of return (IRR) target to make sure their investments are worthwhile. In contrast, the same expectation is not held equal for public market companies, as public equity investors are shielded from much more risk in relation to VCs and growth expectations are not as steep. Liquidity risks, disclosure risks, operational risks, among others are a few added exposures that VCs need to safeguard against.

Final Thoughts

VC valuations tend to deviate more towards the extreme ends of the distribution in comparison to IPO valuations, due to its elevated risk / reward profile. With that, the convergence in 2020 valuations between the two markets was merely a one-off outlying scenario, as the March 2020 sell-off in the public markets consequently sent the VC market to slightly tumble. As mentioned previously, the public markets tend to lead the private markets. This implies that as the public markets rebounded following the major 2020 sell-off, the VC market subsequently followed in a delayed manner, and thus recovered in the tail-end of the year. This resulted in a crossover in valuations between the two markets.

All in all, with all else being equal, initial VC and IPO valuations should not be converging. The valuations for the two markets generally move in the same direction in accordance with market trends. However, VC valuations are much more sensitive to external factors and contingencies. Although valuations for these markets do not typically converge, it is entirely possible. Especially shortly after an extreme event in the public markets, such as a large sell-off or market rally.

Written by Jimmy Vo of Sampford Advisors

About Sampford Advisors

Sampford Advisors is a boutique investment bank exclusively focused on mid-market mergers and acquisitions (M&A) for technology, media and telecom (TMT) companies. We have offices in Toronto, ON, Ottawa, ON, and Austin, TX and have done more Canadian mid-market tech M&A transactions than any other adviser.

Photo by Daniel Lloyd Blunk-Fernández on Unsplash