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— A VPA Perspective

Why an IPO Is Not a Likely or Optimal Exit

Summary
  • How M&A often presents a better outcome for founders than going public
  • Why founders mistakenly opt for an IPO instead of an M&A transaction

Pursuing an IPO is often seen as the epitome of a successful exit for founders, bringing to mind visuals of founders riding off into the sunset, happier and much wealthier.

Despite the hype and inflated valuations of companies that go public, the IPO route may not be the ideal exit for founders.

Exiting through M&A vs. an IPO

Generally speaking, when entrepreneurs talk about making an exit, they are referring to a substantive liquidity event where in one fell swoop they cash in on years of equity building by selling all their shares for secondary capital, whether through an IPO or through a private acquisition.

In reality, an exit may be more incremental, in which founders sell some portion of secondary shares as part of each primary capital raise. This approach is ideal because founders are able to achieve liquidity while the business is doing well and mitigate the risks minority shareholder protections will place on a business.

While going public is a much more high profile exit strategy, staying private and incrementally exiting before closing a final M&A deal is a more common and often more ideal exit path for the average founder due primarily to liquidity.

Lock-up periods limit liquidity for founders

While publicly traded shares are normally highly liquid assets, such is not the case for shareholders in an IPO.

When a company goes public, shares held by company founders and managers are placed in lock-up for 6+ months. During that time, the founders’ shares remain illiquid and carry the risk of decreasing in value. As a result, a high valuation at the time of IPO (what the media focuses on) does not necessarily represent the economic rewards a founder will pull out when the lock-up period ends.

In M&A transactions, on the other hand, founders are not constrained by lock-up periods, so long as they work with an experienced, unconflicted investment banker that negotiates out buyer-friendly transaction terms like earnouts. Upon the sale of a business to a strategic acquirer, founders will receive immediate liquidity and mitigate the risk of loss.

According to the numbers, M&A transactions are where founders should go in search of liquidity. In the M&A space during the three-year period of 2017-2019, software companies based in the four largest markets alone (US, Canada, UK, and Australia) received a cumulative $505B in proceeds from acquisitions. In that same period, all software companies listed on US stock exchanges (excluding Chinese software companies) only raised a cumulative $13.8B in IPO proceeds—2.7% of the proceeds in M&A transactions in the four largest markets.

Even more surprising to consider is that from that $13.8B in proceeds from IPOs, only $1.1B (8.2%) constituted secondary proceeds to shareholders (i.e. cash to founders and VCs). The remainder went to each company’s balance sheet as primary capital.

Comparing the proceeds of the two markets, M&A had 448x the proceeds of IPOs. So despite the high valuations in the public markets, the M&A world holds significant opportunity for founders looking to make a true exit.

Secondary capital for founders in an IPO is minimal

Further exacerbating the liquidity issue for founders, any liquidity that does come out of an IPO tends to go mainly to institutional investors instead of founders or company managers.

During 2017-2019, the 5 software IPOs on the US Stock Exchanges with the largest secondary proceeds* (i.e. Dynatrace, Zoom, Endava, Docusign, and Dropbox) only issued a cumulative $121M in secondary proceeds to founders and management, despite the total proceeds from these five transactions totaling over $2.8B. For Docusign and Endava, none of the proceeds went to founders or managers at the time of IPO.

*Note: This segment ignores the unique direct listings of Slack and Spotify, as these IPOs were atypical.

If your goal as a founder is to receive some significant financial reward upon the sale of your business without delay, an IPO may not be the best option.

Going public outside the US is even less beneficial for founders

For companies who elect to go public in non-US exchanges like the London Stock Exchange or the Australian Securities Exchange, the secondary proceeds from the sale and the level of liquidity is much lower for an IPO than they would be for an acquisition.

Since 2017, the London Stock Exchange has had only 3 software IPOs (i.e. i-nexus, Avast, and Boku). During the same period, there have been 550+ M&A transactions in the UK. Secondary proceeds for the IPOs were ~$43M (average of ~$14M per company), and not all that money went to founders and management. Reported secondary proceeds for M&A transactions, on the other hand, totaled $51B.

The Australian Securities Exchange had similar outcomes: 4 software IPOs led to only ~$50M in secondary proceeds, while 80+ M&A transactions led to $2.1B in secondary proceeds.

While you may feel a sense of loyalty to your country’s stock exchange, consider your responsibility to yourself and your shareholders in determining whether going public is the right move.

Who benefits from going public?

Given that companies that go public don’t generate meaningful exits for management and founders, why do IPOs get so much airtime and general thought space by the entrepreneur community?

Because IPOs best serve the 1% of companies—the Salesforces and Googles with huge market opportunities—these deals are relatively few in number and thus high profile, lending to their caché. Participating in the 1% usually involves a fairly unique business model—for example, a model that requires burning significant sums of money to go after extraordinary market opportunities. The scarcity of companies successfully going public often increases the appeal, despite financial arguments in favor of M&A.

Another contributing factor to the appeal of the IPO are the dramatic spikes in valuation. Spikes in valuation on an upcoming or recently issued IPO draw the attention of and create discussion among a large audience of institutional and retail investors, often leading entrepreneurs to desire a public offering. However, these spikes come as a result of companies raising significant primary (balance sheet) capital and becoming a freely traded security, not from creating actual shareholder returns or improvements in company fundamentals.

IPOs make sense for some companies, companies that:

  • Have huge market opportunities
  • Have unique business models
  • Need to raise a huge amount of primary capital to grow

If your company doesn’t fit the IPO bill, the M&A world will better serve your company, your shareholders, and your personal financial objectives.

Consider M&A as the Optimal Path to Exit

While accepting M&A as the optimal route for selling your company may require you to surrender some of your ego, the final financial outcome will more than compensate you for your trouble.

Hiring an investment bank and starting preparations to sell will reveal the universe of strategic buyers out there interested in pursuing a transaction. These buyers are prepared to pay premiums for the company you’ve spent so many years building.

Modified on Jul 14, 2020