Editorial: Caveat emptor for buyers of IPOs

There is a reason traditional theories of venture capital funding looked at initial public offerings (IPOs) as just an extra round of capital rather than opportunity to exit immediately.

The agreed acquisition of Nasdaq-listed online communication and workplace collaboration tools provider BroadSoft for $1.9bn by Cisco Systems this week reflects the tremendous value creation in the target company since its flotation in mid-2010 at a $222.5m market capitalisation, according to Crunchbase data.

BroadSoft had raised $67.5m in its IPO and $77.5m over six rounds of venture capital starting in the final days of the original dot.com boom in the late 1990s, including from then-active corporate venture Comdisco, according to Crunchbase. 

BroadSoft used its public currency to acquire businesses before agreeing to the purchase by Cisco, itself a prolific acquirer with 154 mergers and acquisitions (M&A) on its scoresheet since the early 1990s, including the $3.7bn acquisition of AppDynamics, a business monitoring software provider, and of Perspica, a company that uses machine-learning to analyse data, this year.

Rob Salvagno, Cisco’s M&A lead, told Axios journalist Dan Primack yesterday not to expect Cisco’s M&A engine to slow down any time soon, particularly as it continues to diversify from its hardware roots.

Cisco is shifting its focus from technology hardware, such as modems and routers, to cloud-based software, which is typically sold as a subscription.

This type of time-to-IPO and capital raising, and use of proceeds was fairly typical of its type, as analysed by EquityZen a few years ago, but fears are increasing that the pipeline could be breaking down.

The traditional conveyor belt of capital has come under strain as these types of mergers shrink the overall numbers on the main US markets and companies wait longer to float.

The number of US stocks has been shrinking for 20 years from a 1997 peak of 7,459 to 3,599 in the Wilshire 5000 Total Market Index by June, according to USA Today.

However, with global equity markets at record highs and volatility low, global IPO activity has been “brisk” this year, especially in China, according to accountants Ernst & Young (EY).

Martin Steinbach, EY global IPO leader, said in its third-quarter report: “Final numbers for 2017 could fall in the range of 1,600 to 1,700 IPOs and $190bn to $200bn in capital raised and this would mark 2017 as the best year for global IPO performance since 2007.”

The Asia-Pacific region continues to dominate IPO activity both by number of deals and proceeds, accounting for 60% of IPOs and 42% of capital raised worldwide so far [first nine months] in 2017, EY added.

But as companies list, their filings can reveal some uncomfortable home truths. China Money Network, which tracks venture-backed companies worth at least $1bn (so-called unicorns) said this week: “As more Chinese companies go public it is becoming increasingly clear that many of them have lied about the level of funding they received as private companies, and thus their pre-IPO valuations.

“The latest example is Rong360, once listed on China Money Network’s China Unicorn List with a $1bn valuation. The company is planning a US listing for its wholly-owned subsidiary Jianpu Technology, raising up to $200m, according to its IPO prospectus filed with the US Securities and Exchange Commission.

“However, a review of the 230-page prospectus shows that the company exaggerated all four of its funding rounds, by an average 40%. It also proved that Rong360 never achieved unicorn status….

“A case of one Chinese company inflating its pre-IPO valuation would not be that much of a big deal. But a review by China Money Network of several other recent IPOs shows that less-than accurate reporting by private companies may be commonplace. For example, both Chinese peer-to-peer lending platform PPdai, which completed an IPO earlier this month, and e-book mobile app developer Zhangyue, also lied about their past financing rounds.

“The trend is significant given the number of Chinese companies going public. During the first half of 2017, a total of 312 Chinese firms completed a public float, up 203% year-on-year. Among them, 158 companies were backed by venture capital and private equity firms, allowing a total of 455 investment firms to exit with an average of 2.69 times return, up 35.86% compared with second half 2016, according to data from a ChinaVenture’s report.”

That these companies are still accessing the public markets indicates investors are taking a view that future probity will not necessary follow past behaviour.

But it is always hard for a leopard to change it spots and if exaggerations are found in one area then other issues are probably not far behind and are likely to be revealed when the tide in public markets starts to flow the other way.