About the author: Ben Rose is President of Battle Road Research, an independent equity research firm.
After a stellar year for tech IPOs in 2021, new listings fell sharply last year. The stock market correction of 2022 caused the largest tech stocks to fall more than the S&P 500 on a percentage basis. The decline in investor interest in even the most established tech stocks was a key reason for the lack of new issuance. The correction signaled the end of the free money era and severe valuation compression made it difficult for private companies to get a clear picture of their public market value.
All technology company IPOs in 2021 came to market after showing revenue growth, often exceeding 20%, in the year leading up to their debut. But virtually all of the tech IPOs we’ve added to our Battle Road IPO Review generated losses leading up to their IPOs. Not only were the companies unable to turn a profit, virtually all of them posted even bigger losses year-over-year, as if the companies were being urged by their shareholders to have one last feast to fuel top-line growth. Many of these companies promised that once they went public they would embark on a steady diet of reduced operating expenses to chart a sensible path to profitability.
One reason for executives and private round-robin investors to justify the spending spree is a belief in the Rule of 40, which says that any combination of 40% combined sales and earnings growth is the best determinant of sustained demand for a company’s public market is rating. For example, in both theory and practice, a company could have a revenue growth rate of 20% and be operating at significant losses. The formula worked for several years, up until last year’s tech stock crisis. But the stress test of last year’s market correction has disproved the 40 rule. Even the fastest-growing companies had their market caps slashed to the bone in a year of growth stock compression.
Demand for growth stocks has changed fundamentally over the past six months. Technology giant Microsoft
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Google
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Amazon
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Metaplatforms and Salesforce
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among many others, laid off staff after unsustainable increases in demand for their services combined with over-hiring during the pandemic. The decision to reduce operating expenses by companies that were already profitable is a sign that the terrain has shifted from revenue growth at any cost to growth with sustained profitability.
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Before answering why profitability matters, it’s worth asking whether companies looking to go public in 2023 have the discipline to demonstrate not only revenue growth but also a pattern of steadily decreasing losses. My guess is that many don’t. However, the message that growth at any cost is no longer enough has to be learned the hard way. Valuations of many private companies have been lowered to reflect the lower valuations of their publicly traded peers. In fact, venture capital funding fell to a nine-year low in the fourth quarter of 2022, the Wall Street Journal reported. Running a business profitably is ultimately rewarded, but the number of companies able to do so is likely to remain limited.
Profitability matters because it shows that a company has the potential, if not the power, to determine its own destiny. Conversely, operating losses are an indication that a company has yet to prove that its business model works. The concern is that a company that’s losing money today will have to be bailed out tomorrow with future stock offerings or convertible bonds, which in turn will dilute interest from existing shareholders. It also means a company can’t buy back shares to offset stock issuance, a favored form of compensation for tech companies that, if left unchecked, leads to shareholder dilution.
A company that can’t turn a profit today — no matter how promising its growth prospects are — may not be ready for the stock market turmoil just yet. And if an unprofitable company slips through the IPO window, it likely needs to be bailed out by a fresh round of investors, public or private. Until private companies and their financiers realize that the terrain has shifted away from growth at all costs to growth and profits — or at least a short-term path to break-even — the tech IPO wave is likely to remain dry.
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