Initial public offering (IPO) season is in full swing. A bunch of young, private companies are actively pitching potential public investors on the future prospects of owning a piece of their vision. Some will succeed and others will fail.
To bolster the chances of picking a successful newly public company, it's important to do your research on every aspect of that company. In this article, we will dive into some of the often overlooked things that really ought to be considered when contemplating purchasing stock that has recently IPO'd. We will be using software companies Snowflake (SNOW -8.29%), JFrog (FROG -3.41%), and Unity Software (U -7.38%) as our high-profile examples.
What's important to factor into an IPO investment
While each newly public company is unique, some consistent themes can be found when studying these 3 IPOs (and others). These include:
- All 3 companies are growing at a rapid clip
- All 3 companies are enjoying improving margin profiles
- All 3 are far from producing positive earnings.
Stocks in the Nasdaq index are valued at an average of 4.1 times annual sales; the three companies we are focusing on here all fetch sales multiples of more than 20 times sales, making their valuations quite inflated. None of the three companies have positive earnings. JFrog is the closest of the bunch to generating positive earnings. It has positive free cash flow and is approaching positive net income. Still -- as is the case for Snowflake and Unity -- even JFrog can't come close to matching the valuation of a more mature public company.
There's a good reason for that: Mature companies are not expanding like these three highfliers are and they are also not sinking all their earnings back into the company. While stocks in the Nasdaq as a whole are set to grow revenue on average by roughly 17% year-over-year in 2020, JFrog and Unity will surpass 50% year-over-year revenue growth and Snowflake will comfortably eclipse 100% growth.
Understanding this makes the valuations more understandable and allows investors to better make a more informed final decision about whether the IPO stock might be a good value.
Don't forget the effect of employee compensation and lock-up periods
All IPOs are dilutive events. Newly public companies will generally issue large amounts of stock and options contracts to management as incentives along with the stock it issues to public shareholders. For example, as part of the Snowflake IPO, executives were awarded roughly $100 million in stock (or options) on top of the hundreds of millions of dollars in shares they already owned. The same is true for both Unity and JFrog, and both companies issued similar amounts to shareholding executives in both stock and options as well.
This practice is quite common, and it has two specific consequences for the company's investors. First, this move dilutes the ownership and voting rights of an individual share. With stock shares being created and issued, a company's share count grows and the intrinsic value of each stake erodes.
Second, these shares and all other shares owned by insiders cannot be sold during the first 90-180 days (the time varies depending on how the IPO was set up) of a company trading. This is referred to as the "lock-up period." It's common to see executives selling large chunks of stock when the lock-up period passes and share prices usually temporarily fall accordingly.
The larger the percentage of shares-outstanding held by insiders and executives, the choppier a share price can be heading into the expiration. This does not mean a long-term investor should wait for the lock-up to pass, but it's something to be aware of.
None of this is to specifically say companies like Snowflake, JFrog, or Unity Software are good or bad investments. Lock-up periods, stock-based compensation, and frothy multiples are all typical -- especially for software IPOs. The same could have been said at one point about every technology company, even the ones currently boasting a $1 trillion-plus market cap. Still, the three mentioned here are high-risk, high-reward names.
Knowing this, it makes sense to go especially slow when dollar-cost averaging your investments into companies like this (if you choose to invest), rather than buying in large chunks or even all at once. For that matter, keeping the position size smaller than you would with a lower-risk name is also usually the responsible decision. If a high-risk company you invest in thrives, you will not need to own a lot today to really enjoy the fruits of any successes. If it fails, you will only have wanted a small piece in the first place.
With IPO season in full swing, there's a lot of excitement in the air and therefore much noise to sort through. As for Snowflake, JFrog, and Unity Software -- just like the others in the IPO batch -- approach any potential investments with caution and do your homework. You will be happy you did.