Revisiting the IPO Boom of 2021

2021 was a milestone year for companies going public. In 2022, the tide turned. In this podcast, Motley Fool analyst Dylan Lewis and Motley Fool contributor Brian Feroldi look back on the IPO boom and discuss:

•  Reasons why companies go public.
•  Newly public companies that may never come back to IPO levels.
•  Questions for investors to ask even when financials look strong.
•  The trends that hit Robinhood (HOOD -2.63%) and Rocket Mortgage.
•  Lessons from "pre-revenue" companies that went public.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on July 23, 2022.

Brian Feroldi: Many of these companies that came public during this time that, I think, are actually pretty darn good businesses have seen their stocks take similar hits to companies that have no revenue or have extremely cyclical demand. But some of these companies came public at very high valuations, they've continued to perform, they've continued to execute. Some of these companies are profitable and should be sustainably profitable and yet they've still seen massive hits to their stock prices.

Chris Hill: I'm Chris Hill and that's Motley Fool contributor Brian Feroldi. 2021 was a record year for companies going public. This year, that market has dried up. Feroldi joined Dylan Lewis for a look back at the IPO boom, why so many companies went public, and the lessons investors can take from the formerly red hot market. They discussed the cyclical companies that may never come back to their IPO prices and the strong businesses making their way through a less forgiving stock market.

Dylan Lewis: 2021 was a milestone year for new names in the public markets. According to Ernst and Young globally, there were 2,500 public debuts last year raising around 400 billion in the process. Different story in 2022, for the first half of the year, proceeds are down almost 50 percent and global IPO volumes are down about 50 percent as well. Joining me to talk about the IPO market and lessons from the last couple of years is Motley Fool contributor, Brian Feroldi. Brian, how is it going?

Brian Feroldi: Dylan, it's good to be here, and those numbers really show how much the sentiment has changed. It seems like a year ago on Industry Focus, we were doing a new IPO show every single week and the volume has come to a screeching halt.

Dylan Lewis: Yeah, we would be a bit more starved for ideas [laughs] if that was the focus of what we do here on Motley Fool Money every single day. It's pretty incredible and I think, it's interesting because over the last couple of years, not only has there been a lot of activity, but there has been a lot of really big name activity and a lot of the companies that have come public have really dominated headlines. We are seeing now as the market is moving into a less growth-friendly environment that not surprisingly, a lot of these high-growth businesses aren't coming public or they're deciding to delay coming public because market conditions aren't as supportive of those businesses right now.

Brian Feroldi: If the last two years have been a reminder of anything, it's that companies, at least good companies, choose when they want to come public. A lot of companies saw that valuations were very high and it was a cash grab for a lot of them to come public, raise a bunch of capital, and with minimal dilution in 2022 with valuations collapsing, it's no surprise to see that companies that could be coming public say, I want no part of that.

Dylan Lewis: I'm sure some investors that have bought some of these new public entrance over the last couple of years are feeling a little disappointed. There's the Renaissance Capital IPO index. It is down 45 percent year-to-date versus about 20 percent declines for the S&P 500. But you could easily look at the freshmen and sophomore class of public companies and see much bigger declines from highs or even from issuance price 50, 60, 70 percent in some cases. We're going to talk a little bit about some of the specific factors that go into that and identify some themes within the IPO market. Before we do that though, Brian, I think we always have to remind ourselves like growth stocks have been hit incredibly hard recently when we're talking about companies that are relatively new to the public markets, these are often some of the growth stocks and that's a huge part of the explanation right there.

Brian Feroldi: That makes sense. Why do companies go from being private to public? One of the main reasons was they want to raise capital and one of the primary reasons why companies want to raise capital is because they are new, they are dynamic, and they are in growth mode, so they want to reinvest in themselves and come public is a very popular way to do so.

Dylan Lewis: As the investor and someone who's seen these companies come public after being private for a while because so many of them were such big names, there was so much investor excitement because we'd seen private valuations swell so tremendously over the last decade as some businesses opted to stay private even longer. The idea of being able to get big returns by buying into some of these high-flying start-ups certainly existed for a lot of people. I think, one of the tough parts about all of this is big-time consumer names were coming public and I think people had expectations that those businesses would perform incredibly well, and often, some of them did in the first year or so that they were on the public markets and set wildly unrealistic expectations for people on what returns look like over shorter periods of time.

Brian Feroldi: A lot of these companies, especially the popular ones, we saw massive single-day pops when they IPOed. We saw a 10, 20, 30, 50 percent jumps in their share price from their issuance price on day 1. Now, the downside to having a stock go up that much is that investor expectations for what you're about to do grow with those share prices. In many cases, the expectations simply became way too far ahead of what companies can actually deliver.

Dylan Lewis: Yeah, and what we saw over the last 6-9 months or so is the long-term picture, got a lot harder to forecast. There were a lot of macro factors beginning to swirl that created uncertainty in the public markets. Inflation's a pretty easy one, but obviously, the geopolitical factors in what's happening in Europe, another one, supply shocks being maybe another third major one, and all of those things make it harder to forecast businesses that are already very difficult to forecast because they are so early on in their development. Investors have decided we have to more heavily discount that than we have in the past.

Brian Feroldi: I think that's a really key point, Dylan. A lot of these growth companies that have been hit the hardest had very high valuations and those valuations make sense in a world of zero percent or one percent in inflation. Now, that we're in a world of much higher inflation, the discount rate that investors used to estimate stock prices have gone up tremendously, and that can have a severe impact on the valuation that investors are looking to pay today, hence the huge decline that we've seen.

Dylan Lewis: Throw on top of that, a more expensive market for cash, Brian, with interest rates going up as well, and it's not surprising that this part of the market has been hit particularly hard, these new companies. We're going to talk through a couple of different big buckets that we've identified to explain what we've seen so far in the first couple of years for some of these new public interests. The first one I want to talk about ties into interest rates almost directly is companies that surged because of cycles in their businesses and are now adjusting to the reality of either the peak and trough of those cycles or just more normalized growth rates for their industries.

Brian Feroldi: A lot of companies that came public in 2020 and 2021, their businesses were on fire due to the pandemic or because of what was happening in the market. One that comes to mind for me, for example, is Coinbase. Coinbase came public and I think their market valuation the day that they launched was $100 billion or something along those lines. Crypto prices were through the roof, and if you looked at the company's trailing financials, they were just jaw-dropping because interests in crypto was so high and crypto prices themselves were so high, so Coinbase was incredibly profitable when it came public. More recently, we've seen crypto prices decline and so have Coinbase's profits with that. That was very much a case where Coinbase was coming public at peak times for its market and we've seen the unwinding of that more recently.

Dylan Lewis: Yeah, and I think there's a really similar story with Robinhood. There was a massive surge in retail investing, I think to a large extent pandemic-driven as people were at home maybe looking for ways to make money. Robinhood benefited in a huge way. The rise of meme stocks really helped this business out. The tailwinds of just generally more average people getting interested in investing are also there for this company. You put some numbers to what they were seeing during that period and you start to realize that we were probably due for an adjustment on some of the key business metrics that drive this company.

Just as an example, to paint a picture, they posted 24 million monthly active users in May of 2021, a number that was higher than their net cumulative funded accounts, which was about 22 million at that time. That's a metric they track to see who actually has money in the platform and can invest. Monthly actives are now down to about 15 million and those funded accounts are a little bit higher, about half a million higher than they were a little over a year ago. Brian, we can see that some of those people that were coming on during that surge never took that step to become what would really be a long-term customer. It's a testament to the fact that there was so much interest in this space. A lot of people that were maybe coming on were a little bit less qualified for this business than some of the previous users that they brought online.

Brian Feroldi: You can add in to the fact that at that time when Robinhood was pointing fabulous numbers, stimulus checks were being handed out everywhere and many people were choosing to invest their stimulus checks. For the very first time, Robinhood was very popular platform to do so. That's what can be so tricky about looking at companies like Coinbase and Robinhood. If you just look at the financials, the financials in many cases looked pretty darn good or very, very enticing. But you had to go one step beyond that in saying are these financials reliable and consistent and can grow secularly from here or are these inflated onetime? I think there's a strong argument to make that both of those companies had inflated financials at the time of their IPO.

Dylan Lewis: Yeah, and I think this is a great opportunity to check in and remind yourselves that even if the financials look good, there are very specific drivers for some businesses and understanding what that is and what this business is generally going to track with is incredibly helpful. In the case of Coinbase, the success of crypto is going to drive interest in crypto broadly and activity in crypto, and that's what's going to drive the numbers for Coinbase. Even if they're delivering an incredible product in a great platform that people really enjoy, it's going to peak and trough depending on what's going on in the overall crypto markets.

Brian Feroldi: If you look at Coinbase in particular, a lot of investors that have looked at this company more recently have looked at the price-to-earnings ratio and they've seen a single-digit number for Coinbase. In so many cases that just makes no sense to them. But what the tricky thing about that price-to-earnings ratio being in the single digits is that's Wall Street's way of saying that E, the earnings, isn't sustainable and isn't going to grow and we've seen exactly that happen.

Dylan Lewis: One other company that I think fits into this bucket is Rocket Mortgage, a little bit different in that it's maybe a more established brand in a space that is a little bit more common for investors to be familiar with. But what we saw with this company was an incredible surge in interest. Their originations in dollars doubled from 2019-2020 and a huge driver for that was the interest rate environment. It was an incredibly good time to either buy a home or if you already had a home and you were borrowing at a relatively high rate, refinance down and give yourself a cheaper monthly payment.

Brian Feroldi: I very much remember looking at Rocket Mortgage's financials when they came public and saying, are you serious? Is this company this profitable? I mean, it seemed to be a cash flow machine and it was at the time. But to your point, they were such a cash-flow machine because demand for refinances and mortgages was at record levels. Now Rocket Mortgage is still the market share leader in its category today. But just because of the broad cooling off in the demand for mortgages, we've seen Rocket Mortgage's profit fall substantially.

Dylan Lewis: I like that you focused there on the market share, Brian because it's not just that this trend was pushing this company forward. The company was doing a great job and they were continuing to gain market share along the way. No beef with Rocket Mortgage. I've actually personally used them and really liked it as a consumer. It's just that these individual datapoint interest rates is going to have a massive effect on the overall company and there's really not a lot that the company can do about that.

Brian Feroldi: I think you can make that exact same argument for all three of the companies we've talked about: Coinbase, Robinhood, Rocket Mortgages. All three of those companies were riding trends that were really outside of their control. Those trends have since reversed and that's why their financial fortunes have since reversed. That doesn't mean that these companies have done anything wrong necessarily, it's just that that's the nature of the markets that they're in.

Dylan Lewis: Honestly, if you're a long-term crypto bull, what we've seen over the last 12 months is just part of the business for you. You just know that that's a reality of investing in this space and it's got to be part of your long-term outlook for the space and if you're investing in Coinbase because of that, for Coinbase.

Brian Feroldi: Yeah, and that makes valuing those companies very tricky because you can't really look at earnings if those earnings are so reliant on a factor that's outside of management's control.

Dylan Lewis: Speaking of having a hard time looking at financials, the second bucket that we're looking at broadly putting some companies into for looking for takeaways here is pre-revenue companies. There's not a bad idea when cash is plentiful. I think that with interest rates being low, with growth on mindset, we saw a lot of more out there ideas come public earlier than maybe they would have five years ago or 10 years ago, Brian.

Brian Feroldi: Pre-revenue companies coming public is nothing new. This is actually a very common thing to happen in the biotech space when companies are going through the research and development process that is hugely capital intensive. During those times, those companies are often making zero dollars. What was a little bit more interesting about 2020-2021 is we saw a few consumer-facing companies come public, they have a pre-revenue. A couple that comes to mind would be Nikola, Joby Aviation, and Virgin Galactic. They were very much pre-revenue companies that were investing heavily in themselves, but they garnered some huge valuations at the time that they came public.

Dylan Lewis: I'm sure a lot of folks are familiar with Nikola, the EV company. It's gotten a lot of headlines over the last couple of years or so. Folks that are less familiar, Joby Aviation is aimed at becoming an air taxi service. Virgin Galactic is focused on commercial space travel. I think just on the explanation of what those companies are, you can quickly realize those are industries that aren't going to materialize overnight. Those aren't industries that are really active even right now and it shows up in the company financials when you actually look. I think those three companies combined over the last 12 months, Brian, have about six million dollars in revenue to their name.

Brian Feroldi: Yet they still garnered multi 100 million or a billion dollar market valuation. The jury is still out on all three of those companies and I think investors should have expected that upfront. Those companies were saying, we're not going to be termed to come revenue tomorrow. There are a number of hurdles that they had to meet along the way, but it was still surprising to see so many of these pre-revenue consumer-facing companies not only come public but really earn multi-billion-dollar valuations.

Dylan Lewis: We probably could have found a couple of names for this list that were not so capital-intensive. But I think one thing to emphasize too with basically all three of these companies is without revenue coming in on the top line, these are capital-intensive businesses. There's a physical product for all of them and there are long-term investments that go into making that. When you don't have cash coming in and the picture gets cloudier looking further out, the fact that cash isn't coming in becomes much more important to investors. Again, this is a spot where the market starts to more heavily discount the likelihood that these things come together and materialize the way that they've been forecasted when that company was a SPAC before it came public or in the prospectus in the case of one that was coming public.

Brian Feroldi: Rivian comes to mind, Lucid Motors comes to mind, they really took advantage of the huge valuations that they saw raising hundreds of millions, or in Rivian's case, I think they raised $10 billion at their IPO, even though they were pre-revenue at the time. When you compare that to the company's market cap today, that enormous valuation was a massive blessing for the business.

Dylan Lewis: It was incredibly advantageous if you're looking to raise capital. We talk about it often when we're looking at new entrance where it's like the incentives here are for this company to go out there, get capital, give themselves plenty of runway so that they can really execute on their growth plans. For a business like this, it's like you know that you're not getting a significant amount of money coming in on the top line. For several years, you want as big of a cash hoard, as much of a runway as you can possibly have because it's such a hard thing to do.

Brian Feroldi: Absolutely. But the flip side of high valuation is being so good for companies that are selling stock is they tend to be not so good for investors that are buying that stock.

Dylan Lewis: Yes, and that is unfortunately the trade-off that we often see, Brian. Speaking of valuations, I think the third bucket that I want to end this on a somewhat inspiring note is there were a lot of really quality businesses that continue to be quality businesses. It's just that market factors created an environment where we were willing to give these companies much more generous valuations during growth on period than we are now because of the uncertainty in the market and because of the contraction we've seen in valuations in general.

Brian Feroldi: Many of these companies that came public during this time that I think are actually pretty darn good businesses have seen their stocks take similar hits to companies that have no revenue or have extremely cyclical demand. But some of these companies came public at very high valuations. They've continued to perform, they've continued to execute. Some of these companies are profitable and should be sustainably profitable, and yet they still see massive hits to their stock prices.

Dylan Lewis: Yeah, backtracking nine or 12 months, it was not unusual to see companies coming public at 20, 30, 40 times sales. That was just a reality of where we were in the market. There were some very good strong businesses that were coming public at that valuation, and the problem is we're just not necessarily willing to give those companies that leash right now.

Brian Feroldi: One company that comes to mind for me that very much interested me when it came public in 2021 was a company called Semrush, the ticker there is SEMR. This is a company that I personally became very excited at and it was one of the very few IPO stocks that I actually purchased because I liked it a lot. The company had great margins, strong top-line growth, a founder-led business, a free cash flow positive, and a profitable high dollar-based net revenue retention rate. All the things that I look for in a good business, and the thing that tripped this stock up is just pure valuation. It came public at about 20 times sales, currently about seven times of sales. Despite the fact that it's grown pretty strongly since it came public and it's really executed, investors like me are still down on it, even though I still think the business is better today than it was a year ago.

Dylan Lewis: It's funny, Brian. I'm a shareholder of Semrush as well and this was a company that we talked in the beginning of 2022 and both felt pretty excited about. To just give people a little bit of a check-in here on where this company was, where it is. What we saw back then was 77 percent gross margins, 40-50 percent revenue growth, narrow net losses, basically a company that could become profitable when it wanted to, and a dollar base net retention rate of 124 percent. All of those numbers are more or less in the same spot or higher.

Margins have expanded, the [...] has actually gotten higher in recent quarters, and yet it's just that we're not willing to give these high-growth names the same valuation multiple that we were a little while ago. Unfortunately, the stock has been punished for that. I continue to be a shareholder of this company. I'm probably going to continue to add to it overtime now that it's at a more reasonable valuation. But I think that that's the check that people have to have with stuff that they own in their own portfolio. Is this down in the core metrics that I'm paying attention to of this company are also down? Or is the picture pretty similar, it's just that the market forces are conspiring to punish a company like this right now?

Brian Feroldi: Dylan, this is why we constantly stress to investors that it's so important to focus your energy on the business and de-emphasize the focus on the stock. The stock is a thing that grabs all investors attention, it's something that media pays attention to, and it's the thing that drives your brokerage account. It's understandable why price is such a thing that people focus on. However, if you dig into these companies that are down 50, 60, 70, 80 percent or something, and you look at the business, it becomes much easier for me to be excited about and even add to a position in a business where the company is thriving, but the stock isn't versus a company where the stock is doing bad and so is the business.

Dylan Lewis: To bring us home, Brian. Why don't we talk a little bit about things broadly that people should have in mind as they're looking at some of these more newly public companies during particularly tough market conditions? The first thing that comes to mind to me is, there are pretty easy financial checks that you can do looking at a company balance sheet, looking at company income statement to have a good feel for just the financial fortitude of a company. I think perhaps more than almost any other group, it matters for these companies because they need the runway to be able to execute on their road map.

Brian Feroldi: I like to break down companies into three broad buckets. There are companies that are raising capital, and for those companies, what we've seen happen in the market right now is truly awful because they can no longer raise capital at valuations. If they chose to do so today, the dilution to shareholders would be horrible. The decline we've seen in their stock prices is really bad. There's other companies out there that are either self-funding, so that could mean that their free cash-flow positive or they have such strong balance sheets that they can ride out a potential wave for 3, 4, or 5 years. I think that those companies will be OK and will do it much better. Conversely, there's also companies that actually thrive when they see their stock price declining because they're in capital return mode. This actually gives them the opportunity to go out and buy competitors on the cheap or maybe even to perhaps repurchase their own stock at very advantageous prices. When I'm thinking about the different risk levels within my portfolio, I think that the companies that are raising capital have a big question mark over their head, and the ones that are returning capital to shareholders, should be licking their chops of what they see in the market.

Dylan Lewis: So that listeners can follow along and do the work at home for companies in their own portfolio. Brian, this is something that shows up on the balance sheet and it's something that shows up on the income statement in a big way. It's helpful to look and check in and see exactly where your companies fit on that spectrum.

Brian Feroldi: Personally, I prefer the cash-flow statement to the net income statement because as we both know there's a big difference between being profitable on a net income basis and being profitable on a free cash flow basis. The dynamics of accounting make it so some companies that look unprofitable are generating cash, and we've also seen the exact opposite of that. But broadly speaking, if you wanted to know what stage is this company in. First, I would go to the balance sheet, just check the company's cash balance, and compare that to the company's cash burn rate over the last year on a cash-flow basis, and that will give you a rough estimate for how many years the company can go without needing to raise capital. Hopefully, the company can rapidly approach free cash flow positive and really minimize that burn. But if they are in cash burn mode, the clock is ticking. If you see a company with say a year or less of cash, they might really have to go out and dilute shareholders significantly just to see it survive.

Dylan Lewis: Yeah, I think that's important, and then you also want to check it and say, from the operations, what are we looking at here? If the company is not in a spot where they are profitable, what is the reason for that? Is it because they're aggressively spending to try to grow their customer base because they're in a land grab mode? Is that something they can dial down if they need to because things get tougher and they need to show some green, or at least lose a little bit less money? I think that's a core thing that people should probably be paying attention to right now as well.

Brian Feroldi: Another thing just a thing in mind, if a company is producing a product or service, ask yourself; because the odds are good we're heading into a recession. Is this a nice-to-have product or is this a needs-to-have product? Ideally, it's a needs-to-have product. For example, I think that the odds are very good that companies are going to continue to spend with Semrush since it has so many uses and helps them with their marketing. But hey, we'll find that out in the next couple of quarters.

Dylan Lewis: I liked the chances of a company like TurboTax, not that they were a reasonably public company with into it that product. I like the chances of people are continuing to spend money on that more so than a consumer product that people need to be convinced to buy often. I think that you just have to remember where does this company fit into consumer-buying decisions? Is this something that is contractually set up already? Awesome. That's so much easier for people to be able to bank on. Or is this something that there's going to have to be heavy marketing spend in order to convince people to buy this? Or this is a new space this company is creating and needs to create the customer base for? That's even harder, Brian.

Brian Feroldi: That sounds like an expensive thing to do.

Chris Hill: As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against them, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.