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Pete Gordon: Hi, I’m Pete Gordon, Director, Equity Capital Markets at Scotiabank in New York, and welcome back to the Market Points podcast. On this episode, I’m joined in New York by Sass Darwish, Managing Director and Global Head, Technology Investment Banking, and together we will be looking at the landscape for technology IPOs and M&A activity in 2025.
Sass, very excited to be chatting with you about this. I know you took a look at IPO and M&A activity in the tech sector for the last few years, and I think that would be a great jumping off point. So, what did you find?
Sasson Darwish: So, what we did, we ran basically in the past 10 years, the number of IPOs we had in tech, pure tech, and this is ex- de-SPACs because we don’t think de-SPACs are real IPOs or M&A. And what we found is that 2021 was the year where you had the most IPOs, which were 86 companies. We also had the most follow-ons, which were 96 companies or 96 deals. And converts, there were 65 converts in technology. So total 247 deals. Which was really a banner year for the technology equity capital markets business.
When you look at the numbers and you say, okay, what is the next best year after that? There are actually two years. One is 2020, where you had basically almost half, less than half IPOs, 37 IPOs. And then 2014 that there were 37 IPOs. And then when you look at the average of those past ten years, you see that there were basically 27 IPOs on average. So, let’s take that number 27 IPOs on average and say, okay, if that’s the case in an average year, because we’re thinking about the future, which is 2025, is that actually a number we can shoot for or think about when you think about companies going to public next year?
So, for that, I’m going to add a couple of other stats. One is the number of unicorns. Unicorns are companies that are worth a billion plus in valuation, and look at the best year ever, which was 2021. There were the most unicorns that were created during that year, and there were about 1,200 unicorns in the global tech world. And we took that list and went one by one and looked at today, how many of these companies are still unicorns today, and how many were added between 2021 to 2024? And the number is 720 companies.
So, basically, there has been a 40 percent decline in number of global unicorns in the world, and those companies are usually companies that always look to go public, although a lot of them do private deals. So, when you think about a 720 number, and you look at an average number of IPOs, which we said 27 in the past 10 years, and you do the math, you can see that you have 20 plus years of backlog of potential unicorns going public, which is very interesting because even if we go to the number 86, which was the best year ever, and you have 720 companies, you’re talking nine years before all these guys clear and can go public.
So, what does it actually mean? What it means is that we’re probably going to see more companies staying private. We can see a lot of companies that will continue to raise private capital, not public capital. And we will see a lot of these companies also doing more M&A. And when you look at the M&A landscape, we went back 20 years and looked at how many tech deals, specifically software deals were in the past 20 years, and the number is close to 13,000.
These are all deals, from the smallest deal that was announced with a number attached to it on the deal value, to the largest deals ever. And when you look at the data, you can see that 2021 was the year where you had the most deals in the space, which is close to 700 deals. And we looked at deals that are a billion plus, because billion is the number that a company is a unicorn. And you ask yourself, okay, if I’m a unicorn, I can go public, or I can potentially maybe even sell myself and we divided the world into, or the numbers into two specific cohorts. One is public companies buying private companies for more than a billion dollars, and public companies doing M&A with public companies with a value of more than a billion dollars.
And when you look at the numbers, you can see that on the public to private M&A transactions, which have to do, obviously, with private unicorns, 2021 is the largest year, which we have 31 deals like that. And the next best year after that was 2018 with 20. 2020 was with 15 deals, again, reminder, public companies buying private companies, and then 2022 was 13. But then you look at 2023 and 2024 year-to-date, it’s seven and five.
So, the activity in that unicorn billion plus cohort has really come down significantly, which is very similar, by the way, to what we had from, call it 2012 until 2020. So, there are really not a lot of deals for private company unicorns when you think about M&A. Which underscores again, what we believe is going to happen in 2025 is that you will see many unicorns are not able to go public and are not able to sell themselves. And they’ll basically have to raise private capital.
So, Pete, given my overview of what I think potentially can happen in the IPO market, especially for unicorns, can you maybe share what investors are looking for assuming 25 companies or 27 companies can go public in 2025?
PG: Yeah, absolutely.
I have the good fortune of keeping in touch with a lot of the high-profile investors that play these IPOs, both in Canada and the U.S. and across the globe. There’s a number of factors I’ll go through. The first thing is scale. For companies that are looking to go public, they need to be at least $300 to $500 million in revenue or ARR in the case of software.
In terms of size, the size of companies looking to go public, investors are looking for companies to be at least three to five billion. So those are just your starting points in terms of size of revenue and equity value of the company.
The next thing is growth. Investors are looking for companies that are exhibiting exceptional growth. They’re looking for companies that are growing, say, 25 to 30 percent. And when they look at that growth, they’re valuing growth at scale more than they are, say, for a company that’s growing faster, but on a lower base.
The next thing they’re looking for is remarkability. It’s fantastic if you’re capturing the things I just talked about, but we can’t just have yet another company that does the same thing as existing public companies. So, you need to be either a platform or you need to be the best at what you do. And so, telling investors what makes you different than other public companies that are already out there is very important.
One thing that touches on profitability and is an expression we use in the tech world is the Rule of 40. So basically, it’s a combination of profitability and growth. During 2020 and during 2021, you would see companies that were growing 60 percent but they were not profitable. So, you’d be adding a number that’s positive against the number that’s negative.
What’s changed today is you’re seeing companies that are profitable and are growing, but just had a more moderate pace. So instead of adding a number that’s plus 60 and minus 20, you’re seeing companies that are plus 30 and plus 10 and you’re getting basically to that same number. So that’s the ballpark number we’re looking at in terms of Rule of 40.
SD: I know, Pete, we do a lot of regression analysis on growth and profitability. What is more important actually, like if you have a company that can use those levers, what do you think is more important or they’re equally important?
PG: It’s a great question. And I was talking to an investor recently, we went down this road. They made a really good point, which is anybody can cut expenses and exhibit profitability, but not everybody can grow at scale.
And so, if you’re growing at scale and you’re exhibiting profitability, that is a true sign of a remarkable equity opportunity. So, investors are less impressed with say, cutting your expenses, and they’re more impressed with managing your capital stack appropriately.
SD: Okay, so let me maybe test that. So, you think 10 percent growth and 30 percent profitability is not as good as the 20/20.
PG: Exactly. In terms of what investors are looking for in public markets, you know, all that’s great, but once you’re public, it is absolutely critical that you hit your numbers out of the gates. So, for at least the first two years as a public company, investors are expecting you to hit your numbers, beat and raise for at least two years.
And if you miss your numbers as a public company, in the first two years it really does hurt your credibility. So, the reason we haven’t seen as many companies go public in this past say year or two is because we’ve had a number of macro factors that really have nothing to do with companies, but it is impacting their ability to forecast and therefore predict what future quarters will look like. So, once we have the election behind us, once we have some interest rate cuts behind us, it’s going to be a lot easier for companies to predict and forecast what their earnings forecasts look like for the next two years.
So, that’s another reason why we’re more bullish on '25, just in terms of general volume. I think there’ll be more macro headwinds behind this, and it’ll be easier for businesses to predict their businesses moving forward.
SD: So, Pete, when you think about converts, I think that’s a little bit different, right? Because a lot of companies converts are usually five or seven years in duration. You’ll see a lot of those recycle or getting paid somehow, right?
PG: There’s a few factors that have gone into the recent popularity of converts in equity capital markets.
One is higher interest rates. Generally speaking, in the past in a lower rate environment when corporate issuers looked at their funding instruments, they could go to the investment grade or the high-yield market and achieve a satisfactory coupon on the debt that they’re paying. But as rates have gotten higher, some of those coupon payments have become sort of difficult to finance and the convertible bond, which basically substitutes a lower coupon for equity upside, therefore letting issuers pay a lower coupon rate, has become quite popular.
During the same time period, we’ve actually seen the accounting standards for converts become a lot more simplified. Whereas in the past, you used to have to accrete the option value embedded in the convert through the income statement and onto the balance sheet, that is long gone. That used to irritate investors. The FASB board has new accounting rules and it’s simplified things for issuers and simplified things for investors. And so, there’s a lot more appetite from treasury functions and investors alike.
So, the combination of higher interest rates, which by the way, today, we’re recording this October 10th, we have higher inflation. We appear to have higher rates with the 10-year trading where it is today. And it appears that converts will be a large part of equity capital markets issuance going forward.
So, Sass, so the volume of IPOs in the past and we talked about run rate numbers of about 25 a year, do you think that it’s more of a supply-side issue or more of a demand-side issue in terms of the volume of IPOs?
SD: I don’t think it’s a supply issue. I think it is a demand issue. And because a lot of these investors were not happy with the recent tech IPOs and we should go back to 2020, 2021, they lost a lot of money. I think your point on hitting the business plan or the forecast is extra scrutinized nowadays, so I believe it’s more of a demand issue, not a supply issue.
I also think that until interest rates come down a little bit more in a significant way, you will see that playing out as well as one of the factors for companies opting to remain private so you can have a better valuation environment for them to be able to go public.
PG: No, I think that absolutely makes sense. I think that a lot of investors can see the wedding, but they forget about the marriage and what I mean by that is the IPO can get done, but then the longer-term life of a company as a public company is more challenging. And that’s when those subsequent earnings come through, and that’s where there are the beats and the misses, and yes, you may have a successful IPO, but your work’s really only beginning. And that’s where if you want to attract high quality shareholders, you need to be able to have that predictable business model.
So yes, there’s definitely you know, some heartburn from the zero-interest rate policy era of IPOs that have now come down in price. But going forward, the best advice we can give to our clients is just go public when you’re ready, go public when you can predict your business, and you’ll attract the right shareholder base.
SD: Yes, I think another factor is the fact that a lot of these companies have been taken out of the public markets by private equity investors, and private equity investors, I believe, prefer not to go public because they want to get all their money back in one shot. And if you go public, you will have to live with that stock for the next three to four years in order to sell down your position. So that’s something that also we need to take into consideration when you think about a lot of these companies being private, but under a private equity ownership, which can make a big difference in terms of their desire or opportunity to go public.
So that’s another factor that we have to consider when we talk to companies and private equity investors.
PG: And it really goes all hand in hand. When you look at the most successful exits of sponsors from public companies, there’s typically a concurrent share buyback alongside the sell down. And you really can’t do that unless you are profitable and you actually have that excess cash to deploy during the secondary. So, I think that means that going forward, if the companies going public are exhibiting profitability and do have excess cash that we’ll likely see some secondaries that are accompanied by concurrent buybacks and that’s a win-win.
And investors like to see those concurrent buybacks, which helps the return on equity. It helps their IRR calculations. Typically, outside of two years you start to see private equity positions chipped down, and so we’ll likely see the continuation of that trend going forward.
SD: So, the scrutiny is back into the investor discussion and when you think about, as a CEO or an entrepreneur, or someone that has a big stake in a private unicorn company, what is your, what are your exit routes?
We still believe that the private markets where you have recapitalization of these companies, bringing new investors, taking out old investors, is probably what we’ll see happening more and more, including by the way, private equity players being part of that recycling of capital.
So private markets will continue to be very active. And that’s something that CEOs and entrepreneurs have to think about, when they think about, okay, where is the next place where I can raise the money to continue growing my company. And it’s not growth at all costs as before. Now, it has to be growth at a profitable way, if you will, which is something that everyone understands.
We went through a really hard three years where a lot of companies weren’t able to raise more money and had to do a lot of down rounds. And if you can avoid that, obviously, and grow a little bit less fast, and be profitable, this is where you can ensure that your company and your employees and your shareholders have better prospects of making money on their investments and have a successful company.
PG: I think the last thing that I would add, it’s just around, AI and how investors are looking at it in public markets and how that could impact IPO markets and therefore private markets as you’re alluding to.
You know, AI very much remains yet to be seen in terms of what the actual revenue will be from it. And so, the best way to position it with today’s investors is to focus on your fundamental business. Make sure that’s in order. Make sure you can deliver on that. So, the underlying software business. And then if there’s an AI tool or some way that you’re using AI to lower expenses and therefore increase profitability or go after higher revenue, that should be viewed more as a call option to the valuation, rather than as the underlying reason for investment. Unless you’re specifically making something in AI that is only related to it. But if you’re a general software company, that positioning has been well received by investors. So, whether you’re looking at a business in terms of private markets, as Sass was alluding to, or taking a business public, that is sort of one successful lens that we’ve seen.
SD: I mean, I want to thread that needle a little bit here on the AI. So, I think a lot of companies that have raised money in the past few years with an AI theme could be either vertical or horizontal AI themes, are going to have very tough time going forward, and it’s really because of the business model that is not proven yet.
So, we all use ChatGPT because it’s free, which is great. But a lot of people once they figure out that in order to continue to use these products, they have to pay $10 dollars a month, they may actually not do it. So that hasn’t been tested yet. I know that the products that are more advanced from OpenAI and other companies are subscription-based, but they actually have to be usage-based.
And that’s something that the industry is trying to figure out. On top of it, the second dynamic that is going on here is how you sell to, let’s say, banks or insurance companies. What’s your B2B sales motion, which is something a lot of companies like Scotiabank are trying to figure out.
It’s one thing to give everyone access to a large language model and let them play with it. But does that actually translate into real productivity gain? And this is what everyone is trying to figure out. And that productivity gain has a number attached to it, and is that number bigger or smaller than what you have to pay to use these products?
So, everyone is in that mode right now, trying to figure out if the productivity gain is there and if it’s there, what it’s worth and is it actually more or less than how much we pay for the product. So, I believe 2025 is going to be a very important or even a pinnacle year for AI in terms of which companies can find the right business model, as well as the adoption of those business models and products within large organizations, like Scotiabank.
PG: That’s a great point Sass, and I think 2025 will really see the confluence of all these factors coming together where we’ll have the election behind us, we’ll hopefully have a couple of cuts behind us, we’ll have businesses that are in a position to predict their business. And ideally, we’ll see a return of a more normalized IPO market, sort of around that 25 number.
So, I’m a little bit biased as an ECM banker, but that’s, hey, that’s what they pay me for. So that’s what I’m hoping for.
SD: Appreciate the time, Pete, my friend, and look forward to the next one.
PG: Thank you very much, Sass. I enjoyed this.
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