Going Public as an Unprofitable Company

Uber, Pinterest, Lyft, and Peloton are household-name companies that have had great success in the public market. Their IPO valuations accorded them “unicorn” status, and yet none of these companies were close to being profitable at the time of their IPOs. Sky high valuations despite unprofitability can seem counterintuitive, but these lofty valuations are still consistent with normal financial principles. Beyond natural curiosity, it is important to understand these principles because you may lead an unprofitable company wanting to go public, or perhaps come across an unprofitable competitor preparing to test the public waters. Regardless, understanding the workings of the market with respect to unprofitable IPOs helps you develop your business strategy and helps you understand the strategy of others.

To help us understand the nature of the profit-valuation relationship in IPOs, we talked with Sam Bernards. As Bernards was the CEO of Purple Innovation, Inc.—a company that was unprofitable when it went public—he understands the nuances of how unprofitable companies can have a successful IPO. We will reference many of his insights throughout the article.

This article focuses less on specific valuation principles and more on the economic foundations that lead to successful IPOs for unprofitable companies. From those economic foundations, we offer new perspectives on the debate about IPO valuation sustainability for unprofitable companies. For more specific information on valuation, please see the following IPOhub articles: Valuation and Tech Valuations (SaaS).

Why do some unprofitable companies have high valuations?

To tackle this question, Bernards started by discussing the general concept of valuation, saying: “Valuation is an art and a science, and sometimes the art and the science seem to disagree. But there is room for both camps. Think about the stage a company is in. Immature, groundbreaking, novel companies’ valuations almost always are more on the art side of valuation.”

First, many investors turn to “science” by using simple models to get to a starting point for valuation. Bernards referenced Deloitte’s¹ revenue multiple research as one of many valuation tools. Deloitte’s model suggests there are four types of companies: Asset Creators, Service Providers, Technology Creator, and Network Orchestrator. Where the company fits within these classifications dictates the multiple used on their last 12 months of revenue. However, a valuation is only valid if someone is willing to purchase at that valuation price, which points to the “art” of valuation that largely involves negotiation between interested buyers and sellers. Many unprofitable companies with no earnings on which to base a multiple still have high valuations because investors are simply willing to pay at that price. It boils down to simple economics. As demand increases, meaning that more investors want to buy securities in a company, the price of those securities goes up. For investors to demand these securities at a high price, there must be what Bernards calls “upside” in the companies. Investors will only buy securities on which they expect to earn a positive return.

All these principles regarding the art and science of valuation set up the following question: If investors are demanding a security, thus leading to high valuations, and they would only demand a security where they see an upside, how and why do they see upside in unprofitable companies?

Bernards answered this question with a simple statement: “Profitability is a choice.” Company leaders are often faced with the trade-off of profit and growth, and the choice management makes is all about strategy. Young companies tend to prioritize growth, and sacrifice profitability by investing earnings and spare capital back into the business, hoping the extra growth will benefit the company in the long run. When management’s strategy is profit, which is typical in more mature companies, the company spends less money for future benefit and does not have the growth rates they had when they were unprofitable. This is common in the life cycle of a business; they sacrifice profits to grow exponentially, and when the time is right, they switch gears to be profitable and reduce their growth rate. The important factor for investors is whether the company's strategy of growth at the sacrifice of profits has been, and will continue to be, successful.

Unprofitable companies must convince investors that, first, being unprofitable is a result of a strategy and not a poor business model, and second, that sacrificing profits has been well worth the growth obtained. Investors will measure the success and profitability of a company in a myriad of ways that fit their investment strategy. When a company can convince investors that the company’s lack of profitability is a choice for growth, then the investor can see the potential upside in their investment. When a company consciously chooses growth over profit in the short run, its valuation can be improved in the long run. Improvement in value over the long run comes because the growth brings greater profits when the company is mature, and from investors' confidence to fund the company.

Are high-valuation IPOs sustainable for unprofitable companies?

Many executives are wondering if the trend of successful IPOs for unprofitable companies is sustainable, and there has been an on-going debate for a couple of years now. Recent articles warn that these high valuations are not sustainable. An October 2019 Wall Street Journal (WSJ) article insists that investors have “soured on unprofitable startups,” citing underperformance from Uber and Slack and the collapse of WeWork’s IPO as sources of worry.² A few months later, another WSJ article added evidence to this claim by pointing to Casper and Lyft.³ Then a February 2020 WSJ article pointed to investor concerns about Airbnb swinging to a loss and joining the growing list of highly unprofitable startups, and the rise of the novel COVID-19 pandemic was only adding to investors’ anxiety.⁴ Since then, the pandemic has rapidly spread throughout the globe, further heightening existing fears of stock underperformance. Many large investors understandably have reservations about excessive red ink in IPOs.

However, some institutional investors and company executives do not share those concerns. A recent WSJ article points to the record $167.2 billion raised in IPOs for 2020, which surpasses the previous record of $107.9 billion set in 1999.⁵ Economic titan Airbnb as well as companies like DoorDash, Palantir, Lemonade, and Snowflake all joined the public market in 2020 despite being unprofitable at the time of their IPOs.

We talked with Bernards about the current conversation on unprofitable companies commanding high valuations in their IPOs. Bernards took Purple, the then unprofitable mattress technology company, public in July of 2017 with a valuation of $1.1 billion. When discussing the conversation of valuation sustainability, Bernards was very hesitant to accept the popular opinion that investors were simply growing weary of high-loss startups, even going as far as saying a lot of the articles are “off” and “a little bit inflammatory.” He pointed to a timeless dynamic not currently being discussed in the conversation about valuation sustainability for unprofitable companies going public: the inherent advantage of first mover network orchestrators.

First Mover Network Orchestrators

The term network orchestrators was coined in the previously mentioned Deloitte revenue multiple research⁶ describing companies that specifically “drive value based on interactions with users, suppliers, and other (community) points of contact.” Social media companies such as Facebook and rideshare companies such as Uber are prime examples. Although being the first company to market brings advantages for many companies, the benefit that network orchestrators gain from becoming the first mover is even more pronounced due to the very nature of their business model. A second Deloitte report explains how network orchestrators create ecosystems and platforms “where the value of the platform [and thus the value of the company itself] increases as the number of users and depth of engagement with those users expand,” which is often labeled as network effects.⁷ The report continues:

Once these ecosystems reach a critical mass of participants, there will likely be a strong tendency toward concentration and consolidation, leading to a small number of powerful platform providers that could become increasingly difficult to unseat. In these kinds of businesses, if you aspire to capture value, you need to become the first mover to build critical mass. Being a fast follower in these businesses is a very risky proposition.

It wasn’t a surprise when, after pointing to this universal dynamic, Bernards said it makes sense that investors are sometimes less bullish on certain unprofitable companies going public. Behind many of the new IPOs are network orchestrator companies that entered markets already occupied by a first mover, so their valuations are lower due to their lesser chance for success, not because of weariness in unprofitable companies going public. As more companies begin to embrace a network orchestrator business model, status as first mover or subsequent mover will continue to play a critical role in IPO valuations moving forward.

Conclusion

When a company goes public, the firm’s CEO often gets the opportunity to ring the bell at the company’s chosen stock exchange. The ringing bell signals a time of accomplishment in the past and excitement for the future. As discussed, the future of those firms and their IPO valuations on that day depend more on their elements of upside, and their ability to successfully execute their strategies, rather than on their past profit margins or lack thereof. Additionally, contextual factors of first mover advantages and business model play an important role in pushing IPO valuations up at times and pulling them down at others, adding an additional layer of nuance not always conveyed in the discussion on unprofitable company IPO valuations. Thus, despite natural shifts in IPO valuations, don’t be surprised to see more unprofitable company IPOs taking center stage at the ring of the bell.

Special thanks to Sam Bernards for his time and insights.

Resources Consulted

• Deloitte, Navigating a Shifting Landscape
• Deloitte, The Revenue Multiplier Effect
• WSJ, Airbnb Files Confidentially for IPO With SEC
• WSJ, Airbnb Plans to File for IPO in August
• WSJ, Airbnb Swings to a Loss as Costs Climb Ahead of IPO
• WSJ, Casper Has Big Dreams, but Wall Street Is Waking Up to Losses as Its IPO Nears
• WSJ, Fear Overtakes Greed in IPO Market After WeWork Debacle
• WSJ, Snowflake’s Stock Price Soars in IPO