The 3-point field goal and UBER’s IPO conundrum

The National Basketball Association introduced the 3-point field goal for the ’79-80 season. An extra point could be earned for shots that originated from outside the ‘D’ therefore encouraging shooters to take more spectacular long shots. While initially criticised as a gimmick, the 3-pointer has become a key weapon for a team’s offense with an average of 30.3 attempts per team per game in the NBA last year. The simple arithmetic is that a 3-point shot has less chance of success than, say, a slam-dunk, but it carries a higher return of 3 points compared with 2 when shooting inside the D. 3-pointers are optimal when the expected return exceeds that of shots closer to the hoop.

It took a few seasons for the NBA to wake up to the fact that shooting early from outside the D has a generally higher payoff than approaching the goal.

This is a lesson that the Tech IPO market might benefit from.

It’s currently in vogue for tech startups to remain private for as long as possible rather than to go public. Pre-IPOs are being advised to approach the public markets cautiously and only shoot when success is a slam-dunk. In the meantime, without a market referent for valuing the company, there is a tendency to systematically underprice each funding round so that the next round is an ‘up-round’ rather than ‘down’. No doubt this behaviour is encouraged by VC firms in order to keep their ongoing investment cheap! This practice is detrimental to the founders and early investors since they experience real-value dilution when late stage investors buy equity cheaply. Surely, then, there must be an incentive to do something to limit this wealth transfer?

An early IPO is similar to a 3-point shot. There are two main benefits of an IPO: (i) access to liquidity and (ii) market pricing. While markets are almost always wrong, they do tend to deliver an unbiased assessment of the value of a company. So, whereas a private firm will price capital raisings low to position for future ‘up-rounds’, basing a cap-raise off a public market price would seem to increase the valuation for the firm. Put simply, shooting early for an IPO may well be a 3-pointer for existing shareholders.

UBER is the poster-child for the stay-private-longer strategy, with its last cap-raise valuation stretching to the $60-70billion region. Its recent governance travails are worthy of a soap-opera, and while no-one doubts its success, the valuation will have definitely suffered. One wonders if an early IPO would have averted some of their struggles?

As a corollary to the above, I am continuously shocked at how complicated the capital structure is that private companies find themselves with before reaching IPO. Preference shares, convertible bonds, pre-ipo discount securities, make-good provisions and so on and so forth. Surely, one of the motivations for remaining private is to simplify the capital structure with, say, common equity? A benefit of going public is that any investor seeking protection is free to contract with counterparties in the secondary markets rather than negotiate directly with the company’s founders.

It is impossible to test the hypothesis that tech startups would be better off with an earlier IPO rather than later. A few disruptive entrepreneurs need to attempt the IPO equivalent of the 3 point field goal to make the case.