IPO or private investment?

IPO or private investment – what’s the best option for growing your tech company?

It’s a hot topic for founders these days as investors show renewed interest in tech IPOs and private capital continues to flow like a spring river.

“IPO windows are open or they’re closed, and the IPO window is clearly open right now,” says Dave Caputo, co-founder and former CEO of Sandvine Corp., one of only two Waterloo Region tech companies –the other being COM DEV spinout exactEarth –to go public over the past 15 years until Magnet Forensics launched its IPO in late April.

“Aspirationally, we should want companies to build to be public,” says Caputo, a passionate advocate for Canada’s tech ecosystem and chair of Communitech’s board of directors. “We want more Shopifys, we want more Blackberrys.”

A veteran tech leader who has been through the private and public funding trenches, Caputo has a preference for going public – as long as the company is ready and the leadership team is well prepared.

“Every window is going to be different but, first and foremost, you have to make a very conscious decision to go public,” he says. “It’s a ton of work but it’s also incredibly satisfying.”

Like other experienced observers, Caputo – who now leads a new company he founded called Trusscore – acknowledges the dilemma created by the current climate, where valuations and the cost of capital are roughly equal in both the public and private markets.

Some experts say the tech IPO market has never been better. 

“This has been the best small-cap market we’ve ever seen in terms of IPOs and one of the best tech-issuance markets we’ve ever seen in Canada,” says Daniel Nowlan, Vice-Chairman, Equity Capital Markets at National Bank Financial.

Defining our terms

What’s the difference between private equity and venture capital? Both bring together groups of accredited investors, known as limited partners, who contribute to a pool of money called a fund. The VC or private equity firm then invests portions of that fund into specific companies. The difference lies mainly between the types of companies VCs and private equity firms invest in. Generally speaking, venture capital is money invested in tech startups; private equity refers to investment in more established companies. As Investopedia says, VCs and private-equity firms tend to “buy different types of companies, invest different amounts of money, and claim different amounts of equity in the companies in which they invest.” Angel investment and seed rounds are the earliest-stage private investment, generally smaller amounts of money intended to get a business off the ground. To keep things simple here, we’ll call it all “private investment,” as opposed to capital raised through an issue of publicly traded stock.

How we got here

For those who ask why Waterloo Region hadn’t seen a tech IPO for 15 years, veteran tech leader Carol Leaman points out that, until recently, the cost of capital was often cheaper through private investment than public markets.

“So when comparing the two, entrepreneurs were like, ‘Well, if I can just stay private and don’t have to open my books and records and my plans and all of that, and be reporting quarterly, and if I can get the same money in the private market and not have to do any of that, then why would I go public, because public markets just weren’t paying up for tech companies,” says Leaman, founder and CEO of Waterloo-based e-learning firm Axonify. “But now they are. So really it comes down to many factors, but one big one is that public markets are paying up now and they weren’t four years ago, so that’s why there were no IPOs – it was just the cost-of-capital equation for an entrepreneur.”

It has taken quite a while for that equation to shift, at least in Canada. 

The big exception was Shopify, whose share price has soared astronomically since the Ottawa-based e-commerce company first listed on the NYSE and TSX in 2015.

Even with Shopify’s success, Canadian tech IPOs didn’t really heat up until 2019 when Montreal’s Lightspeed POS listed on the TSX and raised CDN$240 million. A year and a half later, Lightspeed listed on the NYSE, in addition to the TSX, and raised an additional US$398 million. At about the same time, another Montreal company – Nuvei Corp. – listed on the TSX with an IPO that raised US$805 million. And later in the year, AbCellera Biologics of Vancouver listed on Nasdaq, raising US$555 million.

The trickle led to a trend.

Nineteen Canadian tech companies went public in the first quarter of 2021 and another 17 have announced their intention to do the same, according to a recent Morningstar report. Among those is Magnet Forensics, which raised more than CDN $100 million with an IPO in late April, becoming the first Waterloo Region tech company to go public since Sandvine in 2006. 

Meanwhile, the flow of private-investment capital has remained strong. 

In 2020, a year disrupted by COVID-19, VC investment totalled CDN$4.4 billion across 509 deals – the second-highest level after 2019, according to a report by the Canadian Venture Capital and Private Equity Association. 

And in Waterloo Region, companies such as Faire, ApplyBoard and Arctic Wolf Networks have grown to unicorn status through private investment. 

Why has the IPO window opened now?

There are plenty of views but a variety of factors on both the investor and issuer sides have combined to stoke public-market interest in Canadian tech companies, especially for smaller-cap businesses.

Chris Albinson, a Canadian venture capitalist who recently became CEO of Communitech after 20 years in Silicon Valley, has an interesting take on the “why now” question.

“Some people say, ‘Well, it’s the structural issues around public markets, where the public markets are open now and they weren’t before,’” he says. “I actually think it’s something different, which is – and I love (Shopify founder and CEO) Tobi Lütke's quote on this – that the pandemic basically allowed 2030 to show up early. And so whether it’s Magnet Forensics’ IPO or Clearco’s and Wealthsimple’s growth financing, I think we’ve got a number of companies across Canada that have had absolutely tremendous growth over the last 15 months and they’re just well set up for really thoughtful and great growth financings, whether they be IPO or private.”

Others point to the influence of the Shopify IPO and the fact that many Canadian investors gave that opportunity a pass.

“One of the big drivers for this change – this focus on smaller growth-companies by Canadian investors, which wasn’t really there for a long time – is Shopify, because when Shopify went public it was a more U.S.-directed deal and many of the Canadian investors just didn’t get in on the ground floor and it’s been a massive outperformer,” says National Bank Financial’s Daniel Nowlan.

“If you’re a portfolio manager and you’re benchmarked against the index – and Shopify is such an important part of that index, but it remains now to this day very under-owned by Canadian investors – it’s important for those investors to try to replicate that, to try to capture that alpha that they missed out on and get it somewhere else. And that’s why they’re looking at all these really exciting smaller-growth companies and trying to capture that.”

Albinson agrees.

“On the supply side, we have these quality companies that have come to size and scale and maturity and are positioned to be great public companies or private-growth companies,” he says.

“I also think there’s a realization by a lot of the institutional public investors that private equity really filled a void of their hesitancy,” he adds. “So, credit and shoutout to folks like (pension manager) OMERS that were early investors in some of the growth stories like Shopify.”

For founders, three considerations underpin growth-financing decisions: the cost of capital, the valuation applied to their company by potential investors, and how much dilution of ownership they have to accept.

“From a founder of a tech company’s perspective, (they’re) always going to be looking at dilution as being the primary concern when looking at any form of financing,” says Chris Dale, Managing Director and Head of Equity Capital Markets for National Bank Financial. “The public market has been willing to pay multiples that have been equivalent to what private equity has been willing to pay.”

Another motivating factor for public-market investors is the quality of the management teams currently running many of the most promising Canadian tech firms, as well as the desire of these teams to stick around and grow large, successful companies.

“The deals we’ve dealt with over the last couple of years, the entrepreneurs who started these businesses, they want to stick around and they want to build giant, very successful companies –  they want to build the next Shopify, they want to build the next ultra-successful business, the next Lightspeed,” says Nowlan.

An attractive valuation, the ability to retain control and the opportunity to grow the company in Canada were priorities for the Magnet Forensics team.

“When we were weighing our financing options, we focused on how it would allow us to accelerate our growth plan and maintain our mission,” says CEO Adam Belsher. “The motivating force behind our team is to help our customers with their growing cybercrime challenges and to grow Magnet to its full potential as a global leader of cyber-investigation solutions. To do so, our leadership team thought it would be best to retain a controlling interest and to continue to grow our company from Canada.”

Reflecting on the rationale for taking Sandvine public in 2006, former CEO Dave Caputo says valuation – an investor’s estimated value of a company, based on a variety of financial metrics and comparisons with similar companies – was a major consideration.

“We had a number of VCs give us term sheets­ and the best we could do was a $40 million valuation,” recalls Caputo. “And we thought, well, let’s not go through this again; let’s take the company public at a $180-million valuation. And the catalyst was, at the time, venture capital was overly conservative for that brief period of time… and so the idea that we were going to continue to grow and not be rewarded from a valuation perspective, it felt like we had to get to a broader set of investors.”

Pros and cons

Every company has a unique set of considerations and preferences to weigh when deciding the best way to finance growth. Here are some of the commonly cited pros and cons of going public.

Pros

Daily liquidity and access to more investors.

Ability to do follow-on financing through various public-market instruments

Greater visibility, which attracts analyst and media coverage and builds awareness and confidence among investors and potential customers.

Financial rewards for founders, early investors and employees through share ownership and stock options.

Cons

Intense public scrutiny of financials, compensation, etc. by securities regulators, media, analysts and investors.

The high cost of putting an IPO together – legal, banking, underwriting and accounting fees, not to mention executive time diverted from day-to-day operations.

The ongoing resource cost of satisfying strict securities regulations and reporting requirements.

Short-term fluctuations in share price can distract management from longer-term goals.

Leaman, the Axonify CEO who has grown four tech companies to successful exits, applauds founders and CEOs who have the desire to lead a publicly traded company

But all things being equal – cost of capital, valuations and control – she prefers to run a privately funded company rather than pursue an IPO.

“That’s just not my personal path and I give all the credit in the world to the Magnet guys and to anybody else who wants to run a public company,” says Leaman, who recently negotiated the sale of a controlling stake in Axonify to private equity firm Luminate Capital Partners of San Francisco.

For Caputo, the pros outweigh the cons – as long as the company and its leadership team are ready for the demands of life as a publicly traded entity.

“There will be no public company before its time,” says Caputo, a nod – only half joking – to the old Paul Masson wine commercials.

First, he says, the “IPO window” has to be open, meaning the market has to be in a receptive mood for new public issues. 

Founders then need to focus on the big three: potential for growth, predictable revenue, and profitability.

“Those are, in order, the things that most tech investors value the most,” says Caputo.

What else should a founder be thinking about before starting down the IPO path?

“What goes through your mind is, Do you have some (existing) investors that are looking for liquidity? Do you have a use for the great amounts of money you’re going to raise? Is your organization mature enough to publicly report every quarter? And you have to take all that into account, and whether you want the complete scrutiny of being radically transparent with your results, with your compensation, with the good, the bad and the ugly that might occur in your business, because all of those are material events that have to be disclosed as soon as humanly possible when you’re public.”

Albinson says that, regardless of whether you go public or remain private, founders need to understand that any growth financing is a “five-year journey,” not just a short-term liquidity opportunity. That understanding makes it critically important to choose the right investment partners – ones who understand “where you want to take the business and are aligned to help you get there,” he says.

“If you put that lens on, it’s a lot easier to start to talk about what’s a good IPO alternative against a good private-equity alternative, as opposed to a bad IPO alternative to a good private-equity alternative, or a bad private-equity alternative to a good IPO alternative.”

The last word goes to Dave Caputo.

“I think you should aspire to build a company that could be publicly traded,” he says. “The journey is certainly the reward in doing it, and it’s both a huge relief and euphoric when your company trades on a public market for the very first time. And you should have a really good party for your team.”