In 1996, more than 7,400 companies were listed on the major U.S. stock exchanges; today the number is less than half of that. There are many reasons for the decline, but among the more consequential is the emergence of crossover investing.
Crossovers are traditional institutional investors that also invest in private start-ups. Their growing interest in accessing pre-public equity is fostering a new “gray market” that blurs the line between public and private status.
To a degree, the private markets are cannibalizing the public markets. Today there are more than 300 private companies valued at $1 billion or more — the “unicorns” — and in many cases their cap tables now often feature mutual and hedge funds alongside the traditional VC players.
With access to a broader pool of capital, these companies are able to extend their maturity periods outside the scrutiny of the SEC and public markets. Indeed, we have seen a significant lengthening of the pre-IPO incubation period, from about five years in 2014 to nearly eight and a half in 2017.
Traditional investors are creating crossover funds to access private companies, trading off the risks of an illiquid investment in a less-mature company.
Of course, the venture capital community is built to assume these risks. But institutional investors often hold smaller stakes and no board seats, leaving them to grapple with how to access information and build the influence with management that better enables them to evaluate their investments.
And that evaluation is crucial to the crossover investors themselves, given that institutions must mark the value of their private investments at regular intervals. That effectively creates a quasi-public valuation benchmark that can impair market perception of the company, not to mention the next capital raise.
The inter-relationship of information and valuation is the realm of investor relations. For traditional private companies, however, IR is a capability often not prioritized until close to, or after, the clock starts on an IPO.
Private-company CFOs with crossover investors, especially those with prior public-company experience, increasingly appreciate the need to build IR muscle earlier. The trick is balancing the value in gaining access to Wall Street money and relationships, which can add buzz and pay valuation dividends at IPO time, with the obvious benefits of maturing in private.
Crossover investors tell us they appreciate that they’ll be getting limited information. But at the same time, they say, many start-ups lack basic skills and understanding of how to shape their narratives and communicate effectively with non-VC investors. They worry that not honing these skills will lead to missed opportunities and problems that can surface later during an IPO or in the aftermarket.
As advisers who have worked on all sides of this dialogue, we believe gray-market companies need to be thinking earlier about how to work effectively with Wall Street. They have a unique opportunity to gain valuable insights that can accelerate their maturity and make them smarter and better-informed competitors, ultimately strengthening the IPO story.
On the flip side, getting investor communication wrong can impact Wall Street’s early impressions of a company, leading to unfavorable comparisons to better-prepared peers that can impact valuation.
As the gray market evolves, and especially if private-market valuations lose some of their frothiness, CFOs will see the pressure from Wall Street ratchet up. While investing too much, too soon in IR isn’t optimal, private companies with crossover investors should be accelerating their focus at least into the 18-24-month window ahead of a potential IPO.
Optimize the company’s narrative. Stories aren’t sold to portfolio managers the same way they’re sold to VCs. PMs want to know not just the problem you solve, but a crisp three-to-five-year investment thesis that will ultimately win in the public markets. Having a simple story tuned to a professional investor’s way of thinking can pay dividends in your next round and later in your IPO.
Start earlier on defining KPIs. With Wall Street investors come disclosure decisions. CFOs traditionally don’t focus on selecting metrics to disclose publicly until a short time before the IPO decision. In the crossover world that discussion needs to begin sooner.
Choosing the right KPIs and total-available-market definitions separates the wheat from the chaff. Also, managing the business to disclosable KPIs instills internal discipline and drives better business behaviors.
Don’t wait too long to build a quarterly reporting function. Too often private companies start reporting quarterly only when they have to, either because the cap table has expanded and investors demand it, or because the company has raised a bond or other security that may require it.
But quarterly reports are about much more than nettlesome disclosure. They’re also about creating a disciplined process that helps your finance team mature and provides experience in thinking on one’s feet with sophisticated investors. It’s a function that is vital to ultimate public-market success, and it takes time and repetition to perfect it.
Build your Wall Street credibility, stealthily but purposefully. While performance counts above all else, messaging and relationships play a big role in pursuit of premium valuation.
Successful private companies often boast premium valuations, but carrying those into the public markets is by no means assured. Building constructive and informed relationships with opinion leaders on the Street builds future investor confidence, which impacts valuation.
The influx of private capital has afforded increased flexibility on the go-public decision, giving CFOs more time to judge the readiness of their companies and invest in needed capabilities like FP&A, tax, accounting systems, and critical enterprise functions like HR and legal.
CFOs we talk to often speak of “optionality” — believing an IPO will come later, but being ready to flip a switch if the board decides otherwise. Understanding and communicating effectively with new crossover investors will play an increasingly vital role in creating that optionality.
Jeff Majtyka is the founder and president of Ellipsis, an investor relations and strategic communications firm. Willa McManmon is the firm’s West Coast managing director.