The Hidden Reason Why So Many IPOs Today Seem Unsound

If you're like most investors, one of your dreams is to spot a great company early, before it makes a splash in the market, invest in it, and later reap a giant profit as it becomes the next Amazon.com or Netflix. But lately, it seems like the most interesting new stocks to arrive on the scene are for companies that -- however clever and disruptive their products and services might be -- look like absolute cash sinkholes on the bottom line. Of course, that doesn't prevent any of them from generating feeding frenzies around their initial public offerings, at least for a little while.

It wasn't always like this, and in this episode of Motley Fool Answers, host Alison Southwick gets the skinny from former Fool Morgan Housel, now of venture capital firm Collaborative Fund, on how conditions in the start-up realm have changed and what has led to a situation where we keep seeing companies with multibillion-dollar valuations that are burning through investors' money with apparently no end in sight.

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To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

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This video was recorded on May 21, 2019.

Alison Southwick: Let's move on from market volatility because another thing that's been going on lately in the markets is IPOs, most notably Uber's, which I hear was a huge failure. Dun dun duh! And my response to that is, "A failure for who?" It always depends on who that person is as to your perspective on whether it's a failure or not. What do you think about the recent IPOs?

Morgan Housel: I think what's interesting -- and this is a big, historical anomaly if you compare the long history of IPOs -- is the percentage of companies that are going public in the last few years that are not profitable and basically have no prospects for profits. That is not normal.

Southwick: Right.

Housel: But the percentage of companies that are in that situation over the last few years is most of them. And you look at companies like Uber or Lyft -- we are investors at the Collaborative Fund. Or Blue Apron. Or Snap. All these companies that are going public don't have any prospects for profitability and they are just cash incinerators.

I think an important dynamic that's taken place is in the last decade, the VC and private equity industry has grown enormously. It's literally trillions of dollars in which 20 years ago it was a fraction of that, which has made it so that private companies can stay private for longer.

So, in a different era -- if you go back to the '90s, let's say -- Uber, and Lyft, and Airbnb, and Palantir, and SpaceX], all these companies would have gone public way earlier than they either are today or some of those companies are not even public yet. They would have gone public years and years ago when they were just out of the garage start-up phase.

Once you got a little momentum, traditionally that's when you went public. Today these companies are staying private for a long time and they're backed by venture capital funds and private equity funds. Those types of investors tend to have much more tolerance for the companies losing money. For net operating losses at the company level.

And therefore, by the time these companies go public -- like when Uber goes public, or Airbnb, or Lyft -- these companies are a big, established 10-year-old decabillion-dollar companies, but in terms of their internal financials -- their operating losses -- they're looking like brand new start-ups that are just bleeding money all over the place. And public markets don't have the appetite for that.

So it's this really weird dichotomy where you have these companies like Uber that when they're backed by venture capital funds, they're doing great and VCs will give them all the money they want and then the moment they become public companies, public investors look at their balance sheet and their income statements and say, "What the heck is this?"

This is not a business. Look at something like Uber and Lyft. I have to keep saying that we're investors in Lyft. This is not necessarily a criticism of the investors who have backed these. It's just the reality of where we're at. Every Uber and Lyft ride you take -- investors cover one-third of the cost of that ride. They lose money on every single ride. And that is not something that if you went back before the late 1990s would have ever been acceptable. And I think there's a big difference between a great product and a great business. And a lot of these companies are great products -- they're amazing products -- but they're not good businesses. That's the reality of it.

And just to contextualize the extent to which that did not used to be true, Michael Dell, from Dell Computers, posted last year the income statement that he used for when Dell Computer was one year old when he was running it out of his dorm room at the University of Texas I think it was. This is literally a dorm room company. Like he hasn't even graduated to the garage yet. This is dorm room.

He had 20% net profit margins. I honestly don't think there's a single well-known start-up today that has that. And that was when he was operating out of his dorm room. But I think that was expected back then. If you go back to that era, if you had a business, the idea was of course you're going to be profitable. You're not a business unless you're profitable.

So it's very different expectations, today, at the VC level. And I don't know if that's a bad thing. I think it's too early to tell whether that's a bad thing because companies that don't have to focus on quarterly profits, these days, can focus more on really building a great product and whatnot; but there has to be some balance on the other side. And when these companies go public, like Uber and Lyft have recently, they realize that that other side is completely different than the side in which they've lived in for the previous decade.

Southwick: While I was looking for the doomsday article headlines today, one of the big ones was that Beyoncé was going to make a ton of money off of Uber. Did you see this?

Housel: I read this, this morning.

Southwick: I only read the headline.

Housel: She's something. There's two parts of this. And it didn't look like the most reputable source, but it's a good story, so let's run with it.

Southwick: We should absolutely run with it. I read the headline and I thought, "No wonder Uber's not profitable. They offered Beyoncé $6 million."

Housel: That was my thought, too. That's what actually made me think, "That doesn't sound right." But let's run with it.

Southwick: A lesson in reading beyond the headlines.

Housel: Apparently Beyoncé performed for Uber in, I think, 2013 and they paid her $6 million. And she opted to take the payment in stock, and that stock is now worth $300 million.

Southwick: Smart move!

Housel: I have 50% faith that that's accurate, but let's go with it. The other story that I know is accurate is that Beyoncé performed at Coachella last year. Her fee for that was $8 million, but instead of taking the $8 million, she said, "Just give me the rights to the video. I'm going to record this performance, and that's mine. That's my compensation." She sold those rights to Netflix for $60 million. You hear these stories and think these are some very smart people. She declined her $8 million fee and ended up making $60 million off of it.

Southwick: And what's she going to do with another $8 million? Make even more off of it.

Housel: I love the stories of the people who end up making more money from these side businesses than they do from their actual careers. Michael Jordan made so much more money from Nike than he ever did from basketball. Shaq is another person who's made so much money from investing his basketball earnings than he did from basketball. And you have other people like Jay-Z and Beyoncé that make a fortune outside of their day jobs.

Southwick: How do I invest in Beyoncé? Can I get some equity in Beyoncé?

Housel: Did she IPO?

Southwick: She should IPO!

Housel: She should. She should go public.

Southwick: I would totally invest in her because she's very profitable!

Housel: Yes! More than all these companies!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Alison Southwick has no position in any of the stocks mentioned. Morgan Housel has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon, Netflix, and Nike. The Motley Fool recommends Uber Technologies. The Motley Fool has a disclosure policy.