It wasn’t that long ago that the “pandemic effect” helped drive a record-breaking IPO boom among Canadian technology companies. Fast forward a year, however, and the landscape has completely changed.
Last year, we saw many tech companies forgo private capital raises, opting for a public launch instead. After a sleepy decade averaging approximately one tech IPO a year, 16 tech companies with offering sizes larger than $50 million debuted on the Toronto Stock Exchange during this period of explosive activity.
Valuations are taking a hit, and later-stage companies with near-term IPO plans are seeing the biggest impact.
But markets oscillate, and like a pendulum, it has swung the other way, with private market growth capital once again the pathway of choice for tech firms.
Even when IPOs were at their most attractive, we advised companies to always be ready for change. Who knew when certain opportunities would present themselves again and for how long?
War and geopolitical tensions in Europe, soaring inflation at 30-year highs, tightening central bank policy, surging oil prices, lacklustre IPO debuts, and the pandemic made for difficult ingredients in a recipe for market uncertainty. Interest rates in particular pose a challenge to the tech sector, compressing multiples and deflating previously lofty valuations. With more rate hikes expected from the Bank of Canada, that pressure is unlikely to ease quickly.
Most companies eyeing the public market have put their IPO plans on hold. Valuations are taking a hit, and later-stage companies with near-term IPO plans are seeing the biggest impact.
Still, companies should not be deterred. There is over a trillion dollars worth of capital in private market systems and during the pandemic era, we’ve seen how much of that poured into Canada. U.S. growth equity funds continue to zero in on its northern neighbour – with its diverse pool of world-class talent – as a great investment destination. They are becoming more comfortable in Canada, leading larger funding rounds, investing at earlier stages, and inking bigger investment deals. American firms were involved in more than half of the Canadian venture capital deals in recent years, according to Pitchbook.
Canadian companies raised C$14.7 billion in venture capital funds in 2021 – a record – and another C$4.5 billion in the first quarter of 2022, CVCA data shows. Amid this backdrop, the top seven out of 10 Canadian private tech capital raises last year were led by American investors and they are also behind the funding rounds in 2022, such as Tailscale’s recent $100 million raise led by CRV and Insight, and Montréal-based Paper Education’s $270 million round.
At the same time, Canadian investors are also committing more capital. Ontario Teachers’ Pension Plan, for example, has made clear it intends to more than double or even triple its investments in private tech companies through its newly renamed Teachers’ Venture Growth. Firms such as Georgian, Inovia, and CDPQ are also making large investments in Canada, including recent mega-rounds in Talent.com, Vention, and eSentire.
The rule of 50?
With so much dry powder on hand, there is no lack of activity in private markets. Tech firms, less enticed by strained public market conditions, are eager to grab a share. At the same time, investors are increasingly more discerning about where they put their money. The bar to seize their attention is much higher, making it more challenging for companies to raise funds compared to the previous two years.
Companies that raised at very high multiples before may find attracting new capital at those historical valuations a hurdle. With the public market no longer serving as a reference point, firms looking to raise additional private rounds are likely to adjust their expectations to match the current environment.
Today, companies must either achieve hyper-growth rates in order to attract capital from investors or show a good mix of growth and profitability.
For investors and companies with strong balance sheets, however, the downturn in multiples could actually be an opportunity to acquire and consolidate. Anecdotally, we continue to see strong momentum in the M&A markets. For example, RBC recently advised TSX and Nasdaq-listed Points.com on its announced sale to Plusgrade, a Novacap and CDPQ-backed strategic acquirer. Furthermore, the private market for acquisitions continues to be a fertile ground for both strategic and financial acquirers.
All that being said, high-quality companies will still continue to attract capital at healthy valuations. Still, profitability is becoming an increasingly important driver of valuation, which is a reversal of historical norms where top-line growth tended to have the most impact.
Does this mean the ‘rule of 40’ goalposts have shifted? Today, companies must either achieve hyper-growth rates in order to attract capital from investors or show a good mix of growth and profitability. The metric, where that combination of growth and profit should be greater than 40 percent, has been widely used as a benchmark to attract premium multiples. With the bar set so much higher now, the ‘rule of 50’ might be the new rule.
Where do we go from here?
Tech companies postponing their IPOs are waiting for the markets to stabilize and the next window of opportunity. In the meantime, they are shoring up their balance sheets and taking private capital to accelerate growth while they wait, setting themselves up for a public launch down the road. And unlike the vagaries of being a public company beholden to short-term quarterly performance expectations, there is appeal in operating and growing out of the public eye.
Last year’s record-breaking activity demonstrated an appetite for tech IPOs – one that will likely return when the pendulum swings back. From an investor’s perspective, many are putting in money with anticipation of an IPO in the near term, even though they are not traditionally considered “pre-IPO” rounds. Looking ahead, the time between raising a growth round and going public will likely shorten as soon as that window reopens.
Despite the current public market challenges and the dramatic shift in valuations for tech firms, there is still a record amount of capital in the system from both Canadian and American investors waiting to be deployed. The barrier to accessing some of that capital is higher now, but we predict IPO volumes will eventually return to meaningful levels, even if records are not broken. There are tech companies waiting and biding their time in the wings, even as they eye the private market to help accelerate growth. Meanwhile, IPOs remain a real exit opportunity for VCs putting in private capital.
The 180-degree change in the tech landscape may seem daunting for those who hoped to raise funds through public markets – but like the pendulum that continuously oscillates – that window of opportunity will present itself again. In the meantime, private market options still abound for companies with the right mix of performance, growth and profitability.
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