Yesterday evening, Vroom, a digital used car retailer, priced its IPO at $22 per share, a figure that was a full $7 above the low end of its first proposed IPO price range. The venture-backed firm first proposed a $15 to $17 per-share IPO price range, which it later raised to $18 to $20 per share.
Pricing at $22 per share meant that there was strong demand for the company’s equity during its IPO process. Pricing strength doesn’t guarantee performance as a public company, but it does provide a proxy for investor interest.
TechCrunch has covered a few IPOs lately, noting along the way that some recent offerings have featured heavy financial backing and incredibly slim margins. Not profit margins, mind, those don’t exist for the firms we’re talking about — we’re discussing gross margins, the most basic element of corporate profitability.
Gross margins are part of why software companies are so valuable. Their incredibly strong gross margins make their revenues, and therefore their operations, attractive to investors; higher gross margins mean more money left over to cover expenses and redistribute to shareholders via dividends and buybacks. Lower gross margin businesses, in contrast, have less money once they are done paying for revenue costs, making it harder for those companies to cover operating costs, let alone give away leftover funds to their owners.
So it has been to our surprise that Kingsoft Cloud, Vroom, and, soon, Lemonade are seeing such strong responses. It’s perhaps even more surprising that these companies managed to raise as much private capital as they did in their youth, despite not sporting gross margins that track with what we expect from venture-backed, tech and tech-ish companies.
With markets at all-time highs — and thus comparable valuations contentedly stretched — it’s probably a great time to take low-margin, growth-y companies public. But that doesn’t mean the situation makes perfect financial sense.
Low margin, no worries
Seeing low-margin businesses like Kingsoft Cloud (raised its IPO sale by 5 million shares) and Vroom (priced above its raised range) generate such impressive investor demand in their public offerings was a surprise of sorts. Let’s talk about why.
Software as a Service is a popular venture capital investment and public market play for a number of reasons, but two factors matter for us this morning. First, high gross margins, which we’ve already touched on. The second aspect is repeatability of revenue, or how often software revenues recur. It’s now common for startups to sell their software as a subscription. This locks in high-margin revenue for quarters or years.
Kingsoft Cloud, Vroom and Lemonade do not share these two characteristics. Each has a bit of one or the other. Let’s examine our three companies — two recent IPOs and a hoped-for debut — on the two axes:
- Kingsoft Cloud’s revenues: Low margin and only partially recurring
- Vroom’s revenues: Low margin and non-recurring
- Lemonade: Low margin and only partially recurring
Given the market welcome that our first two companies received, you can easily see why Lemonade wants to get public now, despite having an ocean of cash already on its balance sheet; the getting is currently very good for businesses like it, so off it goes to get.
To make this simpler to see, let’s do a tiny bit of math to demonstrate how slim the gross margins that we’re discussing really are. Software companies tend to have gross margins between 70% and 85%, depending on how they are calculated (which costs are included, really). Here’s our trio, using the most recent available data points:
- Kingsoft Cloud 2019 gross margin: 0.2% (a dramatic upgrade from being gross-margin negative in 2017 and 2018)
- Vroom Q1 2020 gross margins: 4.89%
- Lemonade Q1 2020 adjusted gross margin: 18%
So Lemonade is the best result, though it’s always hard to trust an adjusted number. But with the first two seeing the reception that they have, Lemonade trying to add its name to the same docket is smart. Low margins? No worries!
Even better, these gross-margin-light companies are crushing their final private valuations. Kingsoft Cloud went public worth around $3.7 billion. That was far better than its roughly $2.4 billion final private valuation. Vroom’s IPO price gives it a valuation of $2.48 billion. That’s far greater than its $1.45 billion final private valuation. So why shouldn’t Lemonade, with its strong revenue growth, expect to top its $2 billion final private valuation? We’ll find out soon enough, I suppose.
If investors are being intelligent, buying equity at IPO prices in companies that will in time generate better gross margins, material profitability and strong future cash flows is impossible to tell from here. What is clear, however, is that a lot of capital is going into companies that will have a far steeper hill to climb to reach those goals. We can see that from just their gross margin results.
Long live all-time market highs and strange results. And welcome back, IPOs.