At Calcbench we don’t give investment advice; that’s your job. But we like to help people make informed decisions from available data. That’s why the Oct. 1 WSJ article about money-losing IPOs caught our eye.

“Money-losing companies are going public at a record rate as investors hunger for new issues.” Funny, they make it sound like it’s a bad thing…

But seriously, just because a company is making a loss at IPO, does that necessarily predict much? Heck, was making a loss at IPO.

You need to dig deepr to figure out what kind of loss the filer is making, and what it means for the future.

To discuss this, we will revisit a post we wrote when went public in 2014. And it turned out to be prescient, since the company’s stock languished well below the $17 IPO price for several years.

At the time we called it “Buying revenue at any cost… the new strategy for IPOs?’

The first time I noticed a pattern was when I was looking at Groupon’s prospectus. Then came Splunk, Yelp, and several others in the past couple of years. And just today I saw a new one…

What pattern am I talking about? Companies that spend their pre-IPO year(s) with blowout revenue growth and equally dramatic growth in their costs and losses.

This is expected from early-stage startups. But early-stage startups don’t IPO; late-stage startups do.

Increasingly it seems there is a playbook that investment bankers are selling to hot startups, that reads something like this: If you buy revenue growth at any cost, we can take you public.   

Anyone who has worked in corporate finance can tell you there is revenue and there is revenue. Some is good and some is bad. Revenue that loses the company money is bad…unless you need it to make your company look like it is growing.

Here is the game in a nutshell. If your company loses money, it’s impossible to value based on profit, right? So, investors turn to revenue growth instead. But far too few investors seem to realize that revenue growth can kinda sorta be whatever the company wants. Want more revenue? Steal the market by charging less than all of the competitors. Buy more advertising. Sell deals that cost more than they bring in. Whatever it takes. Who cares what it costs. Because investors aren’t looking at the costs.

But what should you look for to know you are not getting a raw deal?

Simple. Ignore the revenue growth. Everyone’s got that. Focus on the incremental margin:

Good companies are characterized by increasing operating leverage, also known as incremental margin.  Over time, for each dollar in revenue growth, a larger portion of that dollar should fall straight to the bottom line. If this doesn’t happen, then there could be something wrong with the business model.

Let’s look at Each $1 of revenue cost $1.47 dollars in 2011. In 2012? $1.43. How about the first 9 months of 2013? $1.42. COME ON! After revenue rose 125 percent, you couldn’t increase the incremental margin at all?

In other words, if this company keeps on the same track, it will never turn a profit. Business model changes will have to happen… and why is a company filing for an IPO if it doesn’t have its business model figured out?

Now for contrast, let’s take a look at Amazon.

Each $1 of revenue cost $1.59 dollars in 1995. In 1996? $1.38. And in the final quarter on 1996? $1.28. Clearly, if Amazon kept going in a straight line, it would turn a profit. And, eventually, it did.

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