Voodoo economics may have been invented in Washington, D.C., but looking at the latest crop of venture-backed companies launching public offerings, the term could just as well apply to Silicon Valley.
Over the past few months, startups funded in the heyday of the tech bubble—and largely written off as exit prospects during the subsequent implosion—have been coming back to life. Public market investors look to be under the thrall of a similar spell, snapping up offerings from tech companies with strong growth forecasts and sometimes nonexistent profit histories.
Public market investors look to be under the thrall of a similar spell, snapping up offerings from tech companies with strong growth forecasts and sometimes nonexistent profit histories.
VCs, still short on returns from binge investing at the beginning of the millennium, are reluctant to call it another IPO boom. But as the pipeline of proposed offerings swells, optimism seems to be in the air.
“I think it’s the beginning of an up cycle,” says Santo Politi, general partner at Spark Capital, and a former director of digital media storage company BigBand Networks, which launched a particularly well-received stock offering in March. “There’s clearly an appetite in the market for new issues with high growth rates.”
Examples abound. Companies in the storage, semiconductor and networking sectors, from Isilon Systems to Mellanox Technologies to Clearwire, have raised hundreds of millions in offerings launched under often tumultuous market conditions. Investment bankers, meanwhile, are rushing to fill the IPO pipeline with new technology deals.
Companies in the communications equipment, digital media and semiconductor sectors are generating particularly high interest among IPO investors, says Ron Pillar, head of East Coast technology investment banking at JP Morgan. Pillar said his division is planning to add staff to help manage increasing deal flow for both acquisitions and IPOs.
There are a lot of companies in the $40 million to $50 million revenue range that are going to say: ‘It’s now possible for us to pursue an IPO.’”
Santo Politi, General Partner, Spark Capital
Palo Alto, Calif.-based Focus stands to reap substantially greater returns should market conditions hold up. The fund has three portfolio companies—Aruba Networks, Starent Networks and ShoreTel—in registration for IPOs that would collectively raise in excess of $270 million. Of those, Aruba is unprofitable, while Starent and ShoreTel posted profits in 2006.
That’s a bit better than the average among tech IPO candidates. Some 62 percent of the 26 tech firms that filed with the Securities and Exchange Commission for an IPO since January 2005 and are waiting to go public are in the red, estimates Charlie Rice, co-founder and principal of East Peak Advisors, an investment banking firm that specializes in the security sector. Last year, 10 out of 23 tech IPOs were carried out by unprofitable companies.
Survivor: Sand Hill
What’s noteworthy about many of the companies going public today isn’t just their lack of profits, but also the amount of time they’ve been unprofitable. Virtually all of the IT offerings in the past several months have involved companies founded during the dot-com boom and bust.
While cohorts imploded, today’s IPO candidates weathered the downturn and built viable businesses. Their survival was aided by their ability to continue raising money even when their industries were thoroughly out of favor with investors.
For example, optical networking company Infinera, which filed in February for a $150 million IPO, has raised more than $300 million in venture capital since 2000, including $125 million between 2001 and 2003. Likewise, Clearwire, which secured more than $1 billion in VC funding prior to going public, raised some of its largest early rounds in 2001. And BigBand, which is profitable today, raised its biggest annual infusion of venture capital ($30 million) in 2002.
After the bubble “was a particularly good time to be investing because it was not a popular time to be investing,” says Steve Baloff, general partner at Advanced Technology Ventures.
The venture business tends to have very narrow windows where you get great liquidity events and you make all your money.”
Jim Boettcher, General Partner, Focus Ventures
Politi says he isn’t surprised that bubble-era companies are finding exits today because it’s common for industry leaders to get their start at the end of an expansion period. He’s also not concerned about an uptick in IPO filings, given the quality of offerings.
“In the previous IPO bubble, a lot of companies were going public without a real business,” Politi says. “Most of the companies in the pipeline now that are trying to go public have really reasonable, predictable businesses.”
An IPO resurgence may have happened sooner were it not for the costs of complying with Sarbanes Oxley regulations, which can run in the millions of dollars. SarbOx probably added a year or two to the time it takes a company to prepare for an IPO, Baloff says.
Companies are also going public with lower revenue, says Baloff. Last year a company needed to post $80 million or more in trailing revenue to carry out a successful IPO.
“There are a lot of companies in the $40 million to $50 million revenue range that are going to say: ‘It’s now possible for us to pursue an IPO,’” Baloff says. For example, SourceFire, a developer of network security applications with 2006 revenue of $45 million, went public in March.
If the IPO boomlet carries on, the number of smaller offerings should increase, says East Peak’s Rice. That would be a welcome development, he says, given that some of the largest companies today—Amazon, Cisco, Starbucks and Yahoo to name a few—went public with offerings raising less than $65 million and generating market capitalizations of less than $500 million.
Of course, for the turnaround to stay on track, bankers and backers of pre-IPO companies will need to be cautious. If newly public companies fail to meet earnings forecasts, they’ll cast an instant freeze on the nascent recovery.
“On the one hand I’m thrilled to see the market opening up for some emerging players,” Rice says. “But I grow concerned when I see companies admitted to the public market for their growth trajectories and not for a profitable or proven business model.”