If you blinked long enough you might have thought it was 1999. Not because the latest Google IPO chatter was of a $36 billion valuation-which one might deem reason enough to think we’d traveled back in time-but because Nanosys Inc., with all of $3 million in revenue and $9.2 million in 2003 losses, was also considering going public-that its, until it suddenly yanked its offering last month.
Both of the proposed IPOs presupposed that we’d all lost our minds (again) or that the financial world was suddenly shifting back from its ultraconservative stance toward IPOs to one capable of entertaining high-risk offerings if the technology story sounded good enough to whet the appetite of high-risk investors. If Google was proving the ultimate benchmark for a highly profitable, high-growth company-the anti dot-bomb-Nanosys was at the other end of the spectrum, a sizzling technology story with scant financials to justify a market cap of $371 million.
Should VCs take a cue from either or both of these offerings, that if they could go public, it would soon be fair game to take any of our portfolio companies out the door and into the public markets? Hardly.
If VCs consider either of these IPO filings a sign that it’s time to take meetings with bankers and ramp up exit opportunities sooner than we expected, we’d do well to do some deep knee bends and reconsider. Because if these underwritings have the potential to teach us anything it’s that the correct timing and placement for taking any portfolio companies public lies not in following Google or Nanosys out the door, but in learning from them just how much more time we have to wait.
Let’s all agree, first, that Google is an aberration. A once in a lifetime deal for any VC, particularly those fortunate investors at Sequoia and Kleiner-especially given that apparently within a year after investing in Google, things were so bad (lack of management discipline before Schmidt arrived, etc.) that the investors actually contemplated taking their money out. My how things have changed in four years, which is often the nature of the venture business.
Google’s second quarter numbers, ending June 30, were beyond impressive. Revenue jumped 125% to $700 million, while net profits soared 146% to $79 million. With Google’s float expected to be 26.4 million shares, and its stock price trading anywhere between $108 and $135 per share, the company could reach a valuation of $36 billion. By comparison, Yahoo (with a float of 1.2 billion shares) is valued at $37 billion.)
(As VCJ went to press, Google priced at $85 per share and jumped above $100 in its first day of trading on Aug. 19. -Ed.)
To say, then, that Google offers anything more than an example of a fully ripened-and incredibly well-hyped-company ready to go public into a market of panting investors would be to read far more into this IPO than is realistically there. “Will Google alone open up the IPO market? I don’t think so,” says Tony Trousset, managing director for Technology Investment Banking with UBS Securities. “It’s a total anomaly. It can do an auction, a non-auction, whatever it wants.”
Like SalesForce.com, Google will prove that for most companies and VC firms there exists a standard and sober set of expectations for venture backed startups capable of going public in a post dot-com world. For software and services companies, this means a track record of profitability with minimum trailing revenues of $40 million to $50 million. For more capital-intensive businesses you can up that latter amount to anywhere from $75 million to $100 million. Google doesn’t change that. If anything, it actually sets it in stone. For even as good as Google’s numbers are, analysts still worry that it’s a one-trick pony, that its paid search model accounted for three quarters of its business last year in a paid-search market that, according to data compiled by Yahoo, is seeing its growth slip from 220% worldwide in 2003 to 59% this year to possibly 33% next year.
In other words, aside from its sheer size and scale, Google only confirms what we as investors already knew: Companies with the chops to pass muster with most conservative investors will always be rewarded with ample returns and copious amounts of investment capital.
Nanosys, for all of its chutzpah in trying to go public with revenue and earnings still on the short side of pitiful, actually offered the far more interesting lesson for VCs seeking exit strategy guidance from the public markets: For investing in raw innovation, there will either be a reinvigorated market for high-risk deals in a post dot-com world, or there won’t. Given that Nanosys withdrew its IPO on Aug. 4, it appears we have our answer. Though I’m not entirely sure Nanosys was crazy for giving it a try.
While the business media, and a good chunk of the Street’s armchair analysts, scoffed at the notion of Nanosys attempting to go public, I viewed it as more of a new age of enlightenment. Much like any biotech company entering Phase II FDA clinical trials, Nanosys holds patentable positions in completely new markets, yet has utterly no idea whether its patents will ever result in commercial applications. And even if they do, it isn’t clear when commercial opportunities based on such patents might bear fruit.
In its SEC filing, Nanosys claimed more than 250 patents and patent applications based on technology that it either developed internally or licensed from universities and research centers. The company said its research could be applied in a variety of ways-from solar energy to semiconductors to flexible computer displays screens. Its business model is one mainly of pure R&D, with Nanosys gaining revenue from research projects conducted for clients including Matsushita, Intel and Dupont. That such agreements have yielded revenue of only $1.17 million for the quarter ending in March (though almost double the total of the same period a year ago) is a bit beyond the point. That the company has further lost $20.9 million between its founding in July 2001 and the end of March 2004, or that an opening stock price of between $15 and $17 would give it a price-to-sales ratio of more than 120, is an even more useless learning tool. We already knew that, on paper, the deal looked silly.
What was important was that if Nanosys could get out the door it would be because people still covet the opportunity to get in on the ground floor of a completely revolutionary area of technology, one with the possibility of having an impact on nearly every other industry it touches. Nanosys could be, though granted might not ever be, the next Amgen, the next Genentech, the next AOL TimeWarner-in terms of market size and leadership. Conceivably, this is what some IPO investors look for, and what Nanosys’s bankers, Merrill and Lehman, were counting on. If Google represented the opportunity to get in on a stock at the top floor where the only likely direction is down, Nanosys would have at least allowed speculators the opportunity to invest in a technology that fundamentally could change the world, one with high barriers to entry, sustainable advantages in terms of domain expertise, and market opportunities that have yet to unfold.
In language we might better understand, Merrill and Lehman tested the waters and found out that institutional and retail investors were at least willing to look at offering Nanosys a venture round, offering the company the capital to take it from $9.2 million in losses to perhaps $10 million in potential earnings.
For VCs to step in and do this would require another $100 million in funding, with no further guarantee of an exit. For public equity investors, they would have essentially gotten to invest in a portfolio company already armed with 250 patents, roughly $106 million in fresh capital, and some pretty smart scientists who would act as their own personal “entrepreneurs in residence.” That Merrill and Lehman couldn’t get the deal done and had to pull it off the shelf does not, to me, mean that there weren’t public equity investors out there willing to offer up this next round of technology financing. It was more likely the case that there wasn’t enough widespread and sustainable interest to float the stock through several more long and trying years or research and development.
One of Charter’s portfolio companies, Ellie Mae, is facing the same choices and parade of bankers that chased after Google and Nanosys. Yet, with Ellie Mae, we’re going to wait on going public. Unlike Nanosys, we don’t imminently need the cash because the company is already cash-flow positive and is doubling its revenue year over year.
What we need, or will need, is to maximize returns for existing investors while setting the stage for long-term value appreciation. For us it’s about visibility and stability, it’s about introducing three new businesses this year and making sure that those businesses are sustainable and profitable and accretive to Ellie Mae’s core business for years to come. From our perspective, there’s a huge premium investors will be willing to pay for predictability, for knowing a company will be able to continue delivering at a certain growth rate. For VCs this means, “To thine own portfolio company be true.” For Nanosys it means, “Get a revenue stream.”
Knowing that Nanosys was a ridiculous, once-in-a-lifetime bet on an emerging technology was not the problem. Investors are still, in my opinion, willing to take calculated risk; though they are no longer blindly optimistic in their investing habits. We were simply hoping that they would do what VCs have always done-place large bets on raw technologies and innovations, creating markets and businesses where none formerly existed. This proved to be wishful thinking. If IPO investors are no longer as conservative as they’ve been over the past three years, neither are they ready to become far-reaching speculators for companies with little if any track record of success.
For the bulk of venture-backed companies, I’d argue that investors ultimately want to see more companies like Ellie Mae than Google- or Nanosys-type companies. In a sense, we have an obligation to offer them such good long-term investment opportunities. Perhaps they don’t need Google-sized revenues and profits to justify investing in a company’s IPO, but they surely have decided they need more than just a wing and a prayer before they’ll be willing to empty their wallets on companies that even VCs deem as a bit risky to fund.
Ravi Chiruvolu, a general partner of Charter Venture Capital, is a regular technology columnist for VCJ. Send him feedback or ideas to email@example.com. Chiruvolu specializes in enterprise software, software infrastructure, e-business and wireless. He sits on the boards of Ellie Mae, ManageStar, Niku (NASDAQ: NIKU), Quantum3D, Talaris, Verano and Winery Exchange.