Below is an article I wrote that was published today in AllThingsD. The piece outlines the basic fundamentals I believe companies should use as an IPO road map. I also discuss what is new on the road to an IPO and why some business ground rules will never change.
The more things change, the more they stay the same. This French proverb predates the information age by more than a century, but it is a good mantra for today’s beleaguered IPO market.
On the “change” side, the Internet has disrupted and transformed business and society at a rate never seen before. Opportunities for start-ups are proliferating, while new infrastructure efficiencies eliminate start-up costs and barriers. On the “same” side, some basic fundamentals — market opportunity, a unique product or service that meets a real need, financial performance — remain constant, and straddling the two sides is the ever-present and ever-changing elephant of government regulation, about whose feet start-ups must dance.
New and old challenges remain daunting, but the scales are tipping in the direction of innovative technology start-ups that carefully plot and follow the right IPO roadmap. This is especially true for enterprise technology start-ups, which have been outperforming other newly public companies dramatically in the past year. While Facebook may have given the IPO market a black eye, it clearly wasn’t a knockout punch.
Actually, the success of social networks and other cloud-based consumer services is creating opportunities for innovative companies, which can improve or better use the underlying infrastructure. A maturing cloud provides start-ups with a reliable and secure platform for using, developing and/or delivering software as a service (SaaS). The SaaS model eliminates the need to build out extensive IT facilities to support business processes and product development, greatly reducing capital requirements that have been a key barrier in pre-cloud times.
Start-ups still need plenty of capital, including public capital. However, a growing mass of regulations capped by Sarbanes-Oxley have successively crippled the U.S. IPO market and driven some IPO activity overseas. The London Stock Exchange openly promotes itself as a SOX-free zone, and IPOs on Chinese exchanges accounted for 40 percent of global IPO funds in 2011.
Parts of the JOBS Act of 2012 attempt to address this problem by improving the access emerging growth companies have to public capital markets. The rules are still being hammered out, but they have the potential to increase opportunities for start-ups and enable them to grow and prosper.
Consider the start-up that is exceeding expectations and posting impressive quarter-over-quarter growth, and yet rejects the notion of an IPO because of crushing compliance costs, a lack of analyst coverage and/or highly regulated communications protocols. The JOBS Act, combined with streamlined IPO preparation processes and more highly evolved IPO best practices, is expected to encourage such start-ups to rethink the IPO option.
Despite all the dizzying change, a technology start-up’s IPO roadmap is built upon some basic fundamentals that have endured longer than my own 20-year tenure as a venture capitalist. Simply put, the technology start-up’s IPO roadmap must address the size of the market being pursued; the quality and uniqueness of the products or services aimed at that market; the value proposition to the customer; and of course, financial performance.
The market opportunity. The potential market must be large enough to support plenty of competition, plenty of growth and plenty of staying power. Take mobile, a market sector that kept roaring along even at the very nadir of the current recession. Smartphones will soon be the top network access device, even for enterprises, and applications for them are proliferating at a staggering rate.
Another seemingly limitless market is software-defined networking, driven by the explosion in data and the demand for new systems to handle network traffic more efficiently. Start-up Arista’s approach to software-defined cloud networking solutions for large data center and high-performance computing environments features its own Extensible Operating System and got it ranked as the #1 software company Cisco should fear.
Quality and uniqueness. The start-up’s product or service must stand out from the crowd with its quality and uniqueness. And since quality and uniqueness aren’t static, the company’s executive team must possess the knowledge, expertise and vision to evolve its products or services accordingly. Take Cyan Inc., which has developed unique Service Level Aware networking technology that enables network providers to get more out of their existing infrastructures. Pure Storage is another example of a company that is focused on quality and uniqueness. By developing an all-flash approach to the enterprise storage market, the company delivers fast, high capacity systems that are getting traction: the company has shipped more than 100 systems and has deployments over 250 TBs in size.
The value proposition. Start-ups must identify the pain points in the potential customer base, and provide relief with appropriate products and services. Few concerns consistently cause more pain than security issues, so FireEye developed a security appliance that goes way beyond traditional threat protection. Instead of reactively using filters based on known threats, FireEye proactively looks for patterns that point to new ones. Box has tackled another challenging issue: content sharing and collaboration across distributed, remote and mobile organizations. By taking consumer-like approach to an enterprise challenge, Box is shaking up a very traditional market and demonstrating real value.
Financial performance. Ideally, the start-up is growing rapidly, with recurring revenue, increasing earnings, high margins, and little or no debt. Profitability isn’t an absolute requirement, but negative profits — the rate at which the start-up is burning through its funding — shouldn’t be too high. Start-ups can and do go public successfully before they are generating any profits, but this deficit should be offset by the size of the market opportunity and the magnitude of the company’s competitive advantage.
These companies are still traveling down private roads, guided by the IPO roadmap. Splunk and Palo Alto Networks are two start-ups who followed this IPO roadmap to successful public offerings earlier this year.
Splunk, which went public a month before Facebook, is a data analytics specialist addressing key challenges in the huge and critical Big Data market. The start-up produces unique and highly effective tools that help enterprises collect and index data on a massive scale, and then make sense of it.
Palo Alto Networks, which went public July 20 in the wake of the Facebook disappointment, is an innovator in the perennially hot enterprise network security sector.
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Timing can make or break a public offering, and the right timing only looks like luck. Precise timing is based upon the ability to identify evolving market trends and know just when to catch the waves they generate.
Right now, the resurgence of the enterprise is creating a veritable tsunami. As consumer internet companies with charismatic leaders bask in the limelight, technology start-ups quietly focusing on enterprise needs are heating up everything from Big Data to cyber security.
In June, Thomson Reuters analyzed VC-funded technology IPOs from the past year and found that the top five performers were enterprise software and service providers. The valuation of each was up at least 65 percent from its strike price.
This trend appears to be continuing in the second half of 2012, beginning with the aforementioned IPO home run hit Palo Alto Networks. The following week, software-defined networking pioneer Nicira opted for the acquisition route and was bought by VMware for $1.2 billion.
The Road Ahead
Venture capital firms with deep pockets continue to invest in companies that qualify for the IPO fast track. These start-ups don’t tend to need as much, because enterprise technology isn’t nearly as capital-intensive as it once was. Today’s start-ups are also using web technologies to bring products to market and build customer bases.
The fast track is being greased by several factors. We have learned a lot about the IPO process and streamlined it considerably. Start-ups no longer have to shell out $1 million plus just to get all the requisite documents prepared. Best practices have emerged, and our experiences have taught us a lot about timing.
History shows us that economic downturns put a premium on innovation, which today means big opportunities for enterprise technology start-ups. Enterprises must do more with less, by ratcheting automation up to new levels and into new dimensions. Start-ups that can come up with solutions to these problems are following a proven IPO roadmap to successful public offerings.
Disclosure: FireEye and Cyan are in the NVP investment portfolio.