Why Innovators Should Still Aim for an IPO, Not An Acquisition
I was extremely pleased to see Congress pass and the President sign the JOBS Act, which will loosen the IPO process for emerging growth companies. A lot of ink (or is that pixels) was spilled talking about how this bill will help the economy, but I want to dig a bit under the covers to explain why having a robust IPO market is so critical to innovation, even in light of the current indigestion surrounding Groupon, Zynga, and Facebook. To do so, one needs to understand how and why most mergers fail and why growth companies are uniquely positioned to drive innovation.
There are natural inflection points in a private company’s lifecycle which drive financing or exit decisions. As companies cross into the $10 million to $20 million annual revenue band, the entrepreneur and his investors have often been in the business for five or more years. Classic software companies, which used to get 80 percent of their revenues up front, grew to this point a little faster; SaaS companies, despite repeatable revenues and their popularity as a delivery model, grow a little more slowly.
As companies grow past $50 million and towards $100 million, their implicit valuations tend to be about 10 times trailing revenue or somewhere between $500 million and $1 billion.
Years ago, when the US small cap technology IPO market was robust, innovators had a real financial path to build their products and the resulting enterprises to global scale. Often, the difficult task of proving the company’s business model didn’t come until after the IPO.
For example, many doubted PayPal was a sustainable business. PayPal had to test the markets and perform in the public eye for many months before people believed that they had a compelling business. PayPal may have been one of the last companies to make it to the public markets in early 2002 before the Sarbanes-Oxley Act passed on June 30, 2002. In fact, the PayPal example directly reinforces my point, as today PayPal may be the new “core” business within eBay and the latter’s original business concept may now be the also-ran.
Post-2002, company after company faced a future that looked bleak when they sat in their boardrooms with $15 milion in annual revenue. Expanding the company would require expensive venture capital, and yet the team members would have no certainty that there would be a way to obtain liquidity for themselves and early investors. As such, they turned to the M&A market to find homes for their visions, their products and their teams.
However, because these companies hadn’t had a chance to reach the $100M revenue mark or higher by the time of acquisition, the mission and team faced a new type of existential risk. When a company’s sales team is small and the revenue is less than $50M, the buyer hopes the acquisition will grow quickly to become a major contributor to revenue and profitability. But if the larger company runs into financial distress while the idea is still growing, the new venture is one of the easiest things to cut, since its revenue contribution is often small. Added to this, the sheer bulk of the typical acquirer often makes it hard for these ventures to get the attention and resources in marketing and sales, development, or capital expenditure that many of them need to maintain their very high growth rates.
The Zimbra story is a good example of what can happen. After Yahoo! acquired it in 2007, Zimbra was able to keep its core team together but was unable to move the needle on Yahoo’s revenue, even though it organically grew 100 percent. Luckily, because it actually grew, its value was high enough to warrant an offer from VMware three years later.
One well-known acquisition-hungry company in the Valley that has been an exception to the rule (until very recently) is Cisco. A whole family of scrappy R&D companies has been conceived with the sole goal of being acquired by Cisco, and many of these acquisitions have in fact worked out well. Wi-Fi is one of the notable innovations than came from the virtuous machine that Cisco built. However, even Cisco has had challenges: its acquisition of Pure Digital, maker of the Flip video camera, is a cautionary tale for those who believe innovation can always flourish inside a larger company.
In this troubled sea are a few indefatigable ships. Salesforce and Netsuite were able to navigate through the IPO markets in 2004 and 2007 and keep growing and innovating in the post-Sarbanes-Oxley environment. Recently companies like Splunk, Jive Software, Constant Contact, and Yelp have also been able to successfully step through the minefield and keep investors happy while continuing to innovate on top of their original thesis.
Arguably even Pandora Radio has been able to make this process work to support and grow their idea and mission, even if investors haven’t shared that same optimism. Their public equity has had a mixed reception on Wall Street, but Pandora continues to display the kinds of real business metrics that highlight that there is a place for highly personalized online streaming music services.
The real problem is that the combination of the tougher regulatory environment and now a new dose of investor skepticism mean more great ideas will probably go to big companies to die—and with that death so dies a path of innovation. That leaves all of us the poorer. I’m excited about the JOBS Act as one element of a new foundation for greater innovation in public markets.