‘Unfair Advantage’ of the SaaS IPO
Just days before DocuSign’s April $629 million IPO, Tom Gonser—who founded the electronic signature industry leader in 2003—shared the secret behind his company’s meteoric rise.
Drawing on decades as a tech pioneer, including a stint as an Apple executive in its early days and founding NetUpdate, this mysterious ingredient is far from unique to DocuSign. It’s an integral strand in the DNA of many of the most valuable established SaaS businesses, and the key component Gonser looks for when evaluating a startup pitching to Seven Peaks Ventures, the early-stage VC fund where he sits as an investment partner.
He calls it the “unfair advantage.”
Founders and entrepreneurs acquire this unfair advantage through an intimate familiarity with the industry their product is aiming to disrupt, often by experiencing its shortcomings first hand. “[Founders] noticed there was a hole, an inefficiency, something wrong that wasn’t being taken care of,” says Gonser. “That gives them an unfair advantage because they’re seeing something ahead of the market and they’re able then to come into the business with a different perspective.”
When you take a closer look at the high profile 2018 IPOs of DocuSign, Spotify, and Dropbox, the “unfair advantage” emerges as a common thread that binds these seemingly disparate—and highly successful—SaaS businesses together.
From the perspective of Daniel Ek, founder of Spotify, in a letter to investors, “From the age of four, my life was about music and technology—never one without the other. Over time, I realized that by combining my two passions, I could create a new paradigm, one that helped fans and the creative community—singers, songwriters, bands, everyone in the creative process—chart a new course for an entire industry.”
Drew Houston, founder of Dropbox, put it a little differently when speaking to First Round Review: “People make basic assumptions based on what they have now. But you have to ask yourself, ‘Is this really what people are going to be doing in five years?’ Very few people ask themselves what they would actually want instead if they could wave a magic wand.”
Fourteen years ago, in 2004, Salesforce became the first fully cloud-based SaaS company to go public. As of just 2017, over 60 SaaS businesses have followed in their footsteps. Following a brief lull in 2016 and 2017, 2018 has turned out to be the year of the SaaS IPO. Of the 40 plus tech companies to go public in 2018, over a third of them are SaaS. As Rohit Kulkarni, managing director and head of private investment research at SharesPost noted on MarketWatch, “It appears the time is right for cloud or enterprise SaaS companies.”
We studied all sixteen SaaS companies to IPO in 2018 as a lens to gather insight for what 2019 might hold. Each of these stocks traded at double-digit percentages over their IPO target price at some point since going public—six of them had price increases in the triple digits. Zuora, for instance, the SaaS that helps other businesses become subscription-based, at one point traded at $37.78 (89% higher than its first day PPS of $20).
Recent stock market turmoil has seen much of these gains erased for each of the 2018 SaaS IPOs we analyzed. Several are trading at below their initial asking price as of the 2018 year-end market downturn, but analysts predict SaaS companies’ shares are likely to withstand market turbulence in 2019, especially since SaaS and software companies have weathered stock market volatility better than most industries. Already this year, SaaS bellwether Salesforce has gained 17%, outperforming the Nasdaq composite, with SaaS stocks as a whole rising over January.
Market turbulence hasn’t appeared to put a damper on the plans of many prominent names in tech—including Uber, Lyft, Slack, Pinterest, Palantir, and Airbnb—looking to go public in 2019. As Jackie Kelly of Ernst and Young puts it: “The US IPO markets remain strong, with both volume and proceeds surpassing 2017 levels. A number of unicorn companies brought IPOs to market in 2018, with more on record stating that they will be conducting IPOs in 2019. As we head into the new year, we expect IPO volumes to remain steady, with greater activity concentrated in the first half of the year.”
November 1st, 2018 was a historic day for Spotify. After running at a loss for ten years, founder and CEO Daniel Ek announced that Spotify posted a profit with a net income of €43 million for its third quarter—the first profit in Spotify history. Despite this milestone, Spotify stocks tumbled on the results—dropping 5.7% on the day of the announcement.
Why would investors react so negatively to what appears on its surface to be good news? And more fundamentally, how did a company that never posted a profit in the ten years prior to its 2018 IPO receive an initial market valuation of $29.5 billion?
First, a clarification. Technically, Spotify held a direct offering, now also known as a Direct Floor Listing (DFL). Crunchbase described this as “The hipster version of going public when you’re too cool to need to raise money during your [stock] flotation.”
According to Spotify, revenues climbed to €4 billion in 2017, a 40% growth rate from the previous year. Raising capital is often a significant incentive for companies to go public: not so for Spotify.
Spotify’s stated aim for going public with a direct offering was primarily to offer equal access to all investors to purchase Spotify shares.
Spotify did not issue any new stock in the direct offering. Instead, the company only offered shares from existing private investors and employee shareholders for sale. By electing not to issue new stock, Spotify avoided diluting the ownership stake of existing shareholders.
Direct offerings are a rare occurrence on Wall Street, and many experts predicted that this unconventional approach would result in extreme stock price volatility—fears that proved unfounded. Spotify debuted at an NYSE reference point of $132 a share and garnered a $26.5 billion market valuation, closing the first trading day up 13% at $149.01. In an analysis for Wharton Business Radio, Jay Ritter, eminent scholar in finance at the University of Florida, pointed out that Spotify’s intraday high was $169 and the low was $148.26—a 14% spread, about the same percentage for Alibaba and Twitter when they had their IPOs.“So Spotify, in spite of the lack of book building and investment bankers placing shares, had volatility… on the low side of what is typical with prominent tech company IPOs.”
Spotify’s direct offering may have helped set a trend for the way well-capitalized tech companies go public in 2019 and beyond. According to Stacey Cunningham, president of the NYSE writing in The Economist, “Inspired by and working with Spotify’s CFO, Barry McCarthy, our team sought regulatory approval to modernize the listing rules that might have tied the company’s hands.” She continued, “During a 12-month effort, we put forward new proposals to the Securities and Exchange Commission (SEC) to update the rules that govern how a company can go public on the NYSE.”
SaaS businesses with no shortage of cash on hand seeking to reap the benefits of becoming a publicly listed company— such as allowing retail investors to purchase stock and giving early stakeholders liquidity—may well be inspired by Spotify’s example. According to Recode, Airbnb and Slack may be the next tech giants to go public with a Direct Floor Listing.
If so, they appear to have found a willing partner in NYSE. As Cunningham puts it, “In 2019, we should explore ways to reduce the barriers that deter companies from going public, while also avoid ing the pitfalls of the dotcom bubble.” She concluded, “The focus in the future should be on helping more privately held companies open their shares to Main Street investors through smarter, right-sized regulations.”
For a company like Spotify—which few expect to operate consistently at a profit for years to come—any dip in the projected increase in paying subscribers and monthly active users (MAU) is a cause for concern. Spotify earned its initial public valuation of $29.5 billion largely by convincing investors that its number of paying subscribers would continue to snowball—cementing its dominance as the most popular music streaming service, with a 2018 global market share of 36%, according to Midia Research—and that its profit margins would increase. According to influential investor Russ Gerber, founder of Gerber Kawasaki, writing in Forbes, “The bull case for Spotify often revolves around the company’s ability to become the ‘Netflix of music’.”
While it’s easy to understand why investors would be keen to get in on the ground floor of a business superficially similar to Netflix (with its recently posted Q3 revenue of $4 billion) a closer look at the two companies reveals many disparities in their business models. For one thing, Netflix is increasingly producing its own content, while Spotify is almost entirely reliant on licensing its content from third parties. This significantly impacts Spotify’s control—or lack thereof—over its operating costs. If any of the big four music companies—which “control the rights to 87% of the music streamed on Spotify,” according to financial analyst Laith Khalaf of Hargreaves Lansdown speaking to The Guardian—were to withdraw their catalog, or substantially increase licensing fees, Spotify could find itself in an untenable position.
While Spotify faces a few challenges, like relying almost entirely on licensing and massive competitors (like Apple, Google, and Amazon), there are still many reasons to be optimistic about Spotify.
Daniel Ek came by Spotify’s unfair advantage not by spending years toiling in the traditional music business, but by being amongst its enemies. According to a profile in The New Yorker, the Swedish-born Ek was briefly the CEO of uTorrent as a teenager, and uTorrent made money by pirating films and music through the popular BitTorrent file-sharing protocol. Inc reports he started his first business at age 13, and he told Pando that by the time he was 18, he had 25 employees and was bringing in $50,000 a month.
At some point during his teens, Ek struck up an online friendship with a chat room user named Napshon. It wasn’t until years later that he found out that Napshon was the alias of Sean Parker. Parker—now a respected Silicon Valley figure and the first president of Facebook— was at one time the music industry’s arch-nemesis thanks to Napster, the peer-to-peer file sharing service he co-founded with Shawn Fanning.
Parker reentered Ek’s life through an email in August 2009 praising Spotify, which had launched in the US less than a year earlier. It was only when Ek and Parker met in person, in New York several months later that they realized they had spoken online years earlier.
Parker eventually invested $30 million in Spotify and for a time sat on the board.
According to The New Yorker, he was also instrumental in securing licensing deals with several of the global music companies, notably Warner Music Group. Parker sat on Spotify’s board from 2009 through 2017. Through his close relationship with Mark Zuckerberg, Parker also helped broker the partnership between Facebook and Spotify, helping Ek to realize his vision of making social sharing a fundamental part of the listening experience. As Ek told Grammy.com in 2014, “We look at the sharing of music as really, really important for our business.”
In many ways, it’s the archetypal start-up story. Gifted graduate of prestigious college has billion-dollar idea, pitches it to legendary VC, gets funding, receives $3.8 billion valuation along with Series B funding, then goes public with a company that swells to a market valuation of over $9 billion—making the founder a multi-billionaire.
Drew Houston’s eureka moment came shortly after graduation. Without access to the MIT mainframe, Houston often found himself transporting his valuable data on a USB thumb drive. One day, while riding the bus from Boston to New York, he realized that—not for the first time—he had accidentally left his thumb drive behind. As Houston told Business Insider, “I was so frustrated — really with myself because this kept happening. And I’m like, my God, I never want to have this problem again.”
It struck Houston that virtually anyone who relied on technology and information storage faced a similar dilemma. And thus the idea for Dropbox was born. Houston applied to Y Combinator, shortly after graduating from MIT. Y Combinator had yet to attain the near-mythical status as a startup incubator it now enjoys amongst tech entrepreneurs. Alumni like Stripe, Coinbase, and Airbnb were still a ways off on the horizon (Airbnb is, incidentally, reported to be strongly considering an IPO or Direct Floor Listing in 2019). Of the nearly 2,000 startups that Y Combinator has funded to date, Dropbox—the 53rd startup to be accepted into the incubator program—ended up being the first of the group to go public.
Houston’s Dropbox application to Y Combinator was not his first attempt to be accepted into the program. He had previously applied with Accolade—his SAT Prep startup—for the first “class” of Y Combinator funded startups in 2005—a group that included Reddit. The startup incubator rejected this application. His road to acceptance at Y Combinator with Dropbox in 2007 was not much smoother, though it was, fortunately, successful.
According to First Round Review, in 2007, Houston flew to San Francisco to pay an unsolicited visit to Y Combinator founder Paul Graham. It didn’t go well. He had also hoped to find a co-founder for Dropbox on the trip but left empty-handed on both counts. Houston recalled, “That plane ride back was the worst. No co-founder. Lower chance of getting into YC. I was panicked.”
He persevered, however, and finally convinced Graham to fund Dropbox, but only with a co-founder—and he had two weeks to find one. Houston made a short Dropbox demo video that he posted on Y Combinator’s Hacker News. This video not only further solidified Paul Graham’s interest, but it also caught the attention of MIT student Arash Ferdowsi.
What followed was akin to a shotgun wedding. Houston recalled to Business Insider, “So we met in the student center, we talk for an hour or two, and next thing you know, he agrees to drop out of school… It was sort of like getting married on the first or second date.”
At this stage, Dropbox still had a very long way to go to hit MVP. That original Dropbox demo video, which has become legendary, had not yet been coded. He narrates a demo using screenshot mockups for a product that doesn’t yet exist. Making Dropbox work seamlessly across multiple platforms and operating systems would require an enormous investment of time and development. Houston recalls, “It drove hundreds of thousands of people to the website. Our beta waiting list went from 5,000 people to 75,000 people literally overnight. It totally blew us away.” Without writing a single line of code, Houston had his proof of concept for Dropbox. Rather than taking the enormous risk of “making something no one wants,” the demo video took Dropbox for a test drive: and it drove tens of thousands of early adopters to sign up for a product Houston had yet to build. The success of the demo gave Houston tangible proof that Dropbox was a product that consumers were hungry for.
According to TechCrunch, once Dropbox actually launched in September 2008, it took less than a year for them to hit one million users. But, it wasn’t just early adopters that had Dropbox on their radar. Late in 2009, Houston and Ferdowsi received an invitation from Steve Jobs to visit him at Apple headquarters in Cupertino. Jobs was not only familiar with Dropbox—he was prepared to buy the company. According to Forbes, Jobs made a nine-digit offer. Houston turned Jobs down, telling him that Dropbox was not for sale at any price.
Fast forward a decade, and Dropbox listed on the Nasdaq on March 23rd, 2018, with shares priced at $21 the night before the IPO. By the end of the first day of trading, the share price had soared by nearly 36% to close at $28.48. By the time of its first earnings report in May 2018, the stock price had risen to $32 and Dropbox beat expectations at its first quarterly report as a public company.
Since its IPO, Dropbox’s share price has experienced somewhat of a rollercoaster ride, unlike the relative stability of Spotify’s. According to Seeking Alpha, this volatility has presented significant opportunities for investors. Dropbox is one of the several 2018 SaaS IPO stocks that dipped below its initial asking price. In late December, it hit a low of $19.38 after going as high as $43.50 in its first eight months of trading. As of year-end 2018, Dropbox’s share price sat near initial asking at $20.43.
Like Spotify—with the exception of its extraordinary Q4’18—Dropbox has never posted a profit. While the company did become cash flow positive in 2016, it still posted a loss of $111 million in 2017 on $1.1 billion in revenue, a fact they were upfront within their SEC listing.
Dropbox’s ease of use and other positive attributes have won it more than 500 million subscribers and over 300,000 teams are using Dropbox Business, according to the company’s latest figures. But the growth rate of new subscribers has slowed down from the heady levels of 2015 and 2016.
There is much speculation, by Gurufocus amongst others, that this is due to increased competition and pricing pressure from Google Drive, Microsoft One Drive, Apple iCloud, and Amazon Drive. As Adam Sarhan, of investment advisory service 50 Park Investments put it to VentureBeat, “For me, the biggest problem I have with Dropbox is they don’t have any unique competitive advantages or proprietary offerings that differentiate them from the pack.”
Despite the bearish stance some analysts take on Dropbox, there are still many reasons for optimism. The growth rate of overall users and paid subscribers has slowed but continues to be substantial, and revenues have beaten Wall Street’s forecasts in all three quarters since going public. Moreover, the latest guidance from Dropbox projects $1.383 billion to $1.386 billion in revenue across all of 2018, up from analyst projections of $1.372 billion in 2018 revenue. Of course, no one can say for sure, but it will be interesting to see whether Dropbox can continue its run of beating Wall Street’s forecasts and what effect that will have on the share price.
What we can say confidently, however, is that it’s not just the experienced entrepreneurs who succeed in building publicly-traded companies. Much like Daniel Ek, Drew Houston wasn’t a tech industry veteran when he came up with the concept for Dropbox. It was Houston’s time as an every-day student at MIT that led him to his crucial realization: the way people stored their data—and made it portable—was, to use Gonser’s classification, fundamentally broken.
In the case of both Houston and Ek— founders at an early age—their “unfair advantage” came not from years of experience in the business of music and data storage. It came from having the insight to spot ways of making life more frictionless for a substantial number of consumers: people like them.
Houston put this best. When asked by TechCrunch what other solutions he would like to pursue if Dropbox wasn’t consuming all his attention, Houston stated, “There are so many things that are broken. There are problems hidden in plain sight.”
Spring of 2018 was a boom time for SaaS IPOs. Shortly after Spotify and Dropbox went public, DocuSign—the company Tom Gonser founded in 2003 with the aim of transforming the way signature transactions are conducted—followed suit. Wall Street responded with enthusiasm: DocuSign’s stock soared 37% above the IPO price on its first day of trading. According to MarketWatch, DocuSign, “raised $629 million overall, with $470 million going to the company and the rest collected by investors and insiders.”
Since hitting a high of $67.87 in late August—over double, the initial listing price of $29—the stock has trended sharply downwards. As of year-end 2018, DocuSign closed at $40.08—41% below its August high. Many analysts see this precipitous drop as being symptomatic of an overall decline in the stock market. As Keith Noonan, writing for Motley Fool recently put it, “DocuSign is a growth-dependent tech stock that saw big gains following its initial public offering in April, so shares pulling back amid a contraction for the broader market is somewhat to be expected.”
DocuSign’s revenue grew 37% YoY in fiscal Q3’19, up from 33% in Q2. Some of the credit for DocuSign’s recent profitability must lie with current CEO Dan Springer—appointed in early 2017, “after a marathon search lasting more than a year,” according to Reuters.
Springer strongly believes that tech companies with over $500 million in revenue should be profitable. As Springer told the Australian Financial Review in August 2018, “I don’t understand the concept of when you’re at scale, not running a profitable business. It’s a weird message to send to employees, and it raises questions for investors. It feels like there’s a certain discipline that’s almost lazy. It’s businesses saying ‘I can not be profitable.’” He continued, “I believe that governments should balance their budgets, companies should be profitable, and my kids shouldn’t spend more than their allowance.”
In addition to Springer’s strategic acquisitions aimed at consolidating DocuSign’s position as the industry leader (like document management platform SpringCM), DocuSign is highly optimistic about future growth and has continued to evolve with the market. Speaking to TheStreet, CFO Mike Sheridan estimated that, despite being the industry leader in market share, “DocuSign [has] a penetration rate of just around 2% relative to the total addressable market (TAM) for e-signature solutions, which he pegs at $25 billion.” Sheridan is also bullish on cutting operating costs, saying that, “DocuSign is aiming to have an operating margin of 20% to 22% in five years, with sales/marketing spend (equal to 54% of fiscal 2018 revenue) falling to 35% to 39% of revenue.”
Now a serial entrepreneur turned venture capitalist, Founder Tom Gonser stepped back from day-to-day operations at the company by resigning as Chief Strategy Officer in 2016, partly due to his passion for the early stages of starting a business. As Gonser told Geekwire shortly after stepping down as CSO, “My FAVORITE part of starting something is the zero-1 step, where you create something that has not been done before, despite everyone telling you it can’t be done,” he said. “That stage creates amazing things that kill some and make others real founders. Short answer, I love the passion and grit it takes to start something new.”
Gonser was still on the board of NetUpdate—the company he founded in 1998—when he first had the idea for DocuSign. He left in 2002 to devote his time fully to founding the company.
As he revealed in the exclusive interview with SaaS Mag, “It was a perfect time for me to exit that business and start focusing on making the electronic signature process actually work online. There were a bunch of companies that were trying to do that at the time, but they were all doing it wrong.”
He continued, “I literally sat up in bed one morning, and I had an idea that turned the existing processes that people were pushing inside out. People running around, shoving paper into envelopes, sticking them on planes and flying them across the country for $80 to get another person to scribble and then send it back across on a plane, and then scanning the whole thing into a database, was so obviously broken.”
DocuSign had a longer runway to IPO than either Spotify or Dropbox. The company’s journey to going public included 17 rounds of funding, totaling $537.3 million.
By the time DocuSign filed for IPO, Gonser had already cashed out much of his ownership interest, retaining just over 2 million shares, or slightly more than 1% of the company according to Business Insider. Despite Gonser having two co-founders at DocuSign’s inception, according to Business Insider, “He is now hailed as the sole founder [and] is credited with coming up with the idea for electronic signatures.”
The Year Ahead
Gartner has predicted that worldwide revenue from SaaS apps will increase by nearly 18% to reach $85.1 billion in 2019. By 2020, that number is expected to reach $98.9 billion. Given the enthusiastic response of investors to 2018’s SaaS IPOs, many analysts are predicting a robust 2019 for public offerings.
Some of the SaaS companies predicted to go public in 2019 include Slack, Palantir, cybersecurity tool Cloudflare, and video-conferencing platform Zoom, all according to the Wall Street Journal. If most of these companies follow through with an IPO in 2019—and giants like Uber, Lyft, and Airbnb also go public— the Journal predicts that 2019 could be the biggest year in dollars raised for tech IPOs in market history.
There are some warning signs on the horizon to temper the market’s exuberance. Through the first three quarters of 2018, according to data compiled by the University of Florida finance professor Jay Ritter, 83% of all U.S.-listed IPOs were of companies that lost money in the 12 months prior to IPO. That is the highest proportion on record.
Still, few see a likelihood that the current crop of SaaS IPOs will suffer the fate of many of the tech companies that went public in 2000 at the height of the dot-com boom. The companies that went public in 2018—or are considering an IPO in 2019—have much longer track records, and are subject to much more stringent vetting by analysts and investors.
Palantir, for example, was founded in 2003 and could be valued as high as $41 billion, according to the Wall Street Journal. In analyzing Palantir’s financials, bankers at Credit Suisse, “advised that there are only two comparable public companies with growth in Palantir’s range.”
Companies in the earlier stages of growth may be eased to hear legendary VC Fred Wilson, writing in Inc. had some tempered words of encouragement: “If things slow down in 2019—and I am not predicting they will, but I think they might—the startup sector is in good shape to weather it.”
Understanding how these big players come to list on public markets may be the key to parsing out who has the (unfair) advantage in 2019. While it remains to be seen whether the market for SaaS IPOs in 2019 will hit the levels of enthusiasm and optimism from investors and analysts witnessed throughout much of 2018, many experts are cautiously optimistic that more unicorns will come to market successfully either through IPO or Direct Floor Listing.
What does seem clear is that SaaS has truly come of age as a proven and attractive business model and that in the coming years there will be many more SaaS acquisitions and IPOs in the market. Every day new SaaS entrepreneurs and founders find their own “unfair advantage,” and solve problems customers never even knew they had. Just like Spotify, Dropbox, and DocuSign.
As Drew Houston put it in his 2013 MIT Commencement address, “You only have to be right once.”