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Summary

  • Wall Street myth #1 about IPOs: An issuer can't go public with less than $100 million in revenue.
  • Wall Street myth #2 about IPOs: Even if an issuer with little or no revenue can go public, it can't attract high quality, bulge bracket underwriters.
  • Wall Street myth #3 about IPOs: Small issues trade poorly in the aftermarket.

A small software company virtually unknown outside of Silicon Valley, Castlight Health (NYSE:CSLT), priced its IPO on March 13, 2014, and ended its first day of trading up 149%. The sound bite version of this story is: $13 million (in revenue) in '13 becomes $4 billion (in market cap) in '14. Let's investigate.

Castlight Health is a cloud-based software company that helps large, self-insured employers control healthcare costs. The company had $13 million of revenue in 2013. And although the revenue growth rates for the next three years are impressive, the starting base is low, and the company is not projected to reach $75 million in revenue until 2015 and $100 million until 2016 (according to IPO tracking firm Renaissance Capital).

So this busts Wall Street myth #1 about IPOs: An issuer can't go public unless it has $x million in revenue, where x is usually in the range of $75 - $100 million.

Perhaps you think that a company of this size could only be taken public by schlocky underwriters. Surely no respectable, blue chip investment bank would compromise its brand by underwriting such a small company. If you believe that, you are wrong. The joint bookrunners for Castlight's IPO: Goldman Sachs and Morgan Stanley.

This busts Wall Street myth #2 about IPOs: Even if an issuer with little or no revenue can go public, it can't attract the highest quality, bulge bracket underwriting firms.

But we all know that these types of small companies can't attract real institutional investor interest and therefore trade poorly in the aftermarket. True, Castlight did have a problem on their IPO roadshow, but perhaps not the one you might think; the demand for shares greatly exceeded the 11.1 million originally offered at a midpoint of $10 per share. So the company increased the price range to $13-15, and ultimately priced its IPO at a price of $16 per share, which represents a 60% increase from the original midpoint, raising $178 million of gross proceeds in the process.

Then the stock traded up by $23.80 to close at $39.80 on its first day of trading: a first day pop of 149%. And 10.7 million shares traded on the first day, or roughly 100% of the number of shares offered in the IPO, which is fairly typical. With 103 million shares outstanding post IPO, Castlight ended its first day of trading with a market cap of $4 billion.

This busts Wall Street myth #3 about IPOs: Small issues trade poorly in the aftermarket.

There are a few other noteworthy items about Castlight. For example, the company is projected to have adjusted net income of negative $75 million for 2014, and improve this figure to only negative $50 million in 2016, according to Renaissance Capital. In fairness, this lack of profitability until many years in the future is the norm for software companies as they transition from private to public status.

What is truly remarkable about Castlight, and yet another myth buster, is its comparatively low gross margins, which at a projected 33% in 2014, and 52% in 2015, are far below the conventional Wall Street wisdom of the required software industry IPO "minimum" of 60%.

Lest you think Castlight was an outlier, another small software company, Textura (NYSE:TXTR), raised $75 million in an IPO underwritten by Credit Suisse and William Blair in June 2013. Textura's 2012 revenue: $22 million (and at the time of the IPO was only projected to reach $58 million in revenue by the end of 2014). The stock had a comparatively pedestrian first day pop of 39%, but is now up 80% from its offer price.

So what are we to make of all of this?

First, the IPO market remains hot. Consider:

  • There have been 45 IPOs priced year-to-date, a 96% increase from this time last year (There were only 31 IPOs in all of Q1 2013).
  • The total gross proceeds raised in IPOs have been $7.6 billion year-to-date, a 28% increase from this time last year.
  • There have been 80 IPO filings year-to-date, a 233% increase from this time last year.
  • The average IPO has returned 39% year-to-date (from its offer price).
  • There have been four companies with first day doubles. In addition to Castlight, the members of this club are Varonis (NASDAQ:VRNS), +100%, Ultragenyx Pharmaceutical (NASDAQ:RARE), +101%, and Dicerna Pharmaceuticals (NASDAQ:DRNA), + 207%. In 2013, there were six such companies, but there were only eight doubles in total from 2001-2012.

2013 is hardly a soft year for comparison. In fact, by almost every measure, it was the best year for IPOs since 2000.

Investment banking soothsayers on Wall Street tell companies that are planning to go public that IPO windows are temporary and fleeting. They are dead wrong.

We published a myth-busting white paper last year ("IPO Window: Open 79% of the Time") that empirically demonstrated, and contrary to conventional wisdom, that the IPO market is in fact systemically open most of the time. The robust start to the IPO market in 2014 is just another data point dispelling this Wall Street shibboleth.

Now we come to a short and simple lesson about the cost of capital: Because of the lack of marketability, private companies are valued at a discount to public companies. In the real world, this means that it typically costs a private company about twice as much (i.e., half the valuation) to raise the same amount of equity capital as a comparable public company.

It used to be that a venture-backed company could go from a Series A funding round to an IPO in about four years. Today, it takes about double that length of time. However, it doesn't have to take that long. Nor should it. Castlight was founded in 2008 and is only six years old.

The JOBS Act (signed into law in 2012) lets issuers file their registration statements confidentially with the SEC and test the waters with prospective investors for an IPO. It's a free option, and more private companies should exercise it. Instead of raising endless rounds of costly private capital from VCs, promising companies should follow the lead of Castlight and Textura and go public sooner.

Timothy J. Keating is the CEO of Keating Capital, Inc. (NASDAQ: KIPO), a publicly-traded closed-end fund that specializes in making pre-IPO investments in emerging growth companies that are committed to and capable of becoming public. Keating Investments, LLC is an SEC-registered investment adviser that is the external investment adviser to Keating Capital. Mr. Keating can be reached via email at tk@keatinginvestments.com.

The opinions and observations expressed herein are solely those of Timothy J. Keating and are intended to provide insights on the IPO market at large and at the current time. None of these opinions and observations should be construed as relating to any specific portfolio company held by Keating Capital (including the future IPO timing or plans of any such portfolio companies). This article is not intended to be a solicitation to purchase or sell any security (including Keating Capital). Neither Timothy J. Keating, Keating Capital nor Keating Investments, currently own, or have plans to purchase, the shares of any company referenced herein.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: A Lesson In The Cost Of Capital: Castlight Goes From $13 Million In 2013 To $4 Billion In 2014