The long-awaited Dropbox IPO brought a mix of cheers and sighs of relief echoing across a badly battered Silicon Valley desperate for a shiny nugget of good news.
Dropbox went public at $21 per share, having raised its offering price before the IPO. And it closed the first day of trading at $28.48 per share. Here were a couple of well-respected cofounders made good, with a startup born of mega accelerator Y Combinator overcoming all the odds to stage a successful IPO. It helped wash out the bad taste of last year’s Snap trainwreck and offered positive omens for the upcoming Spotify IPO.
For at least one Friday, all seemed right in the world of tech.
If that $28 price holds or goes up, it would offer some relief for investors who were unlucky enough to buy into late rounds for Dropbox. The $21 per share IPO sale valued the company below its reported private valuation of $10 billion, though the first day of trading left it with a $12 billion valuation.
For the moment, that valuation is a bit illusory. The company only sold 9 percent of its stock in the IPO. That’s more than some other big tech companies (Groupon: 4.7 percent; LinkedIn: 8.3 percent; Google: 7.2 percent). But it’s well below the average float of 33 percent for all IPOs between 2001 and 2011. Still, tech companies like to keep the percentage low so it creates scarcity and helps drive up the first-day selling price. Mission accomplished.
In six months, the lockup period will end and much of the rest of the stock could possibly come flooding into the market, a moment that typically causes tech stocks to plunge. In addition, Dropbox will have to report at least two quarters of earnings as a public company. That did not go so well for Snap. The private investors in Dropbox must now grit their teeth and wait for the six-month lockup period to end before they can sell — and hope there are no unpleasant surprises between now and then.
What surprises? Well, it’s always hard to say. But as Dropbox noted in its filing: “As such, in this registration statement we have taken advantage of certain reduced disclosure obligations that apply to emerging growth companies regarding selected financial data and executive compensation arrangements.” It’s probably innocuous stuff, but no one will know until it’s disclosed. On the other hand, if it’s positive, why not share it before the IPO?
Beyond the valuation issues, some widespread misconceptions about the company and its IPO circulated on Friday.
Outlets were widely reporting that the company raised $756 million in its IPO. That is not true. Dropbox sold 26,822,409 shares of stock by insiders, and investors sold 9,177,591. That means that Dropbox itself only pocketed $552 million. The balance went to executives and venture capital firms.
Dropbox will need that money because its expenses continue to climb.
On the positive side of the ledger, Dropbox reported $1.11 billion in revenue in 2017, up from $844.8 million. Net losses fell from $210.2 million in 2016 to $111 million in 2017.
As the company disclosed, it has not yet had to declare a portion of its stock expenses:
As of December 31, 2017, all compensation expense related to two-tier RSUs remained unrecognized because the Performance Vesting Condition was not satisfied. At the time the Performance Vesting Condition becomes probable, we will recognize the cumulative stock-based compensation expense for the two-tier RSUs that have met their service-based vesting condition using the accelerated attribution method. If the Performance Vesting Condition had occurred on December 31, 2017, we would have recorded $415.6 million of stock-based compensation expense.
Expect that income sheet and balance sheet to look a bit less rosy once Dropbox has to start adding those expenses in the coming quarters.
The company may also finally endure more scrutiny of its “free cash flow” metric. Dropbox declared in 2016 that it was “free cash flow” positive, and Silicon Valley rejoiced like it had won an Olympic gold medal. The thing is, “free cash flow” is a metric that is different from “cash flow.”
Dropbox says it had “free cash flow” of $330.3 million in 2017 and $252.6 million in 2016. But this metric leaves out stuff it has to actually spend money on, like leases and investments and tax withholdings for taxes it will eventually have to pay on its mounting stock option grants. Including all of that, cash flow was $77.3 million in 2017, still positive for the first time, but not so robust as it seems.
Finally, when a company loses a total of $1 billion over a decade, it’s not a bad idea to listen when it warns that it may never be profitable. Yes, this is a standard disclosure. But in the case of Dropbox, there are some notable issues and minefields ahead.
For instance, it needs developers to write programs to run on its API. Given the recent Facebook controversy, API-driven businesses may face some serious headwinds in convincing developers and users that more data sharing is a good thing. Certainly, Dropbox isn’t using data to sell ads, but all such businesses using APIs could be facing scrutiny:
“We also depend on our ecosystem of developers to create applications that will integrate with our platform. As of December 31, 2017, Dropbox was receiving over 50 billion API calls per month, and more than 500,000 developers had registered and built applications on our platform. Our reliance on this ecosystem of developers creates certain business risks relating to the quality of the applications built using our APIs, service interruptions of our platform from these applications, lack of service support for these applications, and possession of intellectual property rights associated with these applications. We may not have the ability to control or prevent these risks. As a result, issues relating to these applications could adversely affect our business, brand, and reputation.”
In addition, the company doesn’t have much of a sales force, having relied on word of mouth to grow. Yes, that’s remarkable. And yet now the company is at a crossroads, as it notes in its IPO filing. It can continue to rely on word of mouth, but that could limit inroads into business customers. If it decides to hire a significant sales force, that could have a huge impact on its expenses and force it to rethink its financial structure. And since it doesn’t have any experience managing a larger sales force, that would present some major logistical challenges.
To the extent that Dropbox’s expenses grow, it also will continue pushing hard to ensure its revenues keep pace. But the company recognizes revenue from subscriptions over a long period. That means when it adds new paying customers, they only provide a little financial bump at the start. The good news for Dropbox is that customers who sign up overwhelmingly stick with the service over the long haul and become increasingly profitable.
But in the short term, Dropbox says in its IPO filing that it often loses money on new customers before they turn profitable over the longer run:
“Our subscription model also makes it difficult for us to rapidly increase our revenue through additional sales in any period, as subscription revenue from new users is recognized over the applicable subscription term. By contrast, a significant majority of our costs are expensed as incurred, which occurs as soon as a user starts using our platform. As a result, an increase in users could result in our recognition of more costs than revenue in the earlier portion of the subscription term. We may not attain sufficient revenue to maintain positive cash flow from operations or achieve profitability in any given period.”
For the moment, none of this is bothering investors. And Silicon Valley is too blissed out from its victory lap to look for any blemishes. But for Dropbox, the IPO is done and the real challenge is just beginning. If it can deliver a couple of solid earnings reports in the coming months, the IPO floodgates could really burst open.
But if it turns out be another Snap, expect to settle in for a long IPO winter.