Will Dropbox reset investor demand for tech IPOs?

By Kevin Kelleher , written on January 16, 2018

From The IPOs Desk

Not long ago, the IPO was regarded as a rite of passage into the adulthood that is the public stock market - a less sheltered and often more unforgiving environment, yet the all but inevitable goal.

Then a generation of tech startups privately valued above $1 billion rebelled against that adulthood, finding a steady source of private investment that allowed them to remain in a comfortable state of arrested adolescence. But that may be changing. Venture investors want the kind of exit an IPO brings. And more companies like Dropbox are starting to venture forth.

Dropbox recently filed confidentially for a public offering likely to debut in the next few months. Spotify, another brand-name tech company, is also heading for the public markets through the unorthodox path of a direct offering, which bypasses the pricing process that IPOs undergo. So Dropbox and its reception into the public market may have a bigger influence on other private tech companies mulling an IPO.

Just as important, Dropbox will be biggest and most notable tech IPO since Snap, which went public with great expectations that it quickly failed to fulfill. The best-case scenario is, a successful Dropbox debut will reset investor demand for tech IPOs. The less happy scenario is, the IPO will fizzle, darkening the clouds that gathered over the IPO market after Snap's stumble and that, to some extent, still hover there.

The confidential filing means that financial metrics aren't available yet, but indications suggest that Dropbox's outlook has been improving in recent years. Revenue is around $1 billion and reportedly have been growing close to 30% a year. CEO Drew Houston said last April that it it became EBITDA profitable, that is, before taxes, depreciation and amortization – a notable qualification that I'll come back to.

Just as important as Dropbox's outlook is its valuation. Three years ago, a private round of investment valued Dropbox at $10 billion. Institutional investors like Fidelity later lowered their valuation of the stock, although in the past several months their valuations have risen somewhat. Sharespost indicates that recent valuations have been around $7 billion.

That's quite a haircut, especially considering Dropbox is a different company than it was three years ago, when Houston shifted from a growth-at-any-cost approach to a focus on reining in costs. The company also pushed into the enterprise market, partnering with HP Enterprise and others. As a result, Dropbox claims 200,000 businesses use its service, including 52% of Fortune 500 companies. Clients include Expedia, Under Armour, Hyatt and Spotify.

As it goes public, Dropbox will be compared to other recent IPOs, but none more so than Box, a direct competitor in the market for cloud storage and collaboration. Box is currently valued at $3 billion, or about six times its expected revenue this fiscal year. Based on available data, Dropbox is valued by some of its investors at seven times revenue. Both seem to be growing at a similar rate – Box's revenue is up 28% so far this year.

Yet there are some important differences between Box and Dropbox. Notably, Box reported a 92-cents-a-share GAAP net loss in the most recent nine months, whereas Dropbox has indicated it's profitable. At first glance, this simple distinction makes Dropbox look more attractive. But there are two important considerations.

First, Dropbox's focus on limiting costs may have involved scaling back its sales force. The bulk of Box's operating expenses, meanwhile, comes from sales and marketing, as it reaches out to big companies and competes against Microsoft, Google and others. Box has been more successful here. Its customers include 67% of Fortune 500 firms, including big brands such as General Electric, Toyota, and Procter & Gamble.

So Dropbox may boast more enterprise customers – Box has only 80,000 – but Box has succeeded in catching bigger fish. To compete in the enterprise storage market, Dropbox may need to increase its sales and marketing spend, which would weigh on future earnings.

Second, as I mentioned above, Dropbox is profitable at the EBITDA level. It won't be clear what its GAAP net earnings are until it formally files a prospectus. This matters for Dropbox because in 2016, likely as part of its effort to lower long-term costs, Box dropped Amazon Web Services and began building its own data centers. Typically, the cost of such expensive projects is depreciated over several years. The move may help save money the company had been giving to Amazon, but it also means that its EBITDA could be very different from bottom-line net earnings.

Overall, the Dropbox that is approaching the IPO market is, somewhat ironically, in much healthier shape than the Dropbox that was valued at $10 billion. The company continues to make encouraging moves, such as adding collaboration features and offerings tailored for freelancers. It's also added seasoned executives to its board, including HPE CEO Meg Whitman and former Nike CFO Don Blair.

Dropbox is also reportedly cash-flow positive, which would mean it's entering the public market from a position of strength rather than desperation. The big question is, what will Dropbox be worth once it becomes public? That question will not only influence how the stock performs once it's actively traded, but also the prospects of other aging startups that may find themselves finally entering the IPO pipeline.