Potential, not profits: Twitter joins a wave of tech companies going public despite losses

Potential, not profits: Twitter joins a wave of tech companies going public despite losses ,

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Twitter may be the only technology stock people have been hearing about on the nightly news recently, but it’s actually just the most prominent among a crowd of startup IPOs to hit the markets in the last year. In a single week this September, 13 tech companies went public: everything from Applied Optoelectronics (AAOI), a provider of fiber-optic networking products, which raised around $36 million, to Covisint (COVS), which built a data-sharing platform used by companies in the auto and healthcare industries, and which raised $81 million. Both companies had shown steady losses before going public.

"In the last decade, most companies doing under a billion dollars in revenue couldn’t attempt an IPO," says Alan Patricof, the founder of Greycroft Partners and a veteran tech investor. "So 90 percent of successful startups were eventually acquired by one of the tech giants." In the last year this has changed dramatically, as the broader stock market has come roaring back. "There is a new appetite for young companies." For the first time since 2007, more than 200 companies will likely go public this year. Like Twitter, many are not yet profitable, but they have one thing going for them that wealthy investors are after: growth.

Initial public offerings a year in the US (2013 projected).

A lot of the slowdown in IPOs was due to the 2008 financial meltdown. As stock have stabilized over the last year, public offerings have come on strong. "The markets have also been less volatile, meaning less instability and less opportunity." says Lise Buyer, founder at the Class V Group, an IPO consultancy based in Silicon Valley. "In that environment big investors are hungry for IPOs, which by definition offer more risk and reward."

"Investors are hungry for IPOs, which by definition offer more risk and reward."

Twitter fits this description perfectly. Over the last four years the company has gone from zero to roughly $500 million in annual revenue, but has not yet managed to turn a profit. It is a high risk, high reward investment that looks less secure when stacked up against more mature peers like Facebook.

Twitter's revenue growth by year (2013 projected).

Twitter took advantage of rules put in place by the JOBS Act to file confidentially with the SEC well before revealing financials to the public, and along with the resurgent market, this new law has helped to open the floodgates for more IPOs. "I think we are seeing a dramatic increase in the number of young companies going public because the JOBS Act has meaningfully reduced the time, cost and complexity of the filing process," says Somesh Dash, a principle at IVP, one of the late stage investors in Twitter. "By working privately with the SEC, companies can avoid the late-game red flags that tripped up Facebook and Groupon."

"The 1990s, when all you needed to go public was a smart sounding idea about the internet."

While the market for public offerings from small tech companies has improved significantly in the last year, it’s still a far cry from the heights of the dot-com era, when 477 companies went public in a single year. "These are not the crazy go-go days of the 1990s, when all you needed to go public was a smart-sounding idea about the internet," says Eric Hippeau. "Many of these companies aren’t yet profitable, but they have significant revenues and have shown a real business over several years."

As strange as it may seem, many seasoned tech investors argue profits are a red herring. It’s more important to focus on a company’s free cash flow and overall cost structure. Twitter could likely show a profit if they stopped hiring so rapidly and introducing new products like Vine. But the market is all about a company’s future earnings potential, which is why these young companies optimize for growth. "Compared to Facebook, Twitter is much earlier in its growth curve," says David Pakman, a venture capitalist with Venrock. "Facebook stayed private so long, really only a few hundred investors got to reap the benefits of their most explosive growth. With Twitter, the public has the chance at seeing way more of the upside."