NetSuite's Smokin Hot IPO

December 21, 2007
Hosted accounting software maker NetSuite sold 6.2 million shares, about 10 percent of its stock, at $26 a share, nearly $4 a share higher than the highest forecasts and almost double earlier underwriter predictions of between $13.00 and $16.00. NetSuite CEO Zach Nelson kicked off the IPO by ringing the opening bell at the New York Stock Exchange with colleagues Evan Goldberg, CTO and Chairman of the Board, and Jim McGeever, CFO at his side. The stock accelerated another $9.50 its first full day out.

The lead underwriters were Credit Suisse and W.R. Hambrecht, however, NetSuite used the Dutch auction process made famous by Google in 2004 to achieve a more diversified ownership as well as to limit the downside potential for investment banker discounts. With the Dutch auction method, investors submit individual bids and the price is ultimately determined by the highest bids which ensure that all of the stock will be sold. The investment bankers still have the option to procure another 930,000 shares at the IPO price from NetSuite and its top executives.

Some of the more interesting facts brought to light by the company's SEC registration include the following:

• At the time of the IPO, NetSuite retained 5,400 customers of which most were businesses with less than 1,000 employees.

• NetSuite's roots clearly originate in the accounting software market. The company was originally called NetLedger. After adding a Customer Relationship Management software module, the company changed its name to NetSuite. Many industry observers flatly state that the company's accounting system is quite respectable whereas the CRM application significantly lags its competitors.

• It appears NetSuite's average user count is approximately 6 users per customer. This place in the ERP and accounting software market would indicate that QuickBooks is the primary NetSuite competitor.

• It appears average annual revenue per customer is less than $20,000 per year. From the somewhat vague filings, this figure seems to include both software subscription revenue and professional services / consulting revenues.

• Surprisingly, or perhaps shockingly if you are a NetSuite customer, NetSuite's July 2007 SEC filing indicated that the hosted software company has no backup data center for any of its services and that its single data center is located in a third-party facility in an area of California that's vulnerable to earthquakes. "We do not currently operate or maintain a backup data center for any of our services or for any of our customers' data, which increases our vulnerability to interruptions or delays in our service," the company said.

• NetSuite is still early in its ramp to profitability. The company's profit target of 12% to 15% operating income seems fairly aggressive when considering past performance.

• NetSuite is about to face new competition from SAP and Microsoft. However, NetSuite's greater experience in this market and focus on hosted software will provide key competitive advantages that will largely keep the competitors at bay.

Netsuite has attracted extra attention in part from owner Larry Ellison. The Oracle CEO and visionary backed NetSuite shortly after it was founded by former Oracle programmer Evan Goldberg. That backing earned Ellison about $944 million on the IPO date and a few hundred million dollars since then. Ellison retains a 61 percent stake in NetSuite according to Thomson Financial.

Clearly the Ellison connection influenced and magnified investors' interest in the software as a service company. Ellison's recognition as a technology visionary added to NetSuite's credibility and fueled the demand for the IPO shares, said Sam Snyder, a senior research analyst for Renaissance Capital, a Greenwich, Conn. research firm. To mitigate the obvious conflict of interest claims, Ellison locked away his NetSuite holdings into a lockbox (actually a limited liability corporation) which is supposed to prevent him from controlling the company's board of directors and strategic path. Ellison's two adult children, David and Margaret Ellison, together own another 11.6 percent of the on-demand software company, or about $179 million and climbing. Other big IPO winners former Oracle programmer, Evan Goldberg and former Oracle Marketing executive Zach Nelson. Goldberg is the Chairman and CTO and owns 7.4 percent worth about $117 million and Nelson is CEO and owns a 3.4 percent stake worth about $54 million. The IPO also will benefit NetSuite's 600 employees, most of whom retain stock options.

The success of software as a service competitor, Salesforce.com, inspired investors new to the hosted software business model. Since Salesforce.com went public nearly four years ago, the hosted CRM software company's valuation has accelerated by more than 500 percent. Coincidently, or not, Salesforce.com was started by another Ellison protege named Marc Benioff. However, unlike Salesforce.com which had achieved profitability at the time of its IPO, NetSuite, has lost $242 million since its start in 1998 and has never realized profitability. The losses are narrowing, and for the first nine months of this year totaled $20.6 million as compared to $27.6 million in the red at the same time last year. While still much smaller than Salesforce.com, Netsuite's current year revenues of $77 million for the first nine months make it one of the most recognized hosted software companies, generating interest in its IPO even at a traditionally quiet time of the year.

In addition to the annuity revenue model as a result of software subscriptions instead of one time capital investment purchases, Wall Street apparently believes the SaaS model continues to offer a very large upside. Hosted software currently accounts for about 6 percent of the overall software market and has been the fastest growing part of the business software industry. The public markets continued interest has added a near-50 percent rise in the shares of market leader Salesforce.com since the beginning of September. At a revenue multiple of nearly 15 times the company's expected intake for this year, the IPO valuation places NetSuite at a premium to the 9.6 multiple of the more mature Salesforce.com. While NetSuite may be growing faster than Salesforce, its growth is expected to slow to around 57 percent this year, compared with 51 percent for Salesforce.com.

As a sure sign of industry success, established software companies which initially chastised the software as a service model (as it represented a threat to their shrink wrapped or 'on premise' software licensed solutions) have also gotten into the game, with SAP unveiling a hosted ERP software product called Business ByDesign and Microsoft nearing its delivery of hosted customer relationship management software (previously code named Titan and now named Dynamics CRM).

The SaaS market reached to $3.7 billion in 2006 and is projected to grow at a cumulative rate of 32 percent per year through 2011, elevating revenues to approximately $15 billion, according to an estimate from technology research firm IDC.

Not all are convinced of the software as a service model. NetSuite competitors such as Intuit, maker of the popular small business accounting system QuickBooks, claims that most companies will not relinquish control of critical technology such as an accounting software system to a hosted vendor. "No one wants to risk being out of business if their Internet connection goes down," said Angus Thomson, general manager of Intuit's mid-market group. However, the on-demand software publishers have achieved very impressive continuous uptime since the turn of the century and several hosted software vendors offer offline versions in the event of no Internet connectivity, thereby, refuting many of the claims of licensed software manufacturers.