Box IPO: love it or hate it?

Profile picture for user pwainewright By Phil Wainewright January 10, 2015
Box provokes strong emotions. But love it or hate it, its IPO this month will have important repercussions for the enterprise collaboration market.

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For some reason, cloud storage and collaboration vendor Box is a company that provokes strong emotions in the tech community. It's the same way the Brits feel about the savoury sandwich spread Marmite — you either love Box or you hate Box. There's no middle ground.

Thus the news yesterday that Box's serially postponed IPO is finally set to come to market later this month was met with relieved delight from its admirers and unbridled disdain from detractors.

From the friendly corner, Storm Ventures VC and SaaS entrepreneur Jason Lemkin told TechCrunch "Box is a logical and even cheap bet at the cover price."

The opposite view was summed up in a Pandodaily article headlined IPO of last resort:

Box emerges as a poster child for companies that raise too much money at ever-rising valuations, and in turn spend wildly chasing growth, without ever creating a business that justifies any of it.

Why it matters

From an enterprise buyer's perspective, this may all look like an irrelevant Silicon Valley sideshow, but the outcome of the IPO will determine investment levels for other up-and-coming enterprise collaboration vendors, including Dropbox, Huddle and Egnyte. That in turn will influence the rate of innovation and intensity of competition across the category, including at more established vendors such as Google and Microsoft.

For anyone considering Box as a supplier, a successful IPO of course will provide greater assurance of its continued viability. The only remaining source of uncertainty will be the risk of later acquisition, especially if Box's market valuation sticks to a low range.

Box's current backers will be hoping demand allows them to reprice a little higher between now and the offering date, as well as getting a 'pop' when trading starts. As several commentators have pointed out, recent tech IPOs by Hortonworks, Lending Club and New Relic have followed a similar pattern.

One other factor preying on their minds will be the terms of what my diginomica colleague Den Howlett described as the company's last chance saloon funding round in July. It emerged last month that new investors Coatue Management and TPG Growth had provided the $150 million funding with certain strings attached. If the IPO is priced below $20 they can buy extra shares at a discount — and had Box delayed past July, that minimum was set to rise to $23.

Those terms must have put a lot of pressure on management not to miss any further windows of opportunity to complete the IPO — and lend some weight to the view that it is now or never for Box.

Magic number

At least Box is going into this offering with more favorable financials than it first made public early last year. Many were shocked to discover from its IPO filing last March that Box was not only not profitable but was actually spending more on sales and marketing alone than its total revenues. This gave it a burn rate that at first glance seemed suicidal.

Its most recent quarterly financials, published last month, show that since then, Box has kept a lid on its sales and marketing costs while continuing to grow revenues at a rapid clip. It's still loss-making but two key metrics augur well for its long-term prospects.

First of all, as Jason Lemkin explained in an analysis of the numbers for Techcrunch last month, its cost to acquire a new customer (known to SaaS initiates as the magic number) has fallen below the revenue it earns from that customer in the first year:

Box no longer has any material risk of ever running out of money. In Q3, Box’s magic number decreased from 1.38 to 0.97. In other words, Box now spends less than its first year of customer revenue acquiring and closing its customers. As long as this continues to decline, Box’s losses will decline as well.

This echoes the point made by Zuora CEO Tien Tzuo in an earlier analysis of Box's financials:

In the subscription economy, you invest in sales & marketing to acquire customers, and you recognize revenue from those customers over their lifetime, which often can be 3, 5, 10 years or more. However, accounting rules today do not let you spread or depreciate sales and marketing costs over time.

On track for a billion?

Secondly, Box consistently earns more per customer in their second and third years than in their first. This gives it a customer retention rate, measured by revenue, of 130 percent. That is, it renews customers at almost a third more in revenue on average than they paid in year one. Re/code's Arik Hesseldahl doesn't fully have his head round what this is all about but sets out the contributing factors:

Among its biggest bloc of customers — companies paying at least $5,000 year — most renew their contracts annually at the same level of service they had before. Some — about a third — opt to pay more in their second or third year because they’ve added more features and users, while about five percent don’t renew at all.

So Box signs a customer after spending less than the value of the first year contract, and is then able to increase the annual contract value in subsequent years. This is especially true for the larger value contracts Box has been targeting for the past 18-24 months. As Salesforce has found, those are the most rewarding compared to the initial investment in getting them on board.

Lemkin also observed that Box's growth rate puts it on track to reach a billion dollar revenue rate before the end of the decade:

Box’s growth rate declined a bit in Q3 ‘14, but it’s still growing at an epic rate — 70 percent year-over-year in 2014.

If this gradually declines to 30 percent growth by 2019 — a much lower growth rate than comparable companies like Salesforce experienced at this stage — Box will still cross a $1,000,000,000 run rate in 2019. This is just basic math, the way recurring revenue compounds.

My take

  1. For better or worse, Box is regarded as a bellwether IPO stock for the enterprise tech sector. The performance of this offering will be closely watched and its outcome will set the tone for enterprise tech IPOs at least for the rest of Q1 and maybe longer.
  2. Barring unexpected shocks — of which there's a high risk — it looks as though the timing will work out for Box
  3. Getting the IPO out of the door is just the first of many hurdles for Box this year. It still faces significant competitive pressure from the likes of Microsoft, Dropbox and Google. But it will be a relief to get past this milestone.
  4. I'm not as critical of Box's financials as several of my colleagues here at diginomica and in the wider analyst community. I think its management has a stronger handle on the principles of SaaS subscription business models than most of its detractors.
  5. I've frequently emphasized the importance of collaboration platforms in the emerging cloud enterprise software universe. This market will sustain several billion-dollar revenue businesses and at its current growth rates, Box seems on track to be one of those businesses.
  6. Having said that, there is a lot riding on Box's success in penetrating the enterprise market. It has to perform well here and hold on to those accounts it has won.
  7. The cost of continuing to offer free accounts is a significant drain on resources and Box needs to monitor whether the returns are worth those costs.
  8. I think the biggest challenge facing Box is to do a better job of providing value to midmarket companies that want to take advantage of enterprise-grade functionality but don't have the deep pockets and resources of larger organizations. I think Salesforce faces a similar challenge. It's a matter of finding an efficieint way to help people achieve rapid results from adopting new digital capabilities. It's easy if you can throw lots of bodies at it but the economics of smaller organizations demand a less labor-intensive means of achieving business transformation.

Disclosure: Salesforce is a diginomica premier partner.

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