Every so often an IPO emerges that has lasting impact on the market. For example, despite the fact that in ’11 Zynga and Groupon had a huge amount of attention, another ’11 deal, the LinkedIn IPO, turned out to be far more important, paving the way for Facebook. I believe last week’s Elastic IPO will similarly become a bellwether. The reaction to the deal was certainly remarkable – the filing range was increased from $26 – $29/share to $33 – $35/share, the deal ultimately priced at $36/share and opened (and closed first day) at $70/share, up nearly 100% from IPO pricing and representing roughly 20x forward year street revenue projections. Why did this deal pop so much and what does it suggest about the future? Here are a few thoughts:
- The Power of Open Source Business Model. Elastic’s open source products are downloaded voluminously, with over 350M downloads of its open source software to date. As a result, sales engages with customers who are already users and highly familiar with the products. This leads to shorter sales cycles and higher sales conversions. Additionally, awareness and engaged prospects are generated by popular open source projects, such as Elasticsearch and others from Elastic, obviating the need for top-of-funnel and mid-funnel marketing spend. Elastic still spent a healthy 49% of revenue on Sales & Marketing in FY ’18 (year ending Jan ’18) but this was down from 60% the prior year, and the implied efficiency on Elastic’s Sales & Marketing spend is extremely high, enabling the 79% top-line growth the company has enjoyed. Finally, Elastic shows how disruptive an open source model can be to competition. There are already large incumbents in the search, analytics, IT Ops and security markets, but, while the incumbents start with sales people trying to get into accounts, Elastic is rapidly gaining share through adoption of its open source by practitioners.
- The Importance of the Open Source Governance Model. Elastic controls the code to it open source projects. The committers are all employed by the company. Contributions may come from the community but committers are the last line of defense. This is in contrast to open source projects such as Linux and Hadoop, where non profit foundations made up of many commercial actors with different agendas tend to govern updates to the software. The biggest risk to any open source project is getting forked and losing control of the roadmap, and its difficult for a company to build a sustainable high margin business supporting a community-governed open source project as a result. Elastic, and other companies who more tightly control the open source projects they’ve popularized, have full visibility to roadmaps and are therefore able to build commercial software that complements and extends the open source. This isn’t a guarantee of success. The viability of any open source company rests with the engagement of its open source community, but if Elastic continues to manage this well, their franchise should continue to grow in value for for foreseeable future.
- The Market Loves Cash Efficiency. Elastic has built a $200M run rate software business growing roughly 80% having raised less than $170M to date. Prior to its IPO, the company had over $50M in cash on the balance sheet, so actual cash burned to get to this point is just a bit over $100M. The company generated Cash from Operations of approximately $5M during the July quarter as well. Its clear that the open source model has enabled Elastic to be highly cash efficient and should produce excellent cash flow generation going forward as the company scales.
- The New Software Application and Infrastructure Stack. Elasticsearch is a very popular open source component of the new app and infrastructure stack that has emerged as cloud computing and multi-cloud have grown in popularity and CI/CD development techniques have supplanted prior development paradigms in the leading digital companies as well as the Global 1000. In today’s hyper-competitive marketplace, where software is eating all industries, every company is a software company. Developers have rightly moved to use open source where possible to optimize for speed and quality. Companies like Elastic and MongoDB ($MDB) are paving the way for the future IPO debuts of other fast-growing open source companies who are seeing rapid adoption of their software such as Databricks for Spark, Confluent for Kafka, GGV portfolio company Hashicorp for Vault, Terraform, Consul and Nomad, and Heptio for Kubernetes.
- How Cloud Players Figure Into the Market. The major cloud players – AWS, Microsoft Azure, GCP and Alibaba in China – are all potential partners but also possible competitors to the new open source application and infrastructure companies. Public cloud computing is rapidly becoming the most important and influential trend in technology. The cloud service providers are playing for keeps and they’ll remain hyper-aggressive to win their fair share of the market. As the cloud players move up the stack and look for new ways to serve their customers, the success or failure of the new open source companies will rest on whether they can convince the cloud players to work with them and not against them.
What does this mean for future IPOs? I think the prospects are quite bright for the IPOs of the emerging open source players who are following in the path of Elastic. But, the cloud service providers remain a risk worth watching, and the vibrancy of the open source communities of companies like Elastic will always be a leading indicator of success long term. Stay tuned!