A 'Pre-Mortem' of Proofpoint's IPO

Steve is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I recently came across the term "pre-mortem" in the context of organizational decision making and I was intrigued about how I might use the concept to improve my investing IQ.  Unlike a postmortem analysis which examines the past to reveal how and why something failed or died, a pre-mortem envisions future scenarios to see what can go right and wrong.  This will be the first installment of a continuing series where I will dissect many of the aspects of a single recent IPO.  I am kicking off the series with a look at the IPO transaction of Proofpoint Inc. (NASDAQ: PFPT) which occurred on April 20th.  This will be followed by installments covering business strategy and competitive advantages, financial statements and capital structure, hidden issues, management, the Board of Directors, and other topics.

ProofPoint is a pioneering security-as-a-service company that helps an assortment of public and private organizations defend, protect, archive and govern their most sensitive data. Their solution categories include threat protection, regulatory compliance, archiving and governance, and secure communication.  The company was founded in 2002 and is headquartered in Sunnyvale, CA.  Its main competitors include subsidiaries or units of household names like Cisco, Google, EMC, and Hewlett-Packard.  Obviously, Proofpoint faces an enormous task in establishing itself in its space.  Examining the IPO transaction in terms of existing shareholders, potential dilution, and control will give us a view to decide if the company is starting out on the right foot.

Proofpoint offered 5,130,000 shares or about 16.5% of the total 31 million shares outstanding after the IPO.  Before the IPO, there were about 6.3 million outstanding common shares and about 19.5 million shares of common stock were converted from convertible preferred shares held by early stage investors.  Among the largest shareholders are venture capital funds MDV VII L.P. (4.4 million shares), Benchmark Capital Partners IV L.P. (4.3 million shares), Meritech Capital Partners II L.P. (3.1 million shares), affiliates of RRE Ventures Fund III L.P. (2.3 million shares), and affiliates of DAG Ventures GP Fund III L.L.C. (1.4 million shares).  Current directors and executives as a group hold about 5.0 million shares, excluding those shares held by entities with which they are affiliated.  The largest individual holders are Board of Directors members Jonathan Feiber, who controls the shares of MDV, Kevin Harvey, who controls the shares of Benchmark Capital, and Rob Ward who controls the shares of Meritech Capital.  Only Mr. Feiber reduced his stake, by 400,000 shares or by less than 9%.  Other early stage investors reduced their stakes by 1 million shares combined to about 300,000 shares held currently.

At the offer price of $13 per share, Proofpoint's market capitalization was about $410 million after allowing for additional shares for over allotment.  With the over allotment, total share count is about 31.8 million with total shares issued in the IPO of about 5.9 million.  New investors have less than 19% of total shares while existing shareholders retain about 81%.  The two largest shareholders, Jonathan Feiber and Kevin Harvey, each saw their stakes reduced to about 13% from about 17% before the IPO.

For the next 180 days, lock up agreements are in place which blocks approximately 23.6 million shares (74% of total) from being sold by existing shareholders.  Starting in October when the lock ups expire, a net 6.9 million shares will be immediately available for sale with the remainder subject to volume restrictions per Rule 144 of the Securities Act.

In addition to the share price pressure from this chunk of shares coming to market, the company has granted options, warrants, and restricted stock units (RSUs) for more than 16 million shares.  These grants are from various equity inventive, employee stock ownership, and executive compensation plans, and a 2011 acquisition.  The company's IPO prospectus discloses that even before the dilution from exercised options is considered, " investors purchasing common stock in this offering will have contributed 33.1% of the total consideration paid by our stockholders to purchase shares of common stock, but will own 17.3% of our outstanding common stock."  Assuming full exercise of these options, total share count would bulge to more than 48 million shares with new investors' holdings falling from less than 19% of the total to slightly more than 12%.  Put another way, given the established market capitalization of around $410 million, those shareholders who bought IPO or post IPO shares at $13 (or higher) would see their pro forma share value diluted to less than $9 if 48 million shares are available for trading.

Another consideration for investors is that five top executives of the company would see all of their unvested stock options accelerated in the event of termination following a change of control of the company.  In total, this is more than 3.5 million shares for all of the executives.  This is not currently a great concern for investors because a change in control of the company is highly unlikely given that existing shareholders retain north of 80% of shares after the IPO.  Once the lock up period ends and share ownership becomes diffused throughout the market, this issue will matter more to investors.

I think it speaks well to the attractiveness of Proofpoint as a viable business opportunity that the largest existing shareholders are venture capitalists with exceptional records.  However, the potential future dilution is significant so I think investors who are interested in Proofpoint would be well advised to put off any substantial investment until after the lock up period expires in October.  Once the market has absorbed the full float, investors will have a better feel for the potential for share appreciation.  The next topic in this series dissecting the IPO of Proofpoint will be the company's competitive advantages and business strategy.


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