As Demos pointed out, a study from law firm Fenwick & West analyzed the tech deals that hit the markets from 2011 to 2012 … and it found that 47% of deals priced above the range given, while 24% came in below.
In other words, investment banks have a tough time gauging the right valuations.
This makes a lot of sense. Tech companies are often trailblazing newfangled products which can be difficult to get a proper pulse on. Will they see continued adoption? What about the competition? Will a company keep up its innovation? Answers to such questions are often hunches.
For this precise reason, investors should not devote too much of their portfolio to tech IPOs, as the risk levels are just too great. Heck, just look at the terrible performances of deals from Zynga (NASDAQ:ZNGA) and Groupon (NASDAQ:GRPN).
Of course, that doesn’t mean you should avoid them completely. Instead, be sure to carefully look at these three characteristic before you plow your cash into a tech IPO.
First of all, you want a company that has a secular megatrend, or market that is poised to grow at a rapid pace for at least the next decade.
A prime example is cloud computing. This technology allows for the delivery of business applications via the web. For the most part, it is more cost-effective than the traditional on-premise approach to software.
According to a study from Forrester, the market is forecast to grow from $40.7 billion in 2011 to a whopping $241 billion by 2020. In fact, this may even understate the potential because it looks like mobile will provide a substantial boost as well.
As should be no surprise, the gains in the cloud market havealready been lucrative. One of the standouts is the pioneer of the industry, Salesforce.com (NYSE:CRM), which launched its IPO in May 2004. Since then, the shares have posted a return of over 10x!
Still, having a huge market opportunity is certainly not enough. A company also needs have strong competitive advantages — also known as a deep moat.
This has been the case with LinkedIn (NYSE:LNKD), for one. The company currently has over 200 million members in more than 200 countries and territories. Many of them consider their profiles to essentially be digital resumes.
To replicate this user base would take many years as well as huge amounts of money. Because of this, LinkedIn has continued to grow at a hefty rate. It’s almost no wonder then, that the IPO has been a big winner. Since coming public in May 2011, the shares are up nearly 290% from the offering price.
Last but not least, a tech company may be successful but still fail because it cannot find ways to get customers to pay. This is especially the case with those operators that cater to consumers. Often, they need to rely on business models that focus on ad revenues … and this can be tough to pull off.
Heck, even Facebook (NASDAQ:FB) has had problems. After all, there is always a risk that the advertising will alienate the user experience.
Rather, tech business models tend to be more powerful with those that focus on businesses. This is certainly the case with cloud computing, which charges subscriptions. Even LinkedIn is another good example. The company has leveraged its user base to help companies recruit employees.
The Bottom Line
In the end, no investment strategy is fool-proof … and finding the next Salesforce.com or LinkedIn is no easy feat.
But by focusing on these three factors, you can certainly boost your odds. ore importantly, you should be able to avoid the inevitable duds.
Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of “How to Create the Next Facebook” and “High-Profit IPO Strategies: Finding Breakout IPOs for Investors and Traders.”Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.