6 ways to identify a good tech IPO and avoid future busts

Etsy's initial public offering is the latest in about 35 IPOs so far this year, according to Renaissance Capital. And it begs the same question from investors who want to get in on the action: How do I spot the IPOs that are likely to rise and keep rising, and how do I try to prevent myself from paying too much?

Etsy is an online marketplace for handmade and vintage goods.
Daniel Acker | Bloomberg | Getty Images
Etsy is an online marketplace for handmade and vintage goods.

While there's no fool-proof guide, the history of the 15 years since the Internet boom-and-bust provides a fairly reliable path to telling the Facebooks from the failures. The rules are different for Internet and tech companies like Etsy than they are for slower-growth companies, like IPOs that follow private-equity deals such as leveraged buyouts. Investors in those deals focus more on current profitability and less on growth, because post-LBO companies are often in mature industries where sales and profit margins aren't likely to expand radically.

But for investors interested in the growth stories coming to market, here are six key ideas for investing in technology IPOs. If you use these six characteristics as a checklist when reviewing IPO prospectuses (also known as S-1 filings), you will probably be able to make money investing in new technologies that drive the future.

1. You want a company that's profitable—barely.

The prime time for young technology companies to come public is shortly after they begin generating cash from operations. That means retail investors get a chance to invest in them late enough to assure they are reasonably stable and early enough to exploit at least some of their growth potential.

Examples of this abound, since it's a pretty common strategy. One prominent example is Twitter, which was losing money under formal accounting principles when they filed to go public but was generating positive cash flow and earnings before depreciation, amortization, interest and taxes (known as EBITDA).

If you're looking at an IPO and its income statement shows a loss, search the prospectus (which you can find in the Securities and Exchange Commission's EDGAR database) for its cash-flow statement and any mention of EBITDA. If the company isn't generating cash, it's a higher-risk investment, and the company may be coming public too soon to be suitable for retail investors.

2. You want the company to continue growing rapidly.

Especially with tech IPOs that are light on current profits, you need growth to be able to count on profits later. Indeed, companies will usually explain in their roadshow presentations (generally available at retailroadshow.com once a price range is set) what they expect their profit margins to be a few years out. Almost all of them will need to boost the top line to get there.

If a tech company isn't growing at least 20 percent a year, and often more, demand for shares will usually suffer. The combination of slow growth and low profitability will often kill a deal sooner (as in the case of Buy.com, which never managed to sell its mid-2000s IPO) or later (as with Overstock.com, whose shares dropped from about $70 in 2004 to as low as $13 in the past 52-week period because growth slowed before the company became consistently profitable).

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Sometimes a company will be very large and profitable before it comes public, but that's rare. Unless they are true blockbusters like Google or Facebook, the market will usually want to pay a more modest multiple of current profits for the shares.

3. You want to see a large addressable market.

Big addressable markets are where big growth opportunities come from. Usually, a tech company going public will discuss this at length in the first few pages of its prospectus. In Etsy's case, it's on page 3 under the headline "Our Opportunity."

The key when thinking about market size is to do a gut-check about how realistic the appraisals are and how important the company's product is to the big market that's supposedly developing. For example, a broadline e-retailer like Amazon.com might plausibly tout the size of the overall retail market. But a niche play like Etsy, which sells mostly handmade goods, won't have access to nearly all of those dollars. And a company like A123 Systems, a battery maker, had a big IPO but later fell apart and declared bankruptcy because its forecasts of how quickly the electric-car market would grow were wildly optimistic.

Remember: The size of the market determines how big the company can get—if everything goes right. Then you have to think about the next few questions.

4. Understand the industry enough to know whether its technology is truly disruptive.

Ideally, an IPO company is selling a technology that makes other companies way more efficient or makes consumer experiences better in ways that really matter. eBay and Google are examples of companies that made thousands of other companies more efficient and generated revenue for eBay and Google. Online travel agencies like Expedia were obviously cheaper and better than the corner-store travel agencies. The best example is Amazon.com: They call being disrupted by a tech start-up "getting Amazoned" for a reason.

In the same way, cloud-computing IPOs have worked because cloud computing usually replaces solutions that are more expensive and less flexible. A cloud company that experiences success before an IPO will usually have more reliable sales opportunities—think of salesforce.com or medical cloud-services leader Athenahealth as top examples. In Athena's case, the 2007 IPO prospectus showed that its product helped doctors collect insurance payments 30 percent faster and boosted the amount collected enough to pay for itself. The diagnosis was obvious: Doctors would buy it. Shares have risen sevenfold since.

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Sometimes, though, a technology can be fun or cool but doesn't disrupt much that matters. The cautionary tale is something like Zynga. Its drop in shares post-IPO said something about its execution, but a whole lot more about the fact that its FarmVille video game just didn't change the world much.

Another thing that can hurt is competition: Ciena became a record-setting IPO in 1997 because its fiber-optic technology changed the world, but then-dominant players, including Lucent Technologies and other rivals, soon produced similar products that cut into its market share. The S-1 will include a section on who the competition is. Read it critically.

5. Personnel matters. A lot. So pay attention.

If a tech-company CEO comes across as brash and immature, he usually is (and it's usually a he). And if he says dumb things in the papers or on CNBC, he usually will do dumb things at the office sooner or later.

The best recent example of this is Groupon's Andrew Mason, whose letters to shareholders and employees before the IPO betrayed a certain immaturity that hurt perception of the company. Shares are down about two-thirds since the 2011 IPO. That said, tech CEOs and founders often are more reliable than investors initially think. In 2012, there was no shortage of pundits who thought Facebook's Mark Zuckerberg was unreliable in part because he dressed sloppily. Judge for yourself.

Two things to check. Who backed the company before the IPO? The S-1 will tell you this, as will sites like Crunchbase.com. Blue-chip venture-capital backers don't guarantee a successful run as a public company, but big hits that didn't interest big-name firms early are very scarce. Second, what has the CEO done before? This one is less reliable, since there's a long list of monster IPOs led by first-time CEOs and founders. But it's something to check on.

6. Pay attention to valuation—but not too much.

The history of technology IPOs is that returns are dominated by a few companies that make truly outsized scores, like Netflix's 56-fold jump in 13 years and Amazon's 284x since 1997. A good recent guide to social-networking deals has been that valuations may be about 12 times the company's sales, but that multiple will fluctuate based on short-term market conditions.

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A tendency to get gimlet-eyed about the last 10 percent of valuation is how you miss a Google (plenty of writers were aghast at Google wanting a split-adjusted $65 a share back in 2004) or a Priceline. On the other hand, in most cases, even companies that are going to be huge later spend time below their price on the first trading day—even Amazon did, and Facebook certainly did. If you like everything about an IPO but its valuation, consider buying it, then.

The core idea of technology IPO investing is that the idea is either going to work or it isn't. If it does, valuation usually takes care of itself. If the product doesn't deliver on its promise, it won't matter that you paid less—you'll lose money, anyway. So put your time into researching the idea, the people and the market for the company's product first.

—By Tim Mullaney, special to CNBC.com