Silicon Valley's first IPO of 2017 comes with a caution flag

AppDynamics founder Jyoti Bansal.
Paolo Vescia | San Francisco Business Times

As Silicon Valley prepares for its first IPO of 2017, the hangover from the frothy funding environment is front and center.

AppDynamics, whose software helps businesses spot and fix bugs in their applications, is expected to raise up to $165.6 million next week, selling shares for $10 to $12 each.

If investor enthusiasm picks up in the coming days, the stock could certainly price at the top of that range or higher. But at $11 — the middle of the current range — AppDynamics would be subject to the dreaded ratchet.

Here's what that means:

When AppDynamics last raised private funding in late 2015 in a round led by General Atlantic and Altimeter Capital, the $1.9 billion valuation included certain protective terms. Backers bought 11.6 million shares for $13.71 a share, with the caveat that should an IPO price at $11 or less, giving the company a market cap around $1.4 billion, the investors would be granted an additional 2.3 million shares, diluting other stakeholders.

Venture capitalists refer to it as "structure," and it was a commonly used tactic by late-stage start-ups in recent years to show valuation growth from one round to the next. Square and Box are the two most prominent companies to fork over additional stock to investors after selling shares in their IPOs below the ratchet price.

Silicon Valley spent last year sobering up from the excesses of the 2012-2015 era, when billion-dollar companies were minted so frequently that the term "unicorn" entered into everyday conversation, often as the butt of a joke. Public market investors simply weren't willing to pay up for the prospects of future growth, turning 2016 into the weakest year for tech IPOs since the financial crisis.

Snapchat preps for IPO: What investors should be watching

AppDynamics will be jumping in at a precarious time. Not only will it be the first venture-backed tech offering of the year, but it comes just after the inauguration of President Donald Trump, which brings its own uncertainties, and in the midst of a hefty week of tech earnings reports.

For AppDynamics, the bet is that investors are thirsting for new growth stories.

The company generated revenue of $158.4 million in the first three quarters of 2016, up 54 percent from the prior year. Businesses such as Capital One Financial, IBM and JetBlue employ AppDynamics for tasks like building, testing and deploying software and monitoring how it performs. When load times are slow or transactions in a certain region aren't being completed, AppDynamics can quickly find and fix the problem.

But selling to big companies is expensive, and AppDynamics spends three-quarters of its revenue on sales and marketing. That led to a net loss of $95.1 million in the nine months through October.

To avoid the ratchet, AppDynamics needs investors to see the value in paying at least $12 a share. Silicon Valley is watching.