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Vonage and Its Weather Vane Moment

Kevin Kelleher

Last week's IPO filings offered Wall Street an opportunity to invest in two technology companies -- let's call them Company A and Company B.

Company A is a telecom start-up that in four years helped pioneer a new form of telephony changing how people communicate -- a market forecast to grow 10 times over between 2004 and 2007. The company monetized this disruptive technology, posting revenue that more than tripled in the last year and was 230 times as large as revenue in 2002.

Company B has seen its revenue grow but expenses balloon even faster. It's posted a loss every single year. Its operating margin in the first nine months of 2005 was equal to 110% of revenue, above the 86% in the year-ago period. So, it's spending money faster than it can bring it in. And it recently swapped its CEO, who last ran a company that settled with the SEC in a stock-manipulation scheme, with an alumnus of another scandal-plagued firm.

So, who stays on the island?

OK, it's a trick question. Company A is Vonage, the VoIP (or voice-over-Internet protocol) telephony pioneer that could reap riches by offering super-cheap long-distance calls. Company B is -- that's right -- also Vonage, which is having a hard time not bungling the rare opportunity to overturn a stagnant and inefficient business model.

The schizoid choice that Vonage presents investors says as much about the company itself as it does about the crossroads at which Wall Street stands in the early months of 2006. For the past five years, the IPO market has looked on its pipeline with the same steely, unforgiving gaze that Kenesaw Mountain Landis cast onto baseball, i.e., a very sober gaze (although some would argue too harsh, in a few instances).

But with a new, improved Internet rising from the ashes of the dot-com bust, there is also a growing sense that public investors should be able to get in early on a new generation of upstarts that can improve on the sclerotic business models of the old guard.

What's interesting is that it could go either way, which is why Vonage's $250 million IPO bid is worth following, whether or not you invest. Vonage had little choice but to try for an IPO after eBay bought Skype for a mouthwatering $2.6 billion.

Yet its IPO could quietly die on the vine, as did Buy.com's public-market dreams late last year. Or it could sneak past the IPO censors and get a chance to sink or swim on its own merits as the VoIP saga plays out.

Look closely, though, and the preponderance of evidence that Vonage has offered so far says it will sink. The company may remind some observers of TiVo , the digital-video recording service that also launched a new tech niche while producing losses.

But TiVo's stock is up 54% in the past year amid speculation it would be bought, while Vonage's technology is being copied by the Baby Bells and is being surpassed by Skype and others. TiVo also boasts 4 million subscribers, compared with 1.2 million for Vonage.

As Scott Moritz reported and as Colin Barr hammered home later, there is plenty in Vonage's prospectus to give you the stomach-in-the-throat sensation you get just when the roller-coaster is about to make a precipitous dive.

Both writers also mentioned Jeffrey Citron -- who has shepherded Vonage so far. At Datek Securities, Citron just didn't settle with the SEC, he paid $22.5 million in fines, "among the largest fines ever collected by the SEC against individuals," the filing says. In addition, Citron faces "bans from future association with securities brokers or dealers and enjoinments against future violations of certain U.S. securities laws." Yet Citron is staying on as Vonage's chief strategist -- whatever that means. For most companies, the CEO is the chief strategist.

And new CEO Mike Snyder was most recently president of ADT Security, which according to The Wall Street Journal "was the major contributor to accounting errors at Tyco that totaled $2 billion." Of course, Snyder wasn't implicated in any wrongdoing at Tyco, but somehow that's scarier: The unit he managed toppled a corporate giant -- and he had nothing to do with it. Can that be called management?

What's more, Vonage spent more on marketing alone -- $176 million in the first nine months of 2005 -- than it made in total revenue ($174 million). Knowing that, do you remember seeing a Vonage ad last year?

But the really troubling thing for investors has received little attention: Last December, less than two months before Vonage filed for its public offering, the company sold $250 million in convertible debt to select investors, including private firms like New Enterprise Associates and Bain Capital, as well as, yep, Jeffrey Citron.

That's in addition to the $389 million in debt Vonage previously issued in the form of redeemable convertible preferred stock. Each of those earlier preferred shares converts into eight common shares, the S-1 filing says. Meanwhile, Vonage is paying about 5% interest on them.

The prospectus also notes that, "Our stock price may decline due to sales of shares by our other stockholders" and that "convertible notes contain provisions that could delay or discourage a takeover attempt." In other words, the $639 million in convertible debt that Vonage has racked up to post a cumulative $305 million in operating losses could prevent a takeover and then cause the stock to fall when insiders sell.

If that doesn't raise the hair on your neck, try this: Vonage says, "We may need to seek additional funding by accessing the equity or debt capital markets." Reasonable enough, but wait: "Our significant losses to date may prevent us from obtaining additional funds on favorable terms or at all ... We do not fit traditional credit lending criteria ... the terms of our senior unsecured convertible notes contain significant restrictions on our ability to raise additional capital."

That's all from the same paragraph. This is not standard boilerplate for the "risk factor" section.

Yet in the end, there's hope for Vonage. The success of the IPO will have less to do with its prospectus than with Wall Street's mood of the moment. One would hope the spirit of sobriety of the past five years will continue to prevail, which means Vonage will quietly dip its head back into the fertile soil of private financing. The groundhog sees its shadow, and it flees.

But there's a chance that won't happen: We all know that, on Wall Street if nowhere else, sobriety isn't permanent. If the institutional investors decide it's been a long time since it rock-'n'-rolled at a Bacchanalian orgy (as sordid and bloody as that last one turned out) this IPO will get the OK.

And then it will be up to Vonage to keep the wine flowing.