Vonage Playing to Its Fans for IPO

The VoIP provider is betting its own customers will help re-energize its upcoming offering.
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planned stock offering is shaping up to be the most notable IPO of the year -- certainly the one most worth watching, even if you're not investing in it.

Back in February, when Vonage filed its first preliminary prospectus, I argued it would be a

good acid test for technology IPOs -- especially the return of tech IPOs that were as big on promise as they were short on profit.

Vonage was just that: a leader in the voice-over-Internet protocol (VoIP) market that had signed up more than a million subscribers, but that went to town on marketing costs to get there.

Since then, things have taken an interesting twist.

It seems that institutional investors weren't necessarily stampeding to invest. Of the $20 trillion or so held by pensions, mutual funds and trusts, these institutional investors wouldn't even pony up the $494 million that Vonage is seeking.

So Vonage used a time-honored tradition of companies whose IPOs are in peril: It turned to the retail investor.

Vonage updated its prospectus this month to say it expects a "substantial portion" of shares in the offering to be sold to retail investors.

It set up a site for the 1.2 million or so customers as of Dec. 15, 2005, to buy between 100 and 5,000 shares in the IPO. Investors have until the end of the day Friday to request their allotments on a Web site that underwriters have set up for the directed shares.

So now the offering is becoming an even more fascinating acid test. We now know that institutional investors are for the most part passing on the Vonage offering. But will the individual investors take the bait?

The buzz is that they will. A post on the Web site of IPO research shop Morningnotes, apparently authored by one of its analysts, reads: "It was told to me earlier that the IOIs

indications of interest placed for these shares is now sufficient to cover the entire deal. Suffice it to say, this deal is done."

There was a time in the late 1990s when individual investors were starting fire after fire under the stocks of tech start-ups like


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(EBAY) - Get Report

, while the big buy-side funds held back. If Morningnotes is right, this IPO could mark the return to that trend.

The difference this time, though, is that retail investors have until now been as cautious as anyone.

Those who have come back to the market have stuck with mutual funds and exchange-traded funds, or maybe ventured into proven and profitable tech brands.

It will be a real vote of confidence in the tech sector if retail investors decide en masse to invest in Vonage.

Vonage is setting the bar low: It's selling 31 million shares at $16 to $18 each. If every one of Vonage's 1.2 million customers in December bought the minimum 100 shares, the IPO would be oversubscribed by a factor of four.

By selling only 31 million shares, Vonage is counting on at most a quarter of its customers paying $1,600 to $1,800 for the minimum number of shares.

Vonage says the directed-share program is a chance for its customers, who helped the company become a leader in VoIP, to get in on the proverbial ground floor.

But it's more than that -- Vonage is betting that customers will be so happy with the service that they'll put money in. There are at least five good reasons why they should think twice.

First, as Jonathan Berr

pointed out, eBay's Skype and

Time Warner's


AOL recently introduced free Internet calling products that could make Vonage a less attractive proposition for its current 1.6 million customers. And


(VZ) - Get Report

also recently cut its VoIP prices to match those of Vonage.

And the company has been spending a lot to get the customers it does have -- since 2001, Vonage has spent $401 million on marketing and brought in $488 million in revenue. For every dollar in revenue, it's spent 82 cents on marketing.

Second, the recently revised prospectus lists reasons why customers may not stick around despite all that marketing. Vonage's churn rate in the first quarter of 2006 was 2.1%, up from 1.7% in the year-ago quarter. Vonage says the increase was the result of "less-than-satisfactory customer care." The company also said that it's seeing high turnover among its customer-care staff, driving up training and recruiting costs.

Third, the company has yet to meet the federal requirements on providing 911 service. Vonage had until last November to provide it to all its customers, but currently a quarter of them still don't have the service. While Vonage has applied for a waiver, the company may go public without sufficient resolution to the compliance issue.

Fourth, there are the financial and management issues mentioned in my previous look at Vonage. What were disconcerting numbers in the first filing have only grown larger. Vonage now has an accumulated deficit of $467 million and $253 million of debt in the form of convertible notes.

Fifth, and perhaps scariest of all, is this telling confession that Vonage added to its recent filing: "We discussed a revolving credit facility with commercial banks in the summer of 2005. As a result of those discussions, we believe most commercial lenders will require us to very significantly reduce our loss from operations before they will lend us money."

If Vonage were bent on selling its shares to customers, it could have done that last summer; instead, it went to the big banks. But those lenders know a thing or two about risk -- if they don't, they lose money themselves. The banks said no to Vonage. Then institutional investors said no. And no company has emerged to buy Vonage. So now it's up to the retail investors.

Vonage has been open and clear in its prospectus about the risks involved in holding the stock. But its customers may be tempted to buy into this IPO because they're happy with the company's service.

They're right that Vonage provides a good service. Sometimes, though, a good service or a good product doesn't translate into good financials. Vonage's financial numbers have turned away big investors; it's up to the small investors now to decide for themselves.

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