What investors need to know about Darktrace

Another day, another tech company announces that it wants to IPO in London. Cybersecurity business Darktrace is reportedly targeting a valuation of $5bn (£3.8bn), seemingly undeterred by the shadow of Deliveroo’s (ROO) difficult flotation last month. 

Darktrace is not the only one that has recently been tempted to come to market. Biotech business Oxford Nanopore, which specialises in gene sequencing technology, announced last week that it is also moving towards an IPO. 

But the extent to which Deliveroo and Oxford Nanopore count as ‘tech’ companies is up for debate. Some posit that the former is simply a delivery business that consumers access via an app. The latter could arguably be labelled as a pharmaceutical research company that uses high-end tech – not unlike industry leader AstraZeneca (AZN), which has its own unit dedicated to biotech. 

Software business Darktrace might be what investors have been holding out for. It fits the more traditional profile of a tech company, and is not pursuing a dual-class share structure, which would introduce tiered voting rights. This sounds compelling relative to Deliveroo, but Darktrace does not come without risk – not least from its connection to tech entrepreneur Mike Lynch, who is facing extradition to the US on fraud charges. Here are the three key things to know ahead of its potential IPO:

1. The SaaS trinity: contracts, margins and scale

Darktrace’s cybersecurity product is powered by artificial intelligence (‘AI)’, meaning that the technology is self-learning and theoretically improves the more that it is used, as it gathers additional data. It generates an understanding of what the “normal” environment of its clients' IT estate looks like, and then automatically responds when that is disturbed – without the need for human supervision. 

Unsurprisingly, the software is highly rated within the industry, and especially helpful for small to mid-sized businesses that cannot afford big IT teams. Combine that with the essential nature of robust cyber protection, and Darktrace has the makings of a successful tech company. Its ‘software-as-a-service’ (SaaS) model means that almost all of its revenues are recurring, and have been since at least 2018, with contract lifetimes typically lasting three years. Meanwhile, gross margin sits at a chunky 90 per cent. 

But the retention rate for its net ARR (the annual subscription value for each order booked) did slip to 99.7 per cent in the six months ended in December 2020, from 100.2 per cent the year prior. Its average contract ARR dropped from $62m to $60m in the same period. 

This could be because Darktrace is scaling up quickly, made easier by the digital nature of its product. The company more than doubled its customer base in two years, with the total standing at 4,677 at the end of 2020. 

In the long term, management envisions a so-called “closed loop” approach, which will add remediation and prevention products to its detection and response service. If successful, it should help fatten up average contract sizes – but it will require a serious ongoing commitment to R&D in order to keep pace with industry rivals. 

2. Mostly lossmaking

That might prove difficult. Darktrace is still mostly lossmaking: it made a pre-tax loss of $26.9m in its last fiscal year, narrowing from a loss of $37.5m and $41.6m in 2019 and 2018, respectively. But finance costs reversed that trend, pushing it to a near-$48m loss in the six months ended in December last year. Although it is profitable on an adjusted cash profit basis, recording a $8.9m profit in 2020. 

In short, this is because chasing scale is expensive. Sales and marketing make up the bulk of operating expenses – in 2018, they were worth more than the company’s total revenue. That proportion has ticked down now, but outlays on sales and marketing still seriously dwarf expenditure on research and development (R&D). 

Darktrace’s most recent figures suggest that R&D sits at around 8 per cent of total sales. Compare that with cybersecurity giant FireEye (US:FEYE), which spent more than a quarter of its sales on R&D in 2020. This imbalance might prove to be a bump in the road for management’s long-term “closed loop” product strategy. 

3. The Mike Lynch connection

Tech billionaire Mike Lynch was an early investor in Darktrace via his company Invoke Capital. No doubt support from one of the nation’s most prominent tech entrepreneurs, and then an adviser to the government’s Council for Science and Technology, would have been welcomed with open arms. 

But Lynch is now currently fighting extradition to the US, where he would face conspiracy and fraud charges related to the sale of Autonomy to Hewlett-Packard Enterprise (US:HPE) in 2011. The legal battle has followed him to the UK too: HP has sued in the High Court of England & Wales, with a final judgement expected to land sometime this year.

Lynch denies the charges and is no longer on Darktrace’s board – and, unsurprisingly, the company makes no reference to its early backer in the prospectus it released this week. But a number of Darktrace’s c-suite team had worked at Autonomy, including current chief executive Poppy Gustafsson, as well as chief strategy officer Nicole Eagan. 

Darktrace has warned possible investors that it could end up being embroiled in Lynch’s case. It was subpoenaed by the US Deparmtent of Justice in 2018, and it has flagged that it could face liability under money laundering charges – although it considers the possibility of successful prosecution as ‘low risk’. 

Still, Lynch is already casting a shadow over the company’s IPO ambitions. On Thursday the Financial Times reported that in 2018 the business had said that Lynch left the advisory council the year prior. This week’s stock market registration document says he stayed on until last month. 

Shaking off reputational damage will not be easy. That might be enough to spook investors, on top of the fact that an apparent $5bn target market cap would be a serious increase from its last funding round just three years ago, which valued it at $1.65bn. Darktrace may look like a more traditional tech stock than industry peers that are rushing to the LSE, but there is no guarantee that it will be a safer play.