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INITIATING COVERAGE

Slack is slated for success as a public company—but here’s why you should keep asking questions

Slack IPO
Reuters/Thomas White
This probably looks familiar
Published Last updated This article is more than 2 years old.

Slack’s regulatory filings in advance of its public stock offering last week show how successful the messaging company has become since its founding in 2009. Slack’s customers and revenue are growing rapidly, powered by a sales and marketing strategy premised on viral user growth and converting free members to paid subscribers. Companies all over the world have essentially replaced email for many important functions and now depend on Slack for internal communication. There are thousands of outside developers creating applications that work in Slack, making it even more valuable for customers.

We’d have nothing but positive things to say in the run-up to Slack going public if the company showed some indication of future profitability and if it wasn’t pursuing a risky direct listing process, but those remain significant concerns.

Here are our five biggest takeaways that we think investors should be considering:

Slack is a platform for the future of work

Slack is much more than a replacement for email. Slack offers text, voice, and video communication, collaboration across groups of any size, and sharing of all kinds of files and documents. Slack users also employ more than 450,000 third-party applications or custom integrations in a typical week, including those from companies like Google, Salesforce, ServiceNow, Atlassian, Dropbox, and Workday. Slack’s diversity of user experiences and integration of such a large number of applications makes it a platform for work of all kinds. The scale of integrations across more than 1,500 third-party developers and the breadth of tasks tackled within Slack creates a moat that wards off competitors. As more applications are connected and users do more within the platform, the switching costs and competitive barriers get higher.

We’re particularly interested in the opportunity to apply artificial intelligence to the vast store of data stored in Slack. In its S-1 filing, the company briefly mentions its efforts to leverage AI for automating workflows and improving search features. We think there’s a possibility for much larger and broader applications of AI by both Slack and its integration partners. For example, there is an emerging trend of companies monitoring employee communications. This can be for a variety of reasons, such as security, productivity, harassment prevention, and capturing knowledge across an organization. In an age where suspicion of tech companies is on the rise, Slack may be perceived as more trustworthy than its competitors, making its platform all the more valuable for AI-enabled employee collaboration. With good design, smart applications inside Slack could make the platform significantly move valuable for users and create more reasons for free customers to upgrade to being paid customers.

With an efficient marketing and sales strategy

Slack’s freemium model is ideal for gathering users. New customers sign up and start using the product with their entire organization quickly and easily, for free. More than 500,000 organizations across more than 150 countries currently use Slack at no cost. They act as de facto marketers for the product by recruiting new users to their workspaces. And they represent an ideal group of companies for Slack’s sales people to target for premium, paid services. Customers start paying when they want more sophisticated search capabilities, additional integrations, increased security features, or group video calling. Customers pay increasing amounts for higher-end functionality such as guaranteed performance, security, and data management features. We think it will be fascinating to monitor how Slack optimizes its freemium model as it tries to create the largest possible free user community while also moving as many customers to paid services as well.

Slack’s model is clearly successful in driving customer and revenue growth. It’s also doing so more efficiently, with sales and marketing costs as a percentage of revenue declining from 64% in 2017 to 58% in 2018.

It’s growing fast

Slack is growing—quickly. Last year, the company’s number of paying customers grew by 49% to 88,000 worldwide. And its sales grew even faster, increasing by 82% to $400 million. The company’s revenue is growing faster because it is collecting 22% more per customer than a year ago as customers increase the number of users and pay more for more functionality. The most important driver of this revenue increase is from customers who generate more than $100,000 in revenue per year. This relatively small group—representing only 575 out of 88,000 total paying customers—generated 40% of the company’s sales, up from 32% in 2017, and accounted for half of the company’s total revenue growth. While concentration of revenue in a small group can be risky, we think in this case it demonstrates Slack’s potential as it moves more customers from freemium to paying, and from paying a little to paying a lot.

But it’s still not making money

While Slack’s revenue has quadrupled in the past two years, its losses have barely budged, declining only 5%. The similarity of the losses in the past three years—$147 million, $140 million and $139 million—makes us wonder if the company is solving for a specific number. If not, it’s quite a coincidence. Either way, the lack of change in the company’s losses makes it nearly impossible to predict if or when the company will be profitable. There simply isn’t a trend to use as the basis of a forecast. The company has enough cash to support the current loss rate for more than five years so there isn’t a near-term concern of the company running dry. But at some point Slack will need to make money and investors will need to predict future cash flow in order to accurately value the company.

The big drivers of increased expenses in 2018 were the company’s cost to deliver its service and its general and administrative costs. The cost to deliver grew faster than revenue in 2018 with costs growing 95% and revenue growing 82%. With cost to deliver at only 13%, Slack is far more efficient than other major SaaS companies like Salesforce (26%) and Workday (29%). It wouldn’t be surprising to see its cost to deliver increase as those costs did at Atlassian—increasing from 17% to 20%—but any increase in costs will make it harder for Slack to reach profitability. Slack’s general and administrative costs doubled in 2018 which may simply be a result of the company’s growth and preparing to be a public company.

And it’s not a traditional IPO

Slack is not going public through a normal IPO. Like Spotify, it is using a direct listing process, which converts the company to public ownership without raising new capital or using investment bankers. Slack doesn’t appear to need additional cash in the near-term, but we’re still not a fan of the direct listing process and think investors should be wary of buying shares immediately. Unlike an IPO—which is managed and supported by a team of investment banks—a direct listing is more of a free-for-all. There is no price discovery process of soliciting orders ahead of the listing. There are no banks that have capital on the line during the process. And there is no lock-up period to limit the potential shares offered for sale. While the process may be smooth, we’re wary of adding volatility risk to the demonstrated turbulence of recent IPOs like Zoom and Lyft.

The appeal of a direct listing is primarily to pay lower fees to investment banks than in an IPO. But the process isn’t free. Spotify paid around $30 million in advisory fees for its direct listing, which is about half of what would be expected in an IPO. While the process saved the company money, the costs exclusively benefitted investors by providing them a market to sell their shares. Since the company didn’t raise any money, it’s hard to see how that $30 million benefited the company itself. Slack’s investors will also benefit from a direct listing but the company itself won’t.

But it’s a platform investors can’t ignore

Slack has quickly built an essential platform for half a million organizations around the world. It has a highly efficient marketing and sales model that is driving significant customer and revenue growth. And the capabilities provided by external developers makes it seem like the use cases are endless, especially when considering AI products and applications. Slack faces the toughest of competition, including Microsoft, Google, Facebook, and Cisco, which all offer team collaboration and messaging on their platforms. Investors shouldn’t underestimate Slack’s competitive threats, especially from Microsoft’s Skype and Team products. But those big companies don’t seem to be stopping Slack’s rapid growth, showing that great, user-centered design can win against the biggest companies in the world.

As with so many other recent tech IPOs, Slack has a dual-class share class so investors in the company will be on a passive ride with the insiders who hold voting control. We’re not a fan of this structure but the venture capital industry seems to have accepted it so there’s not much anyone else can do. In this case, Slack’s management team has proven itself a good steward of the company which at least tempers the risk of poor governance becoming an issue.

Without any indication of Slack’s future profitability, it’s impossible to say what the company is worth today and it’s likely the stock will be volatile until profitability is better understood. Despite that uncertainty, Slack is a stock that tech investors likely want to own because it provides an opportunity to invest in a rapidly growing platform that directly benefits from the future of work.

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