Isilon to restate financials

Isilon Systems (Nasdaq: ISLN) announced last week that it will restate its financial statements for 2006 and the first and second fiscal quarters of 2007, a move that could provide evidence for a class action suit against the management and directors of Isilon, including general partners of Atlas Venture, Madrona Venture Group and Sequoia Capital.

The complaint, filed in U.S. District Court in Seattle in mid-December, alleges that the management and directors of Isilon made untrue statements and omitted facts in its communications to shareholders as Isilon stock fell more than 80% after December 2006, when it went public in a $108 million offering.

The lawsuit names VCs Barry Fidelman, a partner at Atlas Venture, Matthew McIlwain, a managing director at Madrona, and Greg McAdoo, a partner at Sequoia, as defendants. It alleges that they “engaged in acts, practices and a course of business that operated as a fraud or deceit.”

Each VC cited as a defendant declined to comment.

The next step for the plaintiffs will be to compare the restated financials to the financials presented in the IPO prospectus, says attorney Matthew Handley on behalf of law firm Cohen Milstein Hausfeld & Toll, which represents the plaintiffs. Once the financial documents are compared, “the entities that propped the company up at the time of the IPO may be in some trouble,” he says.

Handley’s firm has been pursuing its own line of inquiry about Isilon’s financials. Handley says that former employees said that they were aware of revenue recognition issues at the time they were employed at Isilon. “This [announcement] gives us a little more to go back to these witnesses with.”

Handley expects his firm to file an updated complaint on March 28 that will contain more information related to the case.

To be sure, class action lawsuits are not unusual when publicly traded companies experience a sharp decline in share price. However, this suit is noteworthy since Isilon was once a high-flying IPO. The stock of the Seattle-based company, which debuted at $13 a share, rose to more than $27 a share within a few weeks of its IPO. Last week, the stock was trading at just under $6 per share.

“There are law firms that have computer programs in which a decline in stock price triggers the word processor,” says Hank Barry, a lawyer with Howard Rice, which does not represent any part in the lawsuit. “It’s unlikely that there was any active misrepresentation,” Barry says. “Directors are generally insulated from the business judgment rule from actions so long as they have not violated their duty of care … most boards are pretty careful with such things.”

VC holdings

Isilon estimates that it will adjust $7 million of the $67.4 million of previously reported revenue across three quarters. Isilon found three reasons for the misstated revenue. The company counted some of its sales to resellers as revenue although those resellers had not yet identified customers; it swapped its storage product for another unmentioned company’s software and counted the products it delivered as sales; and it counted some sales before customers ever actually signed over any money.

It’s important to note that it does not appear that any of the three venture firms, which are the largest shareholders in Isilon, has sold any shares in the company. The most recent ownership statements on file show that Atlas holds 14.78 million shares, Sequoia with 11.65 million and Madrona with 10 million—the same positions they held following the company’s December 2006 IPO, according to Thomson Financial (publisher of PE Week). It appears that Madrona distributed a big chunk of its shares to its limited partners in June, but the firm declined to comment.

Had they sold at Isilon’s 52-week high of $25.50, the three venture funds could have raised a combined $929 million. That would have been a hefty return on investment, considering the company raised about $71 million in total venture funding from 2001 through 2006 before it went public.

The only venture firm that appears to have attempted to sell Isilon shares is Focus Ventures, which was never a major shareholder in the company. Focus filed three statements of proposed sales for about 59,000 shares for an undetermined price last September, according to Thomson Financial. It isn’t clear if those transactions were finalized. (Focus Ventures was not named in the lawsuit.)

Betting on a rebound

But Isilon may not be able to rebound from the beating it has taken in the public market. Wall Street analysts have suggested that the company may be shopping for a strategic acquirer. The company could be worth as much as $350 million in a sale, according to Clay Sumner, an analyst at Friedman Billings Ramsey & Co.

The company’s shares might even be a good value investment. “We believe there is value in the company’s technology leadership, and we think the company is a potential acquisition candidate, which is not likely factored into the stock price,” Aaron Schwartz, an analyst at JP Morgan, wrote last week after Isilon announced its plan to restate earnings.

One hedge fund certainly seems to agree with Schwartz’s assessment.

Artis Capital Management, a San Francisco-based hedge fund with ties to Sequoia Capital, bought a substantial stake in the company during the fourth quarter of 2007, according to Securities and Exchange Commission documents.

Artis bought more than 4 million shares, or 6.6% of Isilon’s stock outstanding, worth $20.6 million between Sept. 30 and Dec. 31 last year, documents show.