Alternate route

A few years ago, venture backers rarely gave more than fleeting consideration to the idea of taking a U.S. company public in another country.

Today, hardly a gathering goes by in Silicon Valley venture circles without some reference to the merits of alternative exchanges. Granted, few VC-backed companies in the United States are actually going public overseas. But if one believes that today’s hot topic will be tomorrow’s IPO trend, it’s worth noting that startups, venture capitalists, and the exchange representatives paid to mingle with them are spending more time discussing the idea.

They’re turning up lucrative reasons to look abroad, too. As of mid-June, European IPOs had raised approximately $45 billion in 2007, more than a third greater than the amount raised in U.S. offerings, according to Thomson Financial. China, Russia, India and Indonesia boast among the top-performing stock markets of the past two years. And London’s Alternative Investment Market continues to woo growth companies too small to list on more established exchanges.

There are also plenty of reasons why American companies don’t go public overseas. Chief among them is the preference to list in one’s home market, particularly if that market is historically the most receptive to venture-backed deals. Since last year, eight venture-backed IPOs have generated initial market capitalizations above $1 billion, according to Thomson, and all of them took place on U.S. exchanges.

But while U.S.-based startups are largely sticking to domestic markets, the global trend for venture-backed companies is much more international. In 2006, 17 out of 74 companies backed by U.S. venture capitalists that carried out IPOs did so outside of the United States, National Venture Capital Association President Mark Heesen testified during a June House of Representatives committee hearing on securities law reform. Prior to the enactment of Sarbanes-Oxley, this was “virtually unheard of,” Heesen says.

Securities laws aren’t necessarily the main factor driving that trend. U.S. venture capitalists are also investing larger sums in foreign companies, which are more likely to go public on local exchanges. Today, 90% of all companies go public in their own country, according to Ernst & Young.

Take AIM

In terms of name recognition and early momentum, the front-runner among alternative exchanges is clearly London’s AIM.

In the exchange’s fiscal year ended in March, 395 companies completed IPOs. While that’s fewer than the 510 offerings completed in the previous fiscal year, the average new issue is generating more money. In all, companies raised $18 billion from AIM IPOs in fiscal 2007, up from $15.8 billion a year earlier. In May alone, 13 offerings raised $1.4 billion.

Despite the growing size of offerings, AIM officials continue to market the exchange primarily as a venue for raising financing. For venture capitalists seeking a big exit, an offering is more of an interim step towards that goal.

If you look at history, lightly regulated secondary exchanges, even if they’ve had initial success, have not been huge successes.”

Josh Lerner, Professor of Entrepreneurial Management, Harvard Business School

“It got a bit overcooked [in Silicon Valley] that AIM was going to be the answer to everyone’s prayers,” says Graham Dallas, U.S.-based senior manager for the London Stock Exchange. “It’s not.”

For one thing, it’s not especially cheap. An AIM listing’s total cost is generally between 8% and 12% of the money raised, Dallas estimates. That’s fairly comparable to a Nasdaq offering. The flat cost is lower, however, since companies on AIM typically raise smaller amounts and ongoing compliance costs are not as high as on Nasdaq.

AIM’s reputation for light regulation also draws mixed reviews. Companies primarily report to exchange-approved financial advisors. These Nominated Advisors (or Nomads) include most of the same investment banks that profit from taking companies public. “This is sort of like having the monkeys guard the bananas,” quips Gary Benton, a securities law partner at Pillsbury, Winthrop, Shaw, Pittman.

Still, offerings from American companies are trickling in. To date, 26 U.S. companies have gone public on AIM, according to Dallas. Listings include venture-backed companies Burst! Media Corp., backed by Summit Partners; PolyFuel, backed by Chrysalix Energy, Conduit Ventures, Mayfield Fund and Technology Partners; and Protonex Technology, backed by Conduit Ventures, SAS Investors, Solstice Capital and Commons Capital. Pentadyne Power,a Chatworth, Calif. company backed by Nth Power and Rustic Canyon, recently filed to raise $30 million on AIM.

Why not Taiwan?

Options for listing new shares outside the United States and England are also bountiful. Exchanges wooing venture-backed startups include Toronto’s TSX Venture Exchange, the Singapore Exchange, the Hong Kong Stock Exchange, and even the Dubai International Financial Exchange.

The liquidity and sophistication of exchanges in many emerging economies is enough to convince Bill Shaw, managing director for Nasdaq’s corporate client group, that “the U.S. is no longer leading the global markets.” Increasingly, Shaw says, companies looking to go public can choose from a number of exchanges, including markets in developing countries.

Some established foreign markets are even drawing U.S. venture-backed companies. U-Systems, a venture-backed company that makes ultrasound imaging systems to detect breast cancer, is exploring an offering in Taiwan. Although the company is based in San Jose, Calif., it’s seeing significant demand for its technology in Asia, notes Nandini Tandon, a managing director at MDS Capital, one of the company’s backers. U-Systems has also looked into listing on other Asian exchanges.

Some U.S. VCs and private equity investors that have invested in companies based in foreign countries are looking to take them public in their home markets. Info Edge, an Indian employment website backed by Kleiner Perkins Caufield & Byers, had a wildly successful IPO in India last year.

Growth investor General Atlantic, meanwhile, recently took two of its portfolio companies, Frankfurt-based telecom billing services provider LHS Group and outsourcer Hexaware Technologies (which has headquarters in New Jersey and significant operations in India) public on exchanges in Germany and India, respectively.

The U.S. is no longer leading the global markets.”

Bill Shaw, Managing Director, Nasdaq’s Corporate Client Group

It’s easy to see the attraction of alternative exchanges—and AIM in particular—as a route to liquidity, says Josh Lerner, professor of entrepreneurial management at Harvard Business School. However, he notes, business case study archives contain numerous examples of upstart exchanges that have fallen into obscurity.

“If you look at history, lightly regulated secondary exchanges, even if they’ve had initial success, have not been huge successes,” Lerner says. They’re also vulnerable to market forces, as in the case of Nasdaq Europe, which launched in 2001 and closed two years later near the bottom of the tech stock market slump.

Nasdaq’s own alternative

AIM’s strategy of selling exclusively to institutional investors is clearly gaining traction. One indicator: Nasdaq is beefing up its own marketplace for offerings of private stock.

This summer, the exchange plans to launch an alternative to its public market called Nasdaq Portal that will allow companies to sell shares to large institutional investors.

Pending regulators’ approval, Portal will offer securities exclusively to institutional investors that have more than $100 million under management. Investors will buy and sell the so-called 144A offerings, named for a 1990 SEC rule that allows the sale of unregistered securities to qualified institutional buyers.

For small companies, the draw of listing on such an exchange is clear-cut, says Shaw: “No S-1, no Sarbanes.” Beyond offering a way to avoid the hassle of a public listing, Shaw sees the exchange appealing to companies and their venture backers that are looking to raise financing or sell a partial stake in advance of a traditional IPO.

The potential market is huge. Last year, direct investment in securities of private companies totaled $1.25 billion, according to NYPPE, a Greenwich, Conn.-based firm that handles private securities transactions. Researchers project that the market for secondary direct investments in private companies will mushroom over the next several years, as hedge funds and venture funds seek exit alternatives for portfolio companies.

But while selling unregistered securities may be a sensible liquidity tactic for mature companies, Lerner envisions problems applying the model to development-stage startups. His chief concern relates to the difficulty of assigning valuations to venture stage companies, particularly ones that don’t have predictable revenue or earnings. “A private exchange is not going to make that problem any easier,” he says.