Cover Story: IPO OUTLOOK –

Thirty-seven. In any other year, topping that figure would be a cinch. But that was the largest number of companies venture capitalists could manage to take public last year. And this year has started with a whimper.

The industry will be lucky to eclipse that number in 2002, based on interviews with a dozen venture capitalists. If the IPO market heats up, it won’t be until the second half of the year maybe even the fourth quarter, they say. That jibes with the outlook from the Federal Reserve. It held off on its umpteenth cut in interest rates, citing economic data indicating that “the outlook for economic recovery has become more promising.”

Of course, no one can predict what the market will do. Who would have guessed that dreadfully unprofitable Web payment service PayPal (Nasdaq: PYPL) would have received such a warm reception when it went public on Valentine’s Day? Its stock, priced at $13, shot up 50% to $20.09 in its first day of trading.

Even with the March surprise of PayPal, just three venture-backed companies had gone public as of Feb. 15: PayPal, Synaptics (Nasdaq: SYNA) and ZymoGenetics (Nasdaq: ZGEN). (Four other nonventure-backed companies also made it out.)

There’s no shortage of IPO candidates. Fifteen venture-backed companies are registered with the Securities & Exchange Commission (SEC), according to Thomson Financial Securities Data. In addition, the dozen VCs Venture Capital Journal spoke to gave us the names of another 16 portfolio companies that they believe have a shot of making it out.

Menlo Ventures, for instance, hopes to take four startups public later this year if the environment is ripe. “A few years ago, those companies would have been public by now,” says DuBose Montgomery, a managing director at Menlo. “We’re waiting a bit now to see how the market pans out, because if we go at a weak time we will have to sell too much of the company.” All of the candidates have plenty of capital, so there is no hurry, Montgomery adds.

Ten out of the 12 VCs say they expect the market to be receptive to companies in two categories: health care/life sciences and enterprise software. Health care isn’t a big surprise, given that 18 of the 37 venture- backed companies that went public last year were health-care related (see tables at end of story). The largest group (eight) was made up of medical technology and device makers, followed by health care service providers (six), drug makers (two) and health care software (two).

But that was last year. The market soured on new health care issues in January, particularly those without strong fundamentals. Take ZymoGenetics, which priced at $12 per share on Jan. 31. It was trading at $10.29 on Feb. 13.

The company, which is developing “therapeutic proteins” to treat disease, is a victim of renewed scrutiny of financial performance. Its revenue fell 39% to $12.9 million in the first nine months of 2001, and it posted a loss of $41.1 million, up from a loss of $12.2 million in the first nine months of 2000.

Perhaps due to the cold reception for ZymoGenetics, NeoGenesis Pharmaceuticals, canceled its IPO plans on Feb. 8. That’s not a shock, given that the drug discovery company has lost in excess of $24 million since its founding in 1997.

VCs admit they’re concerned about the current market for health care and biotech issues. Several news events drove down the biotech sector in January after it posted gains in December. The messiest bit of news came at the end of the year, when the Food and Drug Administration (FDA) rejected an application by ImClone to start marketing Erbitux, a new kind of drug that promises to kill cancer cells at the genetic level. ImClone then rejected demands from partner Bristol-Myers Squibb to renegotiate the financial terms surrounding Erbitux. A shareholder suit is underway.

The “ImClone disaster” and the poor performance of ZymoGenetics “set the biotech IPO market back three to six months,” says Barr Dolan, a general partner at Charter Venture Capital.

Biotech VC Steven Burrill says he figured 30 or more biotech deals would make it out this year, “but the ImClone debacle and the clinical failures of many companies gave us a bad start.” Burrill is CEO of Burrill & Co., which manages biotech VC funds totaling more than $340 million.

Despite a downturn in biotech stocks, three of the VCs VCJ spoke with hope to take five health care-related portfolio companies public this year. Plus, an inside source tells us that Acorda Therapeutics is looking to go out.

* Acorda makes specialized drugs to treat spinal cord injuries and other neurological conditions. It’s scientists are itching for the company to go public, a source close to the company says. Acorda has $66.1 million in funding from more than 15 investors, including MDS Health Partners, Merrill Lynch Capital Partners and New York Life Venture Capital Group.

* AgraQuest, a natural pesticide company, plans to sell 3.5 million shares for $11 to $13 each. Burrill owns 5.6% of the company, according to the S1 filed with the SEC. Since it’s still developing products, the company posted revenue of just $2.1 million for the years 1996 to 2000 and the first nine months of 2001 combined. During that same period it racked up net losses totaling $28.5 million.

* Zyomyx, which makes protein analysis devices, has not filed an S1, but Burrill, one of its backers, says it has a chance. Besides Burrill, it has $63.2 million in backing from Alloy Ventures, Skyline Ventures and others.

* R2 Technology, a maker of systems that screen for breast cancer, filed an S1 statement on Feb. 11 indicating that it plans to sell 4.5 million shares for $10 to $12 per share. Four VCs own 30% of the company. The largest is Morgan Stanley Venture Partners (11.2%), followed by Alta Partners (7.3%), Sigma Partners (6.2%), and ARCH Venture Partners (4.8%). Even though it’s unprofitable, R2 could be a beneficiary of the public market’s hunger for health-related ventures, says Wade Woodson, a managing partner at Sigma.

* Metabolex, which makes drugs to treat Type II Diabetes, may try to make it out in the second half of the year, Charter’s Dolan says. Metabolex has $79.4 million in funding from Charter, Bay City Capital and several large corporations, like Pfizer Inc.

* Adeza Biomedical, which makes tests for pregnancy-related disorders, is also a candidate for the second half. It has “strong revenue growth and is close to profitability,” Dolan says. It has more than 15 backers, including Charter, Enterprise Partners, JPMorgan Partners and Sprout Group. They’ve poured more than $60 million into the company.

With the health care sector up in the air, VCs may do better to focus on the boring but profitable business of software for designing semiconductors. Electronic design automation (EDA) software proved to be a little sweet spot in the market last year, with two companies making it out successfully. Magma Design Automation – backed by J&W Seligman & Co., Intel Capital, New Enterprise Associates and others – priced at $13 and was trading at $21.40 on Feb. 13. Simplex Solutions – with backing from Mayfield, Intel Capital, Worldview Technology Partners, and others – priced at $12 and has remained flat.

A third company, PDF Solutions, which makes EDA-like software that helps chipmakers improve their yields, popped at $12 and closed at $14.42 on Feb. 13. It was backed by RWI Group, Telos Venture Partners and U.S. Venture Partners.

At least two more EDA startups hope to make it to the big leagues this year.

* Axis Systems should also be ready to go by mid-year, says Walter Kortschak, a managing partner at Summit Partners. The EDA software developer will likely seek $40 million to $50 million. In addition to Summit, the company has $17.6 million in funding from Acorn Ventures and famed serial entrepreneur Wu-fu Chen.

* Sequence Design, which makes software that allows system-on-a-chip designers to create higher-performance and lower-power integrated circuits, is likely to go out this year, says Steven Bird, a general partner at Focus Ventures. The company has total venture funding of more than $47 million from Atlas Venture, Focus, Menlo Ventures, Sigma Partners and others, according to Venture Economics (VE). The post-money valuation for its last round ($10 million in October 2001) was $88 million, down from $111 million in 1999, VE data shows. Without mentioning Sequence by name, Menlo’s Montgomery also says it could file this year. He made reference to an EDA startup in his firm’s portfolio, and the only such company is Sequence. Montgomery says the “unnamed” company has annual revenue in the range of $20 million to $30 million and is growing rapidly. It would likely seek $50 million to $70 million, he says.

Venture capitalists are generally bullish about the entire software sector, not just EDA. Startups with software for specific industry niches also could grab the public’s interest. Last year, the market gobbled up offerings from three companies that serve vertical markets: Oil States International, which sells logistics software and services to oil and gas companies;, a developer of software for health care providers to purchase products over the Internet; and The Princeton Review, which sells software and services to students preparing for college and graduate school. The bad news is that two of the companies were trading 10% to 20% below their offering price on Feb. 13, while one,, was trading 35 cents above its IPO price of $7.

Two VCs VCJ spoke with have IPO candidates targeting niches.

* Alpha Smart, a maker of portable computing appliances and software for students, is talking to investment bankers about a year-end IPO, says Kortschak of Summit. It has $19.5 million from Summit and others.

* Carparts Technologies makes supply chain management software for the automotive and automotive aftermarket industries. Despite the odd name, the market may be receptive to the company because it is going after such a defined customer base. Carparts has a $1.5 million-per month run rate and it’s growing, says Ed Goodman, a managing partner of Milestone Venture Partners. Besides Milestone, at least five other VCs have pumped $68 million into the company over three rounds, including Brand Equity Investors, CMGI’s @Ventures and St. Paul Venture Capital.

About half of the VCs we spoke with say they expect developers that make software for corporations to fare well. When the economy turns up again, so will corporate spending, and enterprise software developers could see a windfall after struggling through a tough 2001.

* Adexa, which develops collaborative planning software that allows partner companies to communicate in near real-time, could go out in the third or fourth quarter of this year, says Bill Younger, a managing director at Sutter Hill Ventures. Adexa’s annual sales are more than $40 million, up from $4 million four years ago, Younger says. Venture backers, including Amerindo Investment Advisors and J&W Seligman & Co., have poured more than $32 million into the company.

* Evoke Software may finally try to get out the door after backing off in late 1999. The data mapping company backed off of a planned IPO three years ago because of the market’s increasing choppiness, says James Robinson IV, a general partner at RRE Ventures. Evoke may go out later this year, Robinson adds. The company has received over $54 million in funding from RRE and others according to VE.

* MontaVista Software, which makes development environments for engineers developing Linux-based operating systems for embedded systems, is another RRE portfolio company that could go public, Robinson says. The two-year old company recently closed on a $28 million Series D round, pushing its total venture funding to more than $60 million from backers that include U.S. Venture Partners, Intel Capital and Sony Corp.

* Edocs, an electronic billing company, might go out in the second half of the year. The company has annual revenue run in the range of $20 million plus, with good year-over-year growth, says Bird of Focus Ventures’. Edocs has more than $87 million from Focus, Amerindo Investment Advisors, Charles River Ventures and others according to VE.

* Finaplex is another possible candidate. The company makes enterprise software for the “wealth management industry.” Menlo Ventures’ Montgomery says his firm has an enterprise software company selling into financial institutions that could be ready to go this year. Finaplex appears to be the only one that matches that description. Montgomery says that the “unnamed” company has growing revenue in the $20 million to $30 million range.

One way we may learn if the IPO market has regained its appetite is how it reacts to Internet offerings.

* PayPal is supposed to be the barometer for 2002. It delayed its IPO on Feb. 6, after it was sued for patent infringement, but the company made it out the door on Feb. 14. PayPal is widely viewed as an IPO barometer because it’s a complete throwback to the Internet frenzy of 1999. It has racked up losses totaling more than $263 million in three years, and yet it believes it has a strong story to tell. Based on the market’s initial reaction, it believes the story.

PayPal raised $70.2 million in its public offering, selling 5.4 million shares for $13 each. With 59.8 million shares outstanding, PayPal had a market cap of $1.2 billion at the close of trading on Feb. 15. Wether or not its venture backers won or lost won’t be known until the lock-up period expires. That group is made up of Clearstone Venture Partners, Madison Dearborn Partners, Nokia Ventures and Sequoia Capital.

* Google, an Internet search engine/portal, may try to get out the door if PayPayl’s stock price holds up. The company claims it has no plans for an IPO this year, but The IPO Reporter, a Venture Economics publication, reports that sources close to the company say it will file to go public. With former Novell CEO Eric Schmidt at the helm, it’s only a matter of time. The respected technology executive didn’t take the CEO job to watch over a small private business. Fueling rumors of an IPO is the fact that Google became profitable in the second quarter of 2001 and posted about $50 million in revenue for the year. “When Google IPOs, everything is going to turn around,” a source close to the company told The IPO Reporter. “It will prove that a dotcom model can work and it will give investors confidence in the stock market.”

Others are more skeptical that any one company can jump-start the market, particularly after the dotcom boom and bust. Many VCs continue to repeat the mantra that it’s all about profits and every company will be treated differently. “What will interest investors most is old-fashioned revenue, growth, gross margins and profitability,” says Tom Simpson, managing partner of Northwest Venture Associates. That sounds altogether too logical. And the market, as everyone knows, is anything but. From VCJ’s vantage point, momentum investors are aching for some piece of solid evidence that the economy is showing steady growth, laying the groundwork for a rebound in corporate earnings. Once that happens, the feeding frenzy will begin anew – and VCs can start queuing up the companies that have been languishing in their portfolios.