Try having a conversation about the current trend in mergers and acquisitions without using the word “growth” or any form of “consolidate.”
It could be difficult, as venture capitalists who were asked to discuss increased sales of VC-backed companies found out.
Consolidation in a diversity of industries, ranging from networking to medical devices, motivated buyers last year. VCs also saw larger companies snapping up smaller players to please Wall Street with growth.
And besides this, Bessemer Venture Partners’ Chris Gabrieli says larger companies are moving away from what he calls “internal-only thinking.”
“I think there’s an unprecedented level of appreciation by large companies that they really benefit from acquiring small companies to build their businesses,” Mr. Gabrieli says.
Although some venture capitalists don’t think last year’s boost in M&A was principally caused by a parched IPO market, it should be noted that 1998 was a slow year for initial public offerings: Only 77 hit the boards, compared with 1997’s 134 and 1996’s incredible 276 (VCJ, February, page 44).
Sales of venture-backed companies totaled 186 last year, 26 more than 1997’s 160 and 85 more than 1996’s 101, according to Venture Economics Information Services, a data provider owned by the same corporate parent as VCJ.
The average sales price for companies in all sectors escalated in 1998 to $79.21 million from 1996’s $66.41 million. But last year’s figure fell short of 1996’s $83.58 million average. And pricing varied dramatically from industry to industry, with communications companies the big winners, biotechnology and medical/health companies the big losers.
VCs are divided over exit preferences – some strongly favor IPOs, some want sales, still others say it’s hard to generalize which is better.
August Capital’s Mark Wilson is squarely in the IPO camp, although he won’t rule out M&A as he balances the risk and reward of a company’s future: what he can build versus what someone is offering to pay.
August Capital portfolio companies – all in the information-technology sector, broadly defined, have three IPOs for every merger, he says, and he prefers going public to a sale. “Mostly, it’s psychological,” he says. “The reason people get up in the morning is to work with great companies.”
Frazier & Co. General Partner Nader Naini has a different take. He invests in health-care services companies, and his firm focuses exclusively on life sciences and health-care companies. None of Mr. Naini’s companies went public last year, and he has come to favor sales. “I think that it’s a cleaner strategy,” he says, explaining that larger companies need to grow to keep stockholders happy, and they look to purchases as a way to bulk up. “If we can provide them with that prey, it works out nicely,” he says.
Alan Frazier, Mr. Naini’s biotech/medical devices-focused colleague, also favors M&A. In any given year, he expects two-thirds to three-fourths of the firm’s exits to be via M&A.
Meanwhile, Foundation Capitals Paul Koontz walks a middle line, preparing companies for IPOs but remaining open to sales. “We never invest where we don’t think there’s a chance to build an independent company,” he says. “In our view, investing to be acquired is just too risky.” Foundation backs IT and communications enterprises.
Weighing the Options
Not surprisingly, a firm’s industry focus plays into its exit preference. Frazier & Co. currently looks to sales because its companies, especially those that produce medical devices, tend to be focused on one product, which often cannot support a free-standing public company. Besides, the market for small-cap biotech and medical device stocks has been lackluster.
IT investors, however, have been busy weighing the enhanced liquidity of a sale with the potential upside of post-IPO stock prices, keeping in mind the possibility that a public portfolio company could tank instead of soar.
Of course, there is more to consider in picking an exit than just the business a portfolio company is in. There is the health of the company and also what might be gained from having a new owner.
Mr. Koontz says he sees two reasons to sell: to give a poorly performing company “a home” or to give a young company some form of valuable leverage.
In the technology world, big buyers can offer distribution channels. In networking, purchasers also offer greater visibility and a built-in customer base. Biotech and medical device buyers have the cash to fund product development through Food and Drug Administration approval.
M&A exits also can work to a venture capitalist’s advantage.
Sales obviously grant much better liquidity, as VCs – and company managers – get stock and/or cash right away, and the bigger company’s shares likely will be easier to unload.
That conflicts sharply with the scenario in an IPO. To begin with, the offering might not put out enough shares for VCs to gain liquidity. Additionally, venture investors must contend with lock-ups established by investment banks, which keep VCs from selling their shares for at least three months and usually six. Even once the lock-up ends, venture capitalists have to hold their shares for a week or two to keep from selling at a lower price to potential buyers looking to take advantage of shareholders’ readiness to sell.
And while successful IPOs can bring in more money to venture firms than sales, the public market doesn’t necessarily provide better return-on-investment figures. As Mr. Koontz explains, companies that go public often are in a portfolio five or six years before an IPO, but sales come much earlier in a company’s development, often in about two years.
Making predictions for 1999, most VCs expect little change in the M&A market, and few expect strategic buyers to lose interest. Some changes to current Securities and Exchange Commission regulations, however, may add a new dynamic.
Sutter Hill Ventures’ Paul Wythes recalls when acquirers wanted to assure a purchase would be accretive to earnings. Today, companies just write off large chunks of the cost of a purchase as in-process research-and-development (IPR&D) and tell investors and Wall Street that while the purchase will hurt earnings this year, the company will be back on track the following year.
However, Mr. Wythes cautions that an SEC crackdown on IPR&D write-offs (VCJ, March, page 5) could dampen would-be buyers’ interest. When accounting for the difference between a purchased company’s assets and the higher sales price, acquirers often chalk some of it up to the value of research and development underway at the purchased enterprise. Otherwise, the acquirer would have to count that difference as “goodwill” and amortize it over several years. By using an IPR&D write-off, the buyer takes a one-time hit against earnings, not over several years.
In general, however, Mr. Frazier expects life-sciences and health-care companies to continue looking for sales, mostly because they must. As the public markets hold these industries out of favor and VCs shy away from them as well, there are few other choices.
Big Increases, Declines Tell a Story
But even M&A wasn’t particularly kind to venture-backed health-care, medical and biotechnology companies last year. Thirteen venture-backed biotechnology companies were sold last year, compared with 10 in 1997. Nineteen medical/health enterprises were bought, an increase of one from 1997.
The bigger story, however, is in the average prices for these companies.
Biotechnology company sale prices averaged $24.14 million last year, down dramatically from 1997’s $60.92 million and 1996’s $48.53 million. Last year’s figure is better, however, than 1995’s $18.27 million or 1994’s $19.38 million.
Medical/health sales prices have been tumbling since 1995’s average of $77.69 million. The figure slid to $71.55 in 1996 and continued falling to $53.24 million in 1997. The average slumped to $38.78 million last year.
The picture was much brighter when it came to communications, computers and electronics companies.
From 1993 to 1998, the computer sector has sold more venture-backed companies each year than any other industry. In 1998, 78 computer enterprises were sold, an increase from 1997’s 64 and 1996’s 34. Twenty-three communications companies were sold last year, a decrease of one from 1997 and an increase from 1996’s 19. Electronics sales have seen a steady, if modest, increase in sales since 1995. That year, five enterprises were sold. The figure edged up to six in 1996, then to nine in 1997 and 12 last year.
But, again, the more significant news is in the average prices.
Between 1993 and 1998, communications companies have had the highest average sales price, coming in at $168.23 million in 1998, topping both 1997’s $117.63 million and 1996’s $112.18 million.
Electronics businesses raked in an average of $101.40 million last year, a sharp increase from 1997’s $18.71 million average and 1996’s paltry $4.61 million.
Computer companies’ sale prices averaged $64.64 million last year, a mild increase from 1997’s $58.29 million, but nowhere near 1996’s $96.94 million.
It should be noted that average sales prices are calculated from deals in which the prices were disclosed, which are roughly two-thirds of the total known sales in 1993 through 1998.
M/C Venture Partners’ Jim Wade knows acquirers’ appetite for communications companies. “I think a lot of our business plans are centered at looking at where the market trends are going, where we believe the large telecom companies need to be,” he said. “But they don’t have the management or the resources to do it at once, so we go in and fill a hole and are ahead of a subsequent wave of consolidation [that pulls M/C portfolio companies in.]”
Mr. Wade also has a theory to explain the lofty prices communications companies notched in 1998. Debt markets, and the high-yield debt market in particular, were very open to telecom companies in 1997 and early 1998, he says. Cheap and available capital allowed companies to grow so when they were finally sold, they were bigger and more expensive. The debt markets constricted last summer and although they have rebounded somewhat, they are not as ebullient as they were, Mr. Wade notes. He was reluctant to make M&A predictions for 1999, but says the year kicked off with a highly profitable sale for his firm.
In January, M/C sold Ovation Communications, a Midwestern local-exchange carrier, to McLeod USA, a larger phone company. For its $31.5 million investment, M/C reaped McLeod stock valued at about $275 million at press time. M/C had owned more than three-fourths of Ovation.
“I think we always perceived that there would be a strategic buyer that would come and be interested,” he says of Ovation, which is really a combination of two M/C portfolio companies.
M/C had backed Phone Michigan, another Midwestern CLEC, in 1996; meanwhile, Ovation, which had originated within M/C, was up and running by late 1997. When a mid-1998 sale of Phone Michigan fell through, M/C folded the company into Minnesota-based Ovation last October, giving Phone Michigan founder Brad Evans his desired liquidity. M/C had invested $8 million in Phone Michigan and $23.5 million in Ovation.
“It made a lot of sense to put the two of them together to create a regional play, both to access cheaper capital and, perhaps, ultimately to enhance exit,” Mr. Wade says.
After the Phone Michigan merger, Ovation was negotiating a $175 million line of credit when McLeod came calling.
Few M/C deals have gone public, given the firm’s current focus on telecom and its previous focus on media and cable companies, which is now the province of spin-out firm Great Hill Partners (VCJ, January, page 18).
“We’re less interested, ultimately, in looking for exits from the public markets than some of the larger venture-backed companies that are trying to create national footprints from day one,” Mr. Wade explains.
Highest Disclosed Sales Prices for VC-Backed Companies in 1998Company Bought Acquirer Price (in $ millions)
Horizon Cellular Telephone Co. Prime Retail Inc. $867.3
Sygnet Wireless Inc. Dobson Communications Corp. $643.98
Aptis Communications Inc. Northern Telecom Ltd. $287.81
Advanced Computer Ericsson TelefonAB $285
Preferred Payment Systems Inc. Concentra Managed Care $263.03
Ambit Design Systems Inc. Cadence Design Systems Inc. $260
Atlantic Cellular Co., L.P. Rural Cellular Corp. $256
Berkeley Networks Inc. FORE Systems Inc. $232.34
Prominet Corp. Lucent Technologies Inc. $200
Cooper Smith Inc. Earthgrains Inc. $193
Source: Venture Economics Information Services