NEW YORK – In another sign that the Internet is rewriting the rules for some first-time stock issuers, select Web-related companies now are loftily informing strategic investors that they will have to pay up to participate in the anticipated aftermarket pop of their public market debuts.
That is a far cry from the traditional practice for capital-hungry start-ups, which is to allow strategic investors to acquire a discounted equity stake in a late-stage private financing just ahead of the initial public offering. By making the strategic investors cool their heels, issuers can capitalize on the cachet generated by the involvement of high-profile partners, while at the same time pocketing a bigger cut of the proceeds from the lucrative IPOs.
The latest example of the phenomenon: Drkoop.com Inc. The Texas-based online consumer-health care information network, founded by former Surgeon General Dr. C. Everett Koop, announced in May that it asked its underwriter to reserve one-third of its upcoming 9.3 million share IPO for a trio of potential strategic investors, including Dell Computer Corp. Each of the three companies will get the chance to purchase as much as $10 million in stock at the middle of the company’s pricing range, now at $7 to $9 a share.
DrKoop.com is not alone. High Speed Access Corp., a Denver-based cable modem company, is reserving more than $8 million of its pending IPO. Meanwhile, Northpoint Communications Group in early May reserved a total of $50 million of its $360 million IPO for Microsoft Corp. and Tandy Corp.
“Some of these companies are avoiding the final stage of VC and going public at a much earlier stage, so by definition the opportunity to make investments pre-IPO are down,” said Marc Paley, co-head of equity capital markets at Lehman Brothers.
That is because increasing venture dollars are chasing fewer deals, a trend which in turn has led to a shift in power from investor to issuer, said Nick Callinan, a managing director at Advent International Corp.
Companies that limit, or eliminate, late-stage venture financing in favor of reserving shares at the time of offering enjoy multiple rewards, said Steve Harmon, senior investment analyst with Internet.com. For starters, the company locks in a minimum amount of working capital and a target share price in defense of a softening market. In addition, the money raised goes straight into the company’s pocket, rather than to investors, who typically receive a 15% break for a late-stage investment in addition to a run-up in the stock post-offering.
“Plus, it’s a marketing thing: Let’s saddle up with a well-known brand here and make a strategic deal that raises our profile,” Mr. Harmon said.
For some investors, that reality can help offset other downsides of not getting in at a cheaper venture level, said Barry Newman, a senior managing director in technology investment banking at Banc of America Securities. “It’s a self-fulfilling prophecy,” he said. “Their involvement increases the value of the companies they invest in.”
There are other benefits to the investor, too. Buying at the IPO reduces much of the risk associated with early-round investing. Investors also have the ability to get a sizable block of shares at a set price – something that would not be possible once the stock were trading in the market. What’s more, strategic investors get a concrete position in the company at a price based on an institutional or whole basis, rather than a retail price.
Still, strategic venture investing is hardly going the way of the dinosaur. Cases like TheStreet.com Inc., which received $15 million from the New York Times Co. and another $7.5 million from Rupert Murdoch’s News Corp. prior to its IPO, remain the more common strategic investment scenario. “You wouldn’t [buy in at the IPO] on a more normal stock,” Mr. Callinan adds. “If you had just a regular IPO and you were a large company coming in, you’d be trying to come in at the mezzanine round or to a discount of the IPO.”
But with the lifecycle of start-up technology companies accelerating so rapidly – to as short as 18 months as opposed to what in other sectors can be as long as five years – the phenomenon looks likely to continue, equity experts said. Start-ups are coming to market so fast that corporate giants do not have time to find out about them in early investment rounds. So reserved share arrangements allow big companies to invest in start-ups, even if they missed out earlier.
Therefore, the arrangement benefits large companies equally or more than the small ones, Mr. Harmon argued.
“I call it extended R&D,” he said. “It gives bigger companies an ability to get a pulse on the next wave [of innovation] and an ability to tap into that knowledge base.”