They were partying like it was 1999 all over again. Well, almost. Taken public at a monster $1 billion valuation, Orbitz, the travel Web site backed by the world’s largest airlines, was the first of what promises to be several new Internet IPOs (and new pure technology IPOs) waiting at the gates of the public markets. It’s been a long wait indeed.
The fourth quarter of 2003 saw the largest number of venture-backed companies go public in a single quarter since late 2000, according to Thomson Venture Economics and the National Venture Capital Association. Seventeen venture-backed companies went public – raising $1.05 billion – in Q4, compared to 21 companies that entered the public markets in Q4 of 2000. Not only did this represent good news that three years of nuclear winter for IPOs has thawed, but also it signaled a pipeline of deals for 2004, which should finally give VCs something to cheer about. All told, 31 venture-backed companies filed with the SEC during 2003 and are preparing their debuts in 2004. That some of these names include Salesforce.com – a well-established brand in the technology software community – and potentially Google, which is widely expected to be the deal of the year, makes it all the more exciting and potentially very lucrative.
Looks like a boon for VCs finally. Finally! Real exit opportunities stand to prove that general partners’ and limited partners’ staying power and support of portfolio companies will finally pay off. Still, there’s a catch.
This time around, we should not be so eager to reap the spoils of our long wait. Even though the public markets are cooperating as an economic recovery gains its legs, going public too soon could be to the detriment of us all.
“If bankers are moving aggressively, VCs are moving even more aggressively in getting companies to market,” says Bradley Smith, managing director for BancAmerica Securities’ West Coast Equity Capital Markets group. “That doesn’t mean bankers and VCs are being reckless about which companies they’ll bring public. But what we are seeing now is more immediate selling by financial interests choosing to take money out of their investments far earlier than before. In fact, the market for secondary selling immediately after the offering is very, very active.”
It’s a phenomenon that’s completely understandable. With at least half of our VC ranks getting thinned over the past three years, Darwinism has not only applied to portfolio companies, but to our own industry colleagues as well, particularly those who were unable to show any returns for their limited partners during the technology boom or at any point thereafter. In that sense, if VCs have felt the pain of the downturn, our limited partners have felt it twofold, thereby requiring returns on their capital now if for no other reason than to prove we should still keep our jobs – and they should keep theirs. That we can pull returns out of new IPOs at what appears to be increasingly generous (though not overly so) public market valuations, all the better.
Get the Timing Right
The question for VCs then becomes one of restraint vs. timing. If Orbitz can go public, if Salesforce.com can file, if Google can be hailed as the second coming of the Internet, what’s to stop us from dumping our entire portfolios into the hands of investment bankers and letting them have at it, putting the greater fool theory into action once again?
There’s actually quite a lot stopping us from doing so, and VCs would be shortsighted not to see it.
First, we are just at the bare upslope of a resurrection in capital spending on technology within the corporate enterprise, and I would offer that even the corporations themselves don’t know how long they will allow a loosening of their purse strings in order to patch holes in their technology infrastructure. Second, many of the RFPs suddenly in the market are not wholesale purchases of next-generation technology systems, whether they are for enterprise software deals or optical networking gear. Purchases are being made in patchwork fashion: fixing gaps in technology, forcing software providers to sell on a pay- as-you-go basis, requiring telecom equipment manufacturers to justify at least a 2X return on the products and services being purchased. In this sense, capital expenditure visibility remains, if not cloudy, at least surrounded by a dense haze.
Third, I would offer that brands alone – perhaps Google being the sole exception – do not business models make, at least in terms of growth from startup to adolescence. And they should not be counted on for sustainable post-IPO share price appreciation.
Fourth, and last, the competition for investor dollars for companies going public will be far more intense and selective this time around. Not only do investors remember how severely they were burned when the market took away IPO gains in such high-flyers as Corvis and Juniper, but the quality of the deals hitting the public markets has had far more time to mature and thus the quality of investment opportunities has risen to a higher level, at least in theory.
Taken together, IPOs should not be seen as the lay-up exit opportunity they might appear to be, even with the slate of 30-plus deals in registration. Yet, with all of that said, “Investors are willing to move further out on the risk spectrum in terms of what they’ll look at to invest in right now,” says Nadir Shaikh, a vice president in Banc-America Securities tech banking group. “That’s not to say they still won’t want to understand the business plan to make sure the deals will work and that companies have at least one quarter of profitability under their belts. It just means that if investors are willing to look at a sector like semiconductors, they are now more willing to count on a further bounce back in the semi industry when weighing an established semiconductor company interested in going public.”
The trick for VCs is knowing which companies to bring to market when, and which companies to hold back for a rainy day. This is under the assumption that LPs would like to start seeing returns now and may hold it against us as general partners if we do not allow even the half-ripe portfolio companies to exit into the public markets, despite whether that backfired on us the last time around.
If you are a Kleiner Perkins or a Sequoia, you don’t have such worries. Not when your first-round combined investment in Google is $25 million on a $62.5 million valuation and your track record alone will carry you into your next successive round of funding. For the rest of us, however, it’s conceivably show time. The pressures on VCs have once again returned to take some of their companies into the public markets (perhaps even prematurely), sell shares quickly after the offering, and prove to LPs that their long wait for returns is finally over.
Yet, if you don’t have a Google in your portfolio, how do you determine the benchmark standards for what the market will embrace under theoretically more highly conservative investor requirements? For bankers like Smith and Shaikh, there are still no minimum requirements in terms of revenue and profitability, though both allow that at least one quarter of positive earnings and a strong enough track record of trailing 12 month revenue are the basics from which most offerings should make their debut. (Orbitz window-dressed itself into profitability by slashing marketing costs the quarter before its IPO.)
There appears to be no rhyme or reason for VCs to follow. Synnex, an IT supply chain services company, went public on $2.87 billion in revenue for the first nine months of 2003, with net income of $21.4 million. On the other hand, Open Solutions, a company which develops technologies for the banking sector, generated net income of just $1.7 million on $43.4 million in sales and was still able to trade above its offer price of $17 per share on its first day of trading.
Meanwhile, Kintera, which sells software to help non-profit groups raise money, was able to float 4.5 million shares on its IPO through SG Cowen at an offer price of $7 per share – with shares trading higher still on its first day – despite posting a loss of $6.9 million on revenue of $7.2 million for the first nine months of 2003.
And as if that wasn’t confusing enough for those of us who thought the bar had been raised on IPOs from three years ago, wireless-chip software maker Atheros Communications Inc. filed in November to raise up to $100 million in an IPO with Morgan Stanley, even though the Sunnyvale, Calif.-based company posted a loss of $22 million on $22 million in revenue last year. Did we completely forget our hard-earned lessons that companies, if not profitable, should at least have a clear and preferably immediate path to profitability?
Though the Kintera deal capped a trying year for IPOs in 2003, the 84 deals that came to market (raising a total of $14.86 billion) may soon be dwarfed by a 2004 IPO market potentially suffering from short-term memory loss. I’ll be the first VC in line to take mature portfolio companies public in the hopes of gaining liquidity for shareholders and a further base of capital to continue a company’s growth. I just hope that what’s not forgotten in that process is that these companies must be ready to leverage the capital raised in an IPO into future meaningful growth for the company and its new set of shareholders. If, as VCs, we don’t stay mindful of that, history will once again not look kindly upon us.
Ravi Chiruvolu, a general partner of Charter Venture Capital, is a regular technology columnist for VCJ. Chiruvolu specializes in enterprise software, software infrastructure, e-business and wireless technologies. He sits on the boards of Ellie Mae, ManageStar, Niku (NASDAQ: NIKU), Quantum3D, Talaris, Verano and Winery Exchange.If you’d like to send him feedback or ideas, email him at