TechTalk: Grab a PIPE –

DigitalThink wasn’t a bargain; it was a steal. Less than a year ago, the San Francisco, Calif.-based e-learning software and services company was trading at $1 per share. DigitalThink’s market capitalization was $40 million, it had $30 million in cash in the bank and was generating revenue of roughly $40 million per year.

“The market was basically valuing the company at $10 million if you take out the cash,” says Steve Eskenazi, a general partner with WaldenVC, the San Francisco-based venture firm whose charter allows it to invest in public as well as private equities. (WaldenVC often makes private investments in public equities, or PIPEs, with up to 20% of its fund.) “So at one times revenue we bought part of DigitalThink. It was two to four quarters away from cash flow break-even, we were able to take a board seat and gain all the same information flow we would normally get if we had invested in a private company.”

For Walden, it was one helluva buy. By May of this year the stock was trading above $3 per share with a market cap of $120 million. Suddenly, at three times revenue, DigitalThink was back to being valued as if it were a sought after venture-backed startup, with the added bonus of having the liquidity of a publicly traded company. “It was a way of making venture-like returns in five to seven quarters rather than over five to seven years,” says Eskenazi. Ask other private equity and venture capital investors who have bought into fallen angels and they’ll tell you the same thing-usually with a smile on their face.

Venture capitalists smiling? What’s wrong with this picture? Perhaps nothing at all. Whether taking advantage of a temporal shift in the market that now favors public equity micro-cap bargains over private equity risk, or simply acting as savvier investors on behalf of their limited partners, venture capitalists now view the public markets like most investors, with renewed enthusiasm. And rather than sitting on the sidelines waiting for the IPO window to open, VCs have taken the initiative to treat already public companies as if they’re simply startups that went public too soon. It’s also an opportunity for the VC industry, which grew too fast in the late 1990s and early 2000s to work through its $80 billion overhang of capital.

“We do the same due diligence, offer the same type of coaching and help in terms of recruiting, business development and technology expertise with public companies as we do with our private companies,” says Eskenazi. And he’s not alone. Though Charter has barely dipped its toe in public equity investments, other firms, including Azure Capital, Institutional Venture Partners and even Kleiner Perkins Caufield & Byers are growing more active by the day. Kleiner invested in Juniper Networks as a public company after helping develop the company as a private startup. It doesn’t take a brain surgeon to see why.

Confluence of Events

Along with the market’s collapse came a series of market mechanisms that automatically kicked in. The first was a pure lack of capital for already public companies that, though public too early, still had a chance at survival. Any number of micro-cap biotech companies would fit this scenario. Kate Winkler and Harlan Kleiman of Shoreline Pacific, a Sausalito, Calif.-based PIPE firm, are betting on this scenario. They are forming a specialized PIPE fund to invest solely in micro-cap biotech stocks valued at $150 million or less.

By looking at investing in companies like revenue-less Pro-Pharmaceuticals Inc., private equity investors like Winkler and Kleiman can offer the cancer therapeutics company enough capital to get beyond Phase I FDA trials, through Phase II trials and into the market. Echoing Eskenazi, Kleiman says: “In just eight to 24 months, our investors can make the same kinds of returns that VCs wait five to seven years for, or more!”

The second market mechanism was the loss of not only investment banking research coverage, but also the ability for large institutional funds to hold these shares. As valuations plummeted, most funds had restrictions on holding sub-$5 stocks, sub-$100 million valued companies or even on holding companies whose average daily volumes dipped to drastically illiquid levels. As a result, VC firms and private equity players like Walden or Shoreline can offer capital to not only prop up beaten-down public companies, but they can add investor relations expertise in shopping such fallen angels around to an entirely new subset of micro-cap or other private equity investors.

Third, because Wall Street’s investment banking business dried up, bankers and a variety of market participants had to seek whole new streams of revenue to make up for the dearth of IPOs and M&A activity. That led to a increase in PIPE deals as well as a dramatic rise in convertible notes (the AskJeeves deal) and deals to buy large chunks of stock directly from insiders or large shareholders. “The PIPEs of two years ago were PIPEs of desperation by the seller,” says Eskenazi. “But now, the PIPEs of last year were generated by the banks and funds who saw a future in these companies.”

Acid Test

If there’s any downside to the PIPE market it’s that PIPEs for the longest time had the tarnished reputation of being “toxic.” If a company needed a PIPE, usually as money of last resort, it often came with onerous terms in favor of preferred shareholders that allowed investors to short the stock and drive down the share price, triggering obligations for even more shares of the company until management and common stockholders were left with nothing.

“We call it a distinction between investing in the security and investing in the company,” says Steve Becker, who runs the Special Situations Private Equity Fund, a PIPE fund based in New York. “We like to be long on the company.” Mr. Kleiman agrees. “We’re a long fund, not a short fund. There’s a rule of thumb companies should know: If the investors can make more money on the stock going down than on the stock going up, don’t do the deal.”

Clearly, Wall Street and Sand Hill Road agree on the new legitimacy of PIPEs. More than 900 PIPE deals were done last year, in contrast to just 72 IPOs, according to Shoreline Pacific. Examples of such so-called “good” PIPEs include Amazon’s $100 million CS First Boston financing in 2001, Liberty Media’s $141 million PIPE in February 2003, and Sirius Satellite Radio’s $200 million deal in March 2003. Not only have shares in these companies appreciated, but also because PIPE deals are privately negotiated with the company often at the standard 15% discount or more, the returns for PIPE investors are even greater than for average retail investors in these stocks.

Private equity money in public equity markets is offering a new sense of legitimacy for companies seen as abandoned, under-followed, undercapitalized and public before their time. Though the new legitimacy for PIPEs is likely permanent, whether the phenomenon of VCs and private equity investors capitalizing on the current public company/private company arbitrage is temporal or permanent remains to be seen. Clearly, the current arbitrage is profound.

Take a company like Niku. The Redwood City, Calif.-based enterprise portfolio management software firm has a run rate of $50 million, is profitable, has $20 million in cash and is attacking a niche in a large and growing enterprise software segment: market IT management and governance. Yet, its valuation until recently was less than one times sales. Yet, in February 2003, WaldenVC along with insiders were able to invest $10.5 million into this solid, profitable company at far less than one times sales. This is not only cheap when compared to profitable, enterprise software companies (three to five times sales is a more reasonable multiple), but it is much cheaper than even its smaller and unprofitable private company peers. It is this arbitrage, provided investors are willing to face the added challenges of investing in public companies (e.g., a more complex deal structure, longer approval processes, added costs/liabilities), that will significantly boost player returns for those investing now.

If structured wisely, investing in the right public companies also has a significantly better risk/return ratio and liquidity outlook than comparable private companies. As Warren Buffett likes to say: “In the short term, the stock market is like a voting machine, and in the long term a weighing machine.”

Yet, not all VCs are short-term PIPE-fitters; and for good reason. First, for many firms it’s simply not in their charters to invest in any way in the public markets. Second, PIPE transactions can be more complicated-and far more transparent-than venture deals. With complications comes added risk, something most VCs would rather live without. Last, the newer more legitimate PIPEs are for common stock, rather than preferred. With common, there are no liquidity preferences promising a two to three times return on your money. There rarely are extra stock options granted for shareholders and management. And it’s less likely that VCs would find that such deals include board seats with their investment.

In other words, PIPEs and other private equity deals in public companies aren’t for every firm. But for those with the guts and charters to allow such investing, selective PIPE investments seem like a great way to make money at a time when we all could use a few returns. A downright license to steal.

Ravi Chiruvolu, a general partner of Charter Venture Capital, is a regular technology columnist for VCJ. If you’d like to send him feedback or ideas, email him at