Pity the venture capitalist with a financially sound startup that’s ready to go public. Accounting scandals, CEO misdeeds and a bear market have all but assured that the only thing to make it through the IPO window anytime soon is a brick thrown by a disgruntled shareholder.
Predictions of a second-half recovery in the IPO market (made in these pages in March) look as probable as a 2004 presidential bid by Kenneth Lay. The odds of a venture-backed IPO getting out the door are just as bad: “Right now it’s zero-don’t even think about it,” says Barr Dolan, a general partner at Charter Venture Capital. The way he sees it, healthy demand for venture-backed IPOs won’t return for at least six months “if you’re an optimist” or 18 months “if you’re not.”
Some VCs are hesitant to even look into the crystal ball. “The problem with predicting is that every time we think it’s getting better, we keep getting hit in the side of the head with a two-by-four with another unknown calamity-whether it’s Sept. 11 or accounting scandals,” says Tom Simpson, managing partner of Northwest Venture Associates.
For now, the venture community will have to be satisfied with the better-than-expected performance of venture-backed IPOs in the first half of the year.
In spite of wild stock market swings, VCs have done relatively well on the IPO front. As of July 11, 38 venture backers held IPO shares worth $2.3 billion, up 10% from the offering prices of the newly issued shares (see chart on this page). And that doesn’t take into account the steep discount at which VCs buy their shares. For example, Sequoia Capital bought into PayPal (Nasdaq: PYPL), which closed at $23.08 a share on July 15, at a cost-adjusted basis of $1.66 per share. It stands to make about 14 times times its money when it cashes out of the company.
The consensus among VCs at the start of 2001 was that the market would start to recover in the second half or the fourth quarter. With just four venture-backed companies going public in the first quarter, that bleak outlook seemed pretty realistic.
The 14 VC-backed IPOs in the second quarter (see chart on page 12 for complete listing) surprised just about everyone. The new issues raised $1.39 billion, the second-best showing in the past six quarters, just behind the 14 new issues that raised $1.45 billion in the fourth quarter of last year. For the full six months of this year, 18 venture-backed companies went public, raising $1.8 billion. Before the crisis of confidence, VC-backed IPOs looked to be on pace to match their 2001 performance, when 37 venture-backed startups raised $3.1 billion.
VC-backed issues made up 37% of the total number (49) and 12% of the total dollar amount raised ($15 billion) by all U.S. IPOs in the first six months of the year.
Under the Hood
While more new issues got out than expected, you need to take a close look at the aftermarket figures to get an accurate picture of what has transpired. The average price of the 18 new issues was $15.09 on July 15, up 7.9% from an average offering price of $13.98. But if you take out the two biggest gainers-Jetblue and PayPal, which were up 59.3% and 77.5%, respectively, during that time frame-the average share price on July 15 is down 2.8% from its offer price. Of the 18 new issues, seven were trading below their offering prices on July 15.
The biggest loser in the group is PrintCafe Software, which was backed by Harbourvest Partners, J&W Seligman, Mellon Ventures, Menlo Ventures and OVP Venture Partners. The company, which makes supply chain software for printing companies and their customers, priced at $10 per share on June 18, closed at $8 on its first day of trading and fell all the way to $4.70 by July 15.
Health-related issues were spotty. On the one hand, you have the dismal performance of Zymogenetics (Nasdaq: ZGEN)-backed by at least half a dozen respected VCs, including Apax Partners, Mayfield and Warburg Pincus. It emerged with an offering in January that fetched $120 million. At an offer price of $12 per share, all seemed well for the biopharmaceutical company. But by July 15, little Zymo was trading at $6.55.
On the other hand, generic drug maker Eon Labs was holding steady around its issue price of $15, while medical device and equipment makers CTI Molecular Imaging and Quinton Cardiology were up 6% and 24%, respectively, and temporary nursing provider Medical Staffing Network was up 5% during that same period of time.
Still, health care is only for the brave-and profitable. Consider the struggle of UBS Warburg, which made repeated attempts this spring to get Alliance Medical Corp. out of the pipeline. The venture-backed company, which makes orthopedic devices, officially withdrew in March. American Medical Laboratories and Altus Medical Inc. also yanked their offers.
Even if you get out, you could face a bumpy ride. After postponing an offering back in 2000, Kyphon Inc. (Nasdaq: KYPH), a medical device maker backed by Investor Growth Capital, Vertical Fund Associates, Warburg Pincus Ventures and others, priced at the top of its range and closed $2.05 above its offering price ($15) on its first day of trading on May 17. But since then, it has retreated steadily, closing at $12 per share on July 15.
Only in a market as unpredicatable as the one we’re in now would Internet-related deals look more attractive than health care offerings. Online payment service PayPal (which has agreed to be acquired by EBay (Nasdaq: EBAY) has posted the largest percentage gain in share price-77.5%-out of the crop of 18 new venture-backed issues. And Netflix (Nasdaq: NFLX), which rents DVDs over the Internet, closed at $1 above its $15 IPO price on July 15. Not bad, given current affairs.
Both companies have subscriber-based models and tout themselves not as dot-coms but as businesses that just happen to work through the Internet. “Wall Street loves subscriber revenue because it ensures predictability, a recurring revenue stream,” says Morningstar.com analyst George Nichols.
Predicting what will spark a late year rally is like guessing if a bathing suit from a catalog will fit. Simpson of Northwest Venture Associates says it’s a crapshoot. “The bottom line on the IPO thing is nobody knows when it’s going to come back,” he says. “However, the one thing that is for certain is when it comes back it’s going to surprise everybody. … It’s going to happen slowly, and it’s going to happen with a couple of oddball, contrarian, basic businesses that do really well and take off and illustrate the mainstay of our economy, which is businesses that make money and grow profitably.”
Charter’s Dolan agrees with the conventional wisdom that healthy financials are king. “The first companies to go out will be solid companies with $20 million in sales, good growth windows and profits-companies that have been around a while,” he says.
If a company meets those criteria, it won’t really matter what sector it’s in, as long as the overall market is receptive to IPOs, he says. “After those companies get out, there may be room for some more-speculative issues,” Dolan says. “Liquidation events in VC [in the short term] will be mostly M&A. That stuff I’m not so grim on.”
The spooks over at the CIA’s VC arm, In-Q-Tel, aren’t any more bullish than their private sector brethren. “There’s a direct relationship between valuations and liquidity events: As the valuations have declined, it’s because of the lack of liquidity, and I think it’s going to be more of the same for the rest of the year,” says Eric Kaufmann, a vice president and partner at In-Q-Tel. “I think [a comeback] is sometime next year.” What about IPOs related to defense? “I’d bet on tech and homeland security rather than having a tank on every corner,” he says.
Securities analysts aren’t any more bullish than those in private equity. Morningstar’s Nichols sees a pickup by the end of the year, “but I imagine it won’t happen before the holiday season,” he says.
Randy Carver, registered principal at Raymond James Financial Services, predicts that the “tech area will not see a good rebound until Q1 or Q2 of 2003, however we will see other areas do OK, as investors look for places to invest. Q3/Q4 could be decent for non-tech IPOs.”
Why should investors go through the turmoil of VC-backed IPOs when they can get close to a sure thing through a spinout offering? Investors have heavily favored spinout offerings since Philip Morris spun out Kraft (NYSE: KFT) to the tune of $8.6 billion last year. One New York-based IPO analyst says spinouts carry the closet thing to a “sold” sign on an allocation this year.
This year seven spinouts went public, pulling in $12.3 billion, dwarfing the amount raised by venture-backed IPOs.
You didn’t honestly think this story would end on an upbeat note, did you?