The level of risk that IPO investors are willing to tolerate continues to plummet, and that spells trouble for venture-backed technology startups.
The meager number of VC-backed IPOs that priced in the first quarter illustrates the severity of the drop: four. That’s the lowest tally since the second quarter of 1978 and a 71% decline from the 14 VC-backed companies that priced in the fourth quarter of 2001.
In fact, of the more than $6.9 billion raised by U.S.-based companies in the first quarter, just $376.3 million (or 5.4%) came from VC-backed offerings. That’s a far cry from the 54% stake that VC-backed offerings had in the overall IPO trough in the fourth quarter.
A look at the sectors VC-backed IPOs derived from is further evidence of disdain for risk taking by IPO investors: a home builder and real estate developer (WCI Communities Inc.), a maker of user interface solutions for mobile communication devices (Synaptics Inc.) and a well-branded online payment service (PayPal). Despite its name, even ZymoGenetics Inc. wasn’t too far out in left field, as the company is a biopharmaceutical maker.
In a climate saturated by international conflicts, oil concerns and continued domestic economic uncertainty, offerings from emerging technologies are rarely getting tapped, as was the case with PayPal. The new issues market hadn’t seen an offering like it since Loudcloud’s IPO in March of 2001. Investors are also shunning especially risky sectors, such as biotechnology, as Lehman Brothers discovered when it pushed ZymoGenetics out in January. That stock has been the leading clunker of the new issues market this year.
“Bad news isn’t as bad as uncertainty,” says Ravi Chiruvolu, a general partner with Charter Venture Capital in Palo Alto, Calif. “With uncertainty you can’t model. If you can’t figure out your discount rate and you don’t have a sense of your cash flows and the moving parts, how are you supposed to take a company public?”
So why did PayPal’s offering get pushed above the watermark with investors? To begin with, lead underwriter Salomon Smith Barney priced the company attractively at $12 to $14 per share. Secondly, PayPal wasn’t looking to raise oodles of cash. In all, the company, which priced at $13 on Feb. 14, raised $70.2 million, a modest amount considering what IPOs once fetched.
However, a meager hit from PayPal isn’t likely to embolden other privately held tech companies to come out, says Steven Tuen, an analyst with IPO Value Monitor. “That was a special situation where the brand was so strong, especially among eBay users, that PayPal was able to post the kind of performance that it did. If they were obscure, I think they would have done rather poorly.”
Market vs. Metrics
Following the worst quarter for venture-backed IPOs in more than two decades, the VC community’s outlook for public exits for the remainder of the year is generally bearish. The majority of the VCs Venture Capital Journal spoke with say they don’t expect things to pick up until at least the fourth quarter. That jibes with what they said in the “2002 IPO Outook” VCJ cover story in March.
A successful IPO candidate must not only have strong revenue and be profitable, it must also have a market capitalization of between $150 million and $250 million, contends Rob Theis, a general partner with Doll Capital Management. “I don’t think a lot of institutions want to hold onto a stock position valued under $100 million,” he adds. “The only exception is the health care and biomedical arena. You can get public with much smaller numbers because the ramp in growth is so much faster.”
Further complicating matters, at least for tech companies, is that overall information technology spending is still down. “Most companies, even if they have critical mass, it doesn’t matter if they’re large or small, are relatively flat quarter to quarter. They’re not showing growth,” says Promod Haque, a general partner with Norwest Venture Partners in Palo Alto, Calif. “That has a lot to do with them not being able to get public.”
And that grim reality isn’t likely to change until next year. “Corporate IT spending is going to come back in a strong way, but for the balance of this year, we’ll probably see IT spending reflective of 2001, meaning spending in 2002 will be flat,” predicts Theis of Doll Capital.
Certainly, it isn’t as if venture capitalists were out of the action on the IPO front. After all, just 17 new issues took place in the first quarter, according to The IPO Reporter (a VCJ sister publication). That isn’t far off from the 20 deals priced in the same period last year. So while overall IPO action remains slow, it appears the real concern for venture-backed tech companies is not the market itself but whom the gatekeepers are now working with.
Another Brick in the Wall
VC’s biggest threat this year comes from a challenger they picked on first. Remember those reports touting the demise of “bricks and mortar” and the so-called “dinosaur theory?” Open mouth, insert foot. Spinoffs, or carve outs, from large corporations are all the rage on Wall Street. Playing to an audience of skittish and finicky investors, underwriters returned to their “old economy” connections and revamped a mutually beneficial business strategy.
Corporations are buried under debt loads after years of expansion, and are operating under a microscope amid Enron-esque concerns when it comes to acquisitions and partnerships. Spinning out divisions of corporations yields proceeds for the repayment of debt and produces the large underwriting fees Wall Street thrives on. And this is accomplished by selling IPO investors shares in corporate divisions backed by strong parents, not in start-up companies with new technology void of a mainstream appetite.
In the first quarter alone, six of the 17 companies that priced were carve out offerings. That compares to just 11 in all of 2001. And those six IPOs raised $8.4 billion, a far cry from the $376.3 million raised by VC-backed offerings in the first quarter.
How does a tiny tech company compete with the likes of Citigroup? It sent its insurance company, Travelers Property and Casualty Inc., out in stunning fashion, raising $3.9 billion in its March 21 public offering. Nestle S.A. carved out its most profitable division, eye care product maker Alcon Inc., on March 20 and raised $2.3 billion in fresh capital. Even a tobacco product maker found open arms from IPO investors, as the Carolina Group, a spinout from Lowes Corp., raised $876 million.
Given the concerns expressed on a global scale between politics and downed economies, it appears that IPO investors are not willing to hedge all their bets on dazzling new technology companies.
“VCs will have to pitch their portfolio companies to investment banks rather than the I-banks courting the companies,” says Randy Carver, a registered principal with Raymond James Financial Services Inc. “The road show is going to get reversed.”
“Why would you buy a stock at $16.00 a share when it could easily trade down and be worth much less?” asks Charter’s Chiruvolu. “There is a flight to certainty, and IPOs are the antithesis of certainty.”
Keeping such concerns in mind, where in the IPO picture can venture capitalists squeeze a portfolio company through this year? More than 20 venture backed companies have filed to go public this year (see chart, page 8). It’s a real mixed bag, indicating that neither VCs nor unerwriters have figured out what the market really wants.
When the market comes back, VCs expect companies in the defense, security, biotech, health care and enterprise infrastructure sectors to do well.
The key to success is not the sector but the fundamentals of the company, VCs say. For example, HealtheTech, a medical device company backed by Doll Capital and others, garnered a warm reception from the investment banking community, Theis says. The company expects to file an S-1 registration statement with the Securities and Exchange Commission soon and it could go public as early as the second quarter.
“In every one of the meetings where we presented, it was like the old days when I-banks would send 15 people to a meeting,” Theis says. “We had bake-off meetings where 10 to 15 bankers would show up to fight for the business, which proves the company has the right set of metrics to go public.”
Steve Bird of Focus Ventures agrees that it’s all about fundamentals now. “The problem isn’t the market and its willingness to accept IPOs, it’s the supply of IPOs,” he says. “We’re in an environment now and will continue to be in an environment for the foreseeable future in which the public market will accept IPOs, but they’re going to have to have more historically normal criteria.”
Prime IPO candidates, Bird says, should have between $30 million and $50 million in revenue, be growing at 30% to 50% per year and be profitable or within a quarter of profitability.
The only problem is that there aren’t many VC-backed technology startups that meet Bird’s criteria. Until they do, the IPO doldrums will continue for flashy but unprofitable tech companies.
Email Colleen Marie O’Connor at: