Will Digital Theater’s IPO Lead a Recovery in the Second-Half? –

For most VCs it has been a summer of dull. But for the few who managed to be part of the three venture-backed initial public offerings in the first half of the year, it has been fun in the sun.

Pardon the partners at Mohr, Davidow Ventures (MDV) if they can’t stop smiling. They were the biggest venture-backed IPO winner at the midpoint of the year, with 5.3 million shares of FormFactor (NASDAQ: FORM) valued at more than $100 million on July 11 (see chart, page 10).

In all, 12 venture firms cashed in on the first half’s three IPOs: FormFactor, Accredited Home Lenders (NASDAQ: LEND) and iPayment (NASDAQ: IPMT). As a group, the venture firms’ shares were worth a collective $350 million on July 11. And that’s not counting the $14.4 million that Crosspoint Venture Partners, Enterprise Partners Venture Capital and Ocean Park Ventures collectively made when they sold shares in Accredited’s IPO.

A Little Rain

As good as the news is for a dozen VCs, it’s still gloomy for the rest of the firms sitting on the sidelines. The three IPOs as of June 30 compare with 18 venture-backed companies that went public during the same period last year, according to research by Thomson Venture Economics (publisher of VCJ) and the National Venture Capital Association. In total, just eight U.S.-based companies went public in the first half of 2003, compared to 61 in the first half of 2002 (see chart, page 11).

That has VCs and analysts looking for an uptick. “I would say the outlook is brighter for the second half of the year than what we’ve seen,” says John Fitzgibbon, a veteran IPO analyst at 123Jump.com, a financial news Web site. “There are some good, solid names on the calendar. The climate is changing, too, because the fear factor is no longer there about stocks. The numbers are saying the worst is over.”

Fitzgibbon notes that the NASDAQ, S&P500 and Dow Jones Industrial Average are all bull markets, having recovered 20% or more from their previous bottoms. Whether the bull market will continue is anyone’s guess, but analysts say two factors should help it: the Bush administration’s elimination of the dividend tax and the resurgence of the markets, which might prompt some investors to reinvest their gains.

Despite the patch of blue, venture capitalists aren’t convinced that the dark clouds have passed. “I do see a window opening, but not in the near future,” says Andrew Goldfarb, executive managing director with Globespan Capital Partners. “I think that the public markets are not available to private equity-backed companies at this point, but they will be available at some point in the future. The exact timing is tough to predict.” His best guess is about 18 months out.

Big Hunker

Barry Stewart, a former managing director of Dolphin Equity Partners, is even more pessimistic. “It will take a number of years for a robust IPO market to re-materialize,” says Stewart, who is now a senior investment professional focused on investing in public communications companies with Principled Capital, a hedge fund based in New York. “The VCs are trying to hunker down and focus on fewer companies, making sure they’re fundamentally sound companies and weather a long drought of exit opportunities,” Stewart says. (He notes that his opinions are his own, not his firm’s.)

Dan Burstein, a managing partner with Millennium Technology Ventures, adds: “There is probably too much pent up enthusiasm from all the depression we’ve experienced over the past few years. People may be going overboard with how positive the situation is.” As a sign of possible frothiness, he points to RedEnvelope, a high-end Internet gift site, which plans to do an IPO before it reaches profitability.

Still, Burstein sees reason to be somewhat optimistic. “I do expect that come this fall Google will do an IPO, Salesforce.com will do an IPO and perhaps a couple of others,” he says. “The window will become ajar in the fall, but there are too many factors constraining really creating a kind of IPO-of-the-week environment we had some time ago.”

While it may be tough to predict when venture capitalists can prosper through public offerings, the market conditions and individual requirements for a public offering are clearer. “What’s easy to predict is that the conditions for going public will be much more stringent than before, when public markets were a stage of private equity investing,” says Goldfarb. “Having demonstrated profits and demonstrating sustainability of a profitable model is going to be a minimum quality going forward.”

That thinking was illustrated by the IPO of Digital Theater Systems (NASDAQ: DTSI). Wall Street went gaga for its shares when it went public July 9, rewarding the venture-backed company for four years of solid sales growth and two consecutive years of profits.

Digital Theater, which makes audio equipment for theaters and home entertainment, priced at $17 per share. Two days after the IPO, the company’s shares were trading at $24.30 each, up 43%. Digital Theater’s venture backers-which put $14.75 million into the company in two rounds-include Eos Partners, JPMorgan partners, Phoenix Partners, Regent Capital Management, Scripps Ventures and Weston Presidio Capital.

Weston Presidio was the biggest winner in Digital Theater’s offering. It was the largest shareholder, and its 3.1 million shares were worth about $75 million on July 11. The next largest venture holders were Eos, with about 977,000 shares worth approximately $24 million, and Scripps Ventures, with about 587,000 shares worth roughly $14 million, according to SEC filings.

If venture capitalists have any doubt about the market’s tougher standards, they need only watch the reception that is given to two money-losing, venture-backed companies on the IPO docket: RedEnvelope and Netgear.

Will Bulls Like Red?

RedEnvelope, based in San Francisco, grew its revenue from $32.6 million in the fiscal year ended April 1, 2001, to $70 million in the fiscal year ended March 30, 2003. But it continued to lose money during that time. Its backers may be hoping that Wall Street is watching the trend line of the losses, which went from $26.4 million in the year ended April 1, 2001, to $7.7 million in the year ended March 30, 2003.

RedEnvelope has more than $100 million in venture backing-the majority of it from the bubble years of 1999 and 2000. Sequoia Capital is its single largest shareholder, with 11.9 million shares (or 16.1% of the total), followed by Direct Equity Partners of New York, which holds 9.7 million shares (or 13.1% of the total). Weston Presidio is the fifth-largest shareholder and third-largest ventureshareholder, with 5.3 million shares (or 7.3% of the pool). Other venture backers that hold stakes of less than 5% include Comdisco Ventures and the Silicon Valley Angel Fund.

Like RedEnvelope, Netgear has managed to ramp its sales considerably. But, unlike RedEnvelope, Netgear has seen its losses pile up. The Santa Clara, Calif.-based maker of computer networking equipment re-filed to go public on July 2. It hopes to sell 7 million shares for $10 to $12 each.

Netgear grew its sales from $111 million in 1999 to $237 million in 2002. However, its net losses went from $6.5 million to $9.7 million during that same time.

Netgear’s backers include Comerica Ventures, Pequot Capital Management and Shamrock Holdings. Pequot Capital Management is the largest venture shareholder, with 6.95 million shares.

If either Netgear or RedEnvelope has a successful IPO, it will certainly be a boost for all venture-backed companies. But the way the market has been behaving, neither should count on a warm reception.