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Red Herring

Venture Capital
Strict criteria
VCs can give the market what it wants-or nothing at all.

By Julie Landry
September 25, 2002

Downtrodden venture capitalists would have us all believe that the public markets have shut the door on new issues, and that nary a company will buy their startups. That's nonsense. While nobody is on the acquisition or road show binges of two years ago, deals are still getting done--but only for companies with the right stuff.

Several well-positioned firms have managed to achieve those elusive exits. Through August 1, 11 firms managed at least five portfolio exits this year, with another several dozen firms selling or taking public three or more companies. Among the leaders are JPMorgan Partners (with $29 billion under management), which held stakes in two of this year's IPOs and has seen eight of its companies bought, and Warburg Pincus (with $12 billion under management), with a whopping six IPOs in the bag and one sale.

An analysis of the list of IPOs and merger-and-acquisition exits doesn't produce any obvious patterns, except for one: anything goes--an airline, a software maker, an optical-networking company--as long as it has strong customer demand.

Small Offerings
Through mid-August, 49 IPOs had been filed in 2002, according to IPO.com, with little rhyme or reason as to industry--companies like the chip maker FormFactor and the online travel agency Orbitz filed right along with the retailer Dick's Sporting Goods and a bottled-water company, the Sparkling Spring Water Group.

Another 56 IPOs priced during that time, and every uptick in the number of IPOs has launched a small wave of filings, most notably in the spring, when four weeks of consistent IPO activity in April yielded a bumper crop of 24 filings in May and June. Meanwhile, withdrawals have been steadily on the rise: of the 36 filings yanked this year, one-third came in July, according to IPO.com.

Although it's tougher to launch an IPO now than it was two years ago, the market's current requirements are not exactly exacting, according to Steven Bird, a general partner at the expansion-stage VC firm Focus Ventures. Bankers have told him they're looking for around $40 million in annual revenue, 30 percent year-over-year revenue growth, several million dollars of cash on hand, a diverse customer base, and profitability now or within two quarters.

IPOs that do get out the door can still return a decent sum to their venture investors--when and if they ever get a chance to sell their shares. Sequoia Capital, for example, stands to reap nearly five times its investment of $30 million in PayPal when the company's $1.5 billion acquisition by eBay goes through. JPMorgan Partners could make up to eight times its $26 million investment in JetBlue Airways (Nasdaq: JBLU), if shares continue to trade around their mid-August level of $45.

Fire Sales
The trouble, investors say, is that there are more cash-burning, low-revenue companies in VC portfolios than there are real businesses able to deliver the numbers that bankers want--and for many, a private sale presents a much more sensible strategy than waiting around. "The time, cost, and risk to get a company public is just too high," says Benjamin Howe, global head of M&A at SG Cowen Securities. As a result, VCs are more than willing to entertain purchase offers for cash or stock, even at a modest premium--or none at all.

There are three kinds of sale right now, says Shahan Soghikian, a general partner with JPMorgan Partners. In the first and most desirable (and rarest) scenario, a strategic buyer makes a strong offer--not the billions in cash or stock of past years, but enough that investors can make some money. In the second scenario, after it becomes clear that a company will need so much capital to succeed that the returns will be too low to bother with continued funding, the company is sold for its approximate current valuation, occasionally with a small premium. "There's very little liquidity, so we're taking some of those proposals more seriously," says Mr. Soghikian. The third type of sale is a straight-up asset sale, in which investors rarely see a dime once creditors are repaid.

Given the high odds of driving down the price through such an apparent show of "weakness," Mr. Howe says it's practically suicidal for companies to actively seek buyers. In many cases, however, VCs will initiate M&A deals on behalf of their companies, with an eye toward what's best for their own portfolio. According to Dick Kramlich, general partner at New Enterprise Associates, his firm maps out the amount of capital and expected exit date at the time of every initial investment. When the capital or exit date change dramatically, Mr. Kramlich says, NEA looks first for ways to consolidate within the portfolio, as it did in prodding Zhone Technologies to buy Vpacket Communications this summer.

VCs won't disclose how much they're making in their M&A exits overall, but it's fair to assume that it isn't much, if anything; the majority of deals have "unannounced" values. Even those disclosed tend to be low compared to the amount of funding that had been shoveled into the companies. For every Ocular Networks (sold to Tellabs for $355 million), there are probably another five NetSchools (sold to PLATO Learning for $30 million after raising more than $85 million) and an Essential.com (assets sold to United Systems Access out of bankruptcy court for an undisclosed amount). While many firms have found their way to the exit, most are being smacked in the bottom line on their way out the door.

Write to Julie Landry.

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