IPOs of Venture Capital Backed Ventures

EXECUTIVE SUMMARY

Table of Contents

  INTRODUCTION  1

  I THE EXIT FROM VENTURE CAPITAL INVESTMENTS  2

  A THE VENTURE CAPITAL CYCLE  2

  B THE IMPORTANCE OF THE EXIT STAGE  3

  C DESCRIPTION OF THE DIFFERENT EXIT ROUTES  3

  a Company Buy Back  4

  b Secondary Sale  4

  c Trade Sale  5

  d Initial Public Offering  5

  D THE FREQUENCY OF USING DIFFERENT EXIT ROUTES  6

  II DIFFERENCES BETWEEN VC BACKED AND NON BACKED IPOS  7

  A ISSUER CHARACTERISTICS  7

  a Industries  7

  b Revenues and Earnings  8

  c Further Characteristics  9

  B OFFERING CHARACTERISTICS  9

  b Offering Size  9

  c Pre and - Shareholding of Venture Capitalists  10

  d Number of Institutional Shareholders  11

  e Quality of Underwriters and Auditors  12

  III DEVELOPMENT OF VC BACKED IPOS AND NON BACKED IPOS  13

  A UNDERPRICING AT THE IPO AND INITIAL RETURNS  13

  a Theoretical Background  13

  b Empirical Evidence  17

  c Possible Explanations for the Differing Outcomes of IPO Underpricing  21

  B PERFORMANCE AROUND THE - PERIOD  22

  a Theoretical Background  22

  b Empirical Results  23

  C - PERFORMANCE AND SURVIVAL  25

  a Theoretical Background  25

  b Empirical Evidence  26

  IV SUMMARY CONCLUSION AND OUTLOOK  29

  REFERENCES  31

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IPOs of Venture Capital Backed Ventures

CHRISTIAN MEHRER and CHRISTIAN MUNZ *

There is a close link between venture capital (VC) 1 and the stock markets in Germany. The foundation of the Neuer Markt (NM), a trading platform for innovative growth companies, in March 1997, caused a boom of Germany’s VC business. In the beginning, the performance of the NM was spectacular: In 1998, the NM Index (NEMAX) increased by 174%. More and more companies went public via initial public offering (IPO) 2 to profit from the positive market sentiment, which guaranteed high cash inflows. Mayer (2001) reports that out of the 206 IPOs on the NM between 1997 and 2000, 115 IPOs (56%) were

VC backed. Thus, the VC business benefited considerably from this bull market. The effect

of the large profits for venture capitalists (VCists) was an exponential growth of the VC industry between 1997 and 2000. The amount of the total portfolio held by members of the German Venture Capital Association (Bundesverband Deutscher Kapitalbeteiligungs- gesellschaften, BVK) grew from € 3.7 billion in 1997 to € 10.7 billion in 2000. Thus, Germany could narrow the gap to the United States, whose VC venture capital market is still by far the largest one in the world. 3

However, the situation completely changed with the bursting of the New Economy bubble in 2000, leading to a worldwide downswing of the stock markets, which have not recovered since then. Due to the adverse stock market environment, the IPO market has dried up, too. The number of VC backed IPOs on the NM dropped from 59 IPOs in 2000 to zero in the first half of 2002 (BVK (2001, 2002)). In the US, the situation is similar with the number of IPOs decreasing from 351 in 2000 to only 16 in the first six months of 2002 (N.N.

* European Business School (ebs) Schloss Reichartshausen, Oestrich-Winkel, Germany.

1 According to Gilson/Black (1999), VC is defined “as investment by specialized organizations (‘venture capital funds’) in high growth, high-risk, often high-technology firms that need equity capital to finance product development or growth.” In this paper, we use the VC definition in a narrow sense, i.e. private equity financing for companies in a later growing stage is not considered.

2 We rely on the definition of Weitnauer (2000) according to which an IPO is the term for the primary public issuing of shares of young and mid-size companies.

3 N.N. (2002c) reports that in 2001 about 620 American VC companies invested some € 111 billion, whereas the 180 German VC companies invested between € 4.1 and 4.4 billion only.

– 2 – (2002b)). The latest climax of this anemic situation was the decision to shut down the NM as of September 26, 2002.

The recent developments on the stock markets provoke a deeper investigation of the IPO market. The aim of this paper is to compare VC backed with non-backed IPOs and to analyze the impact of VC on the performance of the company shares. Thereby, we attempt to shed light on the question if VC backing provides a significant edge in comparison to non-backed companies.

Starting in Chapter I, we describe the VC cycle, enumerate the different possibilities VCists dispose of in the exit stage and point out why IPOs are favored by both VCists and the management of the backed venture. In Chapter II, we compare the non performance related properties of VC backed and non backed IPOs. It will turn out, that there exist significant differences in issuer and offering characteristics. Subsequently, in Chapter III we analyze the influence of VC on the performance of IPO companies with regard to different time frames. Referring to the underpricing phenomenon, we first examine the initial returns. Then, we compare the performance after the lock-up period, which offers the first exit opportunity for VCists. To round off, we observe the long-term performance of the shares, also taking a look at the survival rate. All findings will be concluded in Chapter IV.

I. The Exit from Venture Capital Investments

A. The Venture Capital Cycle

A VC investment can be divided into several consecutive stages: In the first stage, the

sourcing, the VC company identifies potential investments. In the following evaluation stage, the VCist screens extremely carefully the business plans of the solicitors and selects the most promising venture to be backed. 4 Having set up a detailed contract, 5 the VC company provides funding collected by its shareholders in return of control and equity rights and actively or passively manages the venture. In the final stage, the VC company

4 Megginson/Weiss (1991) and Davila/Foster/Gupta (2000) both stress that VCists typically invest in less than

1% of the business plans they receive.

5 For more information about underlying contract specifications refer to Sahlman (1990).

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exits the investment by selling its shares of the backed company. The received liquidity may be paid out to the funds’ shareholders or reinvested in a new VC deal. Therefore, the whole process is called VC cycle (Gompers/Lerner (1999)).

B. The Importance of the Exit Stage

The exit stage is very important for both the VCist and the management of the backed firm. As the VCist does not receive interest payments for the invested capital, the exit stage is crucial to refinance the VC funds and to realize a profit. A successful exit produces feedback effects on investment and fundraising and therefore also influences the health of the other stages of the VC cycle (Gompers/Lerner (1999), Ali-Yrkkö/Hyytinen/Liukkonen (2001)). For instance, a profitable exit increases the reputation of the VCist, which makes it easier for him to raise new capital and to find good investment projects. On the other hand, a blunder may endanger the existence of the VC company because it loses its credibility.

Due to two reasons the exit stage is also decisive for the management of the backed company: First, the exit can be part of a new financing round. Having exhausted the limited capital resources of the VC fund, the venture may get access to new capital sources by going public or by being sold to another company. Hence, the exit can be the preparation for future expansion. Second, the exit is decisive about the organizational future of the venture: Through the exit of the VCist, who had important control rights due to his considerable investment, the management may either regain all decision rights and manage the future of an independent company; or the venture will be acquired by another large corporation which may terminate the existence of the venture as an independent entity.

C. Description of the Different Exit Routes

Excluding the possibility of the liquidation of an unsuccessful venture, there are four ways of concluding a VC investment: company buy back, secondary sale, trade sale, and IPO. In the following, the pros and cons of each exit route will be described.

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a. Company Buy Back

A company buy back is the repurchase of shares by the management of the backed

company, also known as management buy-out (MBO). Generally, this is the least favored exit route for VCists. It is mostly used when the backed company is poorly performing, which results in a lack of other potential buyers. As it is difficult for the management of a poorly performing company to raise money for a buy back, the selling price is often very low (Achleitner (2001), Wall/Smith (1997)).

Company buy backs also occur when the management of the backed company does not accept a sale to a third party (Wall/Smith (1997)). For instance, some family owned, midsize companies often insist on a pre-emption right before an IPO in order to keep the control over the company (Achleitner (2001)). However, Wall/Smith (1997) reported that VCists were reluctant to include buy back terms in the contracts, because this limits the selling price even if the venture has a higher value.

On the other hand, a company buy back seems to be the most feasible solution if the VCist wants to get the investment off his books (Wall/Smith (1997)).

b. Secondary Sale

If a VCist sells shares of the backed company to another financial investor, a secondary sale takes place. It often occurs when the investment does not fit any longer the VCist’s portfolio (Achleitner (2001)) or when the VCist is forced to realize gains, for example before liquidating a closed end fund or due to tax and reporting issues (Wall/Smith (1997)).

A secondary sale may be positive before a new financing round for the VC investment,

because it requires an independent valuation by a third party. Moreover, it is recommended if the relationship between management and VCist has broken down. However, Wall/Smith (1997) argued that financial investors require a high return on their initial investments and therefore would not pay a high premium on the selling price.

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c. Trade Sale

A trade sale is the sale of shares of the backed venture to another company by mergers &

acquisitions (M&A). Generally, the shares are either sold to market competitors or to important customers and suppliers seeking a vertical integration (Achleitner (2001)). A trade sale is a cheap, fast and simple exit route. The VCist can immediately cash in its shares of the backed venture and may receive a premium on the selling price for synergy, market share or market entry. However, this exit route may be opposed by the management, who would be controlled by a third party. Besides, many trade buyers request warranties, indemnities, escrows and deferred consideration from the purchasers (Wall/Smith (1997)). Thus, having sold his shares, the VCist has not terminated his risk exposure. Finally, many VCists raise the concern about an insufficient amount of potential trade buyers. Though this disadvantage can be avoided by an early exit planning and a strategic business orientation according to the needs of the targeted buyers (Achleitner (2001)). Moreover, Wall/Smith (1997) pointed out that many VCists narrowed their search of trade buyers to the same business sector and country. By doing so, they excluded strategic purchasers who might have been willing to pay a premium in order to penetrate a new market, and possibly put a cap on the selling price.

d. Initial Public Offering

The IPO is the “most glamorous and heralded type of exit for the venture capitalist and owners of the [VC backed] company” (NVCA (2002)) because going public may provide the highest exit return for the VCist in a bullish stock market and opens to the venture the possibility to raise capital directly on the financial markets. 6 Another advantage for the owner and the management of the venture is the broad distribution of shares on the marketplace. That is why no third party can gain substantial control rights and the management may take over the full control of the company after the VCist’s exit.

6 A frequently quoted Venture Economics study (1988) found that $ 1 invested in an IPO firm yielded an

average return of $ 1.95 in excess of the initial investment, as compared to only $ 0.40 for the next best

alternative, an investment in an acquired firm.