IPOs of Venture Capital Backed Ventures

Table of Contents

INTRODUCTION

I. The Exit from Venture Capital Investments
A. The Venture Capital Cycle
B. The Importance of the Exit Stage
C. Description of the Different Exit Routes
a. Company Buy Back
b. Secondary Sale
c. Trade Sale
d. Initial Public Offering
D. The Frequency of Using Different Exit Routes

II. Differences Between VC Backed and Non Backed IPOs
A. Issuer Characteristics
a. Industries
b. Revenues and Earnings
c. Further Characteristics
B. Offering Characteristics
b. Offering Size
c. Pre- and Post-IPO Shareholding of Venture Capitalists
d. Number of Institutional Shareholders
e. Quality of Underwriters and Auditors

III. Development of VC Backed IPOs and Non Backed IPOs
A. Underpricing at the IPO and Initial Returns
a. Theoretical Background
b. Empirical Evidence
c. Possible Explanations for the Differing Outcomes of IPO Underpricing
B. Performance Around the Lock-up Period
a. Theoretical Background
b. Empirical Results
C. Long-term Performance and Survival
a. Theoretical Background
b. Empirical Evidence

IV. Summary, Conclusion, and Outlook

References

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. (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 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.

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.

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.

In addition, an IPO creates public awareness, which is useful for both the company and the VCist. Achleitner/Engel (2001) described that VC backed companies in the Internet, software and service sector often have business models requiring high marketing expenditure to establish a brand name and realize first mover advantages. Thus, the quotation at the stock market can be considered as an additional marketing channel for the company. VCists, especially the younger ones, can use a successful IPO to signal their ability, enhance their reputation, and hence improve their long-run fund raising (see Chapter III).

The negative aspects of an IPO are high costs for the preparation and follow-up costs for fulfilling the transparency requirements. A listing on the NM only costs € 7,500, whereas the average annual costs for fulfilling the regulations of the NM amount to about € 200,000 (N.N. (2002a)). That is a lot of money for young ventures, which often have not yet reached the break-even point. In addition, the timing of the IPO is crucial. The VCist has to find an “IPO window” providing a good market sentiment and hence high share prices. Due to the current bearish markets, IPO activity is close to zero and many VCists willing to exit via IPO have to wait for an indeterminate period for the upswing of the share markets. Moreover, the VCist may not realize a 100% exit directly after the IPO owing to stock exchange regulations or agreements with underwriters.

As VCists expect to earn a compound annual return of from 25% to over 50% (depending on the stage) on their investments in private companies (Megginson/Weiss (1991)), they may often insist on an IPO exit.

D. The Frequency of Using Different Exit Routes

An analysis of the year book statistics of the BVK from 1999 to 2001 revealed the frequency of use for the different exit routes in Germany: The most frequently used exit route were trade sales (20.4% in 2001). There was a significant slump of trade sales in 2001 (-47.7%). The second important exit route were company buy backs. The percentage slightly decreased from 20.8% to 18.0% between 1999 and 2001. The number of secondary sales almost doubled within the analyzed period (4.0% to 7.9%), whereas the amount of VC backed IPOs dramatically declined: In 1999, IPOs were the third largest exit channel with 12.6%; in 2001 the percentage evaporated to 0.4%. These figures clearly underline how heavily the bear market has affected the IPO business. Interestingly, the revenues after IPO, i.e. share sales after the end of the lock-up period increased, indicating that more VCists want to limit their losses on the share market. The most striking aspect was the skyrocketing of the divestments through total losses. In 1999, 20.9% of all exits where realized as liquidations, whereas in 2001 36.3% of the ventures were liquidated. Being the highest percentage of all possible exit routes in 2001, this result evidently indicates the hardships, VCists and the backed companies have faced during the current economic slump.

The VC statistics for the US published by the National Venture Capital Association (NVCA), only provide detailed information about VC backed IPOs and trade sales. The number of VC backed IPOs shrunk from 257 in 1999 to 37 in 2001. In the first six months of 2002, only 16 VC backed IPOs were launched (N.N. (2002b)). Contrarily, the number of trade sales increased steadily from 234 in 1999 to 322 in 2001. This indicates that many start-ups rather ally with mature companies instead of exposing on their own to the adverse market sentiment. Moreover, Murphy (2001) reported that “There’s a lukewarm interest in mergers and acquisitions – typically venture capitalists’ exit strategy of choice when the public market turns cold.”

II. Differences Between VC Backed and Non Backed IPOs

In this chapter, we analyze VC backed and non backed IPOs in terms of a variety of non performance related characteristics.

A. Issuer Characteristics

a. Industries

VCists typically focus on high tech industries with a great deal of uncertainty (e.g. due to highly volatile market conditions or large research & development (R&D) front-end investments), where agency problems among entrepreneurs and investors are commonplace. These industries typically have substantial intangible assets, which are difficult to value and to liquidate in case of bankruptcy (Gompers/Lerner (1999)). Hence, conservative financiers are reluctant to back companies in these industries. The empirical data of different surveys supports this hypothesis: In Germany, Mayer (2001) analyzed all 206 IPOs on the NM from March 1997 to February 2000. The highest percentages of VC backed IPOs were among companies producing Internet software (92%) and biotechnology (71%); VC was less involved in more traditional sectors like distribution (29%) and production (37,5%). Barry et al. (1990) examined the frequency distribution of IPOs in the US for VC backed and non-backed issues between 1978 and 1987. Companies producing computer equipment, electrical and electronic components, instrumentation and business services (which includes computer software) accounted for 63.8% of the VC backed IPOs, but only for 30.6% of non-backed IPOs. On the other hand, non-backed IPOs dominated in wholesale trade of durable goods, retailing and catering.

b. Revenues and Earnings

Franzke (2001) examined 199 companies going public on the NM between March 1997 and March 2000. According to her study, the average sales revenues per employee amounted to € 269k in non VC backed companies, whereas the VC backed companies only realized the half (€ 135k). The differences of the growth rates of sales revenues (70.86% versus 86.96%) were not considered to be significant. Concerning the earnings before interest and taxes (EBIT), the discrepancy was bigger: While the EBIT per employee of non backed firms averaged at € 26k, the VC backed companies were loss-making (€ -6k). This finding was consistent with the results for the American market by Barry et al. (1990) (average pre-IPO earnings yields for VC backed companies: –1.54%, for non backed companies: 2.45%).

c. Further Characteristics

Further characteristics analyzed in Franzke’s study are the number of staff of the companies gone public (mean of 250 persons for non VC backed versus 220 for backed companies), the balance sheet total (€ 26,365k versus € 31,339k) and the average age of the companies at the date of the IPO (11 versus 10 years). She considered the differences of theses characteristics as not significant. However, having analyzed 320 VC backed IPOs and 320 other IPOs on the American stock markets between 1983 and 1987, Megginson/Weiss (1991) discovered that VC backed companies were significantly younger than other issuing firms (8.6 years versus 12.2 years).

d. Finding s

It is remarkable that VC backed companies are less profitable and less strong than non backed companies when going public. Besides, VC backed companies seem to be more or less significantly younger than other enterprises at the time of the IPO. Though, both types of issuing companies are similar concerning the number of employees, balance sheet total and growth rates of returns.

B. Offering Characteristics

b. Offering Size

Several studies revealed similar results about the offering size of VC backed and non-backed IPOs. According to Franzke (2001), VC backed IPOs at the NM showed a significantly higher average volume of issued shares compared to non backed IPOs (2,519k versus 1,962k shares). In the US, Barry et al. (1990) computed a mean dollar amount of issued stock of $ 13.5m (VC backed) versus $ 10.0m (non backed). Megginson/Weiss (1991) reported in their study means of $15.0m versus $ 9.2m, respectively. Thus, it is undisputed that VC backed IPOs, on average, have bigger offering sizes.

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^* 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.

^[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).

^[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.