EUROPEAN BUSINESS SCHOOL
Schloß Reichartshausen am Rhein
Seminararbeit
im Rahmen des Seminars des Wahlpflichtfaches
Finanzierung und Banken

IPOs of Venture Capital Backed Ventures

Christian Mehrer
Christian Felix Munz
 15. Oktober 2002

EXECUTIVE SUMMARY

The topic of this paper is the difference of venture capital (VC) backed initial public offerings (IPOs) and non backed IPOs and the share price performance of the companies after the IPO. Compared to non-backed IPOs, VC backed IPOs consist on average of younger and less profitable firms. Nevertheless, VC backed companies have better underwriters, more institutional investors and less underpricing (i.e. a discount on the initial share price due to asymmetrical information). It is therefore considered that the venture capitalist (VCist) has an important impact on the share price performance of the young firm due to his certification role. By screening and mentoring the backed venture in earlier stages of the VC cycle, he can well assess the business’ opportunities. Thus, if he invests in the venture and keeps shares after the IPO, he can proof credibility to other investors (credibility hypothesis).

However, younger VCists tend to bring companies too quickly to the stock markets, because they need an IPO for building up a reputation (grandstanding hypothesis). This may be adverse to the venture. Our findings also outline that there is no clear advantage of VC-backed firms on the long-run. Thus, we conclude that it is not only important to think about a VC backing, but also about the VCist that is backing. Choosing the wrong VCist may even have a negative impact on the company’s future.

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 Post-IPO 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 LOCK-UP PERIOD  22
a. Theoretical Background  22
b. Empirical Results  23

C. LONG-TERM PERFORMANCE AND SURVIVAL  25
a. Theoretical Background  25
b. Empirical Evidence  26

IV. SUMMARY, CONCLUSION, AND OUTLOOK  29

REFERENCES  31

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 Kapitalbeteiligungsgesellschaften, 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.

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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.

3N.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).