SAN FRANCISCO (Reuters) – Venture capitalists are urging start-ups to conserve their funds and look for alternative sources of cash as they sit out a drought in a market for public offerings that shows little sign of easing.
Only five venture capital-backed start-ups made their public debuts in the first quarter of this year, compared with 31 initial public offerings for similarly backed companies in the fourth quarter of 2007.
Underwriters are advising companies to hold off on IPOs until investors regain their appetite for new offerings for fear of securing abysmal valuations.
“The markets are just bad,” said Charlie Coggin, the chief financial officer of Transoma Medical Inc, a medical technology company that shelved its IPO plans in February. “I don't think anybody really has a vision of when it's going to get better,” he said, declining further comment.
Venture capitalists said they expect the shuttered IPO window to let in some light in the first quarter of 2009, but don't see a full recovery until 18 to 24 months from now.
Some venture capitalists said that in the interim, they would dip into rainy day reserves to provide additional funds to late-stage start-ups — mature companies that have already received several rounds of funding from venture capitalists who now seek ways to recover their investment by taking them public or selling them.
Mark Heesen, the president of the National Venture Capital Association, a trade group, said in April that the dollars going into later-stage investments could increase “if the IPO window remains closed … and venture capitalists have to sustain companies longer than expected.”
But a venture capital round, which averaged about $9.6 million for late-stage companies last quarter, is no substitute for the far larger amounts companies try to raise through a public sale of stock.
Companies like Transoma, which had hoped to raise $64 million in its IPO, are thus scouring for cash elsewhere. The St. Paul, Minneapolis-based company chose to raise a combination of equity from its venture backers and debt from a Silicon Valley Bank (SIVB.O: Quote, Profile, Research, Stock Buzz) affiliate.
Another life sciences start-up, Concentric Medical, also withdrew its IPO, citing poor market conditions, and soon after raised a $15 million line of credit. A Concentric spokesman did not respond to a request for comment.
The number of start-ups choosing to take on more debt or raise lines of credit has “steadily picked up pace” in the past six months, said Greg Becker, president of Silicon Valley Bank, which provides commercial banking services to many start-ups and venture capitalists.
“We've had a number of requests from later-stage clients who have their S-1s filed,” Becker said, referring to the regulatory filing in which a company announces its intention to go public, “but now want to raise more money to have that extra cushion. It's an insurance policy.”
Becker said he noticed a similar trend during the last economic downturn, when late-stage companies sought debt from institutions to prevent possible trickling off of liquidity.
Venture debt has since become fairly common in the industry, especially as a way for start-ups to finance rapid expansion in between rounds of raising equity.
“When you're facing a potential (economic) crisis, the more money a company has, the better,” said Adeo Ressi, an entrepreneur who runs thefunded.com, a website that lets entrepreneurs rate venture capitalists. “VCs want to ensure their companies have as much capital” as possible, he said.
GIVING UP STAKES
Ressi said he also is seeing more venture capitalists buying up stakes owned by entrepreneurs in start-ups. “They may buy 10 percent of a founder's stock for a couple of million dollars so the founder has money in their pocket,” he said.
Many of them are senior executives who would typically make money by selling their stake in a company when it went public.
Sanjay Subhedar, a general partner at venture capital company Storm Ventures, said his firm bought one-quarter of the shares owned by the founder of a software company in the firm's portfolio that would have gone public this year had the markets been willing.
“The founder had been there for eight, nine, maybe 10 years, and he was retiring due to health problems, and he wanted to get some liquidity,” Subhedar said.
Some entrepreneurs are also selling their stakes to secondary venture capital firms, said Hans Swildens, founder of Industry Ventures, one such firm.
Secondary venture firms, which make up a tiny fraction of the overall venture industry, usually buy stakes in late-stage companies that other investors want to unload.
Swildens said the number of deals he expects to do has increased 30 percent in the past year, with the closed IPO window pushing investors — including hedge funds, many of which bought large stakes in late-stage companies last year, hoping to cash in when they went public — to consider selling rather than holding on indefinitely.
“If someone thinks they can wait three months, they will. If someone has to wait a year, they really think hard. If it's three years, they think, 'Let's get out of this,'” Swildens said.
Although entrepreneurs searching for cash to fund early-stage projects have not yet faced the same challenges as their later-stage counterparts, the ongoing economic downturn could eventually affect their search for funds, a thought that is prompting many venture capitalists to be more conservative.
“We told our portfolio companies at the beginning of the year that because of concern about the economy, whatever operating plans we had approved for 2008, assume that you're only going to make 80 percent of the (targeted) revenue and so spend accordingly,” Storm's Subhedar said.
By Anupreeta Das