No Exit

Where are companies trapped in the IPO pipeline turning for additional financing?

When Phenomix Corp. finally withdrew its IPO registration in October — after waiting nine months for the markets to improve — it had to figure out how to navigate the tough economy without the roughly $87 million it had hoped to raise.

A biopharma start-up with diabetes and cancer drugs in advanced clinical trials, Phenomix is cash-flow negative and anticipates heavy expenses before its drugs become commercialized. “Our biggest concern is not having enough cash to do everything we need to do in order to build a sustainable company,” says CEO Laura Shawver.

Cost-cutting was one obvious move: the company closed a secondary location and has decided to hold off on some hiring plans. A strategic partnership, aided by the fact that the company’s drugs have already passed the critical stage of proving their efficacy, will give Phenomix a $75 million infusion. To make up for other needed funds, it may ask its initial backers for an additional equity injection.

Phenomix is one of many firms that have been forced to find alternative financing solutions as the IPO market has gone from bad to worse. Already a low year for IPO registration — as of late November there were a mere 148 new filings in 2008 versus 374 in 2007 — 89 companies either withdrew or postponed their initial public offerings, versus 23 in 2007, while just 44 went public, an 82 percent drop from 2007′s 273, according to Renaissance Capital’s IPOhome.com.

With the financial markets traumatized and the IPO drought expected to continue, many of these companies are now courting private capital, but that too has become difficult as valuations have fallen and investors have become ever more selective. “The path to liquidity is cloudy right now,” says Michael Bauer, managing director and global head of capital markets at Jefferies & Co. “The market has become more volatile and a number of players backed away and stopped participating.”

Venture-backed, late-stage companies that abandon IPOs are left to chase a smaller pool of investors, bankers say. Crossover funds from Fidelity, SAC Capital, and others that invested in mature start-ups when cash was plentiful have scaled back. That leaves late-stage venture-capital and private-equity firms as the most likely sources of funding for companies whose dream of going public remains deferred. Companies looking to invest strategically are also loosening their purse strings, but very cautiously.

While private-equity and venture investors have a lot of cash to invest, deals won’t be easy to come by. They have raised the bar — and the cost of capital — for companies they finance. Companies need to be cash-flow positive or have a competitive edge or a promising new product. A firm that is burning cash without a highly attractive and attainable return will be either rejected or offered harsh terms. “Terms are tighter, but deals are getting done,” says Peter Falvey, managing director of Revolution Partners, a boutique investment bank in Boston.

Companies should expect investors to make very conservative assumptions in order to get the internal rate of return required for their funds. Investors are building into their calculations discounts that may be as deep as 30 to 50 percent compared with early 2008. “A green-technology company that could have gotten easy financing a year ago now will be valued a lot lower,” says Jefferies’s Bauer.

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