Investors are also assuming a longer investment horizon, from 6 months a year ago to 18 to 24 months now. That comes at a time when companies already take longer to go public. In 2005 it took an average of 67 months to go from initial funding to IPO; at the end of 2007 that period averaged 85 months, the longest horizon since 1994, according to Dow Jones Venture One.
Late-stage investors are not the only source of funding, however. A strategic partner, as Phenomix found, can be an invaluable lifeline. Such partnerships are common in the biotech sector, as large pharmaceutical companies look for young drug developers with something promising in the pipeline. The partner helps to fund development and marketing in return for participation in the drug’s sales.
The problem, however, is timing. A start-up with a proven drug can command better terms in the partnership, as Phenomix did with Forest Laboratories. If a company, however, pulls out of an IPO and has to strike a partnership earlier than it had hoped, it may have to give up more upside in the future, says Shawver.
Chris Kelly, head of the capital-markets practice at Jones Day, notes that more companies are exploring strategic partnerships because they don’t like the terms they’re being offered in subsequent rounds of financing. As one example of the so-called toxic terms that are sometimes offered, Kelly says that an investor may demand a cash dividend from a young company that barely generates cash. If the company is unable to make the dividend payments, then it must employ a “toggle” feature that allows it to pay back in equity. As the company fails to meet dividend payments, the investor gets an incrementally larger stake. These terms resemble the heyday of private equity, but in reverse: when investors were chasing companies, terms became so loose that they offered companies “PIK” (payment-in-kind) toggles on their debt, meaning a company could choose whether to repay in dollars or in additional debt.
Another example of harsh, if not toxic, terms involves an increasing demand for collateral, particularly for companies that own real estate, machinery, or intellectual property. Phenomix pledged its IP against its debt but was able to pay that debt off without giving up IP rights. “The number of alternatives for companies is shrinking,” says Jefferies’s Bauer. “The number of opportunities for investors is increasing.”
As for Phenomix, while an IPO is off the table for now, the idea is still alive. “We may try again this year,” says Shawver. “For now, we can always tighten our belts some more.”
Avital Louria Hahn is a freelance writer based in New York.
Tapping the Secondary P-E Market
Companies sometimes register for an initial public offering not because they need to finance their operations but because their venture investors have come to the end of their investment horizon and want to exit. Winery Exchange, a venture-backed private-label wine and spirits specialist born in the 2000 tech bust, is not ready for an IPO, but its investors are.
Former CFO John Crean stumbled on an unusual liquidity solution when he met a banker with VCFA, a secondary private-investment fund. After careful due diligence, VCFA acquired $20 million in investments from two Winery Exchange backers. VCFA pioneered the concept in 1982 and has since raised nearly $800 million in nine funds. At least a dozen other companies with capital in excess of $1 billion also play in this “secondaries” space today. — A.L.H.