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Founders and private equity investors need to have an exit strategy to liquidate their shares in a new venture. Most often this is achieved through an outright sale to another corporation or through an initial listing on the stock exchange, an Initial Public offering (IPO). Over the last few years, the biotechnology sector experienced a boom that resulted in many new companies being listed. However, with the collapse in the market, many of these have failed to provide the exit objectives of the investors and have failed to achieve the levels of funding needed for product research to bring new products to revenue generation. With tighter listing rules many of these companies would not have been able to list. Keywords: exit strategies, IPO, exit ready, commercialisation, entrepreneurship
Entrepreneurial ventures in the high technology sectors typically involve the commercialisation of intellectual property, the potential of global markets and short windows of opportunity. Founders normally require financing beyond their personal resources and seek private equity capital from angels and/or venture capital firms. Most often the founders and the venture capitalist see the public market as the ultimate goal. They see the IPO as the means to exit the private equity holders, provide them with growth capital and provide the founders with a vehicle where they can liquidate part or all of their investment. Few start up firms however will ever be listed on a public exchange. Even venture capital backed firms have a low probability of being listed. Golis shows that only 12% of all Australian VC backed firms were listed to the end of June 2002 (Golis, 2002: 235). However in boom or ‘hot’ markets the level of activity increases dramatically. Golis shows that, for VC backed firms, 7 of 17 exits in 1998/9 and 11 of 13 exits in 1999/2000 were floats. Much of the IPO activity in 1999 to 2002 was in the biotechnology sector. This sector experienced a boom market (Intersuisse, 2003: 1). This resulted in many small, often inexperienced, biotechnology companies listing ((Deliotte, 2002: 39). However by early 2003 the market had declined by 40% and many of those firms were faced with a funding crisis. With the closure of the market to new initial public offerings (IPO) and no activity for successive rounds of funding, less resilient biotechnology firms were facing a lack of funds to complete necessary product development to enable them to reach profitability (Yakatan, 2003). The market volatility in biotechnology has seen earlier parallels in other high tech markets with, often, many company failures. The questions that this raises are;
Background Like other sectors before it, enterprise resource planning (ERP), supply chain optimisation, and the internet, the biotechnology capital markets went through a boom between early 1999 and 2002. The market rose 760 percent during the 3 years up to its peak in February 2002 and then fell 30% 10 months later (Intersuisse, 2003: 3). The amount of follow on capital raised in the USA during in Q3 2002 was down 36% and capital raised by medical device firms fell from A$5.5 billion in Q1 FY2002 to only A$643 million one year later (PWC, 2003, p2). Australian biotechnology sector had a similar decline falling 36% during the period 2001-2 (Intersuisse, 2003: 6) Biotechnology IPO activity has dried up along with every other sector. No IPO activity occurred in the USA or Australia during Q1 2003 (PWC, 2003: 2). Not only had the biotechnology burst, the entire public market was frozen. Biotechnology companies generally need significant public financing to see them through the development phases of their commercialisation processes. Many of the 60 Australian Stock Exchange (ASX) listed companies had used IPO funding to assist them to progress their early stage discoveries. The money was used for a variety of purposes from drug development, pre-clinical trials to early phase clinical trials. However most had undertaken the IPO with the view that subsequent public fund raising would see them through to revenue generating products. With the collapse of the biotechnology boom and the freezing of the public markets generally, the prior levels of public funding and the high valuations are unlikely to return. The lucky firms that went to the market early in the boom and had the opportunity of a subsequent round, either domestically or overseas, may well have built up a sufficient cash reserve to take them to profitability or at least to the development stage where licensing or sale is a real possibility. Later entrants may not be so fortunate. An early IPO may not have raised significant funds, perhaps AUD$5 – 30 million. With high burn rates this may not see them to revenue generation. Their alternatives at this point are bleak. They may be forced into a fire sale, they may have to sell off assets or they may be forced to sell R&D achievements at a heavily discounted price to survive (PWC, 2003: 20). The firms that came to market just before the biotechnology crash may not have had sufficient liquidity or after market support to maintain a price higher than their listing price. Where this declined in the first 12 months following the IPO, investors locked up in escrow may not have seen a positive return on their investment, or may not be able to exit without a substantial loss, thus locking them in for some unknown period. At the same time the retail investor may well have suffered with the collapse of the weaker firms. Five firms recently had market capitalisation below net assets (Intersuisse, 2003: 1). At the same time, lack of cash reserves may be damaging to commercialisation progress. R&D may well have to be scaled back, trials delayed, and development opportunities lost. As at September 2002, smaller firms had an average of only 18 months funding (Intersuisse, 2003: 1). Many of the larger IPOs that were expected in the early part of 2003 have been cancelled or delayed due to market conditions (PWC, 2003: 17). The public market has become very risk adverse with the decline in the market. The decline was associated with fewer FDA approvals, unfavourable clinical trials, and negative news (PWC, 2003, pp3-8),. Future public market fund raising efforts by biotechnology firms may experience much higher hurdles in terms of development progress, existing revenue achievement and established alliances. In the medical devices sector, alpha testing may well be a condition of even venture capital investment. Since venture capital has been the primary source of funding for early stage companies, (AusBiotech, Vol 13 No 1: 28), this may well hinder the start up rate of biotechnology firms in the near future. The PWC BioForum concluded that “Suffice to say companies and investors remain cautious about IPO as a viable exit strategy” (2003: 22). The report concludes that “ Australia needs the formation of larger companies with R&D pipelines, preferably with at least half their products in or near clinical trial and better trained personnel. These companies will be more attractive candidates both in Australia and on a global level” (2003: 28). Implications for Exit Strategies and the IPO Process The biotechnology market boom allowed many companies to go to an IPO where in normal times may not have gained the support of the advisor, underwriter or the institutional investors. While some were lucky, the long term costs to the community may well offset these early gains. Longer term implications include:
Of the 60 ASX listed biotechnology firms, over half were listed between 1999 and 2000 (Intersuisse, 2003: 2). ‘Boom’ markets can create market conditions which are not healthy for the founders nor the VC firms. The self-liquidating structure of the VC funds, for example, can also prompt venture capital organizations to rush young firms to an IPO in order to demonstrate a successful track record – even if the investees aren’t ready to go public (Gompers and Lerner, 2001: 99). VC firms typically exit some period after the IPO, often after a period of 12 months. Of the 59 firms tracked by the Intersuisse Biotechnology Index 23 had falls during 2002 of over 50%, 18 dropped more than 30%. In the same period the ASX All ordinaries index fell by 11% ( 2003: 3). Five ASX listed firms recently had market capitalization below net assets ( 2003: 1). Some VC firms with more recent IPO’s may well have failed to recover their investments in this period. Founders are however typically tied in for longer periods. While they may be able to liquidate some equity, markets are uneasy when founders liquidate substantial holdings. In a declining market, there is also the possibility of ‘insider trading’ claims which may cause founders to hold onto stock. Where private equity investors have been ‘locked in’ through escrow arrangements, they may be unprepared to go back into a sector which they regard as volatile. Where they cannot see a real possibility of a successful exit due to a volatile market, they may be unprepared to invest (Martin,1997: 71), (Gladstone and Gladstone, 2002: 93). Successful exits are not only important for remuneration of the VC partners, they impact the VC firm’s ability to raise additional funds (Lerner, Josh 2000: 369). The timing of an IPO is often dependent on conditions outside the company’s control, such as general market receptivity to IPOs at the time; whether the relevant industry is ‘hot’; whether major institutional investors have exceeded their proportion of their portfolios reserved for investment in the relevant industry; and whether there has been an announcement of disappointing financial or regulatory results by a competitor in the industry that causes the market to be wary of the industry as a whole.(Bagley and Dauchy, 1999: 408). Finally, it may well be that taking a firm public is the preferred choice for many when the IPO markets are booming however, these markets are unpredictable even for the best IPO candidates (Petty, 1996: 437-8). Boom markets can create situations where firms are able to undertake an IPO. However due to the unpredictability of boom markets, this may not achieve the successful exit required by the VC firms and the founders. Public listings in ‘cold’ markets tend to be of higher quality and are much more likely to do better over the long term (Seligman, 2003: P50).
The IPO is seen by many VC firms as the ideal exit route for their investment, Generally speaking they can achieve a higher ROI in an IPO than in a trade sale (Wang and Sim, 2001: 347). Golis quotes an IRR of 29 percent for an IPO versus 9.5 percent IRR for a trade sale ( 2002: 342). Thus much of their effort during their investment period is consumed with creating the right attributes within the investee firm that would allow them to take it to an IPO. A boom market seems ideal for the VC firm as the likelihood of taking a firm to an IPO is greatly improved. However, do firms that take advantage of a boom market actually deliver the long term benefits to the VC firm, to the founders and to their shareholders? In order to undertake some tests of the impact of boom markets on exit success, the Author worked with several VC firms and merchant banks to develop a list of ‘desirable attributes’ of firms seeking an IPO event. These firms established a list of desirable outcomes of the IPO. These were:
These objectives seem to be achieved, at a minimum, if the capitalization of the firm over several years subsequent to the IPO is at least equal to the capitalization of the firm at the time of the IPO. For example, Intersuisse reported that, even with the decline in the biotechnology market, seven firms had price increases in 2002, six others were unchanged or fell less than 10% (2003: 3). As a group, did the firms that were able to maintain or improve their capitalization value in a declining market demonstrate different attributes at the time of their IPO? If this is the case and such a list could be generalized across other sectors, it is possible then to use this information to assist VC firms and merchant banks to better select candidates for an IPO path. The proposition was put to these firms in the following form: In reviewing possible candidates for a possible IPO, what are the attributes that you look for given that you wish to achieve the objectives identified above? Each attribute could be graded in terms of a level of achievement on a scale of 1 - 5 in the following form.
This suggests several possible hypotheses:
Boom Market Conditions The Biotechnology sector outperformed the overall market over the period July 1999 to January 2003 (Intersuisse 200: 3). For a good portion of that period, it was double the ASX All Ordinaries Index. To identify the underlying factors of the ‘hot’ market, the Author interviewed several of the Directors of Intersuisse and a Vice President of Duetsche Bank in Melbourne (Buckley, 2003), (O’Brien, 2003). The Author had also been an active CEO in the 80’s during the Enterprise Resource Planning (ERP) software boom, an active CEO in the supply chain optimization (SCM) software boom in the mid 90’s and a founder of an internet company during the internet boom in the late 90’s. The consensus of these meetings is as follows; A hot public market is normally created when the following circumstances coincide:
The hot public market collapses when the following occurs:
These attributes of the hot market need to be verified but are supported by the Author’s experience over several boom markets. The ERP boom was created by the dramatic increase in computing power, the larger computer memories and the emerging network architecture. The SCM boom was made possible by significant increase in PC memory and the client server architecture. The Internet boom was created by advances in internet technology and major increases in internet band width. The Biotechnology boom was created by the human genome project. However hot markets are hard to predict. The interviewees from Intersuisse and Duetsche Bank maintained that hot markets can close at any time. While many VC firms were taking advantage of the hot market being open, they argued that many companies would have lost considerable money in IPO preparation when the market collapsed as they would not have been able to go to an IPO in a normal market. Given that most IPOs take from 3 – 12 months to prepare, few market professionals are prepared to guarantee that a hot market will be open at the end of the preparation period. Johnathan Buckley of Intersuisse maintains that the only firms that demonstrate ‘enduring qualities’ should be prepared for an IPO (Buckley, 2003). His argument was that hot market conditions were unpredictable and that the only firms that could sustain themselves over longer periods could provide an adequate return to investors. The list of enduring quality attributes that were generated over several meetings with Buckley and O’Brien are included within the IPO Ready Index. As can be seen, this list is quite extensive and covers areas of financial performance and expectations, due diligence and governance and strategy. The only other reference to such a list of attributes is provided by Chris Golis, currently Executive Chairman of the Sydney based Nanyang Management, a VC firm. Golis lists the following attributes;
These attributes set hurdle rates higher than the current ASX listing requirements (ASX, 2003).
In order to test the hypothesis outlined some preliminary work will be required. Included in this work will be the following:
The Index as shown in Appendix A, is an initial list of attributes. This will be circulated to a number of VC firms that have been active in IPO exits. In addition, additional merchant banks and brokers will be asked to evaluate the list. This exercise will identify additional items, withdraw items that are not seen as important and help improve the wording to remove any unclear interpretations
The IPO Ready Index will then be trialed with several biotechnology companies that have undertaken IPOs over the last few years. The listing agency, VC firm or advisor will score the firm at the time prior to the IPO launch. This will then be compared to the subsequent market performance of the firm to see if the hypotheses are likely to be supported.
It is proposed to select the biotechnology firms that listed on the ASX between 1990 and 2002. A list of firms is contained in the Intersuisse Monitor (Intersuisse, 2003 p16). This list includes the three major firms, Cochlear, CSL and ResMed as well as 6 firms with a market capitalization of less than $10 million.
For the purposes of this study the boom market in biotechnology will be taken as September 1999 to December 2002. Since the study requires a period of, say, two years beyond the end of the boom period, the data collection and analysis will not be able to be undertaken until the end of 2004.
Boom conditions occurred in other sectors (ERP, SCM and Internet). It would be possible to conduct a similar study for these sectors. Given that these booms occurred some years back, the post boom data would be available to test the hypothesis.
Clearly hot markets create conditions which have unpredictable outcomes for investors. Many VC firms lost money when the internet bubble burst. It is anticipated that the same result will occur with the shake out for the biotechnology sector. This leads to speculation as to whether this outcome would have occurred if the stock exchange had imposed higher requirements (higher IPO Ready Scores) on firms wishing to undertake an IPO. There is a growing body of opinion in Australia that the ASX should develop a code of reporting standards and guidelines similar to that used in the mining industry (Green, 2003: P23). While this may have informed investors better, it would not have avoided the situation where less viable firms should have been discouraged from taking the IPO route to funding. The current listing requirements allow quite small companies to list (ASX, 2003). With tougher listing requirements, fewer emerging companies would have been able to use an IPO event as a possible exit path for the private equity holders. Fund raising would then only have been achieved through further rounds of VC finance or through equity injections from industry partners (Green, 2003: 23). At the same time, more firms would have considered consolidation in order to meet IPO requirements (Blake and Pachacz, 2003: 44). This perhaps would have resulted in more enduring firms with fewer disappointments to public and institutional investors. Yakatan strongly recommended higher hurdles for listing and said more emphasis should be put on consolidation within the sector to achieve more sustainable businesses (2003). With tighter listing requirements, more early stage firms would have taken a trade sale exit route, possibly resulting in better returns to the VC firms, thus avoiding the current poor after market situation.
Each attribute is graded in terms of a level of achievement on a scale of 1 - 5 in the following form.
Alignment Activities Directors agree to a public listing funding strategy Senior managers agree to a public listing funding strategy Key shareholders agree to a public listing funding strategy
Due Diligence/Governance Activities Financial reporting provides monthly monitoring of the business Industry knowledgeable and respected accountants are appointed Industry knowledgeable and respected lawyers are appointed Industry knowledgeable public listing advisor appointed Industry knowledge broker appointed Industry knowledge underwriter appointed Senior management has public company experience Senior financial management has IPO listing experience Management team has significant relevant industry experience Board of Directors has public company experience Board of Directors has a majority of independent members Board of Directors has industry knowledgeable members Board of Directors has reputable public company experience CEO/CFO can articulate the business concept in non-technical terms Firm has existing funding which could cover next two years Management has the capacity to prepare and launch a public listing The firm can afford the costs of a terminated/delayed listing Management understand institutional and public investor requirements
Enduring Market Requirements Revenue is at a minimum of $20 million Expected revenue within 10 years exceeds $100 million The firm has been profitable for at least a year Business model predicts continued profitability Revenue growth is anticipated through continued product releases Revenue resilience is shown through multiple diversified product offerings Risk minimisation shows early and later product developments Industry sector has appeal to institutional investors Industry sector has appeal to the general public investor The firm has national appeal Industry sector has appeal to international investors The product/market offering has sustainable competitive advantage Products have endorsement of name brand global corporations Technology status is supported by creditable international authorities Funds raised will be used for revenue growth Post IPO no shareholder holds more than 30% ownership Post IPO external shareholders hold more than 40% ownership Post IPO market capitalisation will exceed $50 million Sufficient stock (free float) available to create liquidity
in the overseas market The firm has representation in foreign markets where funding is sought
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© Tom McKaskill 2007
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