Cash Management

No Exit

Where are companies trapped in the IPO pipeline turning for additional financing?
Avital Louria HahnJanuary 1, 2009

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

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.

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.

Toxic Toggles

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.

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