Friday, August 31, 2007

Pre-IPO investing - Too Risky For Private Clients?

Pre-IPO investing is one of the themes in the market today. There are, in London, many, many firms dedicated to the sales of shares in this area. It is often said that pre-ipo investing should be avoided as anything worth buying does not need to be sold. I am not sure that is true.

VC firm, Bessemer Venture Partners, have on thier web site an excellent page which details their 'anti-portfolio'. Basically Investments that they passed on for various reasons. Here is a snapshot:

Apollo Computer
(acquired by Hewlett Packard)
BVP's Felda Hardymon was offered a small position in the company's last private round, and waved it away: too small a position, he thought, at too high a price. In less than a year it was worth 17x.

Apple Computer
BVP had the opportunity to invest in pre-IPO secondary stock in Apple at a $60M valuation. BVP's Neill Brownstein called it "outrageously expensive."

Check Point
In 1994, Gil Schwed pitched his idea to BVP's David Cowan, who said that Gil would never get distribution in the US. The next year, Check Point got a huge Sun OEM deal and sold $25M of firewall software.

"Stamps? Coins? Comic books? You've GOT to be kidding," thought Cowan. "No-brainer pass."

Federal Express
Incredibly, BVP passed on Federal Express seven times.

Cowan’s college friend rented her garage to Sergey and Larry for their first year. In 1999 and 2000 she tried to introduce Cowan to “these two really smart Stanford students writing a search engine”. Students? A new search engine? In the most important moment ever for Bessemer’s anti-portfolio, Cowan asked her, “How can I get out of this house without going anywhere near your garage?”

Rob Chandra met these guys in 2000 at the start of the telecom meltdown, and remembers saying something like, “Rajesh, I like you a lot but do you really want to build a communications semiconductor business right now?” He looked at Rob in a sort of funny way and then raised money from Greylock, Sequoia and others. They are now running at a $60 million revenue run rate by focusing 90% of their effort on the telecom boom in China.

BVP's Pete Bancroft never quite settled on terms with Bob Noyce, who instead took venture financing from a guy named Arthur Rock.

Along with every venture capitalist on Sand Hill Road, Neill Brownstein turned down Intuit founder Scott Cook. Scott managed to scrape together only $225K from friends, including HBS classmate and Sierra Ventures founder Peter Wendell, who personally invested $25K to get Scott off his back.

Lotus and Compaq
(formerly known as Gateway Computer)
Ben Rosen, one of the founders of Sevin Rosen, offered Felda Hardymon the chance to invest in both Lotus and Gateway Computer on the same day. Says Hardymon: "Lotus had just missed a payroll, and I was worried about the situation there. As for Gateway, I told him there was no real future in transportable computers since IBM could do it."

David Cowan passed on the Series A round. Rookie team, regulatory nightmare, and, 4 years later, a $1.5 billion acquisition by eBay.

The company has obviously made many successful investments but it shows that we forget that a number of companies that are pushed as investments do work out in the end and the gains, obviously, can be huge.

Does this mean that every one is going to turn out as a Google or and eBay? Of course not, but can it be ignored in a portfolio.. That depends entirely on what you are aiming for from your investments.

Investment in this sector has often been seen as either a rich man's pass time or a the territory of the venture capitalist funds, and there is reason for this. Research into the company, the market and sector requires an enormous amount of time and energy. Any Business Angel or VC worth his salt will also be spending lost of time with management after the event, helping with contacts, management structures expenses, further financing and a multitude of other areas. So can a private investor become involved in this area?

There are firms who have established to work with private clients that effectively operate a 'brokerage service' much like stockbrokers. They keep you on file for their deals and call with recommendations as to the latest deal they are running. This, to me, is a fantastic service if it is run correctly.

By correctly I mean that the service after the event of investment for these companies needs to be something that is inherent in the investment made in the first place. What I mean by that is that, structurally, there needs to be a steady mixture of pain and profit in it for the managers of the company, and there must be a firm commitment to following the plans and projections that have been put in place by the management.

The term 'pre-ipo' should mean just that 'funding prior to an ipo'. So if the company has said that it will float in one year, it should, others wise you have just made a 'private investment' rather than a pre-ipo investment. Corporate finance companies need to have enough influence going into a deal to force the issue on any unwillingness of management to go to the markets once they have said they will. Of course, if they are not in a position to do so, then there is not much you can do, but the plans for IPO should be there at the start, even ring fencing funds from the pre-ipo finance to do it.

Our approach, through our managed accounts, is just that. We are there for a company, to encourage the management, to help the business in anyway and to smooth the road to IPO as quickly and efficiently as possible. What must be remembered, however, is that an investment has been made to see a return, not to make any friends.

The responsibility does not only lie with the corporate finance firm though, it is also the responsibility of the investor. Many companies operate straight equity deals when another structure would be much more favourable. I recall a recent conversation with a corporate finance exec who said "we deal with intermediate clients, however these guys want plain vanilla equity, it is what they understand, complicated structures would reduce our business considerably".

I don't buy it. I just think its laziness. Maybe a few years ago this was the case, but not now. We have ETF's, covered warrants, CFD's and virtually everyone would be able to give some explanation of a spread bet (especially if they are truly 'intermediate' clients). A correctly structured investment that protects a client a lot more than just plain equity is an easier sale, in my opinion, because you can explain all the downside protections to clients. I woud doubt that business would 'reduce considerably' if there were more protections and therefore more winners.

Also, if a client doesn't understand the basics of a structured investment, should they really be dealing in the pre-ipo marketplace?

Me thinks not.

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