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Trends in Financing Innovation JAMES D. MARVER A general assessment of financing innovation through the public equity markets indicates that there is much less creativity in the financing of quality emerging growth companies than in thetnancing of other types of corporations in the United States. While I have written more broadly elsewhere on the subject of financing innovation,* my purpose here is to comment on two other chapters those by William J. Perry and by John S. Reed and Glen R. Moreno in this volume. In discussing the role of venture capital in financing innovation, Perry says that the initial public offering (IPO) market for emerging growth com- panies is highly cyclical. He also alludes to its recent revival but probably only for the more seasoned companiesafter a particularly depressed market in 1984. It is my belief that we can no longer attribute cycl~cality simply to the economic cycle. In 1983, venture capitalists, company managements, institutional investors, and investment bankers contributed to a frenzied IPO market environment. Fear and greed have always ruled the stock market, and collectively we were inordinately greedy in 1983. We fueled an already hot stock market with many qualitatively uneven offerings. The stock prices of 20 companies went up 50 percent or more by the day after the companies * See James D. Marver. Planning the business for a future initial public offenng, ch. 21 in Richard D. Haunch, ea., Start-up Companies: Planning, Financing, and Operating the Successful Business (New York: Law Journal Seminars-Press, 1985). 473

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474 JAMES D. MAR VER went public. Beginning in Me fall of 1983, Me stock prices of most of these companies came tumbling downin many cases to well below their IPO prices. Some were worthy companies, some were not, and the fate of many of those companies still remains to be seen. The backlash in 1984 was a fierce skepticism shown by institutional investors toward new issues a skittishness that transcended the economy and the Dow Jones Industrial Average generally. There were only 136 IPOs of at least $5 million for industrial companies in 1984, versus 361 in 1983, and their stock prices increased an average of 2.6 percent as of the first day after the offering in 1984, versus 9.2 percent in 1983. The now-increased cyclicality of the IPO market is especially problematic for companies in an early stage, that is, companies that have a product in a "beta site" (i.e., product test site), or even for those that are beyond that stage perhaps those with significant revenues but with no consistent or predictable profits. However, even in generally unreceptive markets, there will be public market access for quality companies with proprietary tech- nology, differentiated products, or dominant market share. In late 1984, for example, I was involved in taking public two companies Wyse Technology and AST Research whose valuations were one-half to one-third what they would have been if Hey had gone public approximately 15 months earlier. The offerings were completed successfully, but the effort was arduous. Stock was sold in one-on-one meetings with institutional inves- tors in contrast to the modus operand: in 1983 when salesmen simply sat by their phones and took orders on the day a registration statement was filed. Investors did not blindly bid up He prices of these two stocks. (Wyse was up 1.8 percent and 0.9 percent after one day and one week, respectively; and AST climbed 6.3 percent and 15.2 percent, respectively.) Instead, after- market price movements reflected fundamental performance achievements by He companies for example, meeting or surpassing investors' expecta- tions for earnings, or for introducing exciting new products. Accordingly, the prices of Wyse's and AST's stocks were up S7.1 percent and 135.7 percent, respectively, as of March 15, 1985. Moderate price appreciation of this nature is much better for the capital markets generally and for these firms specifically than are frenetic bidding wars. This renewed rationality provides investors greater confidence in mar- kets and results in the continued access that quality companies have enjoyed in 1985. Even in very down cycles the IPO market nearly always offers a company a better valuation than an institutionally placed private offering, since He latter vehicle is simply priced at discounttypically 30 percent to 40 per- cent to the public market at that time no matter how depressed that market happens to be. Moreover, once a company is public, there is stock for acquisitions; there is access to the public market for additional capital sub- sequent to the initial public offering; there is liquidity for the stock holdings

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TRENDS IN' FINANCING INNOVATION 475 of the entrepreneur and other shareholders; and there are certain unage advantages (e.g., in marketing to large customers who will want the assurance that they are dealing with a public entity that being, rightly or wrongly, a proxy for business and financial stability). Being public also provides a currency (through options, warrants, and the like) to attract key employees, who increasingly are demanding substantial equity positions (and liquidity for the same) over time. One by-product of down cycles is that considerable venture funding is being directed to more seasoned companies (relative to start-ups). One way in which this is demonstrated is through the recent proliferation of bndge, or mezzanine, funds. This results not just from the greater selectivity of the public market but, I believe, also from changing appetites for risk, as well as from the excellent values that some mature private companies offer today. On addition, several factorsa skeptical, value-conscious public market; limited access to private capital from institutional investors; limited partic- ipation by substantial corporations in the less attractive deals, and We fact that many companies were premised on Starve business concepts that could not, as Jane Moms, editor of the Venture Capital Journal, put it, "achieve marketing differentiation or, in some cases, timely product delivery"all contributed to Me 1984 result Mat "most venture capital firms, especially Hose win established portfolios, concentrated more of their efforts in 1984 on working win existing portfolio companies rather than new investments" (Venture Capital Journal, February 19851. Moreover, much venture money in 1984 was invested in public companies. More Man one prominent venture capitalist has mentioned to me that If he had liked or invested in a company privately at, say, $20 per share, then he had to love it at $10 per share a year later especially if the company had enjoyed a year of solid progress and steadily increasing revenues and profitability. Perry (in this volume) noted what I view as one of the fastest-growing trends in financing innovation: corporate partnenug. I worry, though, that in too many cases it is being accomplished more or less willy-nilly and that we will experience a backlash in a year or two as corporations realize (1) that they overpaid for Weir minority interests, or (2) that they do not know how to integrate their partners' achievements. Another form of partnering is the spinning off of an R&D idea or work group with the original corporation holding perhaps an initial 50 percent of the equity. (The corporate partner's ownership interest may be diluted as the start-up raises additional capital, or it will remain the same if the corporate parmer makes subsequent pro rata investments.) Tektronix, in Oregon, was the first major corporation to pursue this strategy consistently. Its initial spinoff was Planar Corporation, a manufacturer of electroluminescent flat panel displays. One additional mechanism, utilized recently by International Business

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476 JAMES D. MAR VER Machines Corporation (IBM) and Convergent Technologies, Inc., is the organizing of a separate, quas~-independent business unit to develop and produce a new product. The IBM Personal Computer (PC) emerged in this way: in 1981 Philip D. Estridge was provided a 12-person task force in Boca Raton, Florida. This independent business unit had the responsibility for developing what Electronics News recently called "small microprocessor based systems for tiny business and personal use." That unit is now the Entry Systems Division of IBM and has 10,000 employees. It shipped 2 million units in 1984, and it is considered a $5-billion business for IBM today. The R&D limited partnership is another financing mechanism that is grow- ing rapidly in popularity. Despite some highly visible failures, the concept's popularity is demonstrated by the fact that large new funds are announced every month or so. My own belief Is that this is a relatively costly means of financing growth, particularly if the young company has no mechanism for buying out the royalty stream or for repurchasing any equity Cat may have been offered. There are three negative consequences of this type of financing. First, there is a direct negative effect on a company's valuation due to the reduced net income. (Valuation is typically a multiple of net income.) Second, there is an indirect negative effect on the valuation because of Me fact that, except in the biomedical field, the R&D partnership is typically seen as a second-class mechanism for raising funds; it is often used by companies that would be unsuccessful in selling straight equity. Third, the problem of control often arises, since what is beneficial for Me limited partners and what is beneficial for the company are not always coincident. I experienced this firsthand recently when a designer, manufacturer, and seller of turnkey office automation products decided that it could expand its market significantly by making available to larger potential customers its software component only, rather than software bundled into a computer of its own design. The company's c~general-partner in its R&D limited part- nership, which had provided $2 million in funds for the development of this product, insisted that the company not offer stand-alone software because the partnership receives a percentage of gross revenues, which obviously are much higher for a they product that incorporates a computer. The computer portion of the product, however, has far lower margins Can the software, and its inclusion would restrict Me company's customer base to small offices that are not already automated. As a result, the co-general-partner has in- hibited the company's ability to provide the type of product it believes will be most acceptable to its market. This is the kind of help that young companies do not need. I wish to make one comment on John Reed and Glen Moreno's interesting and provocative chapter. It is quite clear from their discussion Cat commercial banks are in an excellent position to help start-ups in a variety of ways.

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TRENDS IN FINANCING INNOVATION 477 Although their participation has been limited to date in most of the following areas (interest-rate swaps excepted), commercial banks are not precluded by law from raising equity and debt capital for corporations privately, from providing a variety of merger and acquisition services, or from assisting clients with their corporate partnering. In addition, certain commercial banks have performed advisory functions for start-ups. They have offered venture advisory work by detaining capital needs, assisting in the preparation of business plans, and helping refer companies to venture capitalists and other entrepreneurs. One of Califomia's largess banks has even established a formal IPO advisory service to educate young companies about the process and even to select and to negotiate with investment bankers themselves. This service is one that investment bankers typically want to provide. We offer the ed- ucation process gratis, and obviously we wish to be involved in this informal process partly because it is a means of initiating, developing, and nurturing what we hope will be a long-tenn relationship. The commercial bank's ultimate benefit is presumably a long-term commercial banking relationship, which typically is probably much less lucrative than the investment banker's relationship and thus probably justifies the fee that the commercial bank charges for this service. In closing, my general assessment of innovation financing through the public equity markets leads me to posit that there is much less creativity in the financing of quality growth companies than there is creativity in the financing of other types of corporations in the United States. Entrepreneurial companies, and especially their investment bankers, appear to focus less on the lowest cost of funds and much more on the future availability of funds. As investment bankers for high technology companies, we are very concerned with accomplishing a "successful offering." One cannot price new issues precisely. Our intent is to be roughly right rather than precisely wrong. Lesser companies must resort to warrants, indices, and the like, but for quality high technology companies we essentially want to do straight equity financing when a company makes its initial public offering, and we are striving for an after-market price Hat climbs consistently over time and in concert with the company's results, which we hope are also improving consistently. Basically, we want to be able to return to the public markets repeatedly, largely since the quality high technology company typically requires considerable capital as it grows. Consequently, it is very important for investors to have made money the last time Be particular company raised funds. If as investment bankers we limit ourselves to quality companies with solid back records, and if we price these issues realistically, we are much more likely to achieve the desired results. For example, my fimn, L.F. Rothschild, Unterberg, Towbin, took Intel Corporation public in 1971 through an $~.25- million equity offenug. Subsequently we raised $150 million in convertible debt (1980y, $40 million Trough Puerto Rican Industrial Revenue Bonds

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478 JAMES D. MAR VER (1982), $50 million in Euro-Yen bonds (1985), and $93.6 million through the issue of $215 million in zero coupon notes with attached warrants (1985~. Another example is Tandem Computer Corporation, which we took public in an $~-m~lion offering in 1977 and for which we subsequently raised $14.1 million in equity (1978), $23.4 million in equity (1979), $93.1 million in equity (1980), and $3.1 million through a sale-leaseback of a warehouse facility (19831. ~ am pleased to report that this advocated behavior is already occuITing. In 1984 there were many fewer IPOs, and hey were generally of greater quality than those in the previous year. ~ believe that partially as a result of our industry s more conservative posture, the after-market performance of these new issues has been more consistently positive. As of March 15, 1985, the 1984 IPOs had appreciated an average of 19.5 percent in contrast with the 1983 IPOs which had declined O.6 percept (though general market changes are not taken into account In these figures). Because of this implicit self- regulation, there remains a very reasonable IPO market in 1985. (The 17 IPOs of over $5 million by industnal companies had appreciated an average of 18.3 percent by m~d-March 1985.) It is not a frenzied market; indeed, it is a skeptical market, but it is highly receptive to high-quality high technology companies.