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OCR for page 473
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 companies—after 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 down—in 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 discount—typically 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 factors—a 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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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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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.
Representative terms from entire chapter:
financing innovation
