HISTORY OF BIOTECH IPOS

The first biotech IPO was in 1980; Genentech raised $35M at a post-IPO valuation of $250M. The stock nearly doubled in the first day of trading. Cetus followed in 1981 with a spectacular $120M offering at a valuation close to $500M. But the average biotech IPOs of the 1980's were decidedly more conservative; companies typically raised less than $30M with post-IPO valuations of $100M during the windows of 1983 and 1986-7.

During the windows of 1991 and 1995-6, more companies went public than in the 1980s. The total raised in biotech IPOs in 1995-6 was almost $2B, more than double the $900M raised from IPOs and secondary offerings in 1986, though the average size of a biotech IPO still remained about $28M. The 1997-1998 window was particularly inhospitable for biotech financing in general, due in part to major financial crises around the world. Yet biotech also had itself to blame when platform companies conceded that they would not be able to secure enough revenues from collaborations to become profitable.

What revived investor enthusiasm in 1999 was a combination of hype around the sequencing of the genome and recently enriched hi-tech investors betting that biotech would be the next big wave. Billions in capital migrated to biotech in search of nascent Amgens.

Tularik's IPO in October 1999 marked the beginning of a spectacular period of public financing for biotechnology. Because the company had raised a lot of capital prior to its IPO, concomitantly increasing its valuation to roughly $400M, the IPO was priced slightly higher; Tularik raised $100M at a post-IPO valuation of $500M. More than 60 IPOs followed in the next 14 months, averaging $85M at a post-IPO valuation of nearly $400M.

There were three drivers underlying the tripling of IPO values in 1999-2000: the sellers (VCs and companies), the buyers (public equity investors), and the investment banks. Venture capital funds grew in size throughout the 90's and needed to put more money to work with each investment. With the VCs' generous support, startups expanded their operations without regard for revenue, increasing their burn rate. Because companies often try to raise 2-3 years of cash in an IPO, higher burn rates necessitated larger offerings. Companies try to sell no more than 25%-30% of their stock in an IPO, and raising more money means increasing the valuation. A company that burns $30M a year and wants to raise $75M in an IPO by selling only 30% of its stock would need to have a post-IPO valuation of $250M.

Public equity funds also grew significantly and needed to put larger chunks of money to work without ending up with too large a stake in any one company. If you want to invest $20M into a company without owning more than 5%, the company would need to be valued at $400M, not $100M. Consequently, companies that reached a certain valuation threshold, probably around $300M, enjoyed the attention of many more funds, whose interest sustained and even further inflated valuations.

The investment banks, working on commission, were certainly in favor of larger IPOs. Sell-side analysts could generate more business for their brokerages because larger valuations meant more liquidity and more shares being traded on commission.

Ultimately, just because the sellers, buyers, and investment banks benefited from uncharacteristically large valuations did not mean that these valuations were deserved. Valuations are derived from earnings, and reasonable projections failed to justify the bubble valuations of 19992000. As this realization dawned on investors, their optimism wavered and stocks fell.

Talk of an IPO window wouldn't resume until the end of 2003. Yet when the first of the companies, Acusphere, completed an offering in October of 2003, its stock tumbled by over 25% within a matter of weeks, casting a pall over the market. Several companies announced postponement of their plans to IPO while others pushed forward but lowered their issue price, raising less money than they had hoped.

IN THE AFTERMATH OF THE BUBBLE

In the aftermath of the genomics bubble, a stringent set of challenges facing investors, banks, and companies alike have raised the bar for companies considering their IPO.

With the increased-regulation of the investment banking industry that followed the bubble, Wall Street became more conservative and sensible. While there had long been a Chinese wall between bankers and analysts, the wall gained substance once the SEC called for increased compliance. Consequently, banks can't promise favorable analyst coverage to prospective investment banking clients. No longer beholden to the investment bankers, analysts can be more open about their real opinions on companies. One need only look at how much more often analysts assign SELL ratings to weak companies instead of using the traditional HOLD euphemism. Analysts almost never issued the SELL rating in the 1990s. Unable to leverage the reputation and celebrity of their respective analysts, investment banks compete with one another on the quality of their services.

Investment banks consistently charge fees of 6-7% for underwriting public offerings, e.g. a $75M offering generates $5M in fees. The larger a bank, the less meaningful are a few million dollars in fees and the larger an IPO must be to justify the bank's involvement. Raising $75M by selling no more than 30% of the company requires a post-IPO valuation of at least $250M.

Market interest and analyst coverage are also important variables affecting the likelihood of a company going public. Investors want to know when they buy newly issued stock that there will be analyst coverage to stimulate interest in trading of that stock. Since the transaction divisions of an investment bank cannot force analysts to pick up coverage, the companies have to actually merit analyst interest on their own. An important question, therefore, is what qualifies a company for analyst interest.

Banks earn commissions by executing trades for their investor clients. Investors, in turn, have a history of trading through those investment banks whose analysts provide them with good research and guidance. Before an analyst will initiate coverage of a company, the analyst may consider whether the company is likely to attract enough interest from investors that it will generate decent commissions for the bank. Large institutional investors, who generate most of a bank's commissions, may put millions of dollars to work with each investment decision and therefore prefer stocks with enough liquidity to accommodate such large transactions.

The larger a company's valuation (a.k.a. market capitalization), the more liquid its stock tends to be. Word on the street in 2003 was that a company had have a valuation of $300M or higher to motivate investment banks to underwrite the IPO. More specifically, a company with this valuation would likely do an offering large enough to generate worthwhile fees for the investment bank and would generate enough trading volume to justify analyst coverage.

EXIT STRATEGY

The conclusion of all this reasoning is that an entrepreneur should plan on growing a company to a valuation approaching $300M before expecting to IPO. Biotech companies with late-stage drugs addressing significant markets may achieve such valuations 5-8 years after startup, but few tool/service companies can hope to do so this quickly. Depending on the nature of the company, suggesting that investors anticipate an IPO may come off as unrealistic and even flippant.