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Private Matters and Public Markets3393 words8/28/97 
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Private Matters and Public Markets
 The Rise of the Internet and Public Venture Capital
 Andre de Baubigny, Vice President Robert Heath, Vice President 
Robertson, Stephens & Company
Private Equity Investor: “… Okay, so Release 2 of the software is shipping and revenue this quarter isgoing to be a million dollars plus or minus. So what are your valuation expecta-tions?” Entrepreneur: “Well... Yahoo! has a billion dollar valuation, and Microsoft paid $425 million for WebTV... And we’ve been told by some investment bankers that we could beworth $200 million in an IPO, but what’s important for us is to get the right part-ners in quickly, so we’re looking to raise ten to fifteen million at a $100 to $120 million valuation. That’s only a double from our last round, and we think it’s con-servative since we’ve hit our milestones. What do you think?” Private Equity Investor: “Well, as a general rule, we don’t make investments above $100 million...At those valuations, all we bring to the table is money. But good luck, the story sounds great...” 
Genentech and Netscape
 
In the late 1970’s, the development of recombinant DNA technology led to the formation of Genentech and eventually to its highly successful 1980 IPO. Genentech’s technical and com-mercial successes in turn spawned a “public venture capital” market willing to fund biotech com-panies years before they achieved meaningful revenue, let alone profits. Many of these biotechIPOs involved companies so young that investment bankers joked about their “market capitaliza-tion to Ph.D ratios” for comparative valuation purposes. But they were only half joking; thesecompanies generally lacked any meaningful operating and financial data on which to base avaluation. And they were outstandingly risky investments by public market standards; many of these companies would require multiple infusions of equity before they could hope to becomeprofitable. The existence of the public biotech market may seem unremarkable today, but its de-velopment demanded a dramatic shift in attitudes towards risk on the part of the investors whobought the shares as well as the bankers who underwrote them.While the public market for biotech issues was developing in the 1980’s, information technologystartups were generally held to different standards. Until recently, a software company goingpublic would typically sport a $25 to $30 million sales rate and five consecutive profitable quar-ters. There were exceptions, but for the most part, an information technology company was ex-pected to be profitable and possessed of a relatively mature operating model before most WallStreet firms would consider underwriting its shares.
 
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Netscape Communication’s 1995 IPO was a watershed event for information technology inves-tors. Like Genentech 15 years earlier, Netscape was largely conceived, assembled and quicklylaunched into the public markets by Kleiner Perkins Caufield & Byers, one of Silicon Valley’s lead-ing venture firms. And just as Genentech’s success legitimized the idea of a public market for biotech startups, Netscape’s success has paved the way for IPOs by many early stage Internetcompanies. Since then, scores of Internet-related offerings have been completed well before theissuers achieved profitability. Many of these offerings have been spectacularly successful andothers have been equally disappointing. Not surprisingly, the investing public has demonstratedthe same “hot and cold” attitude towards these stocks that has characterized the biotech marketfor most of its existence.Investment trends come and go, and it’s tempting to dismiss the recent flood of Internet-relatedofferings as a passing fad in a hot IPO market. In contrast, we believe the market’s appetite for Internet-related stocks is likely to persist for years. The emergence of the Internet as a social andcommercial phenomenon presents the potential to radically transform the entertainment andcommunications industries, much as advances in biochemistry transformed the pharmaceuticalindustry fifteen years ago. And, unlike more arcane areas of technology (
especially biotech
); theInternet is particularly accessible to the public investor who wants to evaluate a company’s prod-ucts or services personally. Consequently, we expect that even very young startups will continueto find willing investors in the public equity markets if they possess the potential to build leadingbusinesses based on the Internet.
 
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Public Venture Capital for Internet Navigation Companies
 
Perhaps the most notable examples of public venture capital were the 1996 IPOs of four searchengine or Internet navigation companies. During the second quarter of 1996, Excite, Yahoo!, Ly-cos and InfoSeek all completed initial public offerings. Table 1 summarizes these companies atthe time of their IPOs.
Table 1. Internet Navigation Companies
 
Company IPO DateIPO MarketCapitalization($ million)Founded Filed for IPOIncubationPeriodEmployees
 
Total / R&DRevenueRun Rate
Lycos 4/2/96 $219 Jun 95 Mar 96 9 months 28 / 15 $3.3Excite 4/4/96 $183 Jun 94 Feb 96 20 months 38 / 14 $0.6Yahoo! 4/12/96 $334 Mar 95 Mar 96 12 months 43 / 7 $4.3InfoSeek 6/11/96 $299 Aug 93 May 96 27 months 71 / 26 $6.9
 Average $259 17 months 45 / 16 $3.7 Note: All information is derived from the IPO prospectuses of the respective companies. IPO Market Capitalization is equal to initial public offering price times total shares outstanding and excludes over-allotment shares and options. “Incubation Period” is calculated as the timefrom the company’s incorporation to the IPO filing date. Revenue Run Rate is equal to 4x revenue for the most recent quarter reported in the preliminary IPO prospectus.
On average, these companies were less than two years old, employed fewer than fifty employ-ees, and booked sales of less than $1.0 million in the quarters leading up to their IPOs. Withholdthe company names, and most venture capitalists would recognize the profile as a typical sec-ond- or third-round venture investment. Instead, these four companies went public at an aggre-gate market capitalization in excess of a billion dollars, giving the public investor the opportunityto play venture capitalist. So how has the public fared?We considered the performance of a portfolio consisting of $10,000 divided equally among theIPOs of these four companies. As of this writing (August 28), an investor’s original $10,000 wouldbe worth $20,222 for an annual return of 67.5%. For comparison, $10,000 similarly invested inthe Standard & Poors 500 index (“S&P”) would have grown to $13,962, or an annual return of 27.7%, excluding dividends.
 1
In this instance, the public venture capitalist would have made outquite well. (Given the recent volatility in the markets, by the time of publication, the comparativereturns could be substantially different.)
1
 
For students of the Capital Asset Pricing Model, we also considered risk-adjusted returns. Over this relatively shortobservation period, our portfolio of Internet Navigation stocks had a negative
beta
. This raises the intriguing possibilitythat our portfolio represents the Holy Grail for efficient market theorists, namely, positive expected returns and a negativecorrelation with the market. We suspect the negative correlation will abate over longer observation periods, although itseems logical that the valuations of early-stage companies will fluctuate mostly due to company specific events and lesssignificantly due to overall macro-economic or market factors. Consequently, returns to investors in these companies mayappear to be un-correlated with market returns for extended periods.
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