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Public companies back in VC spotlight

VCs are looking twice at investing in public companies, now that market turmoil has made many a better buy than their private counterparts.

Venture capitalists are looking twice at investing in public companies, now that market turmoil has made many post-IPO companies a better buy than their private counterparts.

The market downturn that stalled or scrapped IPO plans for scores of companies has made these private investments in public entities--known as "PIPEs"--more popular for VCs looking for a quick return on their investment.

Investors who have considered investing in public companies a rarely used option are finding their interest piqued anew now that many of the companies have depressed stock prices and, in some cases, assets worth more than their market valuations.

Usually, VCs make their money off taking companies public or selling them, but this year only a handful of companies have gone public--with most posting only modest gains compared with the booming IPO market of a few years ago.

"We've done PIPEs on a selected basis over the past 20 years," said Dick Kramlich, general partner of VC company New Enterprise Associates. "It's usually been when the public markets have fallen out of favor, and it's in companies where we've had a prior investment.

"Now, with the public markets so decimated and the values really outstanding for public companies, we've broadened our investment strategy to include companies we have never invested in," said Kramlich, who said his company has invested in 10 public companies during the past two decades and plans to invest in two more this year.

Under the usual setup, the VCs arrange to buy shares at below-market value and agree to a lock-up period of six months or longer during which they cannot trade the stock. The companies benefit by getting an infusion of cash.

"We're seeing far more opportunities now than in the past and have begun approaching companies directly--not just getting deals presented to us by (investment) banks," said Phil Sanderson, a general partner at WaldenVC, which tends to focus on companies seeking early rounds of financing.

'We saw it coming'
Softbank set up a $1.5 billion fund several years ago in anticipation of the dot-com downturn, said Charles Lax, a co-founder of Softbank Capital Partners and Softbank Venture Capital.

"When we set up the fund, we saw the market correction coming," Lax said. "We didn't know when it would happen, but we knew it was coming and we wanted to be set to invest in opportunities."

Softbank has made money on all but one of the five public companies it invested in during the past four years, he added.

Executives at Global Sports, a sporting goods wholesaler, said they sought VC funding in 1999 when they planned to launch a new division that would allow the company to build, host and manage the online sales of its retailing customers. Softbank invested $80 million when the company's stock was at $16.75. The stock closed at $15.85 Wednesday.

"We considered raising money through a secondary offering (of stock), but investment bankers told us they didn't want to take it on because they would be raising money for a start-up business contained within an existing business," said Michael Conn, senior vice president of business development for Global Sports.

Global Sports now operates and develops Web sites for sporting goods retailers such as The Sports Authority and The Athlete's Foot, and recently made news by cutting a deal to develop and operate various merchandise categories for Kmart's BlueLight.com, which will allow it to expand beyond sporting goods.

Softbank also invested $20 million in Webhire in 1999, after the software company got the cold shoulder from investment bankers when it sought money to shift its business to selling on the Web.

"We looked at a secondary offering, but it's hard to market it to investors when you're transitioning to a new business from an old one," Webhire Chief Executive Marty Fahey said.

Fahey said it was easier to convince a small group of investors to buy a large block of stock than to convince a multitude of investors in another offering. The company was also able to raise the money faster and avoid large banking fees.

"But the biggest reason for doing a PIPE was the investors' contribution. Softbank has huge contacts and after our deal, they gave us advice on how to approach Yahoo for business," said Fahey, noting that it landed a deal with the portal giant soon after the Softbank investment.

But there are some pitfalls to taking money from VCs.

"Public money from a secondary is very different than VC money--(VC money) comes with strings attached," Fahey said. "They typically want a board seat and want to see you every six weeks." Fahey said his company wanted a close involvement with Softbank.

Shareholders can also get nervous, Fahey said.

"Some of our shareholders wondered if Softbank would take control of the company or step in to take it over," he said.

A shift in thinking
Investment banks, which shop around private placement deals to potential investors, also report a shift in the mindset of VCs.

"Venture capital firms just five years ago were not interested in lining up for pitches on private placements," said Ron Emerick, a principal with William Blair & Co. "It was far from the norm of their business practices, but now all that's changed."

That is partly because many public companies seeking investments today have similar characteristics to the young private companies that VCs fund. These public companies may have gone public prematurely during the markets' gold rush days and still need assistance building their company--a job VCs thrive on.

"To many of these VCs, these companies look like the early stage companies they would have funded in the third or fourth round," said David Williams, global venture banking director for Merrill Lynch's venture banking group.

In addition to the traditional fixed-stock-price investment, some public companies in financial dire straits sometimes agree to deals in which the investor can reset the terms if the stock price drops dramatically. But bankers warn against these so-called toxic converts.

Williams said VCs are not interested in such deals. "Firms who invest in toxic converts can still make a profit if the company goes under and tend to be used by financial engineering outfits," he said.

"Deal flow is the lifeblood of VCs, and, if they want to continue to get references for deals, they need to be viewed as company builders. Reputation is paramount."

But venture companies say they have other considerations when investing in a public company.

"Usually you look to invest in companies with great breakthrough technology that can't get adequate capital in this market," Kramlich said. "Also, we tend to invest in young companies to help build them. The more mature companies usually have too many problems, and you don't really know the situation if it's a new investment."

Softbank is an investor in CNET Networks, the publisher of News.com.