Tough market to continue for IPOs

With half of the year’s new issues underwater, venture firms have to think carefully about floating their portfolio companies onto the Nasdaq.

This has been a big problem for health care IPOs during the first half of the year. Even after a spate of last-minute offering range cuts, some two-thirds of the health care companies are currently trading under their offer prices.

Of the 29 VC-backed companies that went public in the first half of the year, 14 are trading lower than their IPO prices (see IPO Losers list), while 15 are trading higher (see IPO Winners). Life sciences companies made up the majority of new issues (16 in all) in the first half of the year, but most of them have floundered in the aftermarket.

Part of the reason for the harsh treatment of new health care issues is that young health care companies can be difficult to value. The majority of them lose money and many don’t yet have revenue. When the overall health care market is good, public investors seem willing to tolerate short-term losses on a new offering if there’s the promise of a big win in the future. “There’s a bucket of pre-revenue companies that could go public because they are playing in big, well-established markets,” says Michael Carusi, a general partner at Advanced Technology Ventures. “The stories that don’t fit that profile will have a much harder time.”

No proof, no dice

A good example is Northstar Neuroscience (Nasdaq: NSTR). The company is developing an electrical stimulation device that may help stroke patients recover. It’s addressing a huge market opportunity. The annual health care burden of stroke-related illnesses is more than $50 billion each year, according to the American Stroke Association. If Northstar can get its stimulation device working in patients, it may drastically reduce that cost and become a de-facto standard for treatment for the 5.5 million stroke survivors in the United States.

The market gets spooked and the few biotech IPOs that have gotten done have had to take dramatic haircuts.”

Farah Champsi, Managing Director, Alta Partners

But Northstar lost $14.5 million in 2005 and did not record any revenue. It closed up 11% from its first day offering price of $15, but has since dropped to below $10, landing it on our “IPO losers” list.

In life sciences, a little good news will go a long way. Novacea (Nasdaq: NOVC) got a big boost from positive mid-stage trial data for one of its experimental cancer treatments. Its stock price is up more than 40% from its offering price, despite losing $7.4 million during the first quarter on about $370,000 in licensing revenue. The good news made Novacea the best-performing life sciences company out of six such companies on our list of IPO Winners.

VC-backed life sciences issues have also been bruised because the overall life sciences sector has not been doing well. The Nasdaq Biotechnology Index has lost more than 15% of its value since the end of February. Big, well-established public companies have been taking knocks from the U.S. Food and Drug Administration and have posted less-than-positive lab data. That has spooked fast-money investors, says Farah Champsi, a managing director of Alta Partners. “The market gets spooked and the few biotech IPOs that have gotten done have had to take dramatic haircuts,” she says.

Whether health care IPOs will sink or swim in the next half of the year depends more on the market currents than the viability of any new issue, analysts say. Good news from Merck’s (NYSE: MRK) Vioxx settlements or positive data for any one of the small-market drugs in development could raise the boats of all the new health care issues.

M&A going strong

If they can’t make it on Wall Street, young life sciences companies have a good chance of finding a buyer, says Ofer Baharav, an investment banker with Brimacomb and Associates. A strong M&A market has helped to push up the pre-money valuations of life science startups by 20% in the past year, he says.

There’s a bucket of pre-revenue companies that could go public because they are playing in big, well-established markets. The stories that don’t fit that profile will have a much harder time.”

Michael Carusi, General Partner, Advanced Technology Ventures

Big companies have paid more in the last 18 months for venture-backed health care startups than at any point during the last five years, according to data from Dow Jones VentureOne. And they’re buying younger startups. “Big Pharma sees they can get in early and pay less and collect their dividends” Baharav says.

Even with the heady acquisition market, 19 life science companies are still in the queue to go public in the second half of the year. If the market continues to treat them unfavorably, they may think twice about going out.

On the other hand, VC-backed information technology companies are doing fairly well in the aftermarket. The solid financials that Wall Street demands before an IT company can debut are protecting new IT issues from fluctuations in the overall IT industry.

Bet on black

Because of the high financial hurdle, fewer IT companies are braving the IPO market. This is a particular problem in the software industry, says Jason Maynard, a director of equity research at Credit Suisse First Boston. Many software startups have changed their product offerings to the software as a service (SaaS) recurring revenue model, forgoing the one-time sale of a software license and the potential for explosive revenue growth, he says. “It takes longer for an on-demand company to get to the revenue level needed to go public,” Maynard explains.

Profits are king in IT. Look no further than new issue LoopNet (Nasdaq: LOOP). The company, which operates an online real estate business, earned nearly $3 million on $10 million in sales during the first quarter of 2006, up from earnings of $1.8 million on $6.2 million in sales during the same period last year. Its stock is up more than 55% since its June 6 offering, putting it near the top of our IPO Winners list.

The market’s demand for profits sent (Nasdaq: TRFC) into a ditch. The provider of real-time traffic data priced its shares at $12 apiece in January, but then it reported a first-quarter loss of $7.7 million on sales of $10.7 million. The news got worse in May when JMP Securities took a bearish stance on, saying it wasn’t likely to reach profitability without raising another $20 million in the next 18 months. The company’s shares dipped below $6 in July, giving the dubious distinction of being No. 1 on our IPO Losers list.