Net IPO Investors Should Think Like Venture Capitalists, Given Firms’ Youth

For the last year, the Internet has given Wall Street what it craved most: a rich supply of hot stock offerings in an industry growing at a spectacular rate.

But as Net stocks suffer a severe pullback, a new stage might be dawning for the initial public offering market as well.

If Net IPOs are no longer guaranteed to rocket from the get-go, investors who want to make longer-term bets on fledgling Internet businesses will have to think more like venture capitalists--experts at handicapping a start-up’s chance for success.

Because so few Net companies have any history, experts have long argued that individual investors buying the IPOs had become venture capitalists, whether or not they knew it.

With the latest crop of IPOs, that’s more true than ever--in such names as Drugstore.com, which filed for an IPO only three months after creating its Web site, and Stamps.com, which has yet to take in a dime of revenue.

“The public market is acting, in effect, like a round of [intermediate] financing” usually provided by venture capitalists, says Jon Funk, a partner with Media Technology Ventures in Los Angeles.

While some critics say too many Net companies have gone public too early, venture capitalist Funk notes that getting the best terms for financing is part of building a firm. Young companies “will take advantage of this source of cheap capital while it is available,” he says.

Traditionally, there were trade-offs between venture investing and IPO investing.

VCs often lose money on failed start-ups, but their low batting average is typically offset by owning large stakes in big winners at low cost. Some of their investments generate hundredfold profits.

By contrast, IPO buyers knew they were getting into a company at much higher prices but were insulated from the high level of risk that VCs find routine.

But today, most Net IPOs can’t justify confidence in their survival, much less profitability.

Furthermore, the long series of recent Net IPOs is thick with also-rans, says Randall Roth, a senior analyst at IPO tracker and mutual fund company Renaissance Capital. “These early-stage companies tend to be more derivative. There are several drugstores, car sellers, music sites.

Venture capitalists make it their business to cut through the clutter and identify companies that could be true leaders--something that individual investors are finding it more difficult to do amid the glut of offerings.

VCs train their focus on three areas: size of potential market, uniqueness of business model and quality of management.

“How large is the opportunity? You have to start there,” says George Pavlov, a general partner with the Mayfield Fund in Menlo Park.

Calico Commerce, a Mayfield client registered to go public, automates product configuration at merchant Web sites. Even if Calico can’t be called a sure thing, analysts consider this field vital to the e-commerce boom. In other words, the potential is huge.

Another example: Rhythms NetConnections (ticker symbol: RTHM). Research house Dataquest expects Rhythms’ market for digital subscriber-line gear to grow 58% annually through 2003. Even after a steep slide in recent weeks, the market still values the toddler company at $2.7 billion.

One way to approach the scale-of-opportunity question, Funk says, is to ask if the company is bringing to the Internet an offline market that’s already huge--Amazon.com’s (AMZN) stock in trade.

Funk’s portfolio includes Quokka Sports (QKKA). The stock, which closed at $7.44 on Friday, has slumped from its IPO price of $12 on July 28. But Funk expects Quokka to harness the interactive magic of the Web to attract a nice chunk of the vast audience for sports programming.

On the other side of the coin, Dennis McKechnie, manager of the tech-heavy Pimco Innovation fund, wonders whether the market targeted by ballyhooed Drugstore.com (DSCM) will materialize.

“I don’t think that Middle America necessarily finds it a much more convenient way to get medicine, or that the primary potential users--older people--spend a large amount of time on the Web,” he says.

VCs are always hunting for a product or service that can’t easily be replicated, or a market with high barriers to competition.

That’s why L.A.-based Brentwood Venture Capital invested in Stamps.com (STMP), a Santa Monica-based maker of software for printing postage, says Brentwood principal Brad Jones.

Stamps.com’s product is expected to be blessed by the U.S. Postal Service and in use in the near future--the beginning of what could be a powerful revenue stream. Stamps.com’s software-only solution might give it an edge over its chief rival, E-Stamp, which requires additional hardware.

“Other companies that want to do this would have to go through the Postal Service approval process, which is tightly controlled because of the risk of fraud,” says Jones. “The defensibility of the position is how you determine who will be the long-term winner.”

One recent Net IPO with a far less secure business model, according to Jones, is Priceline.com (PCLN). “If it had the potential to be incredibly successful and absorb a high percentage of sales for airlines, etc., the vendors would just sell tickets directly to squeeze them out,” he says.

As for sizing up a company’s management, VCs get to know them much better than small investors ever could. In fact, they often take seats on their companies’ boards.

In most cases, the best an individual can do is closely examine the management bios in a company’s prospectus.

“Look for experience relevant to their business. Look for solid members of the board that can help the company grow,” Funk advises.

Association with elite venture firms such as Kleiner Perkins Caufield & Byers or top-tier investment banks such as Goldman Sachs and Morgan Stanley Dean Witter often translates into a higher stock price.

The essential thing to keep in mind is that VCs are paid well to take outsized risk and that more and more of that risk is being transferred to individual investors. Technology stocks’ familiar caveats go double for the new Nets: Diversify your holdings, don’t mortgage the house to get in and be prepared for extreme volatility.

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Times staff writer Edward Silver can be reached at [email protected].

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Tracking the Deals

A look at some initial public stock offerings planned by California companies. For more information on upcoming deals, contact the companies or the underwriters. Note: Most of the companies and underwriters have Web sites you can visit.

Company: US Aggregates

Ticker symbol: AGA

Size, in millions: $125

Est. share price: $17-19

Underwriter: DB Alex. Brown

Est. week: 8/9

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Company: FirstAmer.Auto

Ticker symbol: FAA

Size, in millions: $105

Est. share price: $15-17

Underwriter: Merrill Lynch

Est. week: 8/9

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Company: Pacific Comm.

Ticker symbol: PCBG

Size, in millions: $58

Est. share price: $15-16

Underwriter: Sutro

Est. week: 8/9

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Company: Quest Software

Ticker symbol: QSFT

Size, in millions: $57

Est. share price: $12-14

Underwriter: BancBoston RS

Est. week: 8/9

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Company: LookSmart

Ticker symbol: LOOK

Size, in millions: $144

Est. share price: $11-13

Underwriter: Goldman Sachs

Est. week: 8/9

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Company: Therma-Wave

Ticker symbol: TWAV

Size, in millions: $36

Est. share price: $10-12

Underwriter: Banc of America

Est. week: 8/9

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Company: Active Software

Ticker symbol: ASWX

Size, in millions: $44

Est. share price: $10-12

Underwriter: Goldman Sachs

Est. week: 8/9

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Company: MyPoints.com

Ticker symbol: MYPT

Size, in millions: $55

Est. share price: $10-12

Underwriter: Robertson Stephens

Est. week: 8/9

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Company: Bamboo.com

Ticker symbol: BAMB

Size, in millions: $55

Est. share price: $10-12

Underwriter: Prudential

Est. week: 8/9

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Company: Women.com

Ticker symbol: WOMNB

Size, in millions: $41

Est. share price: $10-12

Underwriter: Morgan Stanley DW

Est. week: 8/9

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Company: Wink Commun.

Ticker symbol: WINK

Size, in millions: $63

Est. share price: $14-16

Underwriter: DonaldsonLufkin

Est. week: 8/16

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Company: Cybergold

Ticker symbol: CGLD

Size, in millions: $40

Est. share price: $9-11

Underwriter: SG Cowen

Est. week: 8/16

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Company: Takes.com

Ticker symbol: TAKE

Size, in millions: $23

Est. share price: $7-9

Underwriter: Paradise Valley

Est. week: 8/16

Sources: IPO Financial Network (https://www.ipofinancial.com), Bloomberg News