How Long is the Incubation Period?
April 27, 2000
by Kirsten Sharett
Can the new Internet incubators survive their own incubation period?
Internet incubators - publicly-traded venture capital funds that nurture online start-ups - were popping up by the dozen when the IPO market was hot. But now that the IPO craze has cooled, some could perish in their infancy.
Venture capitalists and Internet incubators assist start-ups with funding and advice, but incubators tend to get more involved. For both, the goal is developing a sound exit strategy, so they can profit once the company goes public or is acquired. But venture capitalists are beholden to private investors, and incubators answer to shareholders - making the latter more sensitive to volatile market conditions.
"The valuation of the Internet incubator is in part dependent on the IPO market,? says Phil Leigh, an analyst with Raymond James & Associates. ?And if the stock market catches a cold, then the IPO market has the flu. And that seems to be the case right now."
Steven Frankel, an analyst with Adams, Harkness & Hill Inc. agrees. "What you find with some of these wannabes is that they are investing in lower quality deals,? Frankel said. ?They were born in, and are products of, stock market euphoria, and may not survive now that the IPO window is shut tight.?
And it could be several months before the IPO market ?regains its footing," wrote Renaissance Capital in a report. "Even if the Nasdaq were to recover in a relatively short period of time, the IPO market should stay under pressure."
Consequently, a nervous investor is more comfortable with established companies than unproven ones, which means a tightening of funding for incubators. With a record 332 companies in the pipeline for IPOs, Renaissance Capital predicts there will be "a bottleneck of companies trying to make it out a very small opening.?
Of the 173 newly priced IPOs this year, 61% are trading at a median level of 40.4% below their issuance price, according to an April 24 report from Bridge Information Systems. Of the 39% of companies trading above their opening price, the median gain is 35.63%.
Frankel said that only the larger incubators that are well-financed and have real businesses will be able to weather the storm.
"There is no doubt that an Internet incubator is a riskier investment for investors," said Sanjay Sabnani, president and COO of Internet incubator Venture Catalyst (NASDAQ: VCAT). "The Internet marketplace is saturated with incubators and many will fade away."
Investors need to look for several key indicators when evaluating an incubator firm. The diversity of the revenue model shows how these companies pay for overhead and salaries. If the costs are paid for by the return on the investments made in their incubator firms, then the company is violating the SEC Investment Company Act of 1940.
Public companies can't have more than 40% of their assets invested in non-majority investments, according to the law, intended to prevent them from acting like mutual funds and being too dependent on the stock market for revenue. ?Investors take a big hair cut when the market turns down because of the exposure of having no revenue or profit core business," said Sabnahi.
The company's exchange listing can also say a lot. Regulations on the OTC Bulletin Board are not as strict as the Nasdaq.
Management is also a critical component of success. Sabnahi cited the track record of Bill Gross, the chairman and CEO of the Internet incubator idealabs!, which filed with the SEC for a $300 million IPO. Goldman Sachs & Co. will lead the underwriting.
"Bill Gross is a genius,? said Sabnahi. ?He has built so many businesses we can't even count them.? idealabs! was founded in 1996 with $3 million from movie mogul Steven Spielberg and Compaq chairman Ben Rosen, and has launched eToys (NASDAQ: ETYS), NetZero (NASDAQ: NZRO) and CitySearch, now part of Ticketmaster ? CitySearch (NASDAQ: TMCS).
Even so, Since Jan. 31, all of idealab?s creations are trading off an average 38%.
Being located in a hotbed of deal-making activity, like Silicon Valley, helps, too. And, lastly, diversification in the types of business being incubated helps cushion incubators from a downturn in one industry.
The leader in the Internet incubator space is large cap CMGI Inc. (NASDAQ: CMGI). "CMGI is extremely well financed, has a large stash of publicly-traded securities and can ride the IPO window if it is closed because they have a real business," said Frankel. Leigh said that CMGI has plenty of liquidity and "they understand the Internet better than anyone else."
Idealabs, whose ticker will be (NASDAQ: ILAB) and Divine Interventures, which should go public later this summer, (NASDAQ: DVIN) will be the new leaders in the space, predicts Sabnahi. Divine Interventures was founded by Andrew Filipowski, once the CEO of Platinum Technology, who then sold it to Computer Associates (NASDAQ: CA) for $3.5 billion.
Divine Interventures is scheduled to issue 20 million shares in its IPO led by CS First Boston later this year.
Also playing for incubator dollars are: Harris & Harris Group (NASDAQ: HHGP), Net Value Holdings (OTC BB: NETV), Frontline Capital Group (NASDAQ: FLCG), M&A West Inc. (OTC BB: MAWI), eVentures Group (OTC BB: EVNT), and I-incubator.com (OTC BB: INQU), among others.
Sabnahi said his own company, Venture Catalyst, was both compliant with SEC regulations, has a diversified services revenue stream and benefits from being in San Diego, a hot bed of deal activity.
Another notable is Rare Medium Group (NASDAQ: RRRR) which garnished a 'strong buy' rating from CS First Boston's analyst Barry Chubrik.
Rare Medium has a service-led model and is slightly more insulated from the capital markets, said Chubrik. "What they have been able to do quite well is leverage each of the businesses and drive incremental services revenue as well as incubation clients." With $230 million cash, he added that it was certainly large enough to sail through any market downturn.
U.S. Technologies' (OTC BB: USXX) Chairman and CEO Gregory Earls responded to the list of key indicators in this article during an interview.
U.S. Technologies has partnerships with ten companies and is only incubating three right now. "Everyone won't be incubating with us so we mitigate that risk," said Earls.
The company operates an outsourcing and e-commerce services business that keeps both the revenue stream diversified and the company in compliance with the 1940 act.
Earls is a former Wall Street investor with over 20 years of experience in building companies. He said that the company has filed for a Nasdaq listing and qualified in all aspects, except that its share price ranges between $1 to $2.
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