Markkula Center of Applied Ethics

Who’s Holding the Bag?

An Intervew with Donald Milder

When high-tech IPOs soared, who profited? And when the inflated stock values plunged, who suffered? Were there ethical breaches involved? We asked Milder to comment:

In 1998-99, market valuations rose far beyond any venture investors’ expectations because of excitement about the technology space. If you were fortunate enough to invest in a successful company in the technology sector, your ability to go public was assured, and the company’s valuation in the public market was likely to be far in excess of any historical metric. The venture funds, which are always watching very closely, were quick to pick up on the trend and they started flooding the technology sector.

As the excitement grew, the public eagerly wanted to invest in these companies, as well. So companies that were not quite as mature as in prior years were able to access the public markets. Even if, as an investor, you thought it was too early [for an IPO], it was difficult to tell the founders, "Don't go public," when that meant the company stayed at a lower value, got diluted, the founders had a lower percentage of the ownership and they had no liquid market to sell shares.

It was also difficult for the entrepreneur to resist. After all, an entrepreneur is responsible not only to himself but to an executive team and employees, who want to get off the venture tether. If it were me, even if knew I was taking a risk, I would go for it. It would mean I had more funds to work with, a stock that I could use for acquisitions. I would have a stronger company. Even though I knew that if I missed a quarter, I’d get hammered in the market, at same time, it would be difficult to pass on that opportunity.

As a result, Milder explained, more companies than usual went public, and many could not sustain their early valuations. Traditional checks on this tendency—particularly the investment banks that manage IPOs and the institutions that invest most heavily—had some incentive to ignore the problem, according to Milder.

Investment bankers need to take companies out because they make fees of roughly 6 percent on an offering. If a company raises $100 million, it will generate revenues of $6 million for the bank. Of course, investment banks don't want to be associated with disasters, but they’re incented to do more rather than less.

Once the bank has decided to be involved, they will have relationships with institutional investors and money managers. The company goes on a road show and presents their business plan to these institutional investors, who then buy the stock.

You might think that institutional investors would be the ones to say, "This company isn’t strong enough, so we're not going to buy shares in this public offering." But the reality is that institutional investors can often get in and out quickly. Historically, investment banks attempt to price IPOs at 15-20 percent below what they expect will be the price on the first day. So institutions, which buy at the IPO price, essentially get a discount over fair market value to adjust for the "risk" of backing a private company. At the height of the tech boom, these discounts averaged 50 to 60 percent when day traders and other enthusiasts bid up the price on the first day of trading.

The institutional investors can flip a stock right after the opening. If the stock goes up the first or second day, they can sell and make money. If the shares don't go up, investment banks will usually protect the value of the company by buying up the excess supply of shares, at least for the first week or so of trading.

But is this really an ethical issue? Milder suggests that sometimes the problems are structural.

Windows may open and close; investors may get rich, or if they have the wrong timing, they may get hurt. But in the vast majority of cases, it’s not an ethical issue; it’s just a structural issue, where there may not be perfect structural synchrony that provides all the checks and balances. There’s not really anything shady going on.

If you look at the recent high-tech melt down, who is getting stuck? Some VCs and institutional investors that held their positions and management teams that were unable to diversify experienced substantial paper losses. Many individuals who were looking to get involved in high-growth companies with the chance of making exceptional returns got hammered. If they had been conservative, they would have invested in large cap growth stocks or that kind of thing, but they were looking to ride the tech wave in the belief that it would grow in value at a much higher rate than standard. Who’s fault was it that they didn’t fully understand the companies they were backing?

Donald Milder is managing director of Versant Ventures, a firm specializing in health care investing. Milder developed his expertise in the field at Crosspoint Venture Partners, which he joined in 1989. He has been involved as a first round investor and board member in over 20 companies, including TheraTx (public/sold), Informed Access Systems (merged) and Sonus Pharmaceuticals Corp. (public). Previously, Milder was CEO of Infusion Systems Corp. and president of TRIMED Corp., a manufacturer of dialysis, hemophilia and IV products.