The effects of the weak IPO market are likely to reverberate through the industry long after the current bear market ends, as investors push down company valuations and restrain step-ups between private rounds in an effort to preemptively guarantee an increase in value in the next rounds of financing.

The average pre-money valuation of this year's 19 U.S. IPOs is $51 million. Omitting the four over $100 million, the average is only $32 million. In many cases, those figures don't represent any step-up at all. As John Wilkerson of The Wilkerson Group put it, "The fundamental question is, are there any step-ups? I'm aware of a number of step-downs being discussed. The back of the camel has been broken and people are coming to terms with the price at which their board will take money."

The sea change

One of the first companies hit by the change in attitudes was Arris Pharmaceutical Corp., which went public last November at $7 a share, after filing at $11-13 a share. At the time, the South San Francisco drug discovery company still was using the previous class of IPOs as a benchmark. Many of those companies had been going public with post-money valuations above $100 million, and ARRS was hoping for a small premium on that. Instead, the company ended up with a post-money valuation of $59.5 million.

"At the time we felt put upon," said CFO Daniel Petrie. "It was not pleasant. But there had just been a sea change in the market."

The company also had to swallow hard to go below $8.05, the price at which it had done its last private round in April 1993. ARRS also had warrants outstanding with an exercise price of $8.75, and it was trying hard to stay above that price.

When times are good, step-ups between rounds reward investors for progress, and downticks rarely occur unless a company hasn't met its milestones.

"It's rare not to see a step-up, because there's no independent buyer and seller," said Kenneth Lee, national director of life sciences industry services at Ernst & Young. Step-ups are changing now because the relationship between venture funders and other financing sources is changing, which is reverberating back down the funding chain. (See Ships in the Night Commentary, June 20, 1994.)