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IPO drought leading VCs abroad

PALO ALTO, Calif. -- The U.S. market for venture-backed IPOs is in the dumps, and Charles Lax is more than a little impatient.

The managing general partner at GrandBanks Capital is so at a loss he is discussing launching initial public offerings with three promising startups on the London Stock Exchange's Aim market.

Within the next 12 months, he expects one of these portfolio companies will have floated an issue outside the United States.

"Nasdaq is dead," declares Lax, who declines to name the technology businesses he is urging to look overseas. "You see a real gap for the early IPO" in this country, he says.

With the volume of venture-backed IPOs down 41 percent through the first three quarters of the year, it isn't surprising venture capitalists are looking elsewhere. Many are reluctant to predict an end to the five-year Nasdaq IPO drought or guess at how much the lost opportunities continue to depress their returns.

If the financial markets are strong and corporate earnings are solid, the IPO market could open up by late next year, some say. But the Nasdaq composite index probably would need to strengthen noticeably, something it is showing few signs of doing.

Venture capitalists say the IPO market remains a sore spot in a business landscape that has largely stabilized from the dot-com boom and bust. An uptick of activity in 2004 -- when 93 venture-backed companies went public, raising $11 billion -- dissolved this year. Only 39 startups floated new stock through the third quarter, raising just $2.9 billion, according to National Venture Capital Association and Thomson Venture Economics.

Helping to drive the market last year was Google Inc. (Nasdaq: GOOG), which sold $1.7 billion in stock itself and created a slipstream for other Internet companies to follow it. If an increasing number of these companies depart the United States for markets overseas, any recovery could become that much more difficult.

Venture capitalists point to several explanations for this year's slow market. Many complain that Sarbanes-Oxley Act regulations impose an onerous cost on young companies with annual revenue under $50 million. Others say last year's spike of activity drained candidate companies out of the IPO pipeline.

At the same time, high oil prices have pinched company performance as well as the market's appetite for new issues since the start of the year. From the supply side, few new companies sparked investor fascination the way startups did during the Internet boom.

"There really haven't been any home-run sectors in five years," says Jay Ritter, a finance professor at the University of Florida.

Small companies also have a tough time attracting analyst coverage, and investment bankers are hesitant to get involved in deals with a sub-$100-million market capitalization, venture capitalists say. The boutique firms, such as Hambrecht & Quist, that took technology companies public during the 1990s are gone.

Ritter says it isn't unusual for the IPO market to take several years to recover after a boom period like the late 1990s. A similar surge of investor enthusiasm in the late 1960s and early 1970s over young computer-electronics companies led the IPO market into a long sluggish period from 1973 through 1979.

Some VCs say the downtick of the past five years is bound to end, perhaps by late next year. Allen Morgan, a managing director at the venture firm Mayfield, says a maturing crop of new startups is likely to provide the spark. Venture capitalists funded a new group of companies in 2002 and 2003. Because it takes startups about five years before they are ready for the public markets, "I think you will start to see some (IPO) activity at the end of 2006 and in 2007," Morgan says. "I don't think it should come as a surprise to note we don't have a lot of companies ready to go public."

It is no surprise to see VCs, like Lax, presently looking abroad. Few are ready to argue London's Aim market will replace the Nasdaq, or even steal away a substantial number of startup companies.

"It's not really an alternative to Nasdaq," says Steve Harmston, director of international research at Dow Jones & Co.'s (NYSE: DJ) VentureOne unit in London. "It's an alternative to (taking additional) venture funding."

However, more VCs are considering it, and "the buzz has just been started," says Harmston. "It will be interesting to see where it goes."

For the most part, smaller companies list on Aim than on Nasdaq. Market capitalizations are often less than $100 million, whereas companies signing onto Nasdaq often shoot for values of $400 million to $500 million within a short while after going out.

"Nasdaq continues to be the market we prepare our companies for," says Christopher Spray, senior partner at Atlas Venture in London. And yet, "Aim has come of age in the past 12 months."

"I'm aware of a couple firms" looking at Aim, adds Advanced Technology Ventures General Partner Jack Harrington. Three or four years ago, the firms would have been heading to Nasdaq.

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