Striking Out With VCs?

You're not alone. As venture capitalists become more risk averse, more early-stage companies are tapping the hot hedge fund market.

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Bill burns needed capital, and he needed a lot of it. The co-founder, president, and CEO of Minrad, a manufacturer of medical devices and pharmaceuticals based in Buffalo, was convinced he was on the verge of something big. Minrad's products--which include an anesthetic that can be inhaled rather than injected and a lighting system to help surgeons increase their accuracy--had the ability to make medical procedures quicker and safer for both patients and doctors.

Burns had landed several long-term contracts with pharmaceutical manufacturers and distributors around the world. Now the 11-year-old company, which generated about $3.5 million in sales in 2004, needed cash to expand its anesthetics plant in Bethlehem, Pa., and beef up its sales staff. Burns had already raised and burned through his most recent $3 million round of venture capital. But when he started fishing around for more, he found that VC investors had grown more risk averse than they had been in the past. Indeed, only 19% of venture financing was invested in start-up and early-stage companies in the third quarter of 2005, compared with 22% a year earlier, according to the National Venture Capital Association.

Then a pair of investors suggested that Burns forget the VCs and investigate a complex and relatively obscure financial vehicle known as a PIPE. PIPEs, or private investments in public equity, allow publicly traded companies--in most cases, small- and mid-cap firms that trade over the counter--to sell stock to high net worth investors at discounted prices. These days, most of those investors are hedge funds, which now boast more than $1 trillion in assets. Many of those funds are interested in investing in early-stage companies--and PIPEs are one of their preferred ways of doing so. Last year about $3 billion in PIPE investments was plowed into more than 300 companies with less than $5 million in annual sales, according to Michael Membrado, a New York City securities attorney who advises early-stage companies on such deals and has done extensive research on the topic.

Burns was intrigued. Of course, there was one immediate problem to address. Minrad was not a publicly traded company. And given the current state of the market, Burns doubted he would be able to stage an IPO anytime soon.

It turns out he didn't have to. Traditional IPOs get all the attention, but they're not the only way for private companies to tap public markets. Most of the companies that get funds through PIPEs go public by listing stock on the Over the Counter Bulletin Board, or by merging with defunct publicly traded companies, commonly referred to as shells. The payday is smaller than in a traditional public offering--but so are the costs and the headaches involved.

Burns liked the idea of gaining access to so much capital. He also liked the idea of wading slowly into the stock market.

Burns liked the idea of gaining access to so much capital. He also liked the idea of wading slowly into the stock market, rather than trying to go public right out of the box with an IPO on a major exchange. So in the spring of 2004, he and his financial advisers began hunting for a shell company. In December, Minrad merged with Technology Acquisition Corp., which was founded in the 1970s and had been idle for the past decade. After the merger was complete, Minrad took the shell's spot on the OTC Bulletin Board under a new ticker symbol, MNRD.OB, and Burns began to court PIPE investors.

During the next few months, with his investment bank playing matchmaker, Burns made 35 presentations to hedge fund managers and wealthy private investors from around the world. In May, two funds, Australia-based Rubicon and Northbrook, Ill.-based Crestview Capital Funds, stepped up to lead the deal and negotiate its terms. Several other hedge funds and individual investors signed on, and last June, just six months after taking Minrad public, Burns landed $11.3 million in financing. It had taken him eight years to raise the same amount from angel investors and venture capitalists.

Of course, landing PIPE financing is a lot more complicated and expensive than rounding up investments from angels and VCs. And Minrad's strategy isn't right for all business owners, especially those who don't plan to go public eventually. Pulling together the reverse merger and the PIPE deal cost some $550,000 in accounting and legal bills, on top of about $1 million in investment banking fees. And now that Minrad is publicly traded, Burns also has been forced to spend tens of thousands of dollars to comply with SEC regulations and the Sarbanes-Oxley Act.

PIPE investments also carry considerable risk for entrepreneurs. Unlike venture capital or angel investors, shareholders can sell their stock at any time. To make that less likely, Burns made it clear to potential investors that the value of Minrad's stock was likely to take off in 2007, when several new products, including a drug delivery system that will sedate surgery patients while keeping them alert and responsive, are scheduled to hit the market. "If investors didn't have a 2007 mentality, they moved away from the deal," he says. "It became a self-selecting process."

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