Keating Capital (KIPO) founder Tim Keating explains to MoneyShow how his business development company gets exposure to pre-IPO names. He discusses three of his holdings, and explains why he prefers sub-$1 billion valuations.

Kate Stalter: Today, I’m speaking with Tim Keating of Keating Capital. Tim, you have a very unique business model, in that you run what’s called a business development company, which is publicly traded.

Could you start out today by doing something that I’m sure you must do a lot, which is to explain to our listeners exactly how this works?

Tim Keating: Keating Capital, as you mentioned, is a business development company, which is nothing more than a publicly traded closed-end fund.

We specialize in making pre-IPO investments in innovative, emerging growth companies that are committed to and capable of becoming public. We provide our investors with the ability to participate in a unique fund that allows our stockholders to share in the potential value accretion that we believe typically occurs once a company transforms from private to public.

Kate Stalter: So, let me just drill down a little bit. You buy pre-IPO companies, and do you do that by buying options that employees are selling ahead of the IPO, or do you actually acquire an interest similar to the way a private-equity firm might?

Tim Keating: The best way to think about it is: It’s a late-stage venture capital fund. So to answer your question, we acquire our interest directly from the private companies. We are typically buying preferred stock, and typically these private companies are doing a final round of pre-IPO financing to bolster their balance sheets.

They’re generally fairly large rounds; $50 million is pretty typical. So we are acquiring that interest in the final pre-IPO financing round directly from the private companies.

Kate Stalter: So, what type of companies do you focus on? Say a little bit about some of the holdings.

Tim Keating: Sure. Well, at the broadest level, we’re focused on technology companies, and they run the gamut from Internet companies, to software companies, to clean-tech companies.

The way we look at our portfolio, we break it into three buckets. We have those companies that have already gone public. We have a second bucket of companies that are private, but have filed to go public, and then a third bucket of private companies that are on their path to becoming public.

So, for example, a company in the first category, Solazyme (SZYM), is a biofuel company that makes oils out of algae. Very exciting company, publicly traded.

In the second bucket, we have a company called BrightSource Energy, which specializes in something called concentrated solar power. And what that means in plain English is: They’re building a big plant in the Mojave Desert with a bunch of mirrors that heat up a water tower that converts steam to electricity.

Then, we’ve got a number of very interesting companies in the private-company space. One of them, TrueCar, is disrupting the way cars are bought and sold. They have an online model that allows a customer to search for the best price online, and then print a certificate and take that into the dealer and walk off the lot without ever having to haggle with the salesman.

So that’s a quick flavor of some of the different types of companies in the portfolio today.

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Kate Stalter: How long do you hold these after they go public?

Tim Keating: Well, a typical life cycle for any portfolio company is about 36 months, and for us that’s broken into four discreet phases.

In the first phase, which is typically 12 months, the company is private and is expected to file to go public at the end of that period. Then, we allow an additional six months to complete the IPO, which brings us to 18 months.

Once public, we are always subject to something called an underwriter’s lockup agreement, which is a period during which we cannot sell our stock. That’s an additional six months; that brings us 24 months.

Then finally, we give ourselves typically an additional 12 months to sell or harvest our position. So, the selling part occurs in the final 12 months of that typical 36-month holding period.

Kate Stalter: I want to come back to some of the companies you named. The tech companies sounded pretty R&D-driven, and I was noticeably not hearing anything about some of these hot social media stocks that are out there these days.

When it comes to the companies, what type of business model are you looking for, and what do you want to avoid?

Tim Keating: Well, you really hit the nail on the head. Let’s start with what we’re doing and what we’re avoiding, because I think that’ll give you a great guidepost.

We tend to focus on companies that are under $1 billion in equity value. As a result, we are avoiding some of the well-known private companies…and of course the elephant in the room is Facebook. That has today a valuation of closer to $100 billion.

It’s very important to understand why we’re focused on these sub-$1 billion companies, and that is as follows: There is what we call a value accretion or a value transformation that typically occurs when a private company goes public.

And the reason for that is very simple: Public companies are always willing to pay more for a stock than a private investor would, because of something called the liquidity premium. All that really means is that investors value the immediate liquidity that is associated with a public company.

As a result, public companies are generally valued two times higher, sometimes more, than a private company with similar financial attributes. So if you had two identical companies next to each other—same revenue, same expenses, same profits—and said one’s private and one’s public, the private company might be worth, for example $10 a share, and the public company would be worth $20 a share. What we’re trying to do is buy privately, sell publicly, and capture the difference.

Now, the reason why we avoided the social media companies is that as private companies have been staying private longer—and there are a number of reasons for that—the value transformation that typically occurs when a company goes from private to public recently has been happening in the private stage.

Since that value increase, for a company like Facebook or Twitter or Groupon (GRPN), or LinkedIn (LNKD), is happening while it’s still private, the challenge for us is: When you come into that final round of financing, the valuation might already reflect that higher, almost quasi-public valuation. So we don’t really see the upside potential.

So if you think about it, if we’re trying to buy at $10 and sell at $20, we’re trying to make a 100% return over our typical three-year holding period, and that’s exactly what we’re seeking to do. So, it’s very important for us to make sure that we see a discount to where we think the public company will be traded.