The IPO Debate
The National Venture Capital Association is about to roll out a media effort aimed at getting the word out about the great IPO drought of 2008. The first stop in this campaign was the NY Times: Matt Richtel wrote about it yesterday:
In the second quarter of this year not a single company backed by
venture capitalists has gone public. It is the first time that has
happened since 1978, according to a venture capital industry group.
There’s a lot to this story. IPOs, which made everyone in the venture business a killing from 1996 to early 2000 have been few and far between for most of this decade. As most everyone knows, the IPO boom was way overdone, many companies that should not have been publicly traded were brought public, and many an investor lost money on them.
Of course, once burned twice shy and wall street has not been particularly enamored with venture backed IPOs ever since.
But there is more to the story. VCs themselves, at least this VC, have learned that a sure payday via a M&A transaction is often a better way to generate returns than the hope of a big public market payday.
And then, of course, there is the regulatory environment. In Fareed Zakaria’s book, The Post American Word, he explains that:
In 2001, 57 percent of high-value IPOs occurred on American stock exchanges; in 2005, just 16 percent did. In 2006, the United States hosted barely a third of the number of total IPOs it did in 2001, while European exchanges expanded their IPO volume by 30 percent, and in Asia (minus Japan) volume doubled.
Sarbanes-Oxley and other post bubble, post Enron regulations have certainly made it harder to be a public company here in the US. I know every time I sign a 10K or 10Q, my hand shakes a little. Honestly, it takes a very big opportunity to make me want to be a significant shareholder or a director of a public company. The risks and hassles are just so big.
Paul Kedrosky was quoted at the end of the NYT article as saying:
There is no venture industry if there is no I.P.O. market.
I sent Paul a message on twitter saying that I think the venture business can exist without a vibrant IPO market. We’ve had three exits to date in our first USV fund and none have been IPOs. I think we can generate the returns we need to produce to satisfy our investors without a single public offering in our fund.
But the VC business without an IPO market would be a different business. It would be smaller, with fewer funds, and smaller fund sizes. And it would struggle with big bets like biotech and cleantech, and the kind of hardware oriented IT investments that generated such great returns in the 90s.
And that’s not a good thing. Biotech and cleantech are two industries of the future where the US is at the forefront. We need capital markets in this country that can support the development of these industries. And the overly regulated and cautious public market environment we have right now is clearly problematic.
So it would be nice to see a reduction in the regulatory environment. We need to let markets work and not worry so much that some people will lose money on their investments. And most of all, we need some big successes. What will be the "Genentech of cleantech"? It can’t come soon enough.
I believe that there are sustainable, subscription-based mobile data businesses that can provide a rate of return greater than any portfolio based investment. These opportunities are all located in the professional services market for mobile work flow and work order management, and have been horribly under served by the big ERP companies, established mobile applications vendors, and the VC biz.There are millions of independent, service based businesses that need better mobile apps, and they are willing to pay their 25-50 / mo. in perpetuity to get these services. What a portfolio! For a relatively small investment in a few J2ME apps backed by a hosted cloud type back-end, you can be sitting pretty with 30k subscribers.Yet, this has been the hardest sell, to potential investors, that I have ever faced.
“We’ve had three exits to date in our first USV fund and none have been IPOs.”Fred, to be fair, doesn’t that also have a lot to do with the fact that your fund is focused on early stage more than the average VC? Out of the three exits, how many would have been capable of an IPO?
maybe one of them. but my point is that M&A is a fine way to generate liquidity if you pay the right valuations going in
oops, there I go again! Forget that I wrote that – selling mobile apps and systems to the service industry is a stupid idea, obviously. You can delete that comment.
What situation would compel you or a VC firm to bring out an IPO?
i believe that you need a company that is profitable, can consistently grow revenues and profits at least 20% per year, that can command a $500mm market cap or better, that is not subjected to “lumpy revenues and earnings” and has very high visibility into future revenues and earnings.
Fred,Why haven’t more U.S. tech startups listed abroad?
a few have tried the AIM market in london with limited success. i think its mostly because you want your company to trade in the market its best known. and for US tech startups, that is the US
Thanks. That’s about what I figured. I guess the discount for being less known is still larger than the premium for SOX. I’m guessing the underwriters aren’t cheaper in London….I wonder if we’ll see some more listings in Hong Kong over the next year or two though
Fred,All great points. I’d especially like to stress your last point – the regulatory environment in the US is horrible. Removing the knee jerk over-reaction to the accounting scandals of Enron et al needs to happen post-haste. We also need to be very very careful going forward to not exacerbate the problem by pushing more regulatory hurtles because of the fall out from the credit crunch and housing crisis.
It is interesting that while the IPO’s for companies “backed” by VC’s has declined, it seems that a new interest in IPO’s has emerged in the form of Hedge Funds going public, like BX and OZM. When I first noticed the BX IPO and then OZM, I wondered why during this time of reduced liquidity in capital markets, would these funds choose to go public? For a sector that usually likes to remain very private, and historically have been unwilling to share any aspect of their investment strategies, why would they now be willing to undergo greater scrutiny? I think this is meaningful…I would love to hear someone’s take on it, who is active in the markets.I understand how VC’s would be hesitant to participate in public companies because of the increased regulations. It seems as though transparency is good, and necessary; Enron was a huge fiasco, with a lot of collateral damage. But at the same time, regulations in this sector only leads to smarter work-arounds and more inventions of new, and temporarily opaque financial instruments. Regulation never really results in more transparency. It is foolish to think otherwise. The markets rely on a certain amount of opacity; always have and always will.It seems like there needs to be a new financial instrument, which supports emerging technologies, and allows for a certain amount of opacity. We need another Lewie Ranieri… ; ).And at the same time, we need methods available that allow the public to understand the terminology of the markets, so that fears do not become road blocks and laws which constrict liquidity; AND so they can protect their assets through their own informed actions. Since most American’s savings and retirement funds are now tied up in the markets, this is no longer something to be ignored.It seems as though the problem is trying find a way to let markets function, while at the same time not creating an environment where individuals get harmed because they didn’t recognize the signs. Legislation which provides insurance, in case something goes wrong is good. But legislation which restricts movement usually has no benefit; for either party.
taxation on partners’ carry interest.
IPOs are *so* 90s. You just need to wait around for big media, the “pipe layers”, PE, Hedgies or Google to buy your startups. There’s still gold in them thar hills!
I don’t think IPOs will go away but I do see the rise of other possible methods of exit. You mentioned M&A but that does rely on the existence of a reasonable number of large companies to do the M&A. Given the companies USV has invested in M&A was always going to be a reasonable route.Another exit that I can see growing in importance is privately traded shares. Here the exit is the VC selling their shares on a private markup to institutional and private wealth funds. It allows an exit to a market but without the regulatory hurdles of the public markets. It could even conceivably act as step to smooth the path to public market.
I like that approach a lot and blogged about it a while backI hope the ³secondary market² for startup founders and investors developsover the coming years
I seem to remember that. That was during the VC is broken meme from last year.I think I blogged something along those lines too. Well I guess if it keeps coming back up then its probably going to eventuate.
I bet it develops first in China.
“selling their shares on a private markup to institutional and private wealth funds”I agree; this seems to be very likely an expanding model for the US.
in edge thinking it is understood that it is not “good for the world” to manage firms with the next quarter’s stock price, or exec bonuses, as the criteria for decision makingsimilarly, the ipo model of “making a killing” has hopefully been discredited as being “good for the world”, especially when manipulated, rather than as a result of natural maturationthe pro- argument is that innovation will not occur without incentive, but this represents a misunderstanding of human nature … you cannot stop innovation no matter how hard you try … the argument is speciousit is the same in the intellectual property rights world, a total protection racket operating under the guise of being an incentive for development … the open source movement disproves thisthe very definition of “value” is changing, faster than established players can comprehend. this understanding is being forced upon many models of doing business, simply by evolution, and the ipo model is going to lead the way in the experiment of finding a better way to function that is indeed good for the world
I think the dearth of IPO’s is more indicative that: a) start-ups are migrating to a much smaller and leaner form, and b) the big fish have realized it’s cheaper to acquire early than compete later. And while I personally feel we’re months away from a monstrous financial pull-back globally, I think the IPO drought is more about the above changes than anything else.”There is no venture industry if there is no I.P.O. market,” may not be strictly true, but at the same time, I think the venture business has to start earlier and lower if it wants to better compete.
From another perspective, it disappoints me that Europe (London particularly) did not follow the lead of the US in implementing tighter regulatory controls on the public markets. It would have been better and certainly more equitable if the European markets had also stepped up to the plate and brought their regulatory frameworks to the level of the US for the benefit of shareholders. Only so much business can be lost before Sarbanes-Oxley is scrapped and the next Enron starts to ferment. Thats not good for anyone.To follow your thread about secondary markets, from an entrepreneurs perspective I certainly find the narrow list of possible exit strategies (required by the investment community) a bit like a straight jacket. Surely there are more options to provide acceptable returns to investors than just IPO or M&A? I hope your conversation here starts to get the whole industry thinking at least.
I think other countries in Europe (Germany) and Asia are ahead of the U.S. as far as integrating cleantech into the culture. At least, I hear more news about interesting uses of cleantech from other countries than I do in the U.S. PSFK.com is always posting interesting international developments in cleantech usage both on an experimental basis as well as on a wide-spread scale.
Hi Fred. Hope you and the clan are enjoying summer travel.What level of returns might an LP expect from a tope quartile or top decile fund these days? That is, what ballpark of returns are you referring to when you write, “I think we can generate the returns we need to produce to satisfy our investors without a single public offering in our fund”?
I don’t think in terms of irrs steve. I think we should be able to generate at least 3x on our portfolio gross and at least 2.5x to our lpsThe cash comes in over the first five-ish years and goes out over the last five-ish yearsThat said, our first usv fund is four years old and we’ve returned about 40pcnt of the fund and we’ve called about half so the cash flow dynamics can be even better than thatFred
Looking at the numbers you provide above (and maybe I’m nieve) but rather than ‘exit’ strategies, shouldn’t VC funds be looking at ‘return strategies’ as that is the measurement you use?If a company can provide your returns via profitability, or other method I am not thinking of, should that method not be considered in the investment along with M&A or IPO?This has been part of the reason I have never spent the time to go through the funding dance, as a start-up, I’m looking at what can make this business profitable, not what can I do so a VC will invest so I can be an M&A target.I think this is specifically valid in the web market where investment requirements are dropping.
Fred I normally agree with most of your points, but I am slightly at odds with the need to roll back regulatory standards. This debate seem to be a long standing issue within the business community in general, but everyone seems to have forgetten the reason for its creation. The Enron Era (which includes firms like Healthsouth and Tyco) to me destroyed public confidence in the markets more then the tech bubble did. We needed these tough regulatory standards in order to preserve the integrity of the financial data presented to the public. You can’t just wave a wand and make it dissappear when it becomes a slight hinderance. It would only reaffirm the believe that government simply works for the interest of a few and not the many.I do understand regulation can become stiffiling to growth if unchecked. However, history has shown us that lack of regulatory standards can and will ultimately lead to corruption, and investors will often flood to where they can recieve a safe return on investment.
the regulations are overdone but even worse are the penalties for messingup.I makes it incredibly hard to find good board membersPlus the board meetings are spent with lawyers and accountants instead oftalking about the businessIt’s overkill and is hurting the companies which in the end will hurt theshareholdersfred
It isn’t necessarily any ‘one thing’ that caused the drought in IPO’s. Rather, it is a combination of all of the factors you note: a) faster money from m&a; b) horrendous regulatory environment; and my personal favorite; c) entrepreneurs are smarter today than they were in the past.While you can go public, who wants to deal with all of the headaches of Q/Q earnings projections, analysts hammering the company on any given day based on ‘rumors’ and litigious activist investors when you can build something great, let it be rolled up into something larger, and then go right back to the drawing board with the next idea.Seems to me that if you love to build, that is a pretty sweet way to go.
Very good point
Fred, regulations aside, how many VC-funded companies have a legitimate shot at being long-standing, independent businesses? How many entrepreneurs do you meet that even aspire to to build such companies?Maybe Sarbanes-Oxley and other regulations have raised the cost of being public to the point where a business now needs to generate $150M rather than $75M in annual revenues before an IPO is worthwhile — but to me the biggest shift over the past decade in high-tech has just been in lower expectations among entrepreneurs and investors alike.Blaming SOXA for the IPO drought just seems a little like a cop-out. A lot of startups these days are like very well-paid contract developers, deciding from day one to build an add-on feature to some other company’s products. This can be a very lucrative decision, but it’s hard to characterize such deliberation as a casualty of SOXA. Whoever builds the next Google or Cisco, Apple or eBay is going to have bigger ambitions than that, and if they succeed, they’re going to take it public, SOXA or no SOXA.Regards, Glenn at Redfin
Maybe that post wasn’t crisp and clearI totally agree that IPOs are not the endgame for most of what we fund. I think I stated that in the postBut there are some sectors of VC, like cleantech and biotech, where the capital requirements are so large and the timeframes so great that IPOs become more important in the financing dynamicIn those cases, having a weak IPO market (or a non existent one) is problematicIts not a problem for me or our firm. But it is a problem and overly regulated financial markets are part of the issue
You’re right Fred, I re-read the original post and realized I focused too much on SOXA when your discussion was already broader than that. Thanks for being so gentle in pointing that out.We both agree that SOXA has (unhelpfully) raised the bar for public companies, and too that recent capital markets have raised the bar a little more, and finally that the dearth of IPOs is bad for the industry. But it would still be fascinating to hear what you have to say about why VC-funded startups aren’t growing into large, profitable, stand-alone businesses? Why has the stated endgame changed? Surely regulations wouldn’t be the #1 culprit in a root-cause analysis?At least for the entrepreneurs, it’s not just an economic — or rational — discussion. The whole reason a lot of people are in this business is for love of building things — not just products, or features of products — but building companies, building them to grow and to last.
I think some are in it to build a big public company. We have at least threeentrepreneurs in our portfolio who very much want to do that.But back in the 90s, it seemed that everyone wanted that, and then when theygot it and realized it was not necessarily a path to the most money, theygot smarter.fred
I think the factors contributing to fewer IPOs are many. In the 90s, we used to hear bankers and economists forecasting that the IPO markets are “open” or “closed”. Today, I speak to many VCs who would much prefer exiting via an acquisition vs an IPO. I think many entrepreneurs agree. So the IPO markets are not closed due solely to economic circumstance. The entrepreneurs and investors, especially those who were burned on bad deals, are influencing the markets.Secondary markets for private equity investment are bound to become more efficient over time, giving founders/investors more options (see news of facebook employees putting a block of shares on the market right now). All capital markets should grow more efficient as information becomes more transparent and readily available, giving shareholders more liquidity options and yielding increased opportunity for good businesses. As an investment banker/placement agent, I often had a hard time justifying my role as broker, and could never understand why so much of the financing process hadn’t been streamlined more.
The IPO market has been soft since 2000, and firm and fund size needs to reflect that reality. Sure it would be bliss if the greater fool returned to the trough and feasted, but a VC fund manager shouldn’t raise a series of large funds that requires this unlikely event. It takes some discipline to keep fund size small and investment stage early. Work is harder, risk is higher, fees are lower. But that is the only proven model in venture, which has always been a business that can’t scale.
I agree with you. That is certainly our approach
I think the environment you describe puts an even GREATER emphasis on WHO the VC is (as Charlie and others have written about lately).There’s likely much greater competition in the IPO space, so WHO you know in the banking sector doesn’t help or hurt your chances to IPO nearly as much as WHO you know in the corporate world, when it comes to M&A.What do you think?