29 April 2009

A "4-Pillar Plan" to Fix the IPO Market

Dixon Doll and the National Venture Capital Association have put together a "4-Pillar Plan" to restore liquidity to the IPO market (see bottom of this post for the link).

It's an interesting approach...the "4 Pillars" include both public and private initiatives, and center on: i) regulation; ii) tax incentives; iii) enhanced liquidity paths; and iv) ecosystem partners (i.e., VC firms, law firms, I-banks, etc.).

Why does it matter?

Because the increasingly-tight IPO market is perhaps the major bottleneck constraining the entrepreneurial funding cycle...

In other words, without a healthy outlet for early-stage investments, VCs and other funding sources are more or less limited to the M&A market to achieve returns; yet there exists only a finite number of buyers in any given industry.

It wasn't always so. Most people will recall the "gold rush" days of the late 1990's, when now-defunct I-banks like Montgomery, Robertson Stephens, Hambrecht & Quist, and Alex Brown cranked out the IPOs at an feverish pace. Those were heady times, with newly-public companies rising 3-fold (and often more) on their first day of trading.

Heady times, but not healthy. The quality of the companies was often abysmal-- little more than a business plan and a catchy name, and the claim of being a future "category killer" in some niche within the nascent Internet space.

Indeed, I worked at an investment bank during that period, and I will admit that quite a few of the companies were taken public mainly on the strength of a charasmatic CEO and a slick roadshow pitch. Other problems were systemic throughout the financial system: research was tied to I-banking (meaning supposedly objective analysts effectively became "cheerleaders" for the firm's IPOs), and 'flipping' and 'spinning' (the practice of giving executives shares in hot IPOs in exchange for I-banking business) were commonplace. A lot of investors-- especially the numerous and vocal main street types-- lost a lot of money.

But the remedy may have been worse than the ailment. New regulation such as Sarbanes-Oxley made it increasingly difficult and expensive to go public. In fact, in the NVCA presentation below, 'Compliance Requirements' are cited as the top barrier to an IPO. Stronger 'Chinese walls' between research and I-banking were erected (which I believe to be generally a good thing), but it means smaller companies have a harder time getting analyst coverage, and their stock prices languish.

The end result is that there is a huge void in the market for small and mid-sized IPOs. This undoubtedly causes later-stage VCs to be more cautious, and the effect certainly filters down the investing food chain-- affecting the early stage innovators who are at the core economic growth.

So does the NVCA presentation hold the solution? Probably not, but it's an important evolution of the dialogue. I particularly like the pro-growth taxation changes, which would both encourage investment in young IPO companies AND encourage stable, long-term holding periods (thus helping to reduce the 'flipping' and rampant speculation of the previous bubble).

I like the people involved in this too. Interestingly, I've pitched (with clients, as interim CFO) to Doll Capital Management a number of times, and found them to be solid folks. In addition, my good friend and colleague Brita, who worked with me for many years at VentureArchetypes, is now part of InsideVenture (one of their suggested remedies for 'enhanced liquidity'.)

Overall it is a good start toward loosening the IPO bottleneck in a restrained, conservative manner. Check it out for yourself:

http://www.slideshare.net/NVCA/nvca-4pillar-plan-to-restore-liquidity-in-the-us-venture-capital-industry-1360905?type=presentation

21 April 2009

Q1 VC Numbers Are In...Here's the Good, the Bad, and mostly, The Ugly

The Q1 VC numbers are in, and they ain't particularly pretty...

Here's an excerpt (courtesy of Dow Jones VentureSource):

"Venture capitalists invested just $3.90 billion in U.S. companies in the quarter, a 50% decline from the nearly $7.78 billion invested over the same period in 2008 and the lowest quarterly investment total since 1998."

Other key takeaways are:
  • 477 deals completed in Q1, lowest quarterly total since 1996
  • Overall technology investing is down 51%, while healthcare is a bit stronger (down only 34%)
  • Software had 117 deals done, a 50% decline from the same period last year
  • Median deal size shrinks 73% to $2.4 million
This last bullet is the most intriguing to me, and perhaps there is a tiny silver lining in this otherwise stormy cloud. The median size of $2.4 million is down from the $9-million median seen a year ago...so if deal sizes are getting a lot smaller, does this mean investors are investing in earlier stage companies?

Not necessarily. Dow Jones also states that later-stage financing rounds accounted for 55% of all venture investment in the first quarter of 2009, up from 47% in the same quarter last year.

So what's happening here? It's unclear. In other recessions, such as in the 2002 period, VCs have often shifted their focus to later stage investing, on the assumption that later stage means less risk.

Some VC firms started investing in mezzanine rounds, and some even went much further. For example, way back in 2001, I worked at JP Morgan pitching PIPES -- "private investment in public equities"-- to VCs, which is about as late stage as you can get (the VCs are literally buying public stock, but at a discount). But in this market, the public markets are all but closed. So buying late-stage stock with the goal of flipping doesn't work.

The most likely answer is that: a) VCs are hoarding their dollars and b) the dollars they are investing, they are putting into their existing portfolio companies, but really turning the screws to get them lean and mean. That's the only logic I can find to explain the conflicting trends of later-stage and smaller rounds

Anyway, there's no real way to sugarcoat it-- the venture funding market is in pretty rough shape right now.

But as always, the companies that can bootstrap their way through the "lean times" are always the ones ready to rock and roll when the purses open again. And they always do open, usually en masse. Hang in there!

Tough Market for Entrepreneurs? VC Firms Are Having a Rough Go Of It As Well...

Venture capital investing is supposed to be a long-term investment play...venture funds generally have 7-10 year durations, over which time they invest the money raised from limited partners (e.g., teachers' pension funds, endowments, etc.).

In addition, most VCs will tell you their own time horizons for making investments in startups is pretty long... usually 5-7 years, as this has historically been the minimum amount of time it would take an early stage firm to reach IPO.

So why does it seem that the venture industry is almost totally synchronized and correlated with the U.S. economy and stock market? Shouldn't venture capital, with its lengthy and comfortable 5-10 year time horizons for investing, theoretically be almost counter-cyclical?

Wouldn't it make sense that venture investing might actually pick up in down times, since relative valuations would fall (and thus an investor could buy "more for his/her money")?

Theoretically, it should-- and in a purely rational market it would-- but that would ignore human psychology. In short, the "fear factor" goes all the way up and down the food chain. The public pension funds that put in the source money are looking at the state of the exit market (i.e., IPOs) as of today-- not what they are likely to be 5 years from now (and for the record, the IPO market is abysmal).

As a result, pension funds are not putting as much into the VC firms-- in Q1, according to the database of Private Equity Analyst, 23 venture capital funds raised $2.4 billion in the first quarter, a 64% drop from the $6.7 billion raised by 57 funds a year ago.

This causes the VC firms to clam up as well-- i.e., if you're not going to be able to raise another fund, you might as well drag out the current one as long as possible, right?

We'll see how the difficulties VC firms are having in raising money are filtering down to entrepreneurs in the next posting....stay tuned.