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:


22 April 2009

More SBA Funding for Startups? Maybe...

I had coffee this morning with my father and his friend, Fritz Keefner. Fritz is an interesting cat, and led an interesting career before retiring...he was on Wall Street, then got involved in collateralized lending to small businesses in the 70's, then was one of the first venture investors in Colorado in the 80's.

Anyway, one of the topics we discussed was the concept of diverting some of the bailout money away from the huge investment banks and toward small, innovative businesses.

I think it's a great idea-- i.e., since the governmental wallet is already open, and since those in my generation (and later generations) are going to be paying for the bailouts for decades to come anyway, why not tack on a bit more to create jobs, innovation, and stimulus at the entrepreneurial level?

Anyway, proving that the entrepreneurial DNA runs through my family and friends like the Force in Star Wars, my wife sent this article to me today regarding an idea she's hatching for a business.


Two paragraphs stand out:

"In December, Innovation America and the National Association of Seed and Venture Funds pitched to members of the Obama transition team a plan to create a government-funded $1 billion seed fund that would shore up angel-investing groups and regional early-stage equity investment programs, which provide equity investments to start-ups. He says the new administration seemed receptive to the idea, but hasn't moved forward on the proposal."

Although I think that it probably has a tiny chance of actually happening, it's an encouraging sign that they're out their pitching it.

The other interesting paragraph is this:

"Michael Gurau, president of CEI Community Ventures, a Portland, Maine, venture-capital fund on whose board Karen Mills served, says he would like to see the SBA put more emphasis on equity investments, such as increasing funding for the federal SBIC program, which aims to bolster venture-capital funding for start-ups.

Proponents of increasing federal assistance for small, equity-backed companies say it is high-growth start-ups that create the most jobs. According to the National Venture Capital Association, venture-capital firms account for only 0.2% of all financing, but 10% of all U.S. workers are employed by a company that was once venture-backed.

The association is pushing Congress to pass legislation allowing venture-backed companies to compete for contracts through the Small Business Innovation Research program, or SBIR, which requires that federal agencies give 2.5% of their research-and-development budgets to small, independently run businesses. Venture-backed companies don't generally qualify for the program now."

Their are a couple take-aways here. One is about increasing SBIC funding; I'm hugely in favor-- to me that's a no-brainer. The other is whether VC-backed companies can qualify for SBIR.

Overall I think that would be a net positive (especially if overall funding were incread), although the downside is that the "hot" VC backed companies would crowd out the traditional SBIR firms, which are often pursuing more in-depth, long-term research....much of which never pans out, but some of which occassionally turns into major new breakthroughs...

Either way these discussions are encouraging for entrepreneurs, who are facing a tough fund raising environment.

What do you think? Contact me at nathan venturearchetypes.com.

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.