Emerging Enterprise Center Blog : Boston Startup Lawyer & Attorney : Foley Hoag Law Firm : Startup Financing, Venture Capital

VentureWire had this to say yesterday:

A perceived opening of the IPO markets is the focus of most of investors' optimism. There were two venture-backed IPOs in the quarter, A123 Systems Inc. and LogMeIn Inc., one fewer than the last quarter.

Public-offering activity is not expected to pick up quickly because of the "time it takes to run the SEC gauntlet," Ward said. However, a small number of successful offerings from companies like Ancestry.com Inc. and Fortinet Inc. - a Meritech portfolio company - could "set the table in the fourth quarter for what should be a good 2010."

The two IPOs from the third quarter raised a total $460.4 million, up from $232.1 million last quarter.

With successful recent offerings from companies like LogMeIn, OpenTable Inc. and SolarWinds Inc., public investors are showing a healthy appetite for small-cap technology stocks.
 

Unfortunately, they also had this to say about acquisitions:

The third quarter saw 71 acquisitions, seven fewer than the second quarter and 13 fewer than the same quarter a year ago. Nine of the companies sold were in life sciences with a combined value of $186.2 million, down from $324 million in the previous quarter and $864.7 million in the year-ago quarter. Combined with the absence of any health care companies going public, it made for one of the worst periods for health care liquidity in recent memory.
 

The venture economy (and the rest of the economy -- I think) has been suffering from the acute pain of the Great Recession.  As it goes away, we will find out if there are other problems that were masked by the recession.  If there are not, it does seem as though we should see a return to  IPO and M&A exists that will bring back an appetite for investment.

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It is a truth universally acknowledged that investors in tech companies get the best exit valuations in IPOs. This has been accepted as axiomatic as long as I have been practicing law. As far as I can tell, when public companies get acquired the buyer usually pays a premium over the public valuation. This premium, often referred to as a control premium, suggests that there is “extra” value in not being public. If companies typically command a premium when control is sold, why are they not valued at a discount when they go public and control becomes diffuse? I can imagine a number of rationalizations for this anomaly (that companies command a premium when they go public and another premium when they go private), one is that these companies may have been public for a while and their public values may have sunk considerably from the halcyon days following the IPO.

But the point I want to get to is that you might think that selling a private company would produce a bigger premium than taking it public. The seller could jump all the way to the final control premium price. Another thought is that most venture financed companies that have gone public in the past ten years have not performed well. Obviously we are in the Great Recession, but this observation was, I think, widely thought to be true even before the Great Recession.

One possible explanation, among many, is that IPOs were hyped and sold rather than researched and bought by thoughtful investors. In other words, as Healy Jones said in his blog Startable some time ago, the public was sold a lot of stock that really did not have good investment characteristics (it was a load of crap and people lost a lot of money investing in it). Of course, there were and are a few stars (Google for one). Having said all this, it may be (perhaps certainly is) true that private buyers such as Google, Microsoft, AOL, Zimmer, etc. are just more discerning and more able to accurately value acquisition candidates than public investors.

If you agree with the thought that most of the venture backed companies that have had IPOs should not be public, then you probably agree that the IPO market should not return to pre-Great Recession norms. How much below these norms the IPO market should/will return to is impossible to tell. But, if the so-called venture model is dependent to a material extent on a robust IPO market which in turn is dependent upon investors making poor decisions, then there really is something wrong with the venture model. The venture model needs to work based upon returns obtained from sophisticated private buyers – who seem to pay less than the public.

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LogMeIn has now successfully opened trading – the fourth IPO of a venture backed company since RackSpace in August of 2008. Four is better than zero. But if you consider how many there were in 2007 (fifty something, if memory serves me well), we still have a long way to go before there is an IPO market that will sustain the so-called venture model. In the meanwhile, consider a recent article in VentureWire to the effect that there were 137 M&A exits for venture backed companies in the first half of 2009, and – here is the truly alarming news – only 2 of them reported prices in excess of $100 million. There is more detail in the article about average prices in M&A transactions, but the take away is that the smaller deals don’t represent good returns for venture investors. As a historical matter, most exits for venture financed companies are through the M&A process – not the IPO process. Not long ago, I posted the observation (from Mike Feinstein) that there are north of 9000 venture backed companies and only 30 exits north of $100 million last year. If the IPO market is down approximately 90% from 2007 levels; it is hard to even conceive of how far down the M&A market is.

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As of now there are three: SolarWinds, OpenTable and Medidata. It looks like LogMeIn will make the fourth. Before these you have to go back to RackSpace in August of 2008. Nothing else need be said. 

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I have just finished reading yet another article on the subject of the impending revival of the IPO market for venture financed companies. I also recently heard a partner in a prominent Massachusetts law firm, explain that the IPO market for venture financed companies was going to “come back” this fall. The recent IPOs of Rosetta Stone and Bridgepoint Education (neither of which was venture financed) seems to have people panting. Oh, yea, and there was a Chinese company that went public on the NASDAQ recently. Hence all the titilting trailers hoping to foment excitement for the movie to be released this fall. There has been a lot of discussion about why the IPO market is in the dumps, and it cannot be separated from the general economic collapse we are all experiencing, but people seem to be focusing on a few items as if “fixing” these will somehow bring back IPOs. It is not at all clear that these discussions are focusing on the right issues.

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In yesterday’s VentureWire there were two articles indicating more signs of life in the entrepreneurial world. One had to do with M&A activity and the other with the NVCA ‘s efforts (such as they are) to bring back IPO activity.   Based on my own subjective experience, ther is more postive buzz than there has been for some time.  These two articles fit this mode. 

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Well the new year is not exactly off to a roaring start. According to VentureWire, it appears that there were two (2) venture backed companies that filed for IPOs in January. They were Medidata Solutions Inc. and Open Table Inc. If this pace keeps up, 2009 will see 24 IPO filings, representing an almost 500% increase over 2008 but still something in the general neighborhood of one-third of 2007. Also, we need to remember that filed and closed are two different things.

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In case you needed another signal that times are tough in the entrepreneurial world VentureWire has published and article entitled Turnaround Firms Busy As Start-Up Woes Mount. The gist of the article is as follows:

The number of aging start-ups facing a shortening runway has grown in recent months, these firms say, and some venture capitalists are losing patience with longstanding portfolio companies that have no exit in sight. That's especially true for venture firms with large funds dating back to the tech bubble years of 1999 and 2000 that need to relieve congested portfolios before reaching the traditional 10-year funding cycle.

As I have noted in the past, the number of series A financings has dropped in 2008 compared to 2007 but the number of Series B and later rounds is holding pretty much steady.   I believe this is due to continue to finance existing portfolio companies, but many of these financings are likely to be at disappointing valuations or to be inside rounds.  This article suggests the obvious -- that the commitment to portfolio companies is not infinite and, in a world without exists, will eventually come to an end.

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With reference to IPOs and exits, TechCrunch had the following to say: 

So far the downward spiral of credit and financial markets seems to have left venture capital firms and startups relatively unharmed. Even though the IPO market closed completely in the second quarter (and opened again only slightly in the third), venture capital firms continue to raise money and invest in startups at a healthy pace. During the first half of the year, venture capital firms raised about $16 billion in 141 funds and invested about $15 billion in nearly 2,000 deals.

and this:

On top of that, the exit environment for existing startups is not looking any better. A new MoneyTree report by PricewaterhouseCoopers that is out today notes that both the number of IPOs and M&A exits for startups declined precipitously:

While I agree completely with the conclusions on the number of M&A and IPO exits, our research is not consistent with what TechCrunch (and PWC/MoneyTree -- which is where TechCrunch gets its data) has to say about the pace of investment in startups. 

A more focused look at numbers shows a different picture. Based upon searches of the Dow Jones VentureSource focused on Series A financings and Series B and later round financings in New England and the country as a whole, there appears to be a decline in venture investing in 2008 compared to 2007 (see EEC Perspectives).

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Anecdotal evidence indicates that in the current environment there are a lot of "extension" rounds or bridges from existing investors.  The obvious reason for this situtuation is that it is hard to attract Series B and later round money in a climate where there is as much uncertainty as there is right now.  By extension rounds, I mean selling additional shares of the previous round at the same valuation as the previous round to the same players.  I suspect our research  will show that Series B and later round activity in the second quarter was basically flat.  We wont be able to get numbers for Q3 until near the end of November, but, anecdotal evidence indicates a decline in activity.  Clearly a resolution of the current crisis in the financial markets can only help, but  an improvement in the long term outlook for exits (both IPOs and M$A transactions) is what is needed to turn the investment tide.

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It will come as no surprise that the number of exits (IPO and M&A transactions) for venture financed companies is way off this year -- compared to last year. As I noted in a prior posting, Series A transactions are off year on year. Although some industries are faring well (greentech for one), on a macro level, series A deals in New England are down approximately 30% in the first six months of 2008 compared to the first six months of 2007. You can get more detail on this in our EEC Perspectives October 2008 issue. In addition, however, the statistics for M&A and IPO transactions are worse according to the CNET NewsBlog which points out that as of July 1, 2008 there had been no IPOs for venture backed companies and that in the first half of 2008 there were 56 M&A transactions compared to 97 in the same period last year. We are still compiling the statistics for New England based Series B and later stage deals for the most recent quarter, but these numbers should be available shortly, and I expect they will be consistent with what we are seeing in Series A deals and exits. To some extent the problem begins wiht exits. If investors  don't have good visibility on potential timing or valuation of exits, it becomes very hard to complete a later round deal. If investors are anticipating difficulty raising Series B and later rounds, they are reluctant to take the risk on the early round. The silver lining may be that there is a lot of money sitting on the sidelines, and when the market turns this money will be looking for deals.

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One refrain I have started hearing from some entreprenuers is that they have now gone a long time without a paycheck or angel funding -- let alone venture funding, and they need to pay the rent so they will soon have to put their ventures on hold.

It will come as no surprise that the continuing crisis in the finance sector has put an end to the little IPO activity that seemed to be cropping up just a few weeks ago.   According to an article in the September 23 edition of VentureWire entitled "IPO Flow Perked Up Until Wall Street Crisis Hit" (you can sign up for VentureWire here):

 Until last week, some market observers said they were seeing more companies readying to register initial public offerings in the U.S. While no one believed deals were about to pour into the market, even a whiff of future activity seemed promising.

Then came the filing for bankruptcy protection by Lehman Brothers Holdings, the sale of Merrill Lynch to Bank of America and the government rescue of American International Group Inc. The U.S. government's announcement late in the week that it was working on a plan to bail out the financial system is at such an early stage that it's impossible to know what effect it may have on IPOs

Well, I am not sure it is impossible to know what effect it will have on IPOs.  As long as there is a continuing crisis in the world of exits (IPO and M&A), there will be a drag on venture investment.  As long as there is a continuing crisis in the stock markets, there will be a drag on angel investing.  These factors will also create a drag on entreprenurial activity. 

A lot of our future and our kid's future is tied up with entrerpenurial activity and technology based entreprenurial activity, so this situation can't be good.  There are many good reasons for a bailout of the financial sector of which its effect on entreprenurial activity is a small one but an important one.

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There is a lot of money sitting on the sidelines right now. 

According to the National Venture Capital Association, 235 venture funds raised nearly $35 billion in 2007.  This is after a string of steady growth years beginning in 2002.  Furthermore according to the NVCA, 130 venture funds have raised more than $16 billion so far in 2008.  This seems to me to be a very high number.  It provides support for the anecdotal evidence that a lot of funds, including early stage funds, have been raised in the last few years.

The National Venture Capital Association also reports that venture capitalists invested $7.4 billion in 990 deals in the second quarter of 2008.  This number does not seem consistent with the general economic climate, but there may be an explanation for it that is consistent with the downturn in the general economy.  As with the amount of funds raised, I suspect that the NVCA measure includes many transactions that are not  "traditional" early stage venture investments.

I will do a little more research over the next few days and try to get a more granular focus on the activity level in the early stage fund space.

The NVCA clearly agrees with what we are experiencing that there is a crisis in the world of exits.  According to the NVCA, there have been 5 IPOs so far in 2008 compared to 86 for all of 2007, and there were 120 total M&A transactions in the first six months of 2008 compared to 169 in the first six months of 2007.

My belief is that there is a lot of money that has been raised that needs to be put to work and will not be until either or both of (a) the general economic/financial crises is behind us and/or (b) the crisis in exits passes.  When these things happen, and it could be a while, the flood gates should open because many of the funds will be several years into their 10 year life and will need to put the money work quickly.

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