Saying Goodbye: New Exit Strategies for Today's Venture CapitalistsPublished: March 03, 2010 in Knowledge@Wharton
Venture capitalism is not what it used to be. The bountiful returns of the dotcom years are long gone and venture capital (VC) firms are now struggling to exit their investments via initial public offerings (IPOs) or mergers and acquisitions (M&A). Also, a new regulatory landscape is threatening to hinder rather than help the industry, and the companies VCs invest in require watertight strategies for major growth. VC experts highlighted these issues and others during a recent panel discussion sponsored by Wharton Entrepreneurial Programs and titled, "Business Exits in the Current Economic Environment."
Appropriately, the event was held at Wharton's campus in San Francisco -- on the doorstep of Silicon Valley, which generates about half of all VC investments worldwide and where venture-backed companies earn about $3 trillion in annual revenues and employ 12 million people, noted the panel's moderator, Wharton management professor Raphael (Raffi) Amit.
But regardless of where their investments are based today, no VC firm has been immune to the global downturn. The number of IPOs by venture-backed companies in the U.S. plummeted from 260 in 2000 to 13 in 2009, and VC-backed M&A transactions dropped from 462 deals worth $99 billion (in disclosed values) in 1999 to 260 worth $12 billion in 2009. Investors, meanwhile, have reduced their commitment to the industry, from $41 billion in 2007 to $15 billion in 2009 in the U.S., according to Amit, who was joined by Larry Sonsini, chairman of Wilson Sonsini Goodrich & Rosati (WSG&R), a law firm in Palo Alto; Ted Schlein, managing partner of Silicon Valley VC firm Kleiner Perkins Caufield & Byers (KPCB) and former chair of Virginia-based National Venture Capital Association; and Frank Quattrone, co-founder and CEO of Qatalyst Partners, a technology-focused investment bank in San Francisco.
Among the issues explored by the panel was how -- or whether -- the much-anticipated recovery of the IPO market would be different from what took place after the dotcom crash. To help put the answer into context, Quattrone -- a former managing director and head of technology investment banking at Morgan Stanley and Credit Suisse First Boston -- reached back into history and looked at the technology IPO market of the 1970s. It was like "a backwater," he noted, with less than half a dozen companies going public each year. Despite IPOs from such future industry bellwethers as Intel and Tandem, the average deal size was around $10 million back then, he said. The market started gaining traction, however, with the IPOs of Apple and Genentech in 1980. In that decade, there were 32 technology IPOs a year, followed by more than 100 technology stock market debuts in the first half of the 1990s. From 1996 to 1998 -- the years that experienced the first wave of Internet-related IPOs as well as Amazon's IPO -- there were 240 deals annually, which were followed by the "crazy years" of 1999 and 2000, with nearly 400 deals a year.
As the VC industry picks up steam from its current state, it faces a markedly different environment than it did after the 2000 dotcom bust, according to Quattrone. After 2000, IPO activity was lean for a couple of years but then recovered. From 2001 through 2007, there were 62 deals a year and an average $11.4 billion a year was raised. In contrast, in 2008 and 2009 each, there were only 18 deals with a value of about $3.5 billion. In a sense, the recent deal levels are more or less reminiscent of the 1970s and 1980s, he noted.
Quattrone cited other factors that would make the current recovery different. For example, the dotcom bubble was focused on telecoms and the Internet and was "mostly a U.S. kind of phenomenon," he said. The damage was limited in large part to Nasdaq stocks, whose collective value fell some 80% between 2000 and 2003; the broader S&P index was down about 30%.
Big IPOs from the likes of Google and VMWare, and sufficient credit in the markets, helped VC fundamentals recover from the dotcom crash, as did the increased role of leveraged buyout (LBO) firms in IPO and M&A, according to Quattrone. LBO firms accounted for about 25% of the IPO and M&A markets in the mid-2000s, "buying big technology companies, taking them private and then taking them public again." However, "this time, [the crash] has been much deeper, broader, much more global," he noted. "The bust ... took 17 months to [force the market] down 50%, and it was down 50% not just in Nasdaq, but in the S&P, the Dow and most global indices."
The near-disappearance of credit is also striking. "It's really a 'have and have-not' market," Quattrone said. While each of the top dozen technology companies has $5 billion to $30 billion of cash and "a big advantage over the others," credit is largely unavailable to mid-sized companies. "It's going to take a longer time to come back.... We're going to need to get the credit flowing in the economy again before things really open up."
Of Risks and Rewards
The various players orchestrating the deals are also different from 10 years ago, the panelists noted. For example, there are fewer underwriters helping to take companies public, following a number of bankruptcies and a wave of consolidation. For those that are still in the game, risk-aversion is the new catchphrase. According to Quattrone, "The big VC companies now sort of have a chokehold on the distribution and they're not letting companies go public unless they have very, very large revenues and prospects for big market caps."
Sonsini -- whose law firm has been involved in such deals as Apple Computer's purchase of Netscape, Google's IPO and the HP and Compaq merger -- added that large investment banks today will not do an IPO under $75 million (bearing in mind that the IPOs of Cisco and Apple were under $50 million each). "The institutions have become so large, managing so much capital, that they really don't have time to pay attention to an IPO," especially a venture capital-staged IPO with less than $100 million in revenue and a market cap of less than $500 million."
The loss of independent research has also affected the market, Sonsini added, referring to former New York state Attorney General Eliot Spitzer, who forced investment banks in 2002 to separate research from their other activities, citing conflicts of interest in promoting IPOs. "That void has never been filled again.... The big banks have never found a way to make money by supporting independent research."
Indeed, the playing field among the banks is vastly different than before. Back in the 1980s and 1990s, big names like Morgan Stanley and Goldman Sachs each held between 5% and 10% of the technology IPOs, while the remainder was shared among "boutique" firms such as Hambrecht & Quist, Robertson Stephens, Alex Brown, L.F. Rothschild and Montgomery Securities. "The VC community was pleased to trust those [smaller] firms with book running some of their best offerings, like Sun Microsystems and Adobe," Quattrone said. "Today, it seems like the feeling is if Morgan and Goldman won't take your company public, it's not worth it. It's like saying, if you can't get your kids into Wharton or Stanford, they might as well work in the coal mines."
One solution, according to him, is to use this generation's boutique brokerage firms to lead smaller IPOs for smaller companies. "About half a dozen brokerage boutiques are perfectly capable of taking companies public and are willing to do smaller deals," he noted, pointing out that he didn't have an axe to grind since his firm does not do underwriting.
"[It] just comes down to some trust," said KPCB's Schlein, whose company is among the bigger VC firms. "The mid-bracket banks can get companies public ... [and] they can find buyers for the stock," although the offerings will be smaller. He recommended that firms look at a "two-stage offering." For example, the first IPO might be for $30 million, followed by another $30 million.
"Until we can get research in the system, until we can get more boutique banks to do smaller underwritings, until we can get institutional attention and get capital coming back, the risk-reward ratio [will continue to be] very difficult and you [will] have shrinkage of the IPOs," Sonsini said.
Get Me Out
The IPO and M&A markets are interlinked, Schlein noted. "You need a good vibrant capital market to make a good M&A market. Otherwise, you get a lot of dinky M&As." According to him, companies must be encouraged to build long-term, sustainable growth that leads to an IPO, instead of getting them to focus on M&A too early in their development. "It's very hard as a venture capitalist, as a professional board member, to tell a management team, 'You're going to build this company to be acquired.' When these companies get swallowed by larger entities, the passion dies, the entrepreneurship dies." At some point, if it becomes apparent that an IPO is not the best way out, a company could look at alternatives like M&A deals, he said.
WSG&R's Sonsini agreed that M&A should not be the only exit strategy for a company. Companies that operate with the sole objective of being bought have "a much narrower focus" than others, he noted.
According to Quattrone, IPOs were once within reach of companies with annual revenues of between $30 million and $50 million, a few consecutive profitable quarters, a good management team, and good investment bankers and attorneys. But this changed after the dotcom crash, and investors "wanted safety" in large, very mature companies with revenues of $150 million or more. "That has really sort of been the market bar for the last seven years."
The upshot? Companies now have to wait longer to go public, stretching the investment period of their VC backers. "All of a sudden, the VCs who are used to getting companies public within three to five years of the first venture round need to fund them for three or five more years," Quattrone said.
At the same time, returns have been shrinking: 1998 was "really the last vintage that made significant amounts of money," he noted. Returns on venture funds raised in seven of the last 10 years have been negative. "In only three [years] -- 2003, 2004 and 2005 -- could VCs buy cheap and get [their investments] public before the next market crash [and show] any positive returns ... and they were all single-digit returns."
Moves to tighten regulation are also hindering the VC industry's ability to return to health. According to Sonsini, not only has Sarbanes-Oxley increased the cost of running a public company, but also the plethora of regulations has meant companies have "a hard time finding board members ... because of the big [regulatory] burden." Ultimately, over-regulation "will stymie innovation," which, along with technology, is one of the greatest assets the U.S. has "besides our freedom." The country has the ability "to commercialize technology better [and] faster than anywhere else in the world, and that is really under siege today," he said.
The current U.S. laws on directors' liability and disclosure are "good enough" and don't need to be changed, Sonsini added. "All this rhetoric ... about say-on-pay, cap-on-pay and pay-tied-to-performance is really missing the real issue." He also cautioned against federalizing corporate law, given that "the state laws work.... The federal government has got to get out of that business."
He criticized recent considerations by the Obama administration to tax VC firms on their "carried interest" (the profit earned from returns their investors make from the start-ups they finance). "What problem are we trying to fix? Venture capital returns more to the country in taxes and by creating jobs" than capital gains or carried-interest taxes ever would, he said.
Schlein agreed. "[In the VC industry,] we take .2% of GDP and we generate 21% of GDP. Tell me what's broken about that? Why isn't that a good thing?"
As Quattrone noted, "A lot of times, good intentions on the regulatory side have unintended consequences." In the case of Spitzer and the investment banks' conflict-of-interest issue, the solution could simply focus on better disclosures concerning which reports written by the analysts involve companies that are the bank's clients. But the regulation went too far by prohibiting research analysts from being paid from the fees generated by the investment banking business, he said. "That's great, except there aren't really any other fees in the business to pay analysts, because the trading revenues are going to zero, and as a result, most of the talented analysts have left the business to work at hedge funds, private equity or VC firms."
Both Schlein and Sonsini pointed out that between 40% and 50% of Nasdaq-listed companies today have no analysts tracking their stocks. "We have to get back to some common sense," Sonsini said.
Pressure to Grow
As the IPO market struggles with those issues, M&A transactions have become "the dominant form of exit," according to Amit. However, M&A isn't generating sufficient returns for investors: In the third quarter of 2009, "only two of the 22 disclosed deals had a return of 10 times or higher."
Meanwhile, strategic buyers lose confidence when stock prices fall. "You need the CEOs of the big companies to have confidence, predictability and visibility into their own business before they're willing to pay imaginative prices," Quattrone said, adding that the current credit crisis is worsening the situation.
All the same, the M&A market may have bottomed out in 2008, according to Quattrone. M&A volumes have improved from $77 billion in 2008 to $90 billion in 2009, while interest rates are still low and confidence is returning. However, "we're not recovering as fast as people would hope." There is additional pressure on companies to focus on growth, he said, describing the current price-equity (PE) levels in the stock markets as too high for comfort. "If things don't really start growing, there's risk in PE levels right now."
Schlien said that while the returns may not be "as outrageous as in the boom years," the VC industry could "generate really good solid [internal rates of return of between] 20% and 30%." A few big innovations -- in, say, digital technology, life sciences or green technology -- could help the industry rebound. "Some people think green tech might be the way that we're going to get it rolling again," he added.
Quattrone recommended a "systematic approach" to addressing the VC industry's woes. For starters, "you've got to get the research analysts back in, which means somebody has to lobby to get the Spitzer initiative rolled back." The VC industry would be the biggest beneficiary of that, he said.
According to Sonsini, it's not time to panic and over-regulate the VC industry, but to "step back and ... recognize that we're losing ground ... for the first time." Quattrone joked that it felt "a little bit like that ... guy [who has just had his arms and legs cut off in a duel in the film, Monty Python and the Holy Grail, shouting after a knight], 'Come back and fight like a man.'"
The fundamental changes can't be ignored, Sonsini said. "You had 9/11 and all of the problems it brings. You've had this economic crisis ... globalization and ... the emergence of alternative markets. These are pretty big body blows to the system." All the same, Sonsini was confident that "there's nothing broken with the venture model," even if IPO timeframes are stretched from five years to 10 years. "We can all assume that's what life is going to be like."
"A company's ready [to go public] when it's ready," said Quattrone. "That's the time at which everyone should be willing to take these companies public, and then they have to deliver the goods. They have to go out there and deliver four, six, eight straight quarters of outperformance. And then the system will regain confidence."