Original post on 9 February, 2009
On Dealbook
By Alan Patricof
Alan Patricof, managing director of Greycroft Partners, a venture capital firm that invests in digital media companies, offers this view of how venture capital investing has been changing:
When we conceived of the idea to start Greycroft Partners, we specifically took into consideration that the paradigm had changed since I first entered the venture capital business in 1969. At that time, and continuing for the next 30 years, the ultimate “win” for a venture capital investment was “going public.” It was tantamount to winning the Triple Crown or being awarded an Oscar for best performance.
At one point, the measurement for going public was merely an exciting technical achievement or a modest amount of revenue. This ultimately transmogrified in the late 1990s to an “idea,” the word Internet attached to the name or description, or some sexy romanticizing of a multiple of future projected revenues.
Clearly, West Coast manifestations with brand-name venture capital firms attached to an initial public offering helped to exacerbate the phenomenon of a “hot issue.” Legitimate efforts were made by regulators to control the allocations of these new issues to prevent unfair treatment of the average investor who was shut out of the process and to dampen speculative excesses.
Nevertheless, “going public” remained the ultimate goal for most start-ups in spite of the fact that more than one-third of the actual exits for venture capitalists were through mergers and acquisitions. Today, that percentage has shifted even further to 80-20 in favor of M.&A. exits.
The underlying support for all of this “irrational exuberance” was the myriad small and mid-sized investment banking firms that thrived across the country in the 1970s and 1980s, primarily in New York City and San Francisco, but also in hometown America. They included names like C.E. Unterberg Towbin; Marron, Eden & Sloss; Carter Berlind; Potoma & Weill; Fahnestock; Wessels, Arnold; Adams Harkness & Hill; Robertson Stephens; Montgomery Securities (the old firm with that name);Laird & Company; D.H. Blair; Raymond James; Black & Company; Robinson Humphrey; Loeb Rhoades & Company; G.H. Walker and, of course, Hambrecht & Quist.
These names filled the map with a whole slew of firms willing to take you public with a good story, raising $10 million, $5 million or even $2 million, with a total market value of $10 million to $50 million. It was a great time to be in the venture business and young companies had access to angels, A rounds, B rounds and I.P.O.s at a relatively young age of development. The biotechnology, semiconductor, disc drive and personal computer industries were nurtured on a system of raising capital that supported young companies with access to capital. It was the time of Data General, DEC, Intel, Genentech andSeagate, to mention just a few.
Small investment firms were the lifeblood of the new-issue business. They not only took these companies public, but also made aftermarkets in the shares, at often-times egregious spreads, which created a viable aftermarket and generated sufficient profits to make up for the small floats. This trading “over the counter,” as it was referred to, was done over the phone. When markets went down, one would often hear “1,000 shares offered — no bids.” It was in many respects the Wild West.
Electronic trading and the development of Nasdaq gradually served to reduce these spreads on net trades and lowered commission rates for the others. This made for a somewhat more orderly market, but also reduced profitability on individual transactions for the underwriting firms and market makers.
I remember specifically taking a medical electronics company, Datascope, public in 1971 through C.E. Unterberg Towbin with an initial offering of 100,000 shares at $19 a share. The total market capitalization was $10 million. The same firm had brought Intel public the year before with a not much greater offering and market value.
It wasn’t until the 1980s and 1990s, when offering sizes began to increase, that big investment firms like Morgan Stanley, Goldman Sachs and First Boston started to recognize the potential in the market for young venture-backed companies. Such names as Diasonics, Cordis, Cisco and Network Appliance, along with Apple, AOL andMicrosoft, made for a robust marketplace.
In the late 1990s, the market for high-tech I.P.O.s reached a series of crescendos with valuations based on multiples of projected revenues in the hereafter. It was a heady time and reached such levels that new issues were often oversubscribed by multiples of 5 to 10 times, and there was no easier way to get rich quick than by getting an allocation of an I.P.O.
During this period, the game gradually changed as many of the aforementioned smaller investment firms either went out of business or merged with one of the “four horsemen” as they were commonly known, or a handful of other survivors.
The character of the Nasdaq market also changed. The big players began to assume a more significant role towards the latter half of the 1990s as the size of offerings increased to $25 million, $50 million or even $100 million, with valuations of $200 million, $500 million or even $1 billion, partly because there was so much demand for the new flavor of the day — the Internet — with all its hyperbole of promise of growth and riches.
But the larger the deal, the greater the capital requirements for underwriting and making aftermarkets. The economics of the business had changed and it was no longer possible to do small deals, so small firms could not compete. The bubble finally burst in 2001 and virtually overnight the I.P.O. market dried up as the public realized that in many cases “the emperor had no clothes.”
This situation was exacerbated by a gradual reduction in the pool of analysts who covered small companies with small market capitalizations, as the costs just were not justified by the volume of trading. In addition, the regulators put up Chinese walls between the bankers and the analysts, making it much more difficult to follow small companies. Many companies that had managed to go public found they had no coverage and few market makers. Their shares gradually became part of the living dead: a public company with all the attendant regulatory requirements and no interest from investors.
The collapse of the Internet bubble only served to compound the problem as public interest in I.P.O.s dwindled to a trickle as their losses increased. Then, in 2002, in the wake of the Enron, WorldCom and Tyco debacles, the government intervened with the passage of the Sarbanes-Oxley Act, which imposed tougher rules on corporations. This only added further to the cost of an I.P.O. in terms of legal and accounting requirements for both the issuer and underwriter.
The sum and substance of all of these developments is that the minimum economic level to bring a company public today is at least a $50 million offering at a $250 million market value. With realism back in the market and a return to rational metrics, like multiples of revenues and, better yet, profits, venture capitalists have had to face the hard reality that it is highly unlikely that taking a company from start-up to a point where it can justify this type of market capitalization in a three-, five- and even seven-year time frame is realistic, except in a limited number of situations.
For these reasons, I believe that the paradigm has changed for the venture business. We can no longer realistically expect the same kinds of absolute returns that were achieved in the past through a quick turnaround from start-up to liquidity through an I.P.O. Rather, I believe that most of the companies that venture capitalists are funding today will find an exit through merger or acquisition. And if we expect to achieve a return in a reasonable time frame of three to five years, we are probably looking at a sale price of $20 million to $100 million. This is the valuation range where most young companies are being acquired.
To compensate for these lower gross return expectations, we must establish initial valuations, usually in the single digits, that can provide an adequate multiple return and internal rate of return. Inevitably, this suggests that a true venture capital firm should be reverting to smaller-scale funds and restricting individual investments in early-stage companies to accommodate the realities of the exit opportunity. Larger funds can focus on later-stage growth opportunities that can absorb greater amounts of capital where there still exists the possibility of taking companies public in a timely manner.
This, in turn, requires a more disciplined approach to investing. Entrepreneurs must be guided to use capital more efficiently and we must avoid falling into the trap of C, D and even E and F rounds of funding, with successive layers of participating preferred, in order to prove an ill-conceived concept is viable. Equally concerning are the myriad projects that should not appropriately be financed in the first place by a venture capitalist. (I worry about the myriad alternative energy companies that seem to be the next wave of capital-consuming enterprises that may just be beyond our capabilities in view of the limited exit opportunities.)
Entrepreneurs themselves seem to be catching onto the new risk/reward equation and seem far more willing, at an early stage, to opt for a sale at a lower valuation and lock in their gains, figuring that they are young and can repeat the process later with another start-up.
If the scenario I have described strikes a chord of reality, then until someone solves the cost of going public and increases the liquidity in aftermarket trading, we as an industry have to downsize our expectation for exits as well as downsize the size of our funds. We still can produce significant returns for investors, but we cannot accommodate the size to which funds have grown in the past decade.
Venture capital is definitely not dead or even ill; rather it has just taken on a new set of dynamics. Entrepreneurs in this country are stronger than ever, and venture capitalists are the ones to nurture them!
