Dream of an IPO, but Plan for an Acquisition
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50—but that’s still well below the historic norm and there is no reason to think the number will rise much, if at all, in 2011.
This reflects the demise of the so-called Four Horsemen (the boutique investment banks that specialized in taking venture-backed startups public) and decimalization, or penny increments in stock prices – materially reducing the profitability of making a market in the securities of emerging companies with small floats and lower trading volumes. This makes it extremely difficult for investment bankers to justify the expense of taking relatively small companies public and assigning a securities analyst to follow them. Remember, an IPO is the beginning of a recapitalization process with public investors replacing private investors. When the ecosystem that supports this process fails, life becomes very difficult for even the most promising and innovative young companies. Unless you have a “brand” with broad market appeal, who is going to tell your story to the public markets?
There is no question that the relative lack of competition from a viable IPO market will translate into lower startup acquisition prices. Over time, it could also undermine the luster of Silicon Valley. To counteract these forces, young companies need to focus on capital efficiency (a good thing in any market) in order to generate the returns that justify the risks inherent in building a company from an idea. It also means being deliberate about where you invest your precious capital when building your company. A global sales and support organization is expensive and challenging to build. It you are 1,000 percent committed to going public, you probably don’t have a choice. If you are looking at an M&A exit, chances are your potential acquirers may already have established distribution channels. They are not likely to pay you the same premium they will assign to your products, market validation, intellectual property and team.
This is a big change, of course, from the way things used to be. In the early- to mid-1980s, at the relative dawn of venture capital, as many as 97 percent of successful venture-backed startups went on to go public, according to figures from the National Venture Capital Association. But that’s ancient history. Between 1998 and 2008, the number of startups that went public annually plummeted from a high of 20 percent to a low of virtually zero. Concurrently, the median age of a startup that managed to go public increased from four years in the early ’80s to about 10 years by 2008.
It’s also a noteworthy reminder that the odds of a startup going public have been low for a long time. In recent decades, the average number of companies funded annually by U.S. venture capitalists is 883, according to other NVCA numbers. By comparison, the average number of IPOs annually has been 85, or less than 10 percent of the number of companies funded.
This isn’t to say that relatively small IPOs aren’t still doable. Tom Shanahan, the head of West coast banking for Needham & Co., told our limited partners that startups have a shot if they have at least $50 million in annual revenues, are relatively close to profitability, and have very high short-term visibility. But their odds of success are still relatively low.
Strong prospects for a coming spike in startup M&A activity are well short of financial nirvana. Nonetheless, it’s welcome news that all entrepreneurs should be happy about.