Dream of an IPO, but Plan for an Acquisition
It’s now very clear to me: a successful M&A exit is far more likely for entrepreneurs than the once vaunted IPO. Structural changes in the venture-IPO ecosystem over the past 15 years have made it increasingly difficult for young companies to successfully tap the public markets to fuel their continued growth. While this fact has significant negative consequences for long-term job growth in America, it does not leave startups without hope. Increasingly, the exit pendulum has swung in long-term favor of M&A transactions as multinational corporations have retuned their own innovation models in favor of acquiring outside companies versus internal development of innovation. As a former CEO, I tend to shy away from strategies that require events to occur over which I have very little visibility, and absolutely no control, to make my business plan work. Building startups for acquisition has always been a cornerstone strategy of Allegis Capital and we have had great success, but now acquisition is becoming the only viable strategy for many of today’s start-ups.
The good news is that the M&A market, which has been showing increasing signs of vigor in recent months, is likely to post a healthy showing this year and soar in 2011. This was the prediction of Jamie Montgomery, CEO of Montgomery & Co., at the May 2010 Allegis Capital limited partners meeting in California, and it makes sense to me. Acquisitions of venture-backed companies have always been strong—about 450 a year, on average, compared to a long-time average of 85 venture-backed IPOs annually. This year, Montgomery predicted the number will be even higher—450 to 600—and then soar to 750 to 900 in 2011, or twice the peak between 2005 and 2007. “I still think 95 percent of venture-backed exits will be M&A transactions over the next five years,” Montgomery told our audience.
This is entirely predictable, if you think about it. After a year of near-record lows in M&A activity, conditions are ripe for startups to attract strategic buyers. Prospective buyers have been sitting on cash and their new product cupboards have grown bare at a time when demand is clearly increasing. Corporations have increasingly been relying on startups for R&D for years; things have simply gotten worse because of the severity of the recession. One data point is that Robert W. Baird & Co. recently reported a 93 percent increase in U.S. middle market M&A transactions in March, the largest monthly deal count since June 2000.
The bad news is that the outlook for IPOs of venture-backed startups is relatively bleak. Sure, companies like Facebook and probably Twitter will go public at some point at enormous valuations and create a big stir, but they are clearly the exception. There will almost certainly be substantially more IPOs this year than last—some experts predict as many as 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.