SF Venture

Fighting The Sarbox Monster

There is an excellent editorial in today's Wall Street Journal by Robert Grady of Carlyle.  The Sarbox Monster provides a well organized list of reasons why the IPO market remains largely unreachable the the downstream cost to the U.S. in terms of job creation and innovation.  The article is light on recommendations, but puts the problem is a constructive context.  I view the article as a sign of a more receptive climate to Sarbox reform and other regulatory changes to correct prior political short-sightedness.  Bob reminds us that essentially all of the value creation from venture has occurred through the growth of companies after an IPO.  Fortunately, public market buyers can remember that these winners outweighed the losers, even after the bubble, as evidenced by recent buying of smaller technology IPOs.  It appears that both politicians and buyers may be finally positioned to facilitate positive changes.

Sarbox reform will be necessary as a first step to get companies public, but it will not solve the underlying problem of providing research for small cap stocks. The best solution I've seen is the National Research Exchange (NRE) www.ResearchExchange.com.  Founded by Wall Street veteran David Weild IV, the NRE is working on ways to pay for ongoing research coverage. The basic idea is to carve out a portion of the 7% underwriting fee and put it into an escrow account to pay for research over the first two or three years.  The pool could be used to attract research from firms outside of the main underwriting group.  If an analyst left an investment bank and coverage was dropped, the remaining money in escrow could be used to find another firm to cover the stock.  There would be no promise on recommendation, to avoid the obvious potential conflict.  While NRE is still in process of structuring and rolling out the service, I like the idea of effectively guaranteeing coverage by spreading out the economics. 

Venture Exits – Growth IPOs Are Back

We can now look back at three quarters where multiple venture-backed companies successfully reached the public markets.  In Q1 2007, 17 venture-backed IPOs raised a total of $2.1 billion, up from 10 IPOs in Q1 2006, according to Thomson Venture Economics and the NVCA.

M&A activity fell to 62 deals in Q1 2007 from 104 in Q1 2006.  However, average disclosed deal size was up significantly to $161.2 million, compared to many years below $100 million.

After market performance of many of these IPOs has been positive, although a few, like Sourcefire, have faltered after announcing disappointing results.  We now have enough data points to declare a trend. 

Public market buyers are again investing in smaller capitalization technology companies, looking for growth to boost investment performance.  This is a sharp contrast to years of more risk adverse investing behavior.

Investors had many reasons to be scared away from growth stocks, facing multiple points of trauma from the bursting bubble to terrorism and the fumbled political response to Katrina and a fearful new awareness of environmental challenges.  Through most of this decade, the winning investment strategy was to actively trade among global asset classes from oil to emerging markets with hedge funds.  With increasing public market volatility, buyout funds have profited by taking companies out of the public markets. 

While it’s hard to hope for public market stability, we see a good case for growth stocks to work again.  We have heard from various public investors that they are starved for growth.  The larger companies are either growing more slowly or more expensive. 
With years of M&A activity between public firms, there are few smaller technology growth stocks remaining.  There have been plenty of private companies achieving growth, but forced to sell out prior to attempting an IPO.  IPOs are usually necessary for smaller companies to cross the marketing chasm to achieve higher, sustainable rates of growth. 

We have seen new markets emerge across technology sectors.  Web 2.0 has been getting more media attention, given the surge of consumer activity and rush of advertisers to join the crowd.  Consumers keep showing an insatiable appetite for new devices and increased bandwidth in the digital home, providing opportunities for underlying semiconductor and other communications technologies.  Enterprises are still spending money on software, particularly as they use more web-based applications.  We see room for many new growth areas. 

While pessimists can still point to excess capital in venture, but that has been a factor during previous periods of above average returns by capturing the upside on a few big winners.