SF Venture

Exit Data Dark For First Quarter - Another Cycle Begins

The credit-related traumas impacted exit activity in the first quarter, with only 5 IPOs and 56 M&A deals for venture-backed companies, down sharply from recent levels. 

We don't expect the IPO market will recover until after the election.  We would still expect modest volumes of acquisitions, albeit at lower prices.  Clearly, this is bad for existing venture investments,  stretching out returns. 

Anecdotally, we have not seen pricing of venture rounds come down to reflect these market conditions.  In some areas, like new media, where pricing has appeared excessive, there should be a meaningful correction.  Later stage valuations are also ripe for adjustment.  Generally, we expect pricing of venture rounds to come down over the next few quarters. 

This data marks a turn in the typical cycle.  We saw a similar price correction at the beginning of the decade after the combination of the bursting bubble and 9/11.  We made some of our best investments during that recovery period.  Prices were reasonable and companies needed to find more compelling marketing opportunities while maintaining capital efficiency.  We see the same circumstance starting in 2008, where lower pricing will provide a good start for new investments. 

Venture Exits Rise in 2007

In 2007, 86 venture-backed IPOs raised a total of $10.3 billion, up from 57 IPOs raising $5.1 billion last year, according to Thomson Venture Economics and the NVCA.  Of this total, there were 47 Information Technology, raising $6 billion in 2007.

As of December 31, 2007, 58% of those IPOs were trading at or above offering price. 

The value of M&A deals rose significantly.  There were 304 deals disclosed in 2007 worth $23.7 billion, compared to 363 deals worth $17.1 billion last year.  Average disclosed deal size jumped to $176 million, compared to $111 million last year.

All of this occurred despite the volatility in the public markets associated with the credit crunch.  IPO activity fell off in December, but we view that as more a sign of investor fatigue than of a lack of demand for technology IPOs.  In 2008, we believe public market investors will continue to pay a premium for growth. 

VentureBeat Articles On Credit Crunch And Tech Stocks

Matt Marshall just published a article on the credit crunch subject. 

I had been talking to Matt on the subject and I had provided him with further thoughts, which he just posted as a guest column:

Technology stocks swinging back into favor.

NYT Article - Subprime Fallout Could Help Venture Capitalists

I'm quoted in today's New York Times. 

“People are being scared away from other investment strategies,” said Keith Benjamin, a partner at Levensohn Venture Partners, a San Francisco firm that focuses on technology investments.

Click on here for link to article.

How to Make VCs Happy

Paul Deninger, Vice Chairman, Jeffries & Company gave a great talk at the AlwaysOn: Stanford Summit, with the dramatic title, Why Aren’t VCs Happy?  It starts out a bit heavy, suggesting that VCs should be unhappy in the currently shaky financial market, but ends with a constructive point.  The key to future happiness will be to resist the temptation to sell companies prematurely and make the effort to prepare companies for the public markets.  He asks what if Cisco had sold itself to AT&T instead if going public at roughly a $250 million market cap.  He notes that the public markets are now receptive to growth companies with a market capitalization under $500 million, counter to the post bubble myth.  I agree that the key to venture will be to patiently strive to create growth companies and be prepared to undertake the costs and hassles of the public market in exchange for the potentially significant rewards.

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. 

Venture Exits – Year Ends With Rise in IPOs

After much debate on the death of venture, the data for the year pointed to positive prospects for 2007. 

In 2006, 58 venture-backed IPOs raised a total of $5.3 billion, up from $4.5 billion in 2005, according to Thomson Venture Economics and the NVCA.   The 4th quarter of 2006 showed 21 IPOs. 

M&A yielded $16.6 billion in 2006, up slightly from $16.1 billion in 2004.  Average disclosed deal value for the year was $114 million in 2006, up from $96 million in 2005.

The year ended with a boost from Google’s $1.65 billion acquisition of YouTube.  This transaction distorted the numbers in Q4, which showed a decline in the number of deals, but an increase in the aggregate value.  Net returns from M&A continue to be mixed.  Looking at Q4 of 2006, out of 23 deals, 7 returned more than 10x the amount invested, 8 returned more than 4x the investment, one 1x-4x, and 7 less than the amount invested. 

What are the exit prospects for 2007?  We see all the signs of a receptive IPO market.  IPOs from Q4 mostly performed well in the aftermarket.  Anecdotally, we understand there are at least a half dozen reasonably high profile technology IPOs in the pipeline for the first half of 2007, including NetSuite. 

What are the dynamics for venture investment in 2007?  Within our deal flow, we saw a higher number of companies with good teams, plans and initial results at the end of the year than we’d seen in many years.  Unfortunately, some of the better ones found other VCs willing to pay higher prices than we’ve been seeing on average in 2006 or 2005.  We don’t believe the exit prospects have improved enough to justify much price inflation.  Of course, the true test of prices paid for new investments in 2006 and 2007 will be the IPO markets at the end of the decade.  It’s all about finding the few deals that return 10x or greater.  Prospects for creating those hits appear higher than we’ve seen in years. 

Is Venture Broken? - No

I’m a bit late to the part of reactions to the Sevin Rosen announcement that it was ending after its 10th fund and the related New York Times Article.  I felt compelled to post after reading a series of posts and comments on Fred Wilson’s blog.  I have seen no commentary that acknowledges the underlying math and attempts to take a constructive look ahead.

First, the math is simple.  The vast majority of returns to limited partners of venture firms have come from the value created after IPO.  Some funds have made money through M&A, but YouTube is the exception, not the rule.  However, M&A is not enough to drive aggregate returns to levels much above public market returns. 

Let's not delude ourselves. If you invest $20-40 million and take 5 years to build company from nothing to $20-30 million in revenues and profitability, selling out for even $150 million does not seem to justify the effort and risk.  Buyers typically bury fail to grow acquired technologies.  The goal of venture exercise is to create new, large companies. 

Looking at the long history of venture, the vast majority of growth in revenues and value occurs after IPO, with the IPO validating new markets and/or competitive position against incumbents. Given IPO hurdles, one could argue that the venture market will remain "broken" until there is a more receptive IPO market.  Fortunately, there are signs that the IPO market is returning to accept companies with revenues under $50 million.  Recent deals like Riverbed and Acme Packet have demonstrated strong after-market stock performance.  Failure of bubble IPOs created a fear of investing that has lasted many years.  If investors see a few deals working, the mood could turn from fear back into greed, with a reasonable number of technology IPOs introduced each year. 

VC-Inside Out Launch

The first two episodes of VC-InsideOut, a podcast program on the Venture Capital industry developed and produced by the investment professionals at Levensohn Venture Partners, are available for streaming and downloads on the web at www.VC-IO.com.

VC-InsideOutPascal Levensohn opens a window into the venture capital industry through constructive dialogue and interviews with leading VCs, entrepreneurs, and other influential leaders involved with the VC world.  VC-InsideOut episodes feature original content developed and produced by Pascal Levensohn, Keith Benjamin, Kip Sheeline, Steve Reale, and Jeff Karras on a range of subjects relevant to the venture capital industry.

Typical episodes run between 10 and 12 minutes.  You can stream the content from our website, or download it to iTunes or your favorite media player.  By clicking on Subscribe, you can be notified of new episodes when they are added to the VC-IO.com website.

VC-InsideOut kicks off with two separate series, the Governance Series and the Entrepreneur Series.

About the VC-InsideOut Governance Series

How and why are VC boards different from other boards?  What are some of the common problems faced by VC-backed company boards? Are there early warning signs of trouble in the board room? What are some of the signs of effective and ineffective venture boards and directors?  VC-InsideOut tackles these and other important governance questions head-on in this series of interviews and editorial commentary on the state of VC boards.  Each episode makes clear recommendations about best practices that can be useful to VCs and entrepreneurs in the field.

About the VC-InsideOut Entrepreneur Series

The VC-InsideOut Entrepreneur Series is focused on enabling entrepreneurs to gain access to the information, insights, and tools needed to build successful technology companies.  Leading entrepreneurs, venture capitalists and other service providers share their experiences on the "ins and outs" of creating an idea, business plans, hiring teams, raising capital, and building businesses that scale.

Will the US IPO Market Ever Recover? Can AIM Provide A Viable Alternative?

Quarterly exit data has just been released by Thomson Venture Economics and the NVCA.  Although there was an increase in IPO activity, there overall trend remains flat. 

In the second quarter of 2006, 19 venture-backed IPOs raised a total of $2 billion, up significantly from both the first quarter of 2006 and the second quarter of 2005. 

M&A activity was $3.2 billion in Q1 of 2006.  There were a total of 86 M&A deals with 34 disclosing values.  Average disclosed deal value was $95 million in Q2 of 2006. These numbers are down somewhat sequentially and from last year.  Roughly 29% of those deals returned more than 4x the investment, 42% returned 1x-4x, and only 29% less than the amount invested.  It took almost 6 years on average between founding and M&A exit. 

Levels are still not high enough to provide venture funds returns in excess of competing asset classes, including buyouts and hedge funds. 

Three of these IPOs were US companies on foreign exchanges, 2 on London’s AIM (Alternative Investment Market) and 1 on the London Stock Exchange.  We are encouraged about what we’ve been learning about AIM, which could provide a reasonable alternative for venture-backed companies to go public. 

What is AIM?  It was created 11 years ago as an affiliate of the London Stock Exchange to list smaller companies.  The structure is friendly to smaller stocks.  UK investors receive tax benefits by holding long-term, discouraging the volatility typical on NASAQ.  Relative to NASDAQ, where Sarbanes Oxley makes disclosure problematic and expensive, disclosure rules on AIM are reasonable.  Given Spitzer’s hobbling of the research function, it’s impractical to list a company on NASDAQ with a market capitalization of less than $500 million.  AIM is geared to companies below $100 million.  Until recently, company sizes, exchange volumes, and international investor interest has been low to modest.   A few US technology companies have listed on AIM, allowing financing, but less trading liquidity than NASDAQ.  Liquidity for venture investors has been enabled more secondary offerings than open-market sales.  That appears to be changing, with activity increasing on AIM. 

We’ve wondered how venture-backed companies get large enough to get on NASDAQ.  Historically, NASDAQ’s structure supported more risk taking behavior, allowing companies with modest revenue levels to go public with growth stories, using IPO proceeds and the marketing event of on IPO to validate competitive positioning against larger legacy companies.  Over the last few years, we’ve observed most technology companies have struggled to scale businesses without the help of an IPO with buyers of technology cautious about dealing with private companies.  A few companies have crossed the marketing chasm by taking more time, raising more money privately or merging with other private companies.  If AIM can show it can market technology growth stories, AIM could provide a bridge between venture and NASDAQ, with successful companies achieving the scale needed to move over to NASDAQ.

Based on discussions with investment banks, we expect more US technology companies to list on AIM and will be monitoring trends in the market closely.