Category Archives: Silicon Valley

The Valley and the Bust

Posted on November 12, 2008 | Leave a comment

I found an interesting article in Forbes the other day entitled The Silicon Lining / Why the Bust is Good for Silicon Valley and I thought I’d discuss it a bit here.

Let’s start with this excerpt with some interesting IPO-related stats:

Wall Street has been broken for eight years now, as far as Silicon Valley is concerned. Alan Patricof, a legendary venture capitalist, recently remarked: “We no longer invest with the idea of taking our companies public. If they do [IPO], it’s an accident.”

… Since 2002, there have been just 351 IPOs out of 19,300 VC-backed companies–fewer than one in 50 …

… The ratio of mergers and acquisitions to IPOs has gone from roughly 1:1 from 1996 to 2000 to 6:1 during 2001 through 2008.

As I wrote in Built to IPO, Flip or Last, the IPO bar has been raised and the window has been largely closed for quite some time. This has a number of effects:

  • Since 2001, the IPO window has been closed more than it’s been open so those relatively few companies who get above-bar often end up all dressed up with nowhere to go (e.g., Endeca).
  • Ceteris paribus, a time delay shouldn’t depress venture returns. Provided a company can maintain its impressive trajectory, the whole process should simply take longer at roughly constant IRR. Theoretically, the money remains at risk longer but, ceteris paribus, the IRR should be the same.
  • But, in the real world, ceteris aren’t paribus. Some companies derail between $30M and $60M. Valuations and multiples fluctuate. The lack of IPO exits can potentially depress M&A valuations. So, all things considered, I believe Forbes’ assertion that the net effect of a high bar and a closed window is depressed venture returns. Recent data from the NVCA support the claim as well. (See chart, noting particularly the grim situation in early-stage VC.)

The result of all this, says Forbes, is a sort of infanticide of great companies:

The sad truth is that we are replacing potentially great companies with under performing divisions of mature companies. Acquisitions invariably remove both the future risk and rewards–not just for the company but for society as a whole. Innovation is stifled, and that hurts us all.

Competing with EMC and watching what they’re doing with (or should I say to) their xDB division (formerly EMC Documentum XML Store, formerly x-Hive), I get a visceral sense of their point. Consider the fate of Amazon, says Forbes, in an similar IPO-shut environment:

For example, a company like Amazon.com which went public in 1997, could never have had an IPO in this environment. Instead it would have become a part of Walmart and likely would have been shut down during the tech bust.

While that’s a bit harsh, my beef has always been simple: why can’t the public buy a share of Endeca stock? They’re a $100M company. They’re far past the stage that should require accredited investor status.

All of my previous employers went public in the roughly year in which we did $30M. While I don’t agree with Endeca’s increasingly de-focused (or should I say decreasingly focused) strategy (the latest thing is now digital asset management), I do firmly believe that John Q. Public should be able to buy their stock. By raising the IPO bar to $50 or $100M, you effectively lock the public out of early- to mid-stage investments. That’s bad for the public. It’s bad the companies. It’s bad for the VCs.

But the past is the past. What’s happened in the past 8 years neither dictates nor predicts the coming 8. I recall when I quit Versant being absolutely sure the company would never go public, only to find it IPO-ing 18 months later. (Happily, I’d nevertheless exercised at least half my options on the Kellogg Uncertainty Principle: when in doubt, do half.)

I’m not alone in having some optimism about the future. The Forbes article continues:

The $100 million technology company will become an attractive investment again. Both Silicon Valley and Wall Street will once again bet on creating the next Amazon.com. And in my opinion, the bar for an IPO will go down over the next few years, once again creating a vibrant ecosystem in Silicon Valley.

Economist and former Chairman of the Federal Reserve Paul Volcker has said that the so-called “financial innovations” of the last few years largely rearranged existing resources instead of making real contributions to the economy. As a society we want financial returns to be aligned with value creation. This crisis will jar the the two back into alignment. Value creation is hard. But no one does it better than Silicon Valley.

For a dose of real venture optimism, check out this video I found on the related news section of Forbes.com where VC Charlie Harris predicts an eventual IPO boom.

Reblog this post [with Zemanta]

→ Leave a comment

Posted in Initial public offering, Mergers and acquisitions, Silicon Valley, Venture Capital

Built to IPO, Flip, or Last?

Posted on September 4, 2008 | 1 Comment

While it’s taken me a while to post on this Wall St Journal article, it’s still as relevant today as it was back in July. The article discusses the recent dearth of IPOs, arguing that the long-closed IPO window is changing the way startups think about themselves, they way venture capitalists think about startups, and threatening the great Silicon Valley venture-capital-driven innovation machine.

In a blog that generally offers more critique than praise, I’d simply say: I think the author’s right. Fewer startups run the gauntlet to IPO and I think that’s the result of three things:

  • The SOX “tax” – an estimated $2M-$3M annual nut – which all but wipes out the bottom line of what were previously IPO-ready companies and reduces market caps. Example: for a 50% growth company with a 1.0 PEG ratio, $3M in SOX expense wipes out $150M in market cap.
  • Lack of demand in the public markets. As mentioned here before, when you look the Software Equity Group’s IPO pipeline, you can impute that the IPO window is what I call 50/50/0 — i.e., $50M+ in TTM revenues, 50%+ growth, and 0% EBITDA. But, while that may be the window to make it potentially worth filing – make no mistake – the IPO market is currently closed.
  • Industry consolidation. The article surprisingly misses this point, but the software industry has sufficiently consolidated that plunking down $75M to buy a plateaued startup is nothing, and even paying $300M – $500M to buy someone on a roll is basically chump change. And, if you’re SAP, Oracle, Google, or Microsoft, even $1B isn’t much to buy your way out of a strategic headache – and heck – since goodwill is no longer amortized and they’re typically buying with stock and can cut enough costs to make the acquisitive instantly accretive, it’s effectively “free” anyway.

The last point sometimes makes me wonder if software will end up like pharma or biotech where it seems that big companies have effectively outsourced innovation to startups. The big guys are willing to pay big dollars for the few who succeed in order to avoid billions of R&D that it takes to find the winners. Simply put (and from quite a distance) it seems they’ve outsourced the financing of innovation to venture capitalists.

If I were at one of the big software oligopolists, I probably do the same thing. I’d watch ten startups, let 3 fail, let 3 fail into mediocrity and buy them for chump change, and pay 10x revenue for the one that went red hot. You win some, you lose some. And – even when you lose you win – because you are so much larger than your targets that you can let them grow to even $200M in revenues and still buy them without much pain.

That’s a new dynamic.

This prompts the question: is the next-generation of VC-backed startups built-to-flip instead of built-to-last? Frankly, I think the answer’s a mix.

Increasingly, I think web 2.0 startups that take relatively little capital are running a different formula than classical enterprise software vendors. The latter might raise $30M in VC, hoping to go public with a $500M market cap. The former might raise only $10M, hoping for a quick sale at $50M. This changes venture economics, but the system can still work.

Prior to Mark Logic, I’ve worked at only three software companies: Ingres, Versant, and Business Objects. All three were venture backed. All three went public. And all three went public – more or less – in the year in which they did $30M in revenues. My, how things have changed!

By contrast, let’s look at Endeca, a player in enterprise search who started out in e-commerce search, bringing OLAP-style dimensional navigation to the content world. Later, the company branched into more areas (seemingly too many if the recent stuff I’m reading about spend management, other apps, and a DBMS-like positioning is correct).

Per a recent 451 Group report Endeca did about $100M in revenues in 2007, growing 70% over 2006, with 500 staff, 500 customers, an average deal size of $350K and a 90/10 direct/indirect channel model. They’re silent on profitability, though they recently raised a $15M venture round bringing total investment to about $65M, suggesting they’re still burning cash. The numbers, with the exception of the unknown profitability and the high direct sales dependency (which are quite possibly linked), overall look pretty good.

But Endeca first talked about an IPO in 2006 and 2+ years later they’re still all dressed up with nowhere to go. Why? I’d guess it’s a combination of the IPO window closure and (perhaps) some process issues related to compliance, which these days are another leading cause of IPO stall-out and an indirect form of SOX tax.

Frankly, I think it’s too bad. While I want to crush Endeca in the relatively few deals in which we compete (and complement them in the relatively few where we do that as well), I nevertheless believe that Joe Investor should be able to buy their stock. By forcing the de facto IPO bar ever higher, the US is locking out individual investors from participating in early-stage technology companies. That’s not good.

Why’d we do it, then? Because of the excesses of the web bubble and the early 2000s, one says. But, when I think about that era, the problems fall into two distinct classes:

  • Investors awarding $1B valuations to startups with $5M in revenues. While I think this was ostensibly insane, it should nevertheless be permissible – no one forces you to buy a share of Beyond.com in 1999. No one forces an investor to participate in a speculative bubble. Some would argue they’re a normal market phenomenon. They shouldn’t be outlawed. Caveat emptor.
  • Fraud a la Enron. This needs to be wiped out. No question. (For an interesting perspective on Enron, read Open Secrets by Malcom Gladwell.)

Somehow, I think we mixed up the two different problems along the way by enacting laws that throw the early-stage baby out with the anti-fraud bathwater. The result is that individual investors are denied access to early-stage growth companies and, the Journal argues at least, that we are threatening the health of the Silicon Valley innovation machine.

→ 1 Comment

Posted in Silicon Valley, startups