The Valley and the Bust

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:

• It takes longer to build an above-bar company (I believe the bar has gone up from ~$30M to ~$50M to ~$75M in TTM revenues per the data in this and prior reports.)

• 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.