So, the world of VC is in crisis – at least that is the prevailing view of the National Venture Capital Association and others.  Check out this post from Techcrunch or this article from my friend Kim Hart at the Washington Post.  I talked with Kim as she was writing the article and some of my thoughts are included in the article.  I thought that I’d share some more of my thoughts in this post.

Let’s start with some background.  There was not a single venture capital backed company that went public during the second quarter. Not one, zilch, nada.  That is a significant event for a number of reasons -- the largest being that public offerings are one of only two ways that venture investors can make money -- the other being an outright sale of the business.  The lack of public offerings is a continuation of a trend that began in the aftermath of the bursting of the technology bubble, and has accelerated recently.  Why is this a problem? 

Venture funds exist for a limited period, generally ten years.  During this period, venture funds must make investments in private companies and then have a sale occur (hopefully at an increase in value) and without exits there is no cash to reward their investors. Also, the longer the time between the investment and exits, the lower the internal rate of return realized from a subsequent exit. The venture industry is driven by internal rate of return rankings – success and failure is measured by a fund’s internal rate of return and how it compares to other funds raised at the same time.  Therefore, a longer time period to exit, or no exit, makes it extremely difficult for venture capital funds to generate expected returns for their investors.

The lack of the IPO window for venture backed companies has some other negative effects.  Firstly, companies that successfully become public are able to use their own stock as scrip for subsequent transactions, which is a much more efficient way to grow than cash acquisitions.  Therefore, the lack of access to the public market is a corporate finance problem – without IPOs companies lose a ready tool to finance continued growth.  Secondly, selling a company to the public (which then provides a subsequent opportunity for the venture fund to sell its shares in a secondary offering) often occurs at a higher enterprise value than a sale of the business as a whole (e.g., an “M&A” exit). 

How did we get here?  A big factor is the greater regulatory scrutiny of public companies, which makes it much more expensive to become and stay public. Another factor is that public market investors in the aftermath of the internet bubble became much more focused on revenues and profits.  Finally, and this is a very important factor, the current economic climate doesn’t favor equity investments – check out commodity prices if you want to know where the “smart money” is investing right now……

The net, net, is that in order to become a public company a business needs to be much more substantial, both to support the expenses of being public and also to satisfy the requirements of stock market investors.  Many emerging technology businesses don’t fulfill either of these criteria, even in an economy where investors want to acquire equity securities.

The resulting current market dynamic presents a very interesting dilemma for large venture capital funds and entrepreneurs who finance their businesses with large amounts of venture capital.  Multiple rounds of financing, for significant amounts of capital, combined with the unavailability of the public markets causes a stacking up problem, because in order for the funds to generate their required return, and for the entrepreneurs to benefit from the amount of capital deployed, companies have to be exited at multi hundred million enterprise valuations. That is very difficult to widely achieve without an active public market.

On the other hand, a company that takes a smaller amount of capital in one or two rounds, is better able to benefit from a $50 to $70 million M&A exit (which by the way is where the average M&A exit presently occurs).   Therefore, the more attractive pattern in many instances is to do one or two small rounds of financing, and then perhaps do a single larger institutional round. 

The market is adjusting to this situation in a number of ways.  You are seeing larger funds looking to create their own acquisition or platform companies to try to get to a large enough scale for a public offering.  You are also seeing larger fund organizations becoming more like acquirers themselves – looking for make “growth equity” transactions where they acquire a majority interest in a company. And, you are seeing smaller funds like Amplifier and sophisticated Angel groups getting better deal flow and investment opportunities as entrepreneurs get more concerned about the likelihood of getting a large enough exit to warrant multiple institutional rounds.

How this is going to play out over the next few years is that the venture capital market is going to fragment, with funds being configured to benefit from creating “bite sized” companies that are amenable to a relatively quick M&A event, or having sufficient capital to nurture and grow large platform companies with the scale and profits to become public companies.  Both should provide strong investment returns for their investors, since opportunities exist in both places. The larger issue is what is going to happen to large funds that apply the traditional venture capital model of multiple large syndicated financing rounds from a minority ownership position.  That is probably the biggest challenge of the current market, and since many venture capital funds fall into this category.

I should note, however, that I see a big difference between a short term systemic challenge, and the longer term prospects of investing in technology start ups.  The US technology industry remains world class, and one of the areas of our economy that is internationally relevant. It is also the area where extraordinary returns are most likely to be obtained by an investor.  We are at the cusp of some very significant technology trends that are going to be very rewarding for investors and entrepreneurs, including software as a service, energy efficiency, alternative energy production, tailored medicine, material science and others.  The current flavor of hot money investing – commodities – will morph into other areas, and without question the US technology sector will get its turn as a place of interest and investment enthusiasm.

In the near term, entrepreneurs and venture investors should be very clear about what type of company they are building and making sure that capital requirements match the likely exit.  Quite literally, having too much cash could be as much of a problem for the entrepreneur as not having enough.  You might say, “that’s a high class problem”, but trust me, if you can’t get an exit for your investors at a return that will make all happy – that will be a movie that will not end well.