Dec 11, 2011
The venture capital industry appears to be defying economics. On one hand, early stage fund raising is down 48% year over year. Exits are dwindling. And the number of venture capitalists has declined. On the other, there’s a start up boom. Everyone, it seems, is starting something. Incubators abound. And in Silicon Valley valuations are astronomical. What’s really going on?
Venture funds are partnerships forged between general partners, GPs, and limited partners, LPs. GPs are the individuals investing in start up companies. LPs are generally endowments, funds of funds and high net worth individuals who contribute upwards of 95% of the capital invested by a venture fund. LPs invest in venture funds seeking returns.
But venture capital isn’t as attractive an investment as it used to be. The median cash on cash return in the 2000s fell by 36% (Cambridge Associates). In the 90s, the industry internal rate of return (IRR), a measure of annual performance comparable to an index fund’s annual performance, averaged 25%. In the 2000s, that figure dropped to 6%.
In response, LPs have retrenched from investing in venture funds. For the past 3 years, venture fund raising has receded below the 20 year median of $17.2B per year (VentureSource). As a result, today there are 31% fewer funds and 26% fewer venture capitalists than at the peak in 2000 (NVCA).
Venture backed companies take longer to exit than ever before. And exits are fewer and further between. The median time to initial public offering (IPO) or merger & acquisition (M&A) has more than doubled since 1998, jumping to nearly ten and seven years respectively (NVCA).
The costs of regulatory compliance imposed by Sarbanes-Oxley or SOX, is a hefty drawback for vibrant private companies eyeing IPOs. SOX regulations meaningfully impact profitability margins. 80% of companies listed on Nasdaq have market caps smaller than $2B. For these companies, SOX compliance costs average $1.8M annually or about 3 to 106% of their profits. Facing a significant impact to the bottom line, many start ups delay going public.
Thankfully, last week the US Senate introduced the “Reopening American Capital Markets to Emerging Growth Companies Act” which, if ratified, would allow private companies to delay full SOX compliance for up to 5 years.
Nevertheless, the IPO market has been constricted. Over the past 20 years, 97 venture backed companies have gone public annually. Since 2001 we have averaged an anemic 36. From 2008 to 2009, only 15 companies successfully completed IPOs.
In contrast acquisitions have swelled in number and doubled in value; but this doubling in proceeds hasn’t matched the six-fold increase in VC fund raising during the 2000-era boom. During that time, LPs over-invested in venture capital growing the average annual dollars raised by 16x to $64B. As a result of a capital surplus, returns tumbled.
We’re observing a correction in the venture market. In response to falling returns LPs have adopted conservative investment strategies. They have pared allocations to venture funds and pursued firms with established track records. Since 2005, the average dollars committed to the top 25 venture funds varied between 7% and 57%. Year to date, these 25 firms have raised 100% of all new investments.
Fewer dollars to invest in start ups in the hands of fewer investors should be the makings of a buyer’s market, one in which VCs should command better terms from entrepreneurs. But valuations in Silicon Valley defy this logic. Prices haven’t reached such peaks since the bubble era.
Given the bleak exit environment, declining returns and fewer dollars to invest, a seller’s market is unexpected. But there is a good reason for the incongruity.
Technology breakthroughs tend to occur in waves. They give rise to a raft of new companies pursuing fresh opportunities. We’re in the midst of several confluent technology waves: big data, mobile applications, ubiquitous social infrastructure. As start ups capitalize on these opportunities, they generate disproportionate returns for investors in very much the same wavy way.
The chart below shows the billions of dollars raised from venture backed IPOs since 1978. Disproportionate IPO returns occur in brief, punctuated periods. In fact, there are only 5 years in which the total amount raised from IPOs exceed the 20 year average (1990, 1995, 1999, 2000 and 2007). Most years, IPO market returns are below average.
Venture capitalists are quite aware of this wave phenomenon. Since only a handful of start ups drives each wave, we should expect pricing competition for these industry defining companies. This explains some of the price appreciation.
Though counter-intuitive, longer investment holding periods for IPOs and M&A also increase prices. In 1986, Microsoft went public with a $60M market cap. Over the next 15 years, the company grew to a multi-hundred billion dollar market cap, an increase on the order of 1000x, an unbelievable cash on cash return multiple. But this return didn’t accrue to the VCs.
After an IPO, VCs are required to hold onto the shares during the lock up period, typically six months, to ensure that the market for the shares is stable and the offering is successful. Once the lock up expires, VCs distribute the shares of an IPO directly to LPs. Distributing shares yields tax benefits and provides LPs the freedom to manage their position in the stock directly. After all, LPs don’t pay VCs to pick and manage public company shares.
In contrast to Microsoft, today’s companies remain private for about twice as long. If the theory holds, the next wave of venture backed IPOs will bear much larger IPOs. According to the NVCA, the average venture backed IPO in the 90s raised $50M. In the 2000s, that figure increased to $80M, a 60% increase.
Faced with these trends, VCs should respond in two ways. First, they should be willing to move up market and invest in growth-stage companies planning an IPO in 12 to 24 months. Second, VCs should be willing to pay higher prices for those companies. The data underpins these hypotheses.
Many early stage firms have seized the opportunity to raise funds targeting growth companies including Redpoint, Greylock, Andreessen Horowitz, among others. Over the past six months, these funds have collectively invested in 15 companies all at valuations greater than $500M, many of which are companies generating revenues of $30M or more and are IPO candidates.
While there are many seemingly conflicting forces within the venture capital market, and despite what entrepreneurs may say to the contrary, VCs have acted rationally . VCs moved into growth stage investments in response to longer gestation periods and concentration of capital. They may soon have to respond again to market forces.
Although the past 12 months have seen heady valuations, the looming risk of the European debt crisis will surely impact these investment trends. Public markets dislike volatility and are anathema to IPOs. Should we see a correction in the public markets, a parallel pricing reduction will no doubt occur in the private markets. The correlation between venture backed IPOs and the stock market has grown much stronger over the past 30 years.
But, I’m confident that the industry won’t change too much. After all, VCs are always game to find the next great entrepreneur building the next big thing.