No exit

Start-ups are having a tough time going public these days, so they’re taking buyout offers from more-established companies instead. Is the U.S. selling the next generation of entrepreneurs short?

ON OCTOBER 9, GOOGLE AGREED TO PAY $1.65 BILLION IN stock to acquire YouTube, turning the founders of the hot online video-sharing start-up into multimillionaires a mere 18 months after they had launched the service as a way to share their goofy home videos with the world. The deal was also a tape measure home run for the venture capitalists at Menlo Park, Californiabased Sequoia Capital, whose $10 million stake blossomed into a $495 million bonanza. Not since Google itself went public in August 2004 -- yielding Sequoia $2.17 billion on $12 million in seed capital -- has the world of start-up investing had so much to celebrate.

Trouble is, paydays like these are becoming all too rare in venture capital. More frequently, entrepreneurs and their financial backers are unable or unwilling to take their companies public. They would rather accept acquisition offers that are sometimes less attractive.

“I see it in boardroom discussions more and more often,” says Ted Schlein, a partner at venture capital giant Kleiner Perkins Caufield & Byers. “Entrepreneurs and venture guys are less willing to say, ‘Let’s roll the dice and keep trying to build the next Google.’” Instead, he adds, they grab at “the next reasonable but not exciting acquisition opportunity.”

The irony is that venture capitalists are having a harder time exiting investments profitably even as money pours into their funds from pension systems, endowments and other institutions seeking alternatives to stocks and bonds. Firms raised some $25.9 billion through the third quarter of 2006, compared with $28 billion for all of 2005, according to Thomson Financial. Annual inflows have increased steadily since hitting a postbubble trough of $3.8 billion in 2002 and now rival levels from the start of the late 1990s boom: Venture funds raised $19.6 billion in 1997 and $30.3 billion in 1998. But exit opportunities are nowhere near the levels seen in those years, and that’s causing plenty of worry in Silicon Valley and beyond.

“The quest for alpha on the part of the pension funds is so intense that it’s hard to find a good home for all these dollars,” explains Mario Giannini, CEO of pension consulting firm Hamilton Lane Advisors.

That disconnect prompted Sevin Rosen Funds, a 25-year-old venture firm that has backed such successful companies as Compaq Computer Corp. and video-game maker Electronic Arts, in October to cancel plans for raising its tenth fund. Just a few days before the Google-YouTube deal hit the headlines, Sevin Rosen general partner Steve Dow sent a letter to investors informing them of the firm’s decision, citing “fundamental structural problems” within the venture capital business that made it impossible to deliver the double-digit returns that limited partners expect.

“The average acquisition doesn’t generate a big return; deals like YouTube are the exception,” Dow tells Institutional Investor. “And the normal kind of acquisition premiums aren’t enough to sustain the venture capital industry.”

Unquestionably, start-ups have been finding fewer buyers for their initial offerings during the past two years. Through the third quarter of 2006, 37 venture-backed companies went public in the U.S., raising $3.48 billion. That’s a better pace than in 2005, when 42 IPOs raised $2.56 billion, but well below historical levels. In 2004, for example, there were 93 deals worth $4.98 billion. During the late-1990s heyday for venture-financed start-ups, the market routinely supported more than 200 IPOs per year, with annual proceeds often exceeding $10 billion. Even the pretech bubble period from 1990 through 1995 saw an average of 170 venture-backed initial offerings and $5.56 billion in proceeds each year. Venture-backed IPOs account for just 1.6 percent of all debut offerings today, compared with more than 11.7 percent in 1999 and 8.5 percent as far back as 1992, according to Thomson Financial.

Despite the past year’s broad rally in stocks, investors’ appetite for start-ups still hasn’t recovered from the bursting of the dot-com bubble in 2000 and the deep bear market that followed. Wary of unproven companies, IPO buyers are showing a preference for bigger, more established concerns. Today’s initial offering market is dominated by formerly state-controlled enterprises like Industrial and Commercial Bank of China, which went public for a record $22 billion in October, and companies reentering the public market after leveraged buyouts. In the latter camp are big businesses like car-rental chain Hertz Global Holdings, which completed a $1.3 billion IPO in November, less than a year after a group of LBO funds acquired it from Ford Motor Co.

Another reason entrepreneurs are less willing to pursue IPOs is the increased cost and hassle of running a public company in the wake of postbubble policy reforms. The biggest of these is the Sarbanes-Oxley Act, which among other things requires all public companies to meticulously document and audit internal financial controls. Doing so can cost millions of dollars per year, a burden that business groups have argued falls disproportionately on small companies. Increased scrutiny from activist shareholders, independent directors, state attorneys general and class-action lawyers also is leading CEOs to reconsider whether public ownership is worth the trouble. These same factors are fueling a going-private boom among bigger companies.

“It’s hard to make the case with a straight face that an entrepreneur will be as happy running a public company as he was building his start-up business,” says Ted Dintersmith, a partner at Charles River Ventures.

Nor is the alternative -- selling to another company -- as lucrative as in days past. Between 1993 and 1999, acquisitions of portfolio companies yielded returns of 3.7 to 7.2 times the equity investments of venture firms. Today the average sale yields less than 2.5 times the initial investment, according to Thomson. Worse, financiers now typically hold on to a company for a record-high six years before selling, up from about four and a half years in the 1993'99 period. By comparison, exiting through an IPO typically yields in excess of three times a venture firm’s equity investment.

But the true impact of the shift in the way start-ups raise capital and grow over time may go far beyond difficulties for venture capitalists. The decline in IPOs, and the willingness of entrepreneurs to sell out rather than stay the course, doesn’t bode well for the U.S. economy as a whole, particularly at a time when there are broad concerns about the nation’s ability to compete with Europe and Asia. Initial offerings of both small and bigger, more established companies are increasingly taking place on overseas markets like the London Stock Exchange’s AIM market for emerging companies or in Hong Kong and Shanghai, the host markets for ICBC’s record offering.

In a November address to the Economic Club of New York, U.S. Treasury Secretary Henry Paulson Jr. said that the American legal and regulatory environment was contributing to the decline in IPOs of foreign companies in the U.S. Paulson has embraced the recommendations of the Committee on Capital Markets Regulation, a group of business, finance and regulatory leaders who in November put forward a host of proposed policy reforms that they believe will help the U.S. maintain its edge globally. People in the start-up world attribute their woes to many of the same issues.

“The difficulty we as an industry are experiencing with our exit strategies raises bigger issues,” warns Kleiner Perkins partner Schlein. “Already, the image of the U.S. as the ultimate entrepreneurial environment has an asterisk beside it. If this continues, we’ll turn into . . . France.”

FOR MOST OF THE PAST QUARTER CENTURY, IPOs have been the ideal for entrepreneurs and venture capitalists alike. Building a company into the next Cisco Systems, EBay, Intel Corp. or Microsoft Corp. was the ultimate achievement -- not selling it to one of them.

“Even in bad market environments, IPOs remained the prestige option, the exit of choice,” says Robert Mattson Jr., a partner at law firm Morrison & Foerster who works with many venture firms and start-ups.

Today clients still ask Mattson to draw up initial offering documents, but increasingly these papers are meant to help drum up interest among potential acquirers before the IPO even gets moving -- a strategy known as dual-track marketing. “It’s almost at the point where you start thinking of an IPO as being a sign of a failed acquisition strategy,” he says.

The experience of Vonage Holdings Corp., a voice over Internet protocol company, shows what can happen when dual-marketed start-ups turn down buyout offers in hopes of going public. Early last year Vonage hired bankers at Citigroup, Deutsche Bank and UBS to simultaneously pursue a sale and a potential IPO. When suitors failed to offer what Vonage directors believed the company was worth, the board opted for an IPO. The deal that followed was one of the biggest busts in recent memory. Even after underwriters downsized the offering because of poor investor demand, Vonage’s shares plunged 13 percent on May 24, their first day of trading. Today they change hands for about $7 apiece, far below the IPO price of $17.

Some companies that turn down acquisition offers don’t get the chance to test the IPO market. Friendster, one of the myriad social networking outfits funded by venture capitalists over the past few years, declined a $30 million buyout offer from Google in 2003. At the time, Friendster was just one year old and boasted blue-chip backers like Kleiner Perkins. Soon thereafter, though, Friendster lost traction with its teen and 20-something audience and was eclipsed by rival MySpace, whose parent company was acquired in July by News Corp. for $580 million.

The occasional bonanza reaped from an acquisition further convinces entrepreneurs that holding out for an IPO doesn’t always pay. In October diversified manufacturer 3M Co. bought imaging start-up Brontes Technologies for $95 million in cash. According to Charles River’s Dintersmith, an investor in Brontes, the deal locked in a gain of eight times the company’s valuation from just two years earlier. Compared with an uncertain fate in the IPO market, the promise of a cash payday from an acquisition is making both start-up founders and their financiers more willing to sell out.

“Some venture backers are starting to think of risk as the risk of not being able to raise the next fund and move on, because they are still stuck managing their old portfolios,” says Michael Moe, founder and chief executive of ThinkEquity Partners, a boutique investment bank focusing on small growth companies.

Moe points to a conversation he had one late-September morning with the CEO of a hot new Internet company in Silicon Valley. The company, he says, had all the credentials to attract the attention of stock market investors, including blue-chip venture backers and solid finances. But when Moe brought up the possibility of going public, he received a ho-hum response. The CEO instead talked about being acquired. He asked Moe how big of a buyout premium start-ups would have required to give up their IPO dreams back in the late 1990s, when Moe was a small-stock strategist for Merrill Lynch & Co.

“You would have had to get 100 percent, and probably more, of what you expected to get from the IPO to take the deal,” Moe replied. He then asked the CEO what it would take for him to accept a bid. The response stunned him. “Basically, he told me he would settle for an acquisition offer that was only 40 or 50 percent of the theoretical value of the company.”

That kind of thinking worries Clinton Harris, managing partner at Grove Street Advisors, a private equity investment and advisory firm. It’s true that waiting until a company is bigger before going public increases the risk and reduces venture investors’ time-weighted returns on their investments. “But when you sell early, you don’t have the same chance for megahits that you do when you hang on for an IPO,” he says. Furthermore, companies that sell out early may never reach their full potential once they’re part of a bigger, more mature and more conservative organization. “Sure, if a company gets sold, the technology survives, but as part of a bigger company,” Harris explains. “You have destroyed the entrepreneurial engine that created that technology or product in the first place.”

Even those who make a killing on buyouts voice some regret. “I am a little sad they didn’t take it public,” says venture capitalist Timothy Draper, referring to Skype Technologies, an Internet telephony provider that his firm, Draper Fisher Jurvetson, helped sell to EBay last year for $2.6 billion.

The degree of risk aversion apparent in today’s venture capital and stock markets threatens one of the hallmarks of the American economic system: the relative ease with which entrepreneurs have been able to raise the capital they have needed to transform their “Eureka!” moments into viable, dynamic businesses. As more fast-growing companies choose buyout offers over IPOs, the long-term risk to the U.S. economy rises, contends Robert Grady, head of private equity giant Carlyle Group’s venture investing activities. “It’s absolutely, positively, unambiguously bad from a public policy standpoint,” he says.

Increasingly, the young enterprises that can tap the IPO market are doing so outside the U.S. Only two of the half dozen Carlyle portfolio companies gearing up for IPOs plan to list in the U.S. One will debut on the Tokyo Stock Exchange, and the remaining three are bound for AIM, the London Stock Exchange’s lightly regulated platform for small, high-growth companies. Though sometimes criticized for lax standards and oversight, AIM attracted more IPOs in 2006 -- 400 through November -- than the New York Stock Exchange and the Nasdaq Stock Market combined.

“How can it be a good thing that our public risk capital market is at risk of forfeiting its position as the world’s best?” wonders Grady.

Some regulatory relief is on the way. In December the Securities and Exchange Commission issued new guidance on Sarbanes-Oxley’s hated Section 404, clearing the way for companies to take what it called a “risk-based” approach as to which internal controls must be certified and audited. In practice, this means that controls deemed “material” by companies and their auditors likely will be certified, eliminating less-essential ones from the documentation and auditing process. That move should make compliance slightly less onerous, but it falls far short of the blanket exemption from Section 404 that venture capitalists were hoping the SEC would give to small companies.

The Committee on Capital Markets Regulation, co-headed by former Goldman, Sachs & Co. president John Thornton and Columbia Business School dean R. Glenn Hubbard, has called for a passel of reforms. Leaders in Congress, including Senator Charles Schumer of New York and Representative Barney Frank of Massachusetts, the incoming chairman of the House Financial Services Committee, have signaled their support for at least some of these measures. But it’s far from certain that they will all be enacted, particularly with the liberal wing of the Democratic Party feeling emboldened by its midterm election gains. Even if they were all to pass, that’s no guarantee that U.S. investors will once again embrace the IPOs of smaller, riskier companies.

Meanwhile, the venture community will continue to grapple with what can only be described as a serious structural imbalance: too much money to invest and too few profitable exits.

“The venture industry is probably twice as big as it should be,” says John Thornton (no relation to the former Goldman president), a general partner at Austin Ventures. “We have created this problem for ourselves by funding seven or eight companies in any given industry, where there may be only three or four potential acquirers.”

Sevin Rosen’s Dow warns that his firm won’t be the only one putting a halt to new funds and trying to figure out what to do with its existing capital. “We have to address the fact that too much capital is flowing into our business,” he insists. “The venture capital model is not dead, but it’s broken.”

One potential answer is a shift toward smaller funds and smaller investments. Some of the biggest venture hits of the past decade -- Google and YouTube among them -- have come from investing relatively small amounts of capital. “To the extent people can concentrate on that kind of transaction, they are likely to fare better,” asserts Gary Augusta, executive director of the Octane Institute, a nonprofit group of business executives, venture investors and entrepreneurs dedicated to fostering science and technology innovation. The future of venture capital, then, may lie with tiny boutique firms with $50 million or less to invest rather than with the multibillion-dollar giants lining Menlo Park’s famed Sand Hill Road. These smaller investors are less risk-averse and may encourage the companies they fund to embrace a similar mind-set.

Says Augusta, “This is a new kind of model that can help us as a society maintain our entrepreneurial edge in the world.”