In June, when Goldman Sachs (GS) banker Anthony Noto warned at the investment bank’s F.ounders conference recently that the initial public offering market was effectively going to be closed to Silicon Valley startups all summer, it shook up the Valley. This came on the heels of Y Combinator founder Paul Graham’s warning that the bad performance of Facebook’s (FB) IPO will hurt the funding market for earlier-stage startups.
It was more than Facebook. Nearly all of the recent high-profile tech IPOs—including Groupon (GRPN), Zynga (ZNGA), and Pandora (P)—are trading below their IPO prices. Facebook’s stumble highlights a new reality: The IPO is no longer an important source of capital to fuel startups’ growth. It has become a way to transfer money from the public to institutional investors and little more.
Silicon Valley’s obsession with IPOs sends the wrong message to entrepreneurs, and it papers over problems businesses are having accessing more traditional funding. President Barack Obama has jumped on the bandwagon, repeating the party line of the National Venture Capital Association that what America needs right now is more IPOs (an IPO on-ramp) to spur economic growth. But as Felix Salmon adroitly points out, using statistics compiled by the Kauffman Foundation, big IPOs in the Internet sector don’t create jobs.
The losers here are entrepreneurs in the hundreds of companies that take venture financing early and in large chunks. This reality is even clearer now that secondary markets such as SharesPost and SecondMarket let early investors flee long before the bell is rung on Wall Street. Venture capitalists hurt their companies’ long-term prospects when they rush to cash out on private marketplaces or by going public. Witness Groupon and Zynga, two companies that raced to market with shaky business models reliant on products with no real barriers to entry.
The Valley, VCs, and President Obama have conveniently forgotten that lots of technology companies have grown quite smartly without ever going public. Business intelligence software company SAS, memory builder Kingston Technology, and software company 37signals are just a few examples.
Instead of obsessing over IPOs, we need to enhance the alternatives available to entrepreneurs to grow their companies without taking them public.
A handful of lenders, including Silicon Valley Bank, Square 1 Bank, and Hercules Technology Growth Capital (HTGC), will take a risk lending to startups to fund growth and operations. These loans tend to go to companies that have already raised venture capital. The loan costs run at a premium to the market due to the risk, but they are almost always an improvement over raising another round of equity. “While VCs and angel investors provide initial equity to get the company off the ground and fund losses, debt providers such as Silicon Valley Bank extend companies’ runways” without diluting entrepreneurs’ stakes further, says Greg Becker, the bank’s chief executive officer. He says Silicon Valley Bank has built a business lending to innovative companies where most commercial banks fear to tread.
The problem is that banks willing to do such deals are few and far between. When a bank can borrow money from the Fed at 0 percent and loan it out to people buying houses, or as lines of credit to very large businesses that are extremely low-risk, why bother taking a flier on a late-stage startup? The lack of these sorts of financing vehicles naturally shapes the mindset of entrepreneurs. They rightly assume there are two choices: relatively slow, self-funded growth, or shooting the moon and going for VC money.
Rather than focusing on creating jobs for investment bankers by obsessing over IPOs, our president should instead nourish tech entrepreneurs by finding ways to free up bank financing for companies that either can’t get or don’t want VC money. After all, we want more businesses with a long-term focus and vision, not more that are striving to hit the jackpot through an IPO.