Editor's note: This is the third column in a new series that challenges commonly held myths about entrepreneurship.
Myth: The venture-capital-backed IPO market is going to rebound to the levels of the 1990s.
Reality: The market for initial public offerings is returning from its near-death experience of 2008 and the early part of 2009. Through the first three quarters of 2009, there have been five venture-capital-backed IPOs. While that's less than the seven through the first three quarters of 2008, a rise in IPO filings suggests a stirring in the markets and the potential for an uptick in the fourth quarter.
For venture capitalists, sophisticated angel investors, and the entrepreneurs that they back, this stirring is of great importance. A robust IPO market is crucial to the success of the venture capital model on which they all depend.
Venture capitalists raise money from pension funds, university endowments, and wealthy individuals in funds that typically last for 10 years. The VC funds put their money into new high-potential companies in the hope that some of these companies will grow rapidly, be acquired by existing businesses, or go public, in five to seven years. While only a couple thousand of the more than 1.5 million new businesses started every year receive venture capital, the companies that do are among the fastest-growing businesses in America.
VCs make more money if a greater portion of the companies in which they invest have exits, if those companies are worth more at the time of exit, and if the exits occur more quickly. IPOs are the most lucrative way that VCs can exit from their investments, so what happens in the IPO market matters a lot to these investors.
High ReturnsIt's also important to sophisticated angels who are trying to get the high returns that come from portfolio companies going public, and who are often seeking to get VCs to invest in these portfolio companies in later rounds of financing.
Angels, VCs, and the entrepreneurs that they finance are hoping that VC-backed IPOs return to a normal level from the depressed levels of the past couple of years. A return to normal, they argue, will bring the VC industry back from its moribund state. For entrepreneurs building the kinds of high-growth companies that VCs back, the ability for investors to cash out of their investments is necessary to motivate the investors to invest the $7.5 million that the average VC deal involves. Few exits for VCs mean they can't generate the kinds of financial returns that attract their investors—the pension funds, university endowments, and wealthy individuals who invest in VC funds.
For the couple thousand entrepreneurs in sectors like medical devices, information technology, and alternative energy who are trying to build companies that might reach $100 million in sales in five to seven years, the millions of dollars it takes to build a company aren't readily available elsewhere. So if VCs can't take their portfolio companies public, their returns suffer. And if their returns suffer, VCs can't raise the money they need to invest in startups, all of which leads to a lack of capital for the founders of high-growth companies. So everyone who is part of the VC ecosystem wants VC-backed IPOs to return to a normal level.
But what's a normal level for VC-backed IPOs?
Investors, of course, would like to see a return to the IPO levels of the 1990s. Those were great years for VCs, with the number of IPOs equal to as much as 30% of the number of investments made five years earlier (as occurred in 1996). But the 1990s might have been an aberration from the norm. The "normal" number of VC-backed IPOs might be closer to the average of 52 per year we had in the 1980s or the average of 49 per year that we had in the 2000s as opposed to the average of 150 per year that we had over the 1990s.
To see the difference in what normal means if it is defined as the VC-backed IPO rate of the 1990s rather than the 1980s or 2000, take a look at the figure to the right I created from data downloaded from University of Florida professor Jay Ritter's Web site. (Ritter keeps track of the number of VC-backed companies that have gone public every year since 1980.)
Exception, Not the RuleJust eyeballing the chart suggests that the 1990s might have been the abnormal decade when it comes to VC-backed IPOs.
So what happens if the VC-backed IPO market comes back from current recession-induced level, but only to the levels of the 1980s and 2000s, not the 1990s? The answer is VCs will be in for a fair amount of continuing pain. These investors are backing a larger number of companies than they did back in the 1980s. So a smaller number of IPOs among their portfolio companies will make it harder for them to make a living.
If the IPOs came faster or at a higher valuation, this might not matter so much, but the amount of money raised from the average IPO is lower now than it was at the heights of the late 1990s, and the median age of an IPO firm is double what it was in the VC heyday.
So if the number of VC-backed IPOs only comes back to the levels of earlier this decade or the 1980s, then the VC business will continue to suffer. Moreover, the pain won't be limited to the VCs but will be felt throughout the entire ecosystem that relies on VCs. If VCs have few exits, they won't be making much money. If they aren't making money, then they won't be investing much either. The sophisticated angels who are looking for VCs to follow on their investments in a later round will need to cut back as well, given that fewer VC dollars will be following on the angel investments.
All of this could prove problematic for entrepreneurs who need VC-style equity investments. If there are fewer VC firms around to put several million into a high-growth startup, some of those firms aren't going to get the investment that they need. And that could mean fewer successful companies like Google (GOOG) and Genentech (DNA) that provide jobs for many people and innovative products that are valuable to all of us.