The Worst IPO Market on Record?

The first half of 2008 was dismal for venture-backed initial public offerings, and most VCs don't see the climate improving any time soon

When M. Benjamin Howe headed up technology investment banking for Montgomery Securities in the mid-1990s, the market for initial public offerings was a fountain of profit. In 1996 alone, Howe and other bankers helped take public 270 companies that were financed by venture capitalists. With so much deal flow, it was a wonderful time to be a boutique investment bank like Montgomery, which made a fortune catering to the high-tech set. "We all used to chase the IPO," says Howe.

Today, Howe and other bankers are shunning such deals. To begin with, there are so few IPOs these days. And with all the consolidation in the investment banking business, Howe says that leaves the boutique banks with nothing more than table scraps to split among themselves. At Montgomery, Howe used to get 40% of the shares of a deal as a co-manager; today he says three to five co-managers are splitting 20% of a deal's offering. As the head of a new boutique investment bank, Americas Growth Capital, Howe doesn't even bother to focus on drumming up IPO business. "The economics are so crappy," he says. "It is not even a business strategy for a boutique investment bank."

It'll Be a Rough Year

The market for initial public offerings is on ice. In the second quarter of 2008, there were no IPOs for companies with venture capital financing, according to the National Venture Capital Assn. (NVCA). That's the first time a quarter has passed without an initial public offering since 1978. This dismal performance follows an unusually slow first quarter during which only five venture-backed companies went public. The situation is so dire that representatives from the NVCA are making a press tour and calling it a "capital market crisis" for the startup community. "It will be the worst year in IPO volume in 20 years," predicts Howe.

It's unclear, of course, how 2008 will turn out. The lowest number of venture-backed IPOs since the NVCA started keeping statistics in 1991 came in 2002, when 22 such companies went public. If the second half of 2008 matches the first half, there will be only 10 venture IPOs, or less than half the total of 2002. There may not even be that many: Some 81% of venture capitalists do not see the IPO window opening until next year, according to an NVCA survey of 660 financiers.

Such a crisis, they claim, could have terrible consequences for the U.S. economy. If the current IPO drought continues, venture capitalists fear fewer new companies will get funded. More venture capital firms are likely to go out of business. And without more new businesses, that could crimp the creation of high-paying jobs that are typically generated by the venture-backed startups. "We want to continue to be that engine of growth," says NVCA President Mark Heesen. "It is a very serious issue."

Subdued Interest

It's not only changes in the investment banking world that are hitting the IPO market. The weak economy and poor stock market have also dampened interest in IPOs, say VCs, bankers, and investors. Many parts of the technology industry have matured, making it more difficult to remain independent. There seems to be less interest among entrepreneurs as well for tapping the public markets.

In previous years, say VCs, successful and fast-growing companies such as the social-networking sites Facebook or LinkedIn would consider going public sooner rather than later. But due in part to new government regulations enacted after the corporate scandals at the turn of the century, it's become more costly and time-consuming to take a company public. Two-thirds of venture capitalists surveyed believe venture-backed companies are less likely to want to go public than three years ago, according to the NVCA survey.

Some Good News

It's not all doom and gloom, though. In many ways, mergers and acquisitions have taken over the historical role that IPOs used to play as a so-called exit strategy, although M&A volumes are down as well. Microsoft (MSFT), eBay (EBAY), Google (GOOG), Yahoo! (YHOO), and Hewlett-Packard (HPQ), among others, have been buying up promising startups that perhaps otherwise would go public. Many investment bankers remain hopeful that the cycle will reverse in the fall, especially if the stock market settles down.

Big pension funds that invest in venture capital funds are largely taking a long view. Brandon Park, senior vice-president for Pacific Corporate Group Asset Management, which manages $15 billion for the California Public Employees' Retirement System and other large state pension funds, says his clients are putting the same percentage of their money in venture firms as in the past—and in some cases are boosting their investments. "Rather than trying to time the market, we have a long-term view," says Park. "We are not diminishing our venture capital allocation."

Areas of Concern

But while VCs will be thrilled to hear that note of optimism, it doesn't take away the many concerns they have today. VCs typically make a big profit when the companies they finance sell stock to public investors. But the median amount of time it takes to bring a company public has risen to 8.6 years, the longest time in 27 years. "With the softer economy it's tough to get predictable revenues and earnings," says Dave Power, a partner with Fidelity Ventures. "Results are a little tougher these days."

Part of the issue is that banks have raised the bar for startups to go public. Last year, investment bankers could take a company public that had just turned profitable. This year, companies need a few quarters of profits underneath their belts. "Now we will probably try to lead with companies that have a longer track record of profitability," says Laurence Goldberg, managing director and head of technology investment banking for Lehman Brothers (LEH).

Even the market for mergers and acquisitions has softened this year, pouring salt in the wounds of VCs. In the 1990s, mergers and acquisitions accounted for about a quarter of the exits of venture-backed companies. In the new century, that dynamic has flipped entirely. Last year, for example, there were 86 IPOs, compared to 355 M&A deals. This year, there have been 120 M&A transactions, down 28% from the first half of last year when there were 169 deals.

VCs know they will probably never see a return of the glory days of the 1990s when 200 IPOs a year was par for the course, and unprofitable companies like sold shares to the public. But Dixon Doll, a co-founder of venture capital firm DCM, says he hopes the industry can see at least 100 IPOs a year at a minimum. To make that happen, Doll, who is also the chairman of the NVCA, is lobbying Congress to relax financial reporting regulations on small companies, keep taxes on venture capital at today's rates, and impose uniform global accounting standards for startups. He says it's important for the country's future to reverse the IPO trend of this year. "We have to change the negative psychology," says Doll.

Before it's here, it's on the Bloomberg Terminal.