VC RightsizingJeff Bussgang
The news came out yesterday that VC funding in the U.S. was down in Q1. Really down. VC funding into start-ups averaged roughly $20 billion a year for many years since the bubble crashed and recently (in 2007 and 2008) had crept up to $30 billion a year. The Q1 ‘09 figure was $3.0 billion, suggesting we are on a $12 billion run rate for this year.
Although new financings may pick up a bit in the second half of 2009, I would predict that VC funding for the years 2009 to 2011 doesn't exceed $20 billion per year and probably stays closer to $15 billion annually.
And guess what? VC downsizing is ok. In fact, it's a good thing. Frankly, I'm not sure the VC industry should be much above this range. It's not that there is a lack of great entrepreneurs chasing great ideas. It's simply the lack of good exit prospects. We don't have input constraints. Instead, we have output or exit constraints.
Clearly, the lack of attractive exit prospects is choking the industry right now. VC fund after VC fund can point to portfolio companies that are growing rapidly, taking market share, even achieving profitability in many cases, but have no place to go. The IPO market remains completely irrelevant to VCs. Yes, Rosetta Stone had a successful IPO - the first one since March 2008 to be priced above the range. And there are a few other interesting filings in the pipeline. But don't be fooled by bankers bearing gifts and snake oil. The IPO market may return modestly for some large, profitable companies but will not return anytime soon for VC-backed companies. You know it's a bad young company IPO market when the case studies the bankers cite are Visa and Mead Johnson.
I attended a breakfast last week where JP Morgan's vice chairman, David Topper, gave his review of the macroeconomic picture, including the IPO market. Although he was too polite to say it outright, his data clearly showed the IPO market will be irrelevant to VCs for the foreseeable future. He laid out the four criteria that are required for an IPO candidate:
1) IPO size of $200 million (implying a market capitalization north of $700 million). Without this level of float, there isn't enough liquidity in the stock to attract investors.
2) Profitable, established business (i.e., not "approaching profitable," but proven profitable over many quarters, if not years).
3) Minimal leverage. The IPO market doesn’t want to see companies carrying a lot of debt, which would drain free cash flow sit and in front of the equity holders when dividing up the value of the company.
Of these three, No. 1 is the real killer for venture-backed start-ups. When I was an executive at Open Market and did our IPO in 1996, we executed an $80 million IPO that was then considered mid-sized. In today's environment, where Google is trading at a 6-8x EBITDA multiple and typical revenue multiples are 2-3x, an IPO candidate would need to be throwing off $100 million in cash flow and/or generating north of $200-300 million in revenue, while still growing fast. These are incredible numbers for venture-backed start-ups less than 10 years old.
There are complaints about reforming Sarbanes Oxley - and I have added my voice to those complaints in the past, but I walked away from this breakfast with a greater appreciation for why one of the National Venture Capital Assocation policy leaders recently said to me, "SOX reform is important, but no one is going to focus on that until restructuring the financial system as a whole is done."
I also appreciated why my friend and mentor, Harvard Business School Professor of entrepreneurship Bill Sahlman, told me last week that he thought the VC industry needed to shrink in half. Going from $30 billion per year in outflow to $15 billion per year would mean just that - and it will mean more VC personnel departure and fund shut downs. And, again, that's ok. It's worth noting that the last time annual VC funding dipped below $20 billion was in 2003, which saw $19 billion in VC investment. And 2003 was one of the best vintage years in the last decade, as many are arguing 2009-2010 will be.
Maybe I'm simply a rose-colored glasses optimist, but at the end of the day, an industry that quickly adjusts to new realities is a healthy sign. Until we figure out an alternative exit vehicle (and maybe someday the overall public market health will allow some liquidity to filter down to the VC-backed world, but don't hold your breath), we can't absorb more than $15-20 billion in annual VC investments anyway. So let's get the industry back to that level and vigorously deploy those dollars in as productive and rewarding a fashion as possible.
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