A Prescription To Fix VC-Backed IPOs?

The National Venture Capital Association this morning released a four-point plan to revive the slumped market for VC-backed IPOs. Two of the pillars are aimed at public authorities (tax incentives & SOX/RegD reform), while the other two are aimed at the private sector (ecosystem enhancements like helping form more botique I-banks & creating new liquidity paths via secondary direct markets like InsideVenture, SecondMarket, etc.).

What’s important to realize about NVCA’s presentation (posted below) is that it argues that VC-backed problems are systemic, rather than recessionary. For example, the Spitzer-prompted separation of research and investment banking has caused massive drainage of the analyst pond, thus making it far more difficult for VC-backed companies to obtain coverage. And as much as I hate relaxing regs that were designed to protect investors, I’ll concede that small-cap companies should not be under the exact same rules a large-cap companies. Or at least they should have a more streamlined process (particularly vis-a-vis SOX compliance).

But let me also make a few additional points:
1. One of the biggest problems for VC-backed IPOs is that the public markets require actual cash-flow. Often it even wants profitability (gasp). Venture capitalists may find such requirements short-sighted — after all, an unprofitable company can still become a great investment — but they were largely borne of VCs pushing an abundance of crap into market during the dotcom boom.
2. Speaking of those “glory days,” they were the exception when it comes to VC-backed IPO volume. Just take a look at Page 6 of the NVCA presentation. What you’ll notice is that VC-backed IPO volume for most of this decade has mirrored VC-backed IPO volume during much of the 1980s (when companies like Dell went public). Sure there have been fewer than 10 VC-backed IPOs since the beginning of 2008, but that’s obviously more recessionary than systemic.
3. One more note on the late 1990s: Capital gains rates were higher than they are today. As such, I simply don’t buy NVCA’s argument that the “carried interest as ordinary income” proposal will have much impact on the VC-backed IPO market. (note: carried interest is taxed at just 15% today, and I don’t see VC-backed IPOs flying off the shelves).
4. Finally, the NVCA is trying to make both a macro-economic case (most VC-backed company job growth comes post-IPO) and a VC industry case (IPOs produce best returns for investors). And both cases are sound. That said, most VCs I know have given up on making investments with an IPO in mind. Instead, they want to help their companies build with an eye toward eventual trade sale. Not that an IPO is ruled out, but it’s more a dream than anything else.
Let me use a tortured baseball analogy: A general manager tries to get a guy who hits lots of homeruns to bat cleanup. The hope is that he’ll end of hitting grandslams, but you don’t sign a guy who “hits grandslams” — because that’s mostly a question of circumstance. Same goes for VCs, with trade sales as homeruns and IPOs as grandslams.
5. I briefly discussed this plan on CNBC this morning, alongside Dixon Doll. The video is posted here.
UPDATE 6. Learned more about InsideVenture. Sounds VERY interesting. Hard to pull off, but if they can… Will discuss more tomorrow.

Here is the full presentation:

View more presentations from NVCA.

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17 Comments

  • Dan–I tend to agree with you…There are no boutique banks doing IPO’s and no small IPO’s because there are no buyers of the stocks. It is not a banking problem, it is a buyer issue. If there were buyers of $30 million IPO’s then there would be banks underwriting them. With a 7% spread, the banks can do pretty well even on smaller deals. People have tried to rebuild the four horsemen and people have failed. Public markets are not interested in being late stage VC investors in stocks that are “public” but very thinly traded, except maybe in biotech where the line between late stage VC investors and public investors can be quite thin with many investors playing at both stages (for example, MPM Capital). To compound the problem, in a FAS 157/mark to market world, a thinly traded public stock can be the worst of all worlds for investors…a stock you cannot sell, but must mark down as it falls.

    The tax incentive argument is self-serving and comical. Is the point that a VC would drive a different liquidity outcome depending on the carried interest tax rate?

    Dave

  • Let’s start with some applause for the NVCA which is afterall, a lobbying industry-trade group, existing solely to promote the interests of it’s members and not necessarily the greater good. From that perspective, this release today is certainly understandable and laudable. Job well done.

    Then let’s think about the content of the plan a bit more deeply.

    For starters, let’s note that we did not see any of these issues during the 1980’s and 1990’s. The problems started after the boom, when bankers brought so many bad business models to market, which subsequently flamed out rather brilliantly. The sheer quantity of those deals, and the speed of the implosions made the poor performance an issue.

    Admittedly, the big banks did grow larger after that period, but throughout the first 8 years of this decade, the data suggests there weren’t too many VCs pushing their deals to the still-standing boutiques. In fact, until 10 months ago, there was a lot of celebrating with every phone call exclaiming: “We’ve got Goldman!”

    Why is the IPO market really weak?

    Institutional public market investors eventually walk away because they have a responsibility to provide their investors a return. Retail investors do the same because they too would like a positive ROI. No one wants to be the doormat to bad deals done by the VC community, and repeatedly bitten, eventually shy.

    The solution for the VC community is to invest in great companies and help them to grow into free-standing, self-sustainable, enduring entities. If, after that important VC nuturing, the company turns out to be a good company, then and only then, does it make sense to bring it public.

    Until the recent slowdown, (and watch, for the IPO dearth will prove temporary and recession based, not systemic) we had too many VC’s hoping and assuming the public markets would reward them with extraordinary returns for ordinary, unproven, unsustainable companies – as well as for those that deserved to reach the milestone of an IPO. Alternatively, the hope was that the start-ups would be acquired within 3-5 years. Hope and assumption are not good investment strategies

    Well, both public investors and acquirers are now making clear that, before they part with their investment dollars, they need to see better, stronger, more proven companies coming to market, thus increasing the odds of a positive return on their investments. Regardless of I-bank size, Sarbanes-Oxley, whatever the complaint du jour, that means the only real solution is for VCs to invest in, stick with and shepherd quality teams with good ideas, maybe for as long as 7 years, maybe for (horrors!) 9; however long it takes..

    The long-time successful VCs have always known this and have, appropriately, earned great rewards for having followed the path. That door is still wide open….

  • [...] I’ve put the part about supporting smaller banks in bold (see pillar #2). Also, see Dan Primack’s summary of the news. Finally, here’s a slide show of the [...]

  • [...] I’ve put the part about supporting smaller banks in bold (see pillar #2). Also, see Dan Primack’s summary of the issue . Finally, here’s a slide show of the [...]

  • [...] I’ve put the part about supporting smaller banks in bold (see pillar #2). Also, see Dan Primack’s summary of the issue . Finally, here’s a slide show of the [...]

  • [...] friend Dan Primack has a blog post on the problems and solutions for venture capital. More interesting is Dan’s appearance on [...]

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  • There is a lot on the positive side to be said for the NVCA initiative. Given the vital role that venture-backed companies have played in the growth and competitive position of the US economy over the past 35 years and the challenges that we face in today’s global economy, the report addresses critical issues. There are also a couple of points that merit amplification…

    But first, let me tackle the tax issues.. There really are two streams of consideration here: 1) from the point of view of the entrepreneur and venture capital investor, and 2) the perspective of the venture capital professional and the tax treatment of carried interest. The first category deals with the entrepreneur who takes the risk to back his ideas with his hard work, capital and reputation as well as the investors (friends, family, angels, individuals, funds, what have you) that understand the risk/reward relationship in creating value from ideas and are prepared to accept the risk – assuming the reward is commensurate. This is one area where tax policy on capital gains can have a significant impact in altering the reward side of the equation in such a way as to encourage capital inflows. I would suggest that capital gain tax rates in this area can be structured to support the longer term nature of these investments – say a lower rate if an investment is held for X years where X is greater than 3, 4 or 5 years. This incentivizes long-term patient capital when and where it is most critically needed. With respect to #2 above, the debate ranges as to whether carried interest merits long term capital gain treatment or not. I won’t argue based upon the long term nature of venture investments vis a vis Private Equity or Hedge Funds – though this is an interesting conversation. What I think is perhaps more relevant is the “public good and economic benefit” side of the debate. The US tax code is used – as a matter of course – to shape economic behavior in such a way as to encourage behavior that contributes to the greater good (reference my argument for lower capital gains on venture capital investments or R & D tax credits, or…). When you consider that 17.5% of the US GDP today is generated by publicly listed companies that were venture backed and that 10.3M high paying jobs in the current US economy have resulted – you can rightly conclude that “doing more of that” is a good idea – socially and economically. With the US economy struggling to reinvent itself and compete globally, we should be looking to turbo-charge the engine of innovation that is venture capital. This is where tax rates on carried interest can have a positive impact. The more attractive the opportunities are in venture for the best and brightest – the more likely they are to seek a career in the field as opposed to private equity or hedge. And when you consider the relative size of the venture industry (and its potential carried interest profits) in comparison with private equity and hedge- the numbers are trivial. And remember, carried interest is only earned – and taxes paid – from successful venture investments. And when these ventures are successful and taxes paid – new industries have been created and hundreds to thousands of new high-paying jobs have been created – in the US of A.

    The historical data is clear in correlating venture returns to the IPO-market cycle. Clearly, venture returns can be generated through M & A exits and some firms – ours included – have made a virtue of this approach to venture investing. At the same time, the lack of a “reasonable” path to IPO for venture-backed companies has significant drawbacks – not just in term of venture returns but also in terms of economic growth and broader contribution to the US economy. Dan’s point about venture “junk” having been foisted on the public by bankers egger for fees in the late 1990s rings a bell. That said, the caliber of companies backed up to go public in today’s environment bear little resemblance to the “dogfood.com”s of 1999. By and large, today’s companies are in business because they are providing real value and solutions to real customers – generating real revenues and employing thousands of talented people. They look to an IPO as a path to further funding for continued growth – not just an exit for their investors. Certainly, some investors (and founders) will look for partial liquidity – post the IPO. But after 6, 7, 8 or even 9 years – it would be difficult to describe the motivation here as “looking for a quick buck”. The obstacles to IPOs pointed out in the NVCA report are on the money. The costs of SOX compliance, the lack of knowledgeable bankers who understand emerging industries, the near impossibility of securing vital analyst coverage for young small cap companies all combine to raise the bar for an IPO to a level we have not seen for a couple of decades – regardless of the broader market environment. Can companies still get out – yes they can. Is it harder that ever – yes it is. Is that basically a bad thing – given that we are not talking about dogfood.com – I believe it is for two reasons: First, when a company seeks an M & A exit rather than an IPO – it is basically capping its future growth. The larger “acquiring” company will integrate select components of the “acquired” company into its already existing infrastructure with a correlating negative impact of market competition and economic growth. This is not good for the broader economy as job growth is effected – and these are typically higher paying jobs in industries that compete effectively in the global economy. Second, lack of access to capital that can be provided to young start-up companies from public markets can limit the aspirations of entrepreneurs in some areas of innovation that require larger pools of capital. Basically, if “I can’t raise the capital to get to my destination – should I really begin the journey?” Clearly, there are exceptions here, but.. The inability to access larger capital markets does steer investment and innovation in to areas requiring less capital and where the innovations may be considered to be incremental as opposed to ground breaking or foretelling the creation of entirely new industries. And let’s be clear – our economic viability lies in the ground breaking and creation of new industries.

    Lastly, additional attention should be focused on core research – or the demise of same in the US over the past 30 years. Many of the great corporate R & D labs are gone. University’s focus on applied research and struggle for the dollars with which to pursue their efforts. Government investment has declined. As we have shifted our focus to shorter term – more immediate results – we have cannibalized much of the foundational research that the venture community has leveraged over the past 35 years. The initial Internet came from the ARPA/DARPA programs – look at where entrepreneurs and the venture capital process have taken it today. Industries have been transformed and major new markets created. Venture capital typical focuses on applied research as opposed to core research. In many areas – it depends upon the seed cord that results from core research. I think we all need to consider where is the seed corn that will power the next generation of breath taking innovations come from?

  • Regarding your comment that VCs were pushing an abundance of garbage on the public market, did you consider the fact that the investment bankers were aggressively trolling silicon valley and Rt. 128 looking for anything that smelled even remotely like a dot com company? They were equally responsible for foisting this “garbage” on the public. This so called “garbage” generated a great deal of fee income for the I-bankers. Unfortunately, it also created a big credibility problem in terms of institutional appetite for IPOs.

  • Go to UNIFIEDMARKETS.

  • Nice presentation but irrelevant to the creation of real value.

    The mechanics of venture capital are just fine, it is the driver not the car we need to blame for getting into the “accident” we are in. We are simply not spawning companies that have disruptive value and public and private shareholders are fed up with the lies spread around technology “innovation”. The real issue is that risk is sucked out of the venture business which generates low returns (by any measurement).

    Just like in subprime lending we have created a subprime VC business with the majority of operators not being able to assess business risk adequately. No restructuring of mechanics can make up for that, only a different selection of VCs, those that align better with the needs of entrepreneurs will.

  • [...] Capitalists is so concerned about the lack of IPOs in venture land that it recently laid out an ambitious proposal to change the [...]

  • [...] Capitalists is so concerned about the lack of IPOs in venture land that it recently laid out an ambitious proposal to change the [...]

  • [...] Capitalists is so concerned about the lack of IPOs in venture land that it recently laid out an ambitious proposal to change the [...]

  • [...] Capitalists is so concerned about the lack of IPOs in venture land that it recently laid out an ambitious proposal to change the [...]

  • [...] Capitalists is so concerned about the lack of IPOs in venture land that it recently laid out an ambitious proposal to change the [...]

  • [...] Capitalists is so concerned about the lack of IPOs in venture land that it recently laid out an ambitious proposal to change the [...]

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