Who’s Afraid of an IPO? Everybody, At the Moment

There are two main doors that a venture-backed company can go through to provide a payday for its early investors: go public, or get acquired. And for the time being, the first door has slammed shut. In the second quarter of 2008, which ended yesterday, there were no initial public offerings by venture-backed companies in the United States. Zero.

It’s the first time since 1978 that U.S. IPO activity has come to a complete halt, according to the National Venture Capital Association (NVCA). The first quarter wasn’t much better, with only five IPOs by venture-backed companies. In 2007, by contrast, there were 86 (18 in Q1, 25 in Q2, 12 in Q3, and 31 in Q4). In a report issued today in cooperation with financial news organization Thomson Reuters, the NVCA calls the situation “concerning enough to be characterized as a capital markets crisis for the start-up community.”

Nobody thinks the IPO market is dead—but it may be in for at least several more quarters of suspended animation. “It’s not Chicken Little,” says Michael Greeley, a general partner at Flybridge Capital Partners and president of the New England Venture Capital Association. “You just have to modulate your plan.”

For companies, that could mean going out to investors for another funding round—or just making their existing capital last longer. “Clearly, if you thought your company was going to raise capital based on an IPO price, that is not going to happen for another year or two,” says Greeley. “At Flybridge we just finished our partners meeting and for us, the lesson is what can we be doing now to operate our companies in a really disciplined, capital-efficient way.”

That’s looking like a wise idea. Statistics gathered by the NVCA show that 2008 is on track to be the worst year for IPOs since 2002, right after the dot-com crash, when there were only 22 IPO exits for venture-backed companies. And the bad year is part of a relatively disappointing decade, at least compared to the early 1990s: Between 2001 and 2007 there were only 385 IPOs among venture-backed companies, compared to 1,353 for the period 1991-1997. As a corollary, there’s a longer wait for the companies that do go public: the median age of venture-backed companies at IPO was 8.6 years in 2007, compared to just over 6 years in 1997.

M&A and IPO Activity Among Venture-Backed Companies, by Year
Source: National Venture Capital Association
M&A and IPO Activity by Year

In a survey last week, the NVCA asked its own members to name the three biggest reasons for the current IPO drought. Of the 662 venture partners who responded, 77 percent named “skittish investors” as a reason, while 64 percent pointed to the credit crunch resulting from the subprime-mortgage debacle, and 57 percent blamed the high cost of complying with Sarbanes-Oxley accounting rules for companies preparing to go public. A few other interesting reasons came up as well: lack of analyst coverage of smaller companies (18 percent), a generally poor selection of IPO candidates recently (15 percent), and the disappearance of investment banks willing to invest in early-stage companies (14 percent).

There was little optimism among NVCA members that the crisis will lift soon. Asked when they thought the IPO window would re-open, only 20 percent thought it would be this year. The largest group—43 percent—predicted that IPOs will pick up again around the summer of 2009, while 32 percent thought it might take until mid-2010, and 5 percent thought it would take even longer.

But while IPOs have dried up, the number of companies “in registration” with the Securities and Exchange Commission—that is, companies that have filed the paperwork to pursue IPOs—is about the same right now as it has been for the last five years:

Number of IPOs Per Year and Companies in Registration on the Last Day of Each Year
Source: National Venture Capital Association
IPO and Registration Counts By Year

I asked Heesen whether it was possible that the current dearth of IPOs would be offset later this year, if some of the 42 venture-backed companies currently in registration decide to stop circling the airport and come in for a landing.

He didn’t think so. “A very large number of companies, about 20 recently, have de-registered, saying they are no longer going to go the public route, and they’ve either been acquired or they’ve tried to secure additional financing,” Heesen noted. “And we also see quite a few companies registering just so that they can show the public at large and large corporations that they are Sarbanes-Oxley compliant and therefore ‘clean’ and ready to be acquired. It’s a for-sale sign, unfortunately, rather than a sign of interest in actually going public.”

There’s disagreement within the VC community over what all of this means for entrepreneurs and innovators. Greeley says that funds have raised a lot of capital that they’re itching to disburse, and predicts that partnerships like Flybridge that focus on early-stage startups will continue to be active this year. “This could be one of our best years, from a new investment perspective,” he says. “The difference is that you are seeing more milestone financing. From an entrepreneur’s perspective, if you thought you needed $10 million, you may find you can raise $5 million, and then $5 million more based on reaching a certain milestone. The caution is reflected in the investments being more structured, and the investors holding a tighter rein on the business plan.”

But the NVCA’s Heesen says that if the IPO drought continues much longer, it could keep venture partners from cultivating new investments. “The most important commodity a VC has is time, and if they have to hold on to companies that they thought they would have exited by now, they have less time to go out and find and fund new emerging companies,” Heesen says. “If this continues over the next couple of quarters I do think you will see a reduction in the number of new companies being funded.”

So if an IPO isn’t a viable option for a growing startup right now, what about Door Number Two—acquisition? That doorway, too, has swung partway closed, though there is still room to squeak through. In the first two quarters of this year, there were only 120 mergers and acquisitions involving venture-backed companies, compared to 169 for the same period in 2007, 212 for the same period 2006, and 162 in 2005, according to the NVCA. Information technology companies were the luckiest in the second quarter: 36 of them found a buyer, compared to three life sciences companies and 11 companies in other fields. In most cases, the parties didn’t disclose the amounts of the transactions, but for the 14 M&A deals where the values were disclosed, the average take was $171 million.

Wade Roush is a freelance science and technology journalist and the producer and host of the podcast Soonish. Follow @soonishpodcast

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