By Alex Vieux, CEO and publisher, Red Herring
Two years ago, while having lunch with a former Sequoia Capital partner, I was surprised by his bitter complaints about the difficult state of venture capital. The problem? In short, limited partners--the institutions (endowments, pension funds, foundations, etc) pouring cash into venture capital firms--were flooding the industry. In turn, it led to too many deals, higher valuations and eventually lower returns on investments. Unfortunately, his diagnosis has become reality. At the recent National Venture Capital Association meeting last month, many professionals felt that with over $28 billion dedicated to U.S. venture in 2008 and a less-than-stellar trend for exit opportunities, the prospects seem increasingly gloomy.
If the past two years were an accurate indicator of the future, the venture industry would be doomed. Less than a handful of quarterly venture-backed IPOs have occurred since January 2008. Even worse, for the first time in Nasdaq history the bell went silent on new issues for two consecutive quarters (Q4 and Q1). On the M&A front, which represent no less than 90 percent of the number of exits in the United States, things have also slowed down: Although large public companies seem acquisitive, they procrastinate. In this buyers's market, according to one senior executive at SAP, they scan many deals but wait for prices to fall. No wonder that liquidity events have tumbled for most venture firms, hence triggering the ire of their backers.
In 2004, there were 3,000 venture-backed investments. A good fraction should have matured by now and brought cash back to the venture sector. At any other time in the technology sector’s history, tens if not a few hundreds of legitimate red herrings, S1 and S2 documents, should have been filed with the U.S. Securities and Exchange Commission. A quick scan at the top 50 VC firms in the United States shows that they are each nurturing a couple--if not more--startups that have crossed the traditional hurdles to face the markets. It is not uncommon to identify several portoflio companies with annual tracking sales exceeding $100M, yet no appetite for going the IPO route.
Indeed in the 1980s, conventional wisdom was that startups needed to meet five criteria to file for an IPO:
• Four trailing quarters of profitability.
• A stable management team and a confirmed CEO.
• Over 30 percent of revenue at a compound growth rate.
• A fraction of international sales.
• A branded banker on both sides of the prospectus.
That all went out the window in the dot-com gold rush, of course. During those twenty-four months of irrational exuberance, a surge of concept startups without revenue and only promises would file with the SEC. Today more than 80 percent of these companies have disappeared or been delisted.
However, it seems that today we have not only reverted to ‘80s methodology but move backwards. Some would argue that Sarbanes Oxley explains the reluctance to go public. Others will suggest the low price-to-earnings ratios of brand name stocks such as Google offers more attractive bets compared with riskier new entrants, becoming a deterrent for public equities investors. Dixon Doll, the former NVCA chairman, adds that the lack of research analysts or bankers has slowed down the IPO pipeline. All of the above are true but at the end of the day, a somber reality comes out: The lack of liquidity will drive many limited partners away from the venture business.
For a good reason: Venture capital as an asset class has not returned the money that it has raised from the limited partners--far from it. Some studies show that many of the vintage 2000 funds have barely brought back 40 cents per dollar in almost nine years. Only the top quartile have fared better. To make matters worse, many LPs, even prestigious ones, had not managed to access the best venture capital firms at that time; hence, they consciously bet on lesser-known outfits. In few cases, it has paid off. Yet more often than not, the cash returns have left something to be desired.
Economists have long studied the relationship between the abundance of cash infusions, the ineluctable decrease of returns and the withdrawal of investors from that overcapitalized sector. Venture capital economics do not suggest any exception to that rule. With a long string of misfortunes to report, many LPs will reduce their involvement in the asset class in the coming months and downgrade their allocations. It has already started, with some marquee endowments putting some of their venture capital stakes on the secondary market. Most venture funds (with the exception of the top quartile) find it more difficult than ever to go back to the well. What this means is that many could close their door at the end of their 8- to 10-year cycle.
That’s why Red Herring has entered the fray. Since 1995, the editorial staff has selected the top 100 venture-backed startups and has expanded that to cover Europe and Asia. Now, in keeping with its tradition, the publication has moved to identify the best venture capital firms in a field drastically changed by globalization. Most would correlate the best startups and the best exits with their backers over time. We have jumped one step forward and decided to pinpoint the best performers in the United States and across 30 nations.
This week, we will release the Global Top 200 venture firms that come from a pool of more than 1,800 peers we have watched for the past decade. Each firm’s level of activity and the number of investments varies widely. Regardless, we have studied this list to determine the top 100 venture capital firms, to be released soon.
At a time when limited partners will adopt more restrictive rules of engagement, the venture capital industry contraction seems inevitable, for the flight to quality will irrevocably eliminate the lowest performers. We hope that you will appreciate the complexity of our task at hand in a sector that has avoided transparency since its early days. We look forward to your feedback and your support in this new Red Herring endeavor.