Finding no exits

Viewpoints Venture capital

Image: Venture capitalA troubled economy has slammed the IPO (initial-public-offering) window shut—tightly. With no venture-capital-backed exits in the second quarter of 2008 and just one in the third quarter, the VC-backed IPO market is at a 30-year low. This does not bode well for venture capital firms, which depend on public stock offerings to cash out their investments. How long will the slump continue? According to a new study on the current state of the IPO market, the exit slowdown is projected to continue until at least the middle of 2009.¹ If that projection is accurate, a protracted decline is likely to significantly alter the VC landscape of the future.

Image: The decline of venture-capital-backed exits

Observers have attributed the exit slowdown to a number of factors, including jittery investors, an unstable credit market, and the higher costs of complying with Sarbanes-Oxley. And the statistics aren’t positive. Only five VC-backed exits took place in the first quarter of 2008, raising $283 million. One third-quarter IPO raised $188 million. By comparison, in the first half of 2007, 43 venture-capital-backed IPOs collected over $6 billion. As a result, today’s declining liquidity levels are causing venture capitalists to wait out the current IPO drought. According to the National Venture Capital Association, 75 percent of venture capitalists surveyed believe that the IPO window will not reopen for another one to two years.

In addition, because venture capitalists are exiting fewer IPOs, the venture-capital-backed life cycle is lengthening. However, once the window of opportunity opens up again, IPOs are likely to be larger and more stable because the process will be more expensive and more rigorous.

In the meantime, venture capitalists are taking fewer companies public and instead are hoping to recoup investments through acquisitions. Unfortunately, the mergers and acquisitions (M&A) market is sagging as well. Compared with last year, the number of venture-capital-backed M&A deals dropped 29 percent in 2008’s first two quarters.

Will strategic investors jump in to fill the gap? Some VC-backed enterprises—especially those that don’t see an exit in the near future—say they will. For those organizations, establishing partnerships with potential strategic investors has become vital. Those investors, however, are in a comfortable wait-and-see position and are looking to buy at the best prices. This is leading some venture capitalists to abandon their roles as IPO pipelines in favor of acting as incubators for the strategic investment community.

Despite the potential role change, venture capitalists are continuing to raise funds and to invest in promising industries. For example, in the first two quarters of 2008, venture capital funds raised over $16 billion. Investment in clean-tech, in life sciences sectors, and in digital media has been strong. In addition, VC investment has been feeding both sides of the IPO pipeline—by providing seed money for start-ups and by funding more-mature companies. However, if future exits prove to be less profitable than in the past, the study suggests, venture capitalists will become less receptive to investing in capital-intensive and longer-to-maturity start-ups.

For now, some venture capitalists are playing the waiting game. Others, however, are continuing to invest in strong, stable companies with lots of future potential.

¹PwC, The exit slowdown and the new venture capital landscape, September 2008.