Venture Capitalists – The Last Holdouts on IPO Alternatives

I began my career at a law firm (now known as Fulbright & Jaworski in New York) that represented a number of leading venture capital firms. I worked on dozens of venture deals back in the go-go 1980s that led in many cases to lucrative initial public offerings that brought millions to the vc’s and the institutional investors in their funds. So I believe I have a sense of the vc mindset when it comes to “exit strategies” (every venture investor puts money into a private company with a long-term plan to be able to cash out at some point).

In the past these exits were about evenly split between an acquisition of one of their portfolio companies and an IPO. More recently, however, the exits are more like 90% acquisition and 10% IPO, and that 10% number continues to decline. Most vc’s will admit that they are more likely to obtain a higher ultimate return on their investment following an IPO than an acquisition. So why have the number of venture-backed company exits structured as IPOs fallen so much?

On June 29, the New York Times reported, “So far this has been a challenging year for companies hoping to go public. But it has been even rougher on venture capitalists who were hoping to get a big payday from such an offering…In the second quarter of this year not a single company backed by venture capitalists has gone public. It is the first time that has happened since 1978, according to a venture capital industry group.”

Yet despite these difficulties, the vc and private equity community (other than in the biotech space) have steered clear of taking their portfolio companies public through reverse mergers, self-filings or other IPO alternatives. So why are the number of IPOs down so much? Why do these investors avoid IPO alternatives? How can we fix that? Let’s explore.

Why is it tougher to complete IPOs?

The vc’s have clearly hit a new low if this is the last time since your humble blogger was in high school where a quarter went by without a venture-backed IPO. The main reasons that IPOs for venture-backed companies are so much harder to complete are (1) smaller IPOs have disappeared and (2) the IPO market has been extremely rocky, even for larger companies, since the market crash of 2000. Let’s take each one of these separately.

Death of Smaller IPOs. Why have smaller IPOs disappeared? As I described in my book, in the 1980s and 1990s, many small brokerage houses took smaller companies public through IPOs and would raise $10-50 million on average- some even less. Many of these companies were venture-backed. Many started trading on Nasdaq, the exchange of choice for most vc’s. Some fared well and others didn’t.

It should be noted that even during the IPO heyday, reverse mergers also remained strong. Why? Because as fast as one could take an Internet company public in 1997, some wanted to be public even faster (and cheaper). The reverse merger still offered (and continues to offer today) a faster, simpler, cheaper and less dilutive alternative to an IPO.

In any event, following the crash of the Internet stocks and the market as a whole around April 2000, the IPO market initially disappeared entirely. Then entered our former (now disgraced) New York Governor Elliot Spitzer. Spitzer decided to go after the small brokerage firms, a number of which were engaged in questionable activities such as “pump and dump” and issuing rosy research reports without clearly disclosing conflicts of interest.

Once a number of high profile criminal cases were brought, and major investigations about issuing of research reports, well, it all just stopped. Soon thereafter these small brokerage firms, or the ones that survived the market shakeout in the first place, discovered that life is easier raising money for companies through PIPE transactions that do not involve regulatory scrutiny prior to an investment, and hence one of the reasons for the explosion in PIPEs, now an $80 billion a year industry.

So that’s why smaller IPOs are virtually nonexistent. In 2007 only six IPOs involved companies raising $25 million or less. The average market capitalization of a company completing an IPO in 2007 was $330 million.

Difficult IPO Market. So why has the IPO market, even for larger companies, been rocky since 2000? It is hard to predict the opening and closing of the so-called “IPO window.” Sometimes IPOs cease even when the overall stock markets are fine. Sometimes a difficult market for technology stocks alone will cause the IPO market to take a hit.

But since 2000 the IPO market simply has never gotten close to back where it was in the heydays of the 1990s. I’m sure others can put up tons of statistics on that, so no need to do so here. Why so difficult?

First, the overall market has been difficult and that never helps. Second, enter again Spitzer. In the mid-2000s as New York Attorney General, he went after virtually every underwriter of large IPOs from Merrill Lynch on down. He claimed that in the IPOs of the 1990s even they engaged in illegal actions including improperly setting aside shares of IPO stocks for favored investment banking customers, and again that whole research thing. These firms ponied up literally billions of dollars to settle with Spitzer, who this time had the SEC and the US Justice Department working with him.

So bottom line, the regulators took all the fun out of the game. Yes there are still IPOs and 2007 was a better year (though 2008 has been a horrible year again). But again the underwriters have determined that it is not worth playing the game unless the company is of a very substantial size.

Why have vc’s shunned reverse mergers and IPO alternatives?

I have spoken at several conferences for vc’s and private equity investors, including one specifically titled “alternative exit strategies.” At each one I explain the benefits of reverse mergers and suggest that while not for every deal it can be an efficient way to help take a company to the next level. I try to employ what I learned at a sales seminar I took when I used to own a radio station, namely, that selling is the process of overcoming objections. Here are the main objections vc’s raise to reverse mergers and my response to them:

Objection #1: Reverse mergers are shady. If there is one thing I can be pleased about, it is that it appears this objection has been virtually eliminated. It is true that 5-7 years ago, many vc’s, often advised by then ill-informed major law firms, believed that only bad guys were involved in reverse mergers. Virtually all the vc’s (and their lawyers) now understand that there are a number of legitimate players. They look, for example, at SPACs and realize that some major big time success stories are seeing the legitimacy of these alternatives.

Objection #2: Better to wait for an IPO. The vc’s argue that, even if it takes an extra year or two, the IPO will result in a better ultimate pay-day for them. The best companies, they say, will ultimately qualify. The “dogs” (badly performing portfolio companies) are not worth trying to salvage. The medium success stories, doing OK but behind expectations, they say, are not worth taking public because there are problems that need to be dealt with before. My response: (a) that hoped-for IPO may never come based on the discussions above, even for some of the best ones, leaving them with only an acquisition exit which likely will be less lucrative, (b) there are quite a number of reverse merger success stories that belie the theory that an IPO provides a better pay-day and (c) medium success stories can benefit from being public if they have a continuing need for capital and are having trouble raising it, thus making an IPO alternative attractive. It should be noted that this has been the most stubborn of the objections, despite my entreaties to the contrary.

Objection #3: I will never be able to liquidate my investment. Many vc’s express the concern that companies completing reverse mergers never build trading in their stock. They say, “I don’t want to have to become an investor in a public company, that’s not what I know how to do.”

My responses: (a) Although the stock doesn’t generally “pop” as it does after an IPO, as I have written here and in the book many times, market support builds over time after a reverse merger – assuming the company deserves the support and engages qualified professionals to assist in educating Wall Street. They should talk to the many CEOs whose company stock has built very strong trading and moved up to higher exchanges – or talk to my client Rick Rappaport about his WRASP structure to take a private company public through a merger with a virgin shell followed by a small public offering and immediate trading on the American Stock Exchange.

(b) After an IPO of a venture-backed company, the vc becomes an investor in a public company, so it is not correct to suggest they do not do this. Most vc’s are required to lock-up their shares for at least six months following an IPO, and most do not simply sell the minute the six months is over. They sometimes sell some and hold some and voila, they have become an investor in a public company. If they view the reverse merger not as the liquidity event but a step in the path to liquidity, that big pay day may yet await them.

I would love the chance to continue this dialogue with my super-smart friends in the vc and private equity community. Maybe some of their big firm lawyers who are regular blogees will help in suggesting these alternatives as legitimate, transparent and as effective as leaving a company private while struggling to grow and raise money.

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