January 7, 2011
About a year ago, we successfully exited our investment in Threadsmith, in which we had been the seed investors in early 2008. We ultimately ended up selling to a very logical strategic acquirer, NASDAQ-traded Vistaprint (VPRT). It was a good outcome, and we made a very nice, if not spectacular return. But our process was severely compromised, and the ultimate value realized was considerably lower than it could/should have been, because each of the two very best fit potential acquirers were private companies stuck at a standstill in the IPO pipeline. While still private they didn’t have the cash, we didn’t want their private stock, and they felt like they shouldn’t be doing anything dramatic strategically as they prepared themselves to go public.
While Vistaprint was without question on every Threadsmith board member’s list of the 5 most logical acquirers, the strategic logic was stronger and the likely value greater for two other interested parties. These two companies, had we been operating in a 2006-2007 IPO environment, each would have already been public. We know based on conversations with their management that they would have loved to have owned us. If public, they almost certainly would have been interested bidders, eager to do the deal and tell Wall Street about how Threadsmith was going to be a great driver of new growth for them. But in late 2009, as they languished waiting for the IPO market to improve, their hands were tied.
So we went from probably 4 really strong possible acquirers down to 2. When one of those two dropped out early, our opportunity for a competitive process was gone. And so, for a $50MM fund working through what in the grand scheme of things was a relatively tiny trade sale, the state of the IPO market had a dramatic impact on our outcome.
I tell this story because with the wires all abuzz over the past week about LinkedIn’s plans for an IPO this year, I’m still hearing entrepreneurs and investors say “So what? We don’t need IPOs to make money.” So what??!! Thank god, I say! We ALL desperately need a wave of this stuff to start rolling this year. While there has been much written recently about the challenged state of the IPO markets and the fact that many entrepreneurs and investors think they’ve gone out of style (Bill Gurley has been particularly thoughtful, as usual), I haven’t seen enough people talking about why we so desperately need more activity here. If anything, I’ve heard too many of my peers in the seed & early stage markets saying they don’t care.
2010 – “The Year of the Super Angel” – saw no shortage of claims about the old rules being dead and how these new forces in the VC landscape were responding to the fact that everything has changed. Some of these claims are perfectly valid, especially around the various elements of the lean startup – it indeed no longer takes a $5MM Series A to build a fantastic web service, achieve product-market fit, etc. But the claims I’ve heard from a lot of new entrants to the seed and early stage investing landscape about our collective freedom from reliance on a robust IPO market just don’t hold water.
Small VCs (like me) and, increasingly, so-called Super Angels and MicroVCs, love to say that amongst the reasons we can consistently drive great returns is “As a small fund, we’re not dependent on the state of the IPO market. We can make plenty of money, and drive great returns for our investors, even if we never sell a company for more than $100MM.”
I’ll confess – I’ve been guilty of making exactly that claim to LPs and others. But I won’t be making that case anymore, because it’s simply not true. Or at least half of it isn’t. Let’s parse the quote above into its two statements: the second is indeed true – we can have a great fund without a $100MM+ exit; but the first is without question B.S. We are ALL dependent on the state of the IPO market.
The problem is that the second statement is so dearly dependent on the first. In a world where great companies aren’t getting public, we end up with a paucity of buyers for our terrific, smaller companies. In aggregate, exit opportunities, and values of those exits, are greatly dependent on the number of public buyers out there. Public companies have two things that private companies don’t have – (a) a good stockpile of cash (admittedly, Facebook and others are finding their own ways to build such stockpiles, but they are very much the exception) and (b) a liquid, non-cash currency for making acquisitions. So when fewer companies are getting public, you have a decrease in the number of buyers who feel like they have the resources, currency, or strategic flexibility to do deals. And thus lots of people feel the same pain as my Threadsmith story.
Here’s a remarkable fact: over the past 10 years, the total number of NASDAQ-listed companies has shrunk every single year. Or, said another way, in each of the last ten years, the number of potential public buyers for private companies has been smaller than the year before. Ask any infrastructure/enterprise SW investor if it’s helpful for their portfolios that Oracle has, in recent years, purchased (and taken off the table as potential competitive buyers) public companies like Sun, BEA, PeopleSoft, ATG, and Retek, amongst others. Ask any digital media investor if they think an AOL-Yahoo merger would improve the exit prospects for their companies. Of course not – it takes a buyer off the table.
Now sure, as small funds, we don’t need IPOs or $300MM trade sales in our own portfolios to move the needle for our LPs. As I said before, the second half of that quote above is true – our two funds at High Peaks, at $25 and $50MM, can each drive great returns without ever selling a company for more than $100MM. However, you simply can’t say that makes us immune to the state of affairs in the IPO market.
We should all – investors and entrepreneurs alike – actively cheer for more IPOs. As long as they’re good companies (and lord knows there’s dozens of good ones out there languishing in the public markets’ waiting room), the more the merrier, for sure.
To all the seed and small fund investors out there – let’s stop conveniently denying the interconnectedness of our ecosystem. The IPO market matters to all of us in a big way. Super Angels and MicroVCs are no silver bullet solution for LPs looking to make money in venture while the IPO pipe stays frustratingly tight. I’m a fan of the small fund model, but we need to be intellectually honest about how we describe it.
That said, that honesty can and should include trumpeting the fact that with the exception of a tiny handful of large, diversified funds, smaller funds are in fact better positioned to make money. Despite the conventional wisdom, small funds have in fact consistently outperformed their larger brethren over the past 30 years, as last year’s Silicon Valley Bank study on small funds illustrated so compellingly. We’re at the most profitable end of the market – let’s just avoid discrediting ourselves by lying about why.