IPOs dying again

I got an email from one of my former students this week who works with startup companies trying to IPO:

It's a brutal market out there! … Many companies were looking to go public in late Q3/early Q4, however, the continued demise of the stock market has many folks running from the idea of an IPO.

Her remarks brought home a nasty side-effect of this month’s stock collapse. And sure enough, MarketWatch and USA Today later reported that at least 8 announced IPOs have been deferred due to “current market conditions.”

PWC (as reported by Business Insider) notes that 2011 was shaping up to be a much better year for IPOs than 2010. Now that trend is in doubt.

As I’ve been saying for years, I think entrepreneurs should look at it the other way: the normal exit will be by acquisition, because only during certain rare (and frothy or bubble-y) periods will an IPO be available. Perhaps the IPO window will open again, but (as has been true since the dot-com crash) the opening will only be temporary.

Death of the IPO

We all know the IPO has been dying a slow death since the dot-com crash. While the liquidity that IPOs provide startups was seen as providing a major advantage to US startups, all signs point to the 1980s and 1990s as being an aberration in the long-term economy.

Earlier this month, Barry Silbert of SecondMarket spoke at the Stanford Technology Ventures Program on his new vision for capital markets.

A key 5 minute segment of that was about the “long, slow death of the IPO.” During that segment, Silbert asserted that "I don’t think a lot of people realize that over the last 10 years, the IPO market has been dying a slow death”.

(Actually, most of us who study entrepreneurship are at least dimly aware of this, as are entrepreneurs. A year ago I asked if we had seen the “end of the IPO anomaly.”)

Silbert provided specific evidence of this death. He showed a chart with the IPO rate down by 75% during this century, and almost complete disappearance of small IPOs (under $50m).
He attributes the end of the IPO to:

• end of research on small cap companies due to
• end of full-service brokerages (at the hands of Charles Schwab, eTrade etc.)
• shift from fractional to decimal pricing and thus the end of the bid/offer spread
• successful litigation against big 10 brokerages by then-NY AG Elliot Spitzer to end incentive compensation for stock researchers
• Sarbanes-Oxley increase in regulation and costs
• an explosion strike price class action litigation

The net result is increasing the time to IPO from 5 years to 10 years, which (as he notes) doesn’t work for angels, VCs or employees.

Of course, as the CEO of a secondary financial market Silbert has a stake in all this. The IPO traditionally achieved four goals for young companies.

1. raise capital
2. provide liquidity to investors (an exit event)
3. allow the stock to be used as a currency for acquisitions and employee compensation
4. and as a branding event

Silbert argues that the secondary markets are providing the first three. Certainly the success of Facebook suggests that this is a route available to highly visible consumer-focused companies.
The rest of the talk is, naturally, why the audience should believe in SecondMarket.

Hat tip: VentureBeat

It's not what you know…

The morning papers report the news that Hulu hopes to IPO this fall and raise $2 billion. (The story was first reported in the NY Times on Monday.) As with a lot of tech IPOs, the company is seeking to go public without a lot of revenues.

The company is not a tech startup in the normal sense. Its raison d’être is not its technology, but its connections, specifically its corporate founders — Disney, NBC Universal and News Corp. (who later sold a minority stake to a private equity firm.)

In other words, anyone could have done the technology: what mattered was that it had direct access to three of the four major TV networks: ABC, NBC and Fox. Hulu succeeded — in true Web 2.0 style as measured by traffic rather than profits — not because of its entrepreneurial spunk, but because of its guanxi. (This seems appropriate since supposedly the name was chosen for its Chinese rather than Hawai’ian meaning.)

Because of its connections, Hulu got favorable content deals as the anti-Apple, the distribution channel that Hollywood loves to hate. It is a lot like Orbitz, founded in 2000 by five of the biggest airlines to compete with Travelocity (a venture of the Sabre reservation service) and Expedia (founded by Microsoft).

In these sort of oligopolistic (or oligopsonistic) industries, the opportunities for success are based on industry connections — or in this case, entry by intrapraenurship rather than entrepreneurship.

Still, no alliance is forever. Some wonder if NBC content will remain on Hulu once it’s acquired by Comcast, which would like to destroy the open Internet (at least for video content) and lock everyone into their premium cable TV subscriptions.

Finally, Hulu’s business model has always been hamstrung by the competing goals of the media giants: take market share away from portals they don’t control (iTunes, YouTube) while not cannibalizing the existing TV offerings. As with newspapers, the online per-user revenues are a fraction of the 20th century traditional distribution channel.

So in the end, what will retail shareholders be getting? Is this more or less secure than the IPO of a pure startup like Tesla or Facebook or some solar panel maker? Thanks to its great connections, there is only one Hulu, but that’s no guarantee it will be able to come up with a viable revenue odel.

End of the IPO anomaly?

In 2008, there were only six IPOs nationwide, compared to 365 twenty years earlier. The end of IPOs means that founders no longer run their companies, but instead get acquired by big firms and then quit to do something else.

Sunday’s Merc, presented its annual compilation of the Silicon Valley 150. One noticeable result was a reduction in the number of public companies and also of IPOs.

Columnist Chris O’Brien remarked on the trend:

From 2001 to 2008, there have been 90 IPOs in the valley, an average of 11 annually — and the last one was more than a year ago. Compare that with 331 IPOs in the years from 1990 to 1998, an average of 41 annually. The two years in between were so insane — producing 163 IPOs — that it's no use considering them for sake of comparisons.

We’ve long known that Silicon Valley has a higher rate of IPOs than in other countries, but the evidence also suggests it has a higher rate than the rest of the US.

In my own research on communications startups in San Diego, I’ve noticed a much lower rate of IPOs. By my most recent tally, there are eight public companies in the telecom cluster (a few were either acquired or died after their IPO).

So, I’m sorry to say, the data is starting to confirm my conjecture. The 1980s and 1990s offered an unusual window of opportunity for IPOs — both in terms of the availability of financing and the ability to create a new stand-alone company.

Acquisitions do have a few advantages: they are quicker, available to a wider range of firms, and less dependent on the cyclical capital markets. My mentor Charlie Jackson planned for an IPO but sold his company to Aldus in 1990 when the IPO market closed.

I wonder when (or if) the business (or engineering) school courses in entrepreneurship will notice the change, and adjust their curriculum accordingly.

Build or flip?

Once upon a time, tech entrepreneurs were motivated by a desire to build something of lasting value: a better mousetrap, a great company, or to change the world. In 1938, Bill Hewlett and Dave Packard sold eight oscilloscopes to Walt Disney, who was making Fantasia. Seventy years later, the successor business-to-business instrument division is at the core of Agilent.

It always helped to have good timing — either by being lucky or making your own luck. HP was there when Disney (and soon the war effort) needed electronic instruments. Fairchild bet big on silicon just as the military was shifting from tubes to transistors. Intel took the integrated circuit to the next level with its 4004 microprocessor, and bought back the rights from Busicom. Steve Jobs and Steve Wozniak went to the Homebrew Computer Club and saw how the microprocessor would enable personal computing.

In the original waves of tech startups, going public meant generating enough of a track record of revenues and profits that investors could reasonably hope that your stock would go up. Those (relatively rare) IPOs meant a few tech entrepreneurs got to be fabulously wealthy and endow vanity foundations (that today seem likely to do less good for society than their companies did). But the wealth was not the thing, at least until the hippies of Apple Computer created dozens of millionaires with their IPO, and later IPOs from companies like Sun, Oracle and SGI permanently changed the Silicon Valley mentality.

However, a much larger number of companies didn’t change the world, or create large (or even small) fortunes. Instead, they provided value to their customers, income and training to their employees, and a chance to have a vocation of meaningful work. It’s a standard power law distribution: if you buy a lottery ticket, you’re far more likely to win $5 than $50 million.

This more typical path was my own experience. We didn’t have an exit strategy because I hadn’t heard of the term when we started the company in 1987. Every penny that I made off the company came out of positive cash flow which (without the benefit of reduced capital gains taxation) is a much harder to way to throw off profits. But we produced good quality software for 17½ years before closing the doors in 2004.

The dot-com bubble seems to have changed things. Companies went public without profits and sometimes barely with revenues. There was a gold rush mentality and people who weren’t really qualified (either by talent, ethics or disposition) to build a real company were looking for a get rich quick scheme. This has continued into the current Web 2.0 era, as I was reminded when I gave a presentation at USC Thursday on Web 2.0 business modes.

So the new mantra is “flip this company.” As a 2004 Business 2.0 article proclaimed

The New Road to Riches
How To Get Ahead In The Postbubble World
Build A Company Cheap. Flip It Fast. Repeat.

Flipping a company today is about selling out to a big company ina just a few years: the Holy Grail is the $1.8 billion that Google paid for YouTube after only 18 months. However, the philosophy is similar to the dot-bomb (some say dot-con) era, companies built using this philosophy were sold to the public as a naked demonstration of the “greater fool” school of ethics.

This may be the road to riches, but it’s not a way for entrepreneurs to create value or success (more broadly defined). This philosophy was dissected by author Jim Collins in a thoughtful 2000 essay. He illustrated a point using a 1985 medical equipment startup:

The real question, the essential question is this: Is your company built to work? The answer rests on three criteria: excellence, contribution, and meaning. Again, consider Cardiometrics. The company may not have been built to last, but in all of its activities, it adhered to the highest possible standards: Instead of relying on expedient studies and marketing hype, it conducted rigorous, costly clinical trials in order to demonstrate the value of its technology. And the company clearly made a significant contribution -- to the market, to its investors, and to the lives of patients all over the world. Finally, the people of Cardiometrics found their work to be intrinsically meaningful: They worked with colleagues whom they respected and even loved, and they pursued a worthy aim to the best of their ability. Built to Flip? Built to Last? Cardiometrics embodies neither of these models: It was built to work.

Today, I believe that the opportunities for startups to IPO are greatly diminished, for a variety of reasons. IT is mature with a large number of diversified established incumbents. Biotech startups have disappointed investors with both the risk and the payoff. Both types of startups lack the complementary assets such as distribution or economies of scope to fully capitalize on their innovations.

Today startups are being acquired, and sometimes a piddly little company can create a value that they will be unable to unlock on their own, but can be realized by a Google or a Cisco. But in a free economy, every excess eventually self-corrects, so if acquiring companies don’t get value, they will buy fewer companies and pay less for those that they get — or their mistakes will put them out of business.

Either way, assuming that a bad business will be bought at a good price seems like a lousy bet.