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The Dark Side of the Late 2009 M&A Surge

With the year—and decade—coming to a close, the business press has been awash with stories about just how lousy the ‘00s were. As Paul Krugman details in the New York Times, it was a decade with a tiny amount of job creation, and the first decade on record where private-sector jobs shrunk. The typical family got no economic boost at all. And when the volatility rollercoaster ended there was also no appreciation in home prices and zero gains on stocks.

That pain was felt by venture capitalists as well. I’ve argued for a while now that once the gains from 1999 and 2000 fall off the ten-year index of VC returns, we’re going to be looking at an industry that has returns at or below the S&P 500. Given we’re coming out of a “decade of zero,” that’s a pretty bad thing. Especially for an asset class that is (supposed to) take huge risks in the name of potentially outsized returns.

Dow Jones VentureSource is releasing its year-end liquidity numbers for 1999 this morning and no surprise—it’s just another data point nail in the coffin.

At a high level you can put a good spin on the facts: In the fourth quarter acquisitions rebounded mightily. Public companies snapped up some 86 venture-backed companies for a total of $7.3 billion and three IPOs raised a—let’s be honest—paltry $220 million. And the median amount paid for a company in the fourth quarter was more than $100 million for the first time since 2000.

But as frequently happens in quarter-to-quarter surveys, that $100 million number was skewed greatly by a few large deals, most notably, Zappos’s $1.2 billion purchase by Amazon. Overall, for the year the median acquisition price was just $27 million.

And the overall rebound in fourth quarter liquidity is only impressive compared to the nine months prior. For the year, the industry produced just $17.1 billion in returns, 34% less than the $26.1 billion generated in 2008. And that wasn’t a particularly good year.

The surge in M&A and talk of some promising companies waiting in the wings to go public aside, this industry is in as much trouble as ever for three simple reasons. If these reasons don’t get addressed the 2010s may be worse than the ‘00s for the asset class.

1. The Math Doesn’t Work. An industry that invests roughly $20 billion a year (or even more), can’t survive on returns of roughly $20 billion a year. The basis of a portfolio investing business is that the hits have to make up for the losses—not just pay for themselves. It doesn’t matter how much you believe in innovation, how much you believe in the Valley and how much you believe in venture capital itself—the numbers are now and have for the last decade been hopelessly out of whack. Unless investors can discover an area that can produce many billion-dollar homeruns like the ecommerce, enterprise software and telecom did in decades past, there needs to be dramatically less money investing in early stage firms, period.

As we speak, many once proud venture firms are having a hard time raising their next funds, and many are turning towards less-desirable limited partners out of necessity. A host of funds were supposed to close in 2009 and haven’t yet. Watch the news in 2010 closely: If firms are taking money from state pension funds, raise an eyebrow. Back in the early 2000s state funds came under pressure from Freedom of Information Act requests to divulge information about underlying portfolio investments and privacy-conscious VCs turned their backs on those pension funds as a result. Anyone going back to them now was likely told no by nearly everyone else. Of course, those firms will still be in business. But not all firms will once their current funds are depleted, and ultimately, that’s a good thing for the industry.

2. M&As Alone Will Not Sustain VCs. While it’s true that the bulk of exits VCs get are from acquisitions, this is not where the bulk of returns come from. The economics of venture capital are based on homeruns. That’s why some 5% of the industry makes some 95% of the money. And those big hits come from IPOs or in some cases the threat of an IPO that makes a publicly-held competitor pay a huge premium for a startup. This is why M&A values surged so high in the late 1990s. Companies like Cisco had to shell out hundreds of millions or even billions to buy a company because it was so easy for them to go public. That’s not the case today and when you only have a handful of companies out buying, even a Google or Cisco shopping spree can only net so much in returns.

3. The Perilous Ripple Effect. There is a way that venture capital can adjust to a new normal of smaller exits with smaller multiples: Taking less risk and selling early. That means a switch of focus from building companies to building products. This is how much of the world outside Silicon Valley invests now. The benefit is it requires less capital and less risk. If you build something of value, there’s a likelihood you can get $5 million or even $20 million for it. But that’s the cap of what you’re going to get without a business to back that product up. But that’s OK economically, because you have fewer failures since you’re taking less risk.

Indeed in 2009, Dow Jones found that companies raised a median of just $18 million in venture capital before getting acquired. That’s 18% less than in 2008. And the companies sold faster. It took a median of five years to get an exit, versus six years in 2008.

A lot of entrepreneurs and angel investors argue there’s nothing wrong with this. With far less capital needed to start a company these days, what’s wrong with a smaller exit? You’re still making money, right? Not every idea has to be a $1 billion one to be worth starting.

That’s true for a bootstrapped or angel-funded startup, but not for venture backed deals and the Valley at large. That kind of thinking will eventually destroy an ecosystem that is built on a foundation of homeruns paying for all mistakes. Put another way, the reason we are so famously free to fail in the Valley is that a big homerun can economically make up for those failures. That is what has set Silicon Valley apart for decades. If that changes, the output of the Valley will change too.

And don’t forget: The companies providing these modest exits are the homeruns from previous decades. Without the past big hits of Google, Microsoft, Yahoo and Cisco, who’d be paying $20 million for your Web 2.0 app today? Consider that Facebook—a company that was ridiculed by the press and analysts for not selling for $1 billion or less back in 2006 —has already bid $500 million for Twitter and acquired FriendFeed. Good thing for the Valley Facebook didn’t listen to critics.

You don’t have to look too far to see what a world where VCs only build-to-flip would look like. It’s largely happened already in lifesciences. The industry that gave birth to Genentech, Amgen and a lot of promise for returns, job creation and cures, has now turned into big pharma’s outsourced R&D lab.

I’m not blaming investors. Because of the high costs of clinical trials, biotech companies used to go public to fund clinical trials. But in the post-2000, SarbOx chill it became all-but impossible for pre-clinical trial, pre-revenue companies to go public. That meant the work had to get financed another way, and that other way was licensing deals with big pharma. Unfortunately, that means a lot of the value from those breakthroughs goes to big pharma, all but ensuring the next Genentech or Amgen may never be created.

But tech doesn’t have those costly restrictions. Do we really want to embrace and celebrate an M&A only world of returns anyway?

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MoneyTree report: Venture capital still rebounding

Contrary to what you may have heard elsewhere, venture capital investment is still growing, at least according to the latest MoneyTree report from PricewaterhouseCoopers and the National Venture Capital Association.

Yes, that’s pretty much the exact opposite of what Dow Jones VentureSource concluded last week — that a potential VC rebound had stalled. It looks like the disagreement has less to do with the Q3 numbers, where MoneyTree shows a total of $4.8 billion in venture capital investment, compared to $5.1 billion shown by VentureSource, and more with Q2, where there was a much bigger gap in the numbers (MoneyTree: $4.1 billion, VentureSource: $5.4 billion).

Tracy Lefteroff, global managing partner of venture capital at PricewaterhouseCoopers, said the difference boils down to varying methodologies. VentureSource includes debt financing while the MoneyTree report doesn’t, he said, so MoneyTree is a better indicator of “permanent investment.” Let’s hope that’s true, since MoneyTree shows a nice, steady increase in VC investment since last year’s financial crash, when venture capital plummeted along with everything else.

But even if we look at things optimistically and believe the numbers will continue going up, that doesn’t necessarily mean things will eventually return to the high investment levels of the last few years.

“We’ve returned to more of a historical norm for venture capital, one that’s not only sustainable, but will go up for here,” Lefteroff said.

In terms of industry, cleantech saw the serious growth, with an increase of 89 percent of Q2, to $898 million invested in 57 deals. Software, meanwhile, dropped 9 percent to $622 million invested in 122 deals. This may reflect some permanent changes in the software industry, Lefteroff said, as startup work shifts from big, ambitious platforms to smaller applications.

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So much for that venture capital recovery

Optimists hoping that venture capital investing might be bouncing back will be disappointed by the latest numbers from Dow Jones VentureSource. After venture investments saw an encouraging uptick during the second quarter of 2009, they dipped again in the last three months.

Specifically, VCs invested $5.1 billion in 616 deals during Q3. That’s down 38 percent from the $8.2 billion invested during the same period last year, a drop you’d expect. But it’s also down 6 percent from Q2, when VCs invested $5.4 billion, so if there’s going to be a recovery, it isn’t here yet.

Looking closer at the numbers, you can see the continuation of several of  trends: Later-stage deals are becoming a larger piece of the pie, representing 40 percent of all deals this year compared to 33 percent last year. Deals are getting smaller, too, with a median deal size of $5 million, compared to $7 million last year.

In terms of which industries are attractive money, information technology (IT) reclaimed the top spot after being overshadowed by health care last year. Within that IT umbrella, it looks like Web 2.0 investments are continuing — in fact, they beat traditional software investments for the first time. VentureSource didn’t provide an exact number for Web 2.0 deals, but categorizes them as part of the information services sector, which actually improved 11 percent from last year, for a total of $627 million in 86 deals. On the other hand, investment into renewable energy, another industry that’s getting a lot of headlines in the tech world, fell 73 percent to $343 million.

None of this is terribly surprising, since venture firms themselves have been raising much less money and the liquidity of venture-backed companies is also down. Together, these numbers suggest we shouldn’t expect to a return to the startup and VC environment of 2007 and 2008 anytime soon. Indeed, they may back up speculation about a permanent industry contraction.

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Venture Exits Still Anemic In Third Quarter, Down Nearly 50 Percent (Charts)

Despite a couple large IPOs (LogMein and A123Systems) and a steady but tempered flow of mergers and acquisitions, financial exits for venture-backed companies remained anemic in the third quarter of 2009. Data released by both Dow Jones VentureSource and the National Venture Capital Association/Thomson Reuters show declines in both M&A and IPO dollars. VentureSource counts $2.9 billion in combined M&A exits in the third quarter, 49 percent lower than a year ago. The NCVA tallies up a $1.8 billion total, which is down 46 percent.

The two organizations have different sets of data, but they show similar trends. For example, VentureSource counts only the two IPOs mentioned above, whereas the NCVA also counts Cumberland Pharmaceuticals. That’s down from five venture backed IPOs in the second quarter.

IPOs Down

The IPO for battery-maker A123Systems last week was particularly strong, raising $380 million. LogMein’s IPO at the very beginning of the quarter raised $107 million, and Cumberland’s brought in $85 million, for a total of $572 million. That amount is down from the $720 million venture-backed IPOs brought in last quarter, but is up from the $188 million a year ago. Compared to year’s past, though, the IPO window is still fairly shut.

The M&A picture wasn’t much brighter in the quarter. VentureSource tracked 71 deals worth $2.3 billion, down from $5.2 billion last year and $2.8 billion in the second quarter of this year. Some of the larger deals during the quarter were VMWare buying SpringSource for $362 million and Intuit buying Mint for $170 million. (Remember, these are only venture-backed exits. Deals for publicly traded companies like Adobe buying Omniture for $1.8 billion, Dell buying Perot Systems for $3.9 billion, or Xerox buying Affiliated Computer Services for $5.75 billion are not counted in these numbers).

The NCVA’s data shows 62 M&A deals in the quarter (down from 88 a year ago), with disclosed values of $1.2 billion (down from $3.1 billion a year ago). And the returns aren’t looking so great either. VentureSource says the median acquisition price in the third quarter was $21 million, compared to a median amount of $17 million in equity funding raised prior to the acquisition.

The NCVA similarly shows a decline in average deal size from $96 million a year ago, to $58 million. And the number of deals worth less than the money put into them is more than the number of deals that made money, which is normal.

Average M&A Deal Size Drops

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